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Things Fall Apart, Even in Industrials

Wear, tear, and competition will drive a comeback in this sector.

Philip Guziec, 12/28/2010

This article first appeared in the December 2010/January 2011 issue of Morningstar Advisor magazine. Get your free subscription here.

The third quarter of 2010 was good for industrials, and looking out a bit further, our analysts are still optimistic about industrial demand. In November, I sat down with some of Morningstar's industrials team to discuss the reasons for their optimism.

Q: What kind of operating performance are we seeing in the industrials at this point in the economic recovery, and what's the outlook for the next year and going forward?

Adam Fleck: So far, in the general industrial space, the outlook has been the strongest in emerging economies, like those in Latin America and China; that's not too surprising. We've seen some good bounce-back in a number of industries that were beaten down severely last year here in North America. Europe has generally seen a weaker recovery, but areas like Germany are probably a little bit stronger, as we've heard from companies like 3M MMM. Eastern Europe and Russia particularly continue to suffer.

Q: How about across categories of industrials? Where are we seeing strength, and where are we seeing weakness?

Fleck: We're seeing strength in heavy equipment, particularly again in emerging economies and even here in North America. We've also seen a pretty good pickup in farm equipment--the farm income numbers here in North America are looking pretty good. Shortages of wheat due to drought in Russia and the fact that the crop yields here in the U.S. are down are both pushing up prices of crops. These are key inputs that should lead to increased purchase activity this year and especially next year.

Daniel Holland: One thing I'd add is that we're seeing a normal behavior in a recovery. A couple of quarters ago, we started seeing the shorter-cycle end-markets improve with more of the consumable products. Now we're starting to see more of the capital- intensive goods come into favor, with order growth rates getting back into double digits. For example, in the automation and control environment, companies are actually spending money to improve their own infrastructure. This is a normal cadence to how the industrials swing back into things.

The other element that I'd add is that while Europe is not necessarily as strong as the other markets, it's nowhere near as bad as what folks were predicting in May/June of last year when you had the Greece crisis. At that point many people thought that Europe was going down and taking the rest of the world with it. Europe's OK. It's not great, but it's manageable, and a lot of companies are OK in an environment where they can plan for a single-digit-growth or no-growth environment.

Rick Tauber: On the weakness side, I would say that the defense sector is weak. It's pretty well telegraphed and priced into the market, but as an example, Level 3 Communications LVLT recently reported earnings; they cut their revenue estimates for this year and for next year and lowered their earnings targets for next year--they're seeing much more competition on the defense side, as well as margin pressure. But the stock was basically flat on the news, so a lot of that is priced in, as it was pretty well- telegraphed by the U.S. Department of Defense.

Fleck: I would also like to highlight Daniel's point about the short-cycle products. 3M is a great example; most of their orders are going to be filled within 30 days, and this offers us a pretty good view of where we are in the industrial economy. Their organic growth for the first two quarters has been very strong, near 20%. It dipped a little bit in the third quarter because of some tougher year-over- year comparable sales, but we're seeing great growth in areas like sandpaper, other abrasives, automotive original equipment--all across the industrial spectrum. We're also seeing a lot of companies that supply the consumer electronics space enjoy some pretty heady results as consumer spending and confidence comes back. 3M is a great example again, because it provides film for LCD televisions. IRobot IRBT is another company we cover; in the consumer electronics space they're just seeing immense domestic and international growth.

Q: That's actually a good point. So, autos are a big piece of the economy and things obviously hit the headlines, with bankruptcies and "Government Motors" and all of that. How are we seeing autos recover, and what do we see going forward?

Dave Whiston: The best is still yet to come in the auto recovery, volumewise. People bought 10.4 million vehicles in the U.S. in 2009; we'll probably hit around 11.5 million this year. I'm looking for more, about 13 million, next year. The big story in autos is that there are millions of units in pent-up demand. We're still scrapping more vehicles than we sell in the United States. That hasn't happened since World War II. According to my research, per-capita sales levels are the lowest ever since 1951. That just is not sustainable.

Used-vehicle prices hit a record high in May--that is not sustainable. Eventually consumers will go to a showroom intending to buy used, and they'll say, "You know what? There's not a lot of inventory here that's really attractive, and for the prices you're asking, I'd rather just buy a new car." We haven't hit that tipping point yet, and when we do, we're not going to be talking about selling 13 million vehicles; we could be talking about easily selling 17 million or 18 million-- and we did a study in August that implied a demand of 20 million.

Q: Those are some pretty big numbers, so I guess that, if you add some operating leverage and financial leverage on to the number of autos sold, we're pretty bullish on the auto space?

Whiston: Yes. Unfortunately, our margins of safety are so wide that we don't have a ton of 5-star calls in the auto space. But purely from a price/fair value ratio standpoint, there are certainly some interesting stories all over the supply chain, particularly in the OEM space. Toyota TM--which got crushed by the recall crisis--has a very cash-rich balance sheet; they're trading below book value now, which doesn't seem appropriate, in my opinion. Ford F is just really firing on all cylinders; Europe is their weakest market, but unlike GM they're at least profitable there. They'll probably get an investment-grade credit rating, perhaps as soon as next year, and that would be another catalyst for the stock price. GM is going public soon, so you've got a stock there that's really getting dinged for the whole "Government Motors" stigma, which I think is unfair. I think a patient investor would probably be rewarded in GM stock over time.

Q: So, does the dynamic of the vehicle fleet wearing out apply elsewhere across the industrial space with the long-cycle stuff, where eventually wear and tear is going to drive the replacement cycle?

Eric Landry: Yep, we're actually seeing that right now. If you look at the gross fixed investment segments of the gross domestic product, there are three sections specifically that we look at: industrial equipment, transportation equipment, and construction equipment, and each of those is seeing a significant bounce off of what were really generational lows, when you compare the amount of investment in those areas to GDP. So, we're seeing a bounce there; it's very evident in things like Caterpillar's CAT construction equipment sales, Rockwell's ROK factory automation sales, and the significant pickup in the order book at Emerson EMR.

As you say, Phil, those things aren't like a house, or something more focused on the consumer--if you do not keep up with this equipment, you lose competitiveness. The last I checked, this is a very high-labor-cost environment, so these investments need to be made, and we're starting to see that now.PAGEBREAK

Q: So we're actually seeing not just wear-and- tear replacement, but discretionary investment because of relative labor cost differentials and trying to compensate for high labor costs with high capital investment?

Landry: I wouldn't say that's a change of pace--that's always been the case here, but for a couple of years that was neglected. Throughout all of 2009 and early 2010 that was definitely the case, and companies are now saying, "We can't neglect this any longer--we're simply losing competitiveness."

Q: That's good to hear. Are there any areas that you want to shy away from?

Landry: I would say commercial construction remains fairly problematic, but there are even some signals there--for instance, if you look at the architectural billings index, it's started to perk up recently. But we're not seeing it in any of the results of any of the very, very late-cycle companies.

One of the laggards has been GE GE, unfortunately, but the company's order book has perked up: 7% and 8% order growth over the past two quarters, respectively. So, we expect even our latest-cycle businesses to pick up here over the coming quarters.

Fleck: I would agree with that point about commercial construction. We see it in the late-cycle businesses of a company such as Terex TEX. They're a crane and aerial work platform business, which is highly tied to commercial construction. However, again going to your point, Phil, about aging fleets-- rental equipment fleets have been aging as well, and we do expect a bounce back. Still, in a recent conference call, management indicated that it's probably going to be later rather than sooner. Things are still pretty weak, especially in Europe.

Whiston: I would also echo Eric's commercial construction comment with some language from Johnson Controls JCI. They just gave their fiscal 2011 guidance recently, and they were very blunt about Europe, saying that the company has to look for growth elsewhere. Fortunately for them, emerging markets like the Middle East and China are just booming.

Q: Merger and acquisition activity has been heating up. Do you see areas of potential M&A?

Landry: That is correct. The unfortunate thing about working in industrials is that it's much easier to identify the acquirers than the acquirees. Here's an example: Caterpillar CAT recently bought Electro-Motive, a locomotive manufacturer, from private equity. It's very difficult for public investors to profit from that transaction, and unfortunately that's sort of the texture of the M&A situation that we're seeing now. There are lots of large companies buying tuck-in strategic acquisitions from entities whose ownership most investors don't get to partake in. It's not like in, say, health care where our analysts have identified certain characteristics in, say, biotech firms that make them more attractive to the big drugmakers. In the industrial space, there are a lot of companies buying from private equity right now because the financing is opening up for private equity; many of these shops are trying to clean out their portfolios to make room for the stuff that they want to acquire going forward.

Q: Are these deals happening at reasonable valuations? Do you think these are value- creating deals?

Landry: We definitely think so with Caterpillar. Correct, Adam?

Fleck: They got a pretty good deal with EMD, paying about half of sales rather than a multiple. That's unlike a company like 3M, which has been pretty active in the health-care and tech spaces lately, paying upward of 3 to 4 times sales. With 3M, however, it's hard to criticize; they've done 60 or so acquisitions in the past five years and have never written off any goodwill. It's a company that's very experienced in acquisitions and probably will continue to make them.

Overall, I think it depends on what space you're looking at. Terex sold their mining business to Bucyrus BUCY for certainly not a rich amount, maybe there was a bit of a discount just to get rid of it.

Landry: I wouldn't call the deals we're seeing supercheap, either. Neither Daniel nor I would be surprised if Danaher DHR went out and made a deal here at some point. We wouldn't be surprised to see GE doing some stuff at some point. But, as I said earlier, trying to make bets on the targets is extremely difficult in this industry.

(Update: On Nov. 15, Caterpillar agreed to buy Bucyrus for what we think is a hefty price.)

Q: Speaking of targets and opportunities, now that we've got a general lay of the land, do you have any strong picks in industrials apart from autos, which we've already heard about?

Landry: I think that by and large we're seeing the most value on our coverage lists, in general, with auto dealers and some residential construction-related names, because both are relatively out of favor right now (but getting less so). The number of outright screaming 5-star buys is very low, as one would think, given the market rally of the past year and a half. Things like Lennar LEN we think are moderately cheap; NVR NVR and Lithia Motors LAD are priced pretty attractively. There are also some very high-quality names, like 3M selling at a cheap valuation relative to its history.

If our bullish thesis on autos comes true, we think these dealers could be a pretty good bet, as well as some of these construction names. Housing production will not stay at current levels forever.

Holland: I'll throw General Electric into the mix as well. It has turned into a stock where investors just want to see results--"if nothing else, just show me something." There hasn't been a lot of actual, real top-line growth or concrete signs of improvement to gain the favor of investors. But, as Eric mentioned, order rates are picking up, and the company's going to have in excess of $25 billion in cash on the balance sheet at the end of the year. There are a lot of interesting things going in its favor right now that might change sentiment. GE's a 5-star stock right now, and I think a long-term investor could benefit mightily from it.

Q: Any names to stay away from?

Fleck: With some construction-equipment firms, we think a lot of the good news that they've seen recently has been priced into the stock. There's concern about mix-shift next year, if residential construction really starts to bounce back sharply. A lot of that is tied to compact construction versus the heavy infrastructure and mining sales that these companies have enjoyed recently. Generally, the smaller the equipment, the smaller the margins. A good example would be Caterpillar, which, in the big bounce from 2004 to 2008, saw tremendous, double-digit top-line growth, but if you look from 2006 to 2008, there was very little change in net income. So, I think some of the construction-equipment names look a little frothy, but they are still 3-star stocks; they're not screaming shorts by any means.

Landry: I don't think we have anything that we're telling people to go out and sell tomorrow.

Q: So, you think the space is about fairly valued, with a few bargains here and there?

Landry: I think that's pretty accurate. And because our goal is never to buy anything that's fairly valued, the opportunity set is not large.

Philip Guziec is co-editor and portfolio manager of the Morningstar OptionInvestor online research service.

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