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Long-Term Value among Industrials

Morningstar's industrials team looks beyond today to find value for the future.

Haywood Kelly, 06/03/2009

When the economy sneezes, industrials catch the flu. Of course, today's global economy has come down with something between whooping cough and tuberculosis, so we're not sure exactly where that leaves industrials stocks. To find out, we're talking with several key members of Morningstar's equity research team: Adam Fleck, a senior analyst who covers 3M MMM and a variety of transportation firms; Daniel Holland, an analyst covering such stocks as General Electric GE, Honeywell HON, and Danaher DHR; and John Kearney, a senior analyst covering Caterpillar CAT, Deere DE, and Illinois Tool Works ITW, among others.

Haywood Kelly: The industrials sector is broad, to say the least. Some companies feel a cyclical downturn immediately, others only after a significant lag. Which firms are furthest along the downward curve?

Adam Fleck: The homebuilding and land transportation industries have been feeling the pain for some time and were hit very hard as the economy turned sour. As the economy eventually picks up, we'd expect these industries to enjoy early success, and a company such as FedEx FDX could benefit. Somewhat similar, auto manufacturing dropped in early 2008 and may see a healthy recovery because of underproduction. While we think many of the companies in this industry--including manufacturers such as General Motors GM and suppliers like American Axle AXL--will face substantial financing challenges, well-capitalized dealerships like CarMax KMX look attractive.

HK: For these companies, are you modeling a bottom in 2010?

AF: We don't expect this recession to last forever. At a certain point, there will be a recovery, and we're expecting some positive signs through 2010 in our base-case modeling. To put it simply, these companies are operating at rates far below our estimate of normalized demand. For example, we think housing formation and replacement spending suggest a natural rate of demand near 1.5 million homes annually. The industry looks to build less than half a million homes this year. Although the inventory of for-sale homes may prevent a rapid recovery, we think the current rate of production is simply unsustainably low. However, we caution that near- to medium-term housing demand is highly dependent upon job creation, something that's definitely not a tail wind right now.

HK: What's your pessimistic scenario? And how do you factor a pessimistic scenario into your fair value estimates?

Daniel Holland: Our pessimistic scenarios take the downturn deeper into 2010, with a recovery pushed out to 2011. This time frame varies by the end markets for the companies, with those closer to consumers coming back a little sooner in pessimistic scenarios than companies selling to other industrial companies. For companies whose pessimistic scenarios result in debt-covenant violations or a hint of financial distress, we factor in the likelihood of a possible bankruptcy or a dilutive capital infusion. In healthier companies, we use the pessimistic scenarios to assess if our uncertainty rating is in line with the range of possibilities for the firm.

HK: What companies, if any, are on your death watch list--meaning they may not come out the other side, at least as currently structured?

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