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Our Outlook for Industrials Stocks

The current industrial slowdown could persist for several additional quarters, but we think pockets of value exist.

Eric Landry, Associate Director, 09/29/2011

--The industrial slowdown we warned about in our second-quarter outlook continued in the third, with several leading indicators worsening across the world.

--Many industrial companies remain cautiously optimistic as we write, however, highlighting strong order growth, solid backlogs, and healthy balance sheets. Several firms have also turned to major share-buyback programs following the recent market sell-off.

--We think several moat-worthy industrial companies now feature compelling valuations for patient, long-term investors. However, the conditions might remain difficult for some time, and it's anybody's guess as to what share prices do in the short term.

The industrial slowdown continued in full force during the third quarter, but many firms we cover remain cautiously optimistic given their continued orders growth through July and August and solid balance sheets. The market has definitely punished many industrial stocks during the past several weeks, as the Industrial Select Sector SPDR XLI currently resides about 23% lower than its recent highs as opposed to a more modest 16% sell-off for the market as a whole. As a result, we think the sharp sell-off has created discounts for several high-quality companies that could offer better downside protection to those investors who believe the odds might have tilted in favor of a renewed global downturn.

Across the board, we've seen key leading indicators further slide during the quarter. U.S.-focused metrics such as the Philadelphia Fed Index, Empire State Business Survey, and Chicago's PMI posted worse results in the period, leading to a continued decline in the national Institute for Supply Management's purchasing managers' survey. These readings typically lead domestic industrial production, and this quarter was no different; industrial production continued to chug along at a slow 3.3% year-over-year growth through August (though the index was slightly ahead of June's production level). If our continued negative interpretation of the above and other indicators is correct, that 3.3% annual growth will likely not persist into 2012.

Internationally, manufacturing indexes for both Europe and China slipped below 50, indicating expectations of near-term contraction among those regions' manufacturing executives.

That said, although manufacturing companies are seeing a slowdown, we're encouraged that input-cost increases are in the process of abating. The ISM national PMI index gives a pretty good forward look into industrial commodity prices, and here the news is encouraging. The prices-paid component of the index has fallen to 55.5 from a high above 85.0 just a few months ago, which is in line with more-muted price increases seen in China's survey. This silver lining could help to preserve some profitability for manufacturers in the event of further economic slowing (though negative operating leverage would undoubtedly work against the companies in some fashion, as well).

Management teams of many of our largest bellwether firms do not expect the U.S. economy to slip back into recession, but few are calling for robust overall growth either. For instance, at its recent analyst day, United Parcel Service UPS management noted an expectation of further stagnation, but not decline; competitor FedEx FDX maintained a similar cautious tone in its recent quarterly results. Nonetheless, both Emerson Electric EMR and Tyco International TYC have recently posted better order growth than one may have expected (though we caution that these names tend to perform best later in economic cycles), and Caterpillar's CAT dealer deliveries--while slowing--have continued to grow at a healthy rate. Overall, it's hard to argue against a bearish case that has undoubtedly risen in potential probability in recent months. That said, if indeed the current tepid recovery deteriorates into another contraction, we wouldn't expect a deep recession in our base-case assumptions across our coverage universe. Inventories are not bloated, balance sheets are extremely sturdy across the space, and fixed costs are lower now than before the prior recession indicating better trough profitability. In all, we think industrial stocks are well-armed to handle whatever the markets throw at them.

Industrial Companies Putting Cash to Work
One area of encouragement we're seeing is a recent rise in share-repurchase activity. Companies must, of course, balance their investments among internal growth (preferably at rates of return above their cost of capital), external acquisitions, and shareholder returns, but given the rapid decline in many firms' market prices, we think stock purchases could offer opportunities for shareholder value creation to those companies buying shares at less than intrinsic value. Several large industrial firms, including Deere DE, UPS, and 3M MMM, have outlined or accelerated such actions, highlighting the companies' longer-term focus.

We expect that industrial merger and acquisition activity could also pick up if share prices remain muted for an extended period. Many large, diversified companies hold sizeable cash hoards, and we've already seen interest in large deals such as United Technologies' UTX just-announced purchase of Goodrich GR. We wouldn't be surprised to see additional announcements from some of the better-financed companies during the remainder of 2011, though we expect mostly bolt-on acquisitions rather than further megadeals given the general economic uncertainty.

Defensive No Longer a Defensive Investment
Some industries are facing more headwinds than just a potential cyclical downturn, with defense the most explicit example. We think the industry will see a negative secular shift during the next several years, driven by government austerity measures and attempted deficit reductions. In the past quarter, the U.S. Congress passed and the president signed into law the Budget Control Act of 2011, which raised the U.S. debt ceiling. However, the law will have adverse implications for defense spending during the coming decade. The act proposes to save around $350 billion from defense-related expenses as part of the $917 billion in total U.S. budget cuts over 10 years, followed by up to $600 billion in additional defense spending cuts as part of the $1.2 trillion-$1.5 trillion in reductions during the same time period. Importantly, the impact of these reductions on the suppliers we cover will be larger than to the overall Department of Defense budget because personnel pay is excluded from budget cuts.

Altogether, we anticipate that the DoD budget will decline on an average annual basis of about 3% through fiscal 2018, whereas the line items that we feel are more related to defense-industry revenue are expected to decline by around 5% annually. Under this scenario, we feel public companies would potentially reduce headcount by around 5% to match staffing with the lower-revenue opportunity, thereby maintaining operating margins. However, the operating margin results would also depend on strategic decisions by individual companies. For example, steady or expanding expenditures on research and development would lead to lower operating margins but could generate additional revenue through market share gains.

With our new, lower base-case revenue forecasts, we have adjusted mostly our sales estimates for our coverage list. We still believe Raytheon RTN and General Dynamics GD remain undervalued, but our aggregate aerospace and defense coverage universe now sits at a price/fair value ratio of 1.06, compared with 0.84 a quarter ago.

Other Industrials Valuations Marked More Compelling
Outside of defense, we've seen valuations across the industrials sector become quite attractive during the past three months, with the aggregate price/fair value ratio improving to 0.78 today from 0.87 in June. We still think auto manufacturers look promising (with a price/fair value ratio of 0.57, down from 0.69 in June), and several other sectors have slipped into attractive areas, as well. Farm and construction equipment makers now sit at a price/fair value ratio of 0.81 versus 0.94 three months ago; the industrial product industry (which includes firms such as United Technologies, Rockwell Automation ROK, and 3M) is at 0.72 (was 0.91); and residential construction companies still look cheap at a price/fair value ratio of 0.64 (was 0.72). We believe several individual industrial names in particular are pricing in a downside scenario and could offer investors substantial upside if our base scenarios play out.

3M MMM
With a diversified revenue base and mostly short-cycle businesses, 3M tends to feel the pinch of economic weakness very rapidly. That said, the company proved its ability to maintain decent profitability even during economic weakness during the last recession and was notably able to also increase pricing as volumes cratered. We believe this wide-moat firm's competitive strengths allow it to avoid a large portion of potential weakness during downturns, and we doubt a renewed recession would impede the firm's long-term prospects for increased new products as a percentage of sales and economic profitability.

That said, declining revenue would undoubtedly lead to lower earnings, even if 3M can largely stem a massive drop in its wide profitability. In our bear-case modeling, we assume that 2012 revenue falls in the midsingle digits, leading to operating margins near 21%--similar to the profitability garnered in 2009. Beyond next year, our downside scenario assumes continued margin erosion and returns on invested capital in the midteens range (versus ROICs north of 20%, on average, during the past 10 years). Nonetheless, our fair value estimate in this case would drop to a level that's in line with the current market price.

Rockwell Automation ROK
Rockwell is the go-to vendor for a manufacturing company looking to upgrade its manufacturing facilities. With technology that is the core of any manufacturing process, the firm's customer relationships are sticky, but the market goes through stages where the company will be out of favor. The fact that manufacturers need to stay technologically adept to survive is at the core of our thesis and why we think Rockwell deserves the attention of investors.

The current market price reflects a dismal scenario, in our opinion, which suggests operating margins 5 percentage points lower than the previous midcycle level or assuming 2015 revenue equal to 2010 revenue, all else equal. Either scenario, or combination thereof, seems improbable, in our opinion. While a recession undoubtedly would hurt 2012 earnings, as we saw during the 2008-09 recession, Rockwell's revenue is rather resilient as cuts in capital expenditures by manufacturers only lead to pent-up demand on the other side of the spending cut.

United Technologies UTX
United Technologies' collection of industrial businesses is built to weather a variety of economic environments. Current valuations discount the balance of the overall portfolio and we think might be overpunishing the firm for its defense exposure as well as beating down the firm's construction-sensitive segments, Otis, Carrier, and Fire & Security. Backlog and order rates buoy the company's growth prospects, and we think continued improvement in internal operating margins should provide more earnings leverage going forward. Significantly, the recovery completely bypassed the residential and nonresidential construction markets, which drive more than half of United's revenue. Although we do not forecast a resurgence in these end markets in 2011 or 2012, investors should be mindful that this additional earnings catalyst is lurking in the background.

Expeditors International of Washington EXPD
Among transportation stocks, there's no higher-quality name than Expeditors. It enjoys an attractive outsourced logistics industry, a nonasset model, leading margins, and outstanding net revenue and earnings growth. Management is also focused on the long term, refusing to lay off employees during the 2008-09 recession in order to stay ready for the subsequent recovery, a strategy that we believe won the company increased market share. Moreover, Expeditor's bullet-proof balance sheet boasts $1.2 billion in cash ($5.68 per share) against zero debt.

In all, we don't think anything has compromised Expeditors' model. In our view, the only recently changed factor is a lower expectation for freight-forwarding volume, based primarily on Expeditors' report that second-quarter air-freight tonnage declined 1% and ocean-freight volume was flat versus that of the prior-year period. Perhaps of greater concern, demand metrics declined sequentially from month to month during the quarter. With that said, this top-shelf freight forwarder normally is priced out of reach of investors constrained to "reasonable" P/E multiples, but shares have become more affordable of late.

 

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