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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?

DH: Auto manufacturers and suppliers are at the top of the list right now. When consumers stopped buying cars en masse, the manufacturers had a tough time covering the cost of the labor force. The auto suppliers were weak before the manufacturers went south, and now they are faced with low volumes and financially distressed customers. Companies like American Axle and Lear LEA may not make it to the other side as currently structured. In general, industries that operate on leverage are getting weaker. Dry bulk shippers, including bellwether DryShips DRYS, and other marine transport firms are in a tight spot, as are some airlines.

HK: Your team recently published a study on President Obama's plan to raise taxes on overseas corporate income. What were your conclusions and how much of a hit would this be to industrials stocks?

AF: We've found that a large number of our firms would be affected, from some of the largest diversified industrials like General Electric and Eaton ETN to some of the most-niche operators like Tidewater TDW. The issue revolves around taxes on overseas income, which is typically taxed at a lower foreign tax rate. The current tax code allows those companies that don't repatriate the income to not pay the difference between that lower rate and the U.S. statutory 35% corporate rate. Obama has proposed in vague language to force U.S.-based companies that enjoy this tax break to pay higher U.S. tax rates on overseas income regardless of whether or not it's brought back home. The thinking is that this will discourage off- shoring, but we're not so sure.

HK: Let's turn to happier thoughts. Are there any names that you think will come out of the downturn in better competitive shape--because competitors are struggling or for other reasons?

John Kearney: One name we think has the potential to emerge from the downturn with a better competitive position is Mohawk Industries MHK. Mohawk is one of two floor-covering manufacturers that dominate an otherwise highly fragmented industry. While the company has seen its profitability deteriorate with the rest of the industry, Mohawk has the wherewithal to make it to the other side of the trough. Conversely, we believe the current economic malaise will drive a number of its smaller, capital-constrained competitors out of business, providing an opportunity for Mohawk to buy these firms at bargain prices. In either case, we believe that the company can further expand its market-leading position in the flooring space as it emerges from this protracted downturn.

HK: If I screen for industrials stocks with price/cash-flow multiples less than 10, I get pretty much the entire sector. Is that even a good way to look at the sector right now? Do those cash flows have a lot of room to fall?

JK: We tend to look at price/sales more than price/cash flow, but both are reasonable measures to value the sector, and both would suggest the sector is relatively cheap at current prices. With revenues and operating margins likely to contract further over the near term, we believe that cash flows do have room to fall. That said, we think cash flows will hold up better than earnings because of more-efficient working-capital-management initiatives implemented over the past several years. In past downturns, we saw inventories balloon and subsequently consume vast amounts of cash because of softened demand. With leaner operating practices and a heightened focus on working capital needs, the variability in cash-flow changes has been mitigated to a certain degree compared with that of earnings.

HK: If I wanted a list of five industrial stocks to own for the next five years--currently undervalued, great balance sheets, long-term growth potential--what would they be?

JK: Caterpillar and 3M are two names we think should top that list. They are excessively cheap because of short-term profit concerns, but both have strong credit ratings and robust long-term earnings power. Illinois Tool Works is another one of our longtime favorites that rarely goes on sale but looks very attractive at current prices. We also like beaten-down transportation firms like Expeditors International of Washington EXPD and Norfolk Southern NCS, which could be early beneficiaries in a recovery.

HK: Daniel, you cover the biggest name in the sector, GE, and just about everyone owns it either directly or through a fund. Your fair value estimate is $22. Walk us through potential downside and upside fair values.

DH: A lot of GE's valuation boils down to how much of a diversion GE's bank, GE Capital, becomes. In an optimistic case, the bank will require no more capital from the parent company and management's restructuring of the division will result in meaningful  earnings contribution by the end of 2010. In this case, industrial cash flows can be used for reinvestment in promising green infrastructure areas. A fair value of $40 per share is not unrealistic in this scenario. Holding us back, though, is the fact that GE's bank unit has yet to face the eye of the hurricane in terms of losses. In a pessimistic case, which takes the loan losses in the bank through 2011, the parent may have to send over more cash to the bank. This would potentially stunt the growth of the industrial businesses, leading to a fair value around $15 per share.

HK: Where does the Morningstar industrials team deviate from consensus the most?

DH: Because our time horizon is longer than most, we are going to be a bit more optimistic at the bottom of the cycle and pessimistic at the top of the cycle. Take GE. As soon as you are able to rule out liquidity and financial distress, the long-run earnings potential of the entire enterprise suggested that a $6 stock price was way too low. While today's challenges are nothing to scoff at, there will be a tomorrow, and by forecasting beyond 2010 we are able to pick up value that other market participants may be unwilling to pursue. One of our guiding philosophies is that it's tough to make money doing the same thing as everybody else. Only when you employ independent thinking can you expect to outperform. As simple as it sounds, thinking long-term is a key component in our toolbox. You'd be surprised how few actually do it.

Haywood Kelly, CFA, is vice president of equity research at Morningstar.

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