Our Outlook for the Industrials Sector

<< Return to Main Market Outlook Page

Even with the considerable February/March market sell-off, the Dow Jones Industrial Average  is still about 17% higher than the lows it saw last summer and about 65% higher than where it was about four years ago (implying a 12% compound annual growth rate). If the recent subprime contagion underlies real domestic weakness and foretells a slowing economy, then the broader U.S. stock market might well decline substantially further.

In view of these developments, it is not surprising that the 231 stocks in Morningstar's industrials sector carry an average star rating of 2.48 (equal-weighted) and a price/fair value estimate of 1.11 (market-capitalization weighted). The dominant factor in this bias, however, is our simple expectation that an economic contraction, almost regardless of severity, duration, or global reach, is practically certain to come. The impact of such a slowdown--built into our discounted cash-flow models to varying degrees--will hurt cash flows and, in turn, keeps our valuations from chasing corporate profits to the very peak of the upcycle.

How likely are we to see the economic expansion reverse in 2007? We're almost doctrinally opposed at Morningstar to prognosticating on the direction of the economy, but we can say that we've been surprised in recent quarters by the resilience of many industrial businesses. By and large, raw-material and manufacturing production have remained strong, particularly in chemicals, building materials, metal products, machinery, and transportation equipment. On top of that, firms have enjoyed steady, and in some cases improving, pricing. We also noted that in the The Wall Street Journal's March Economic Forecasting Survey, 49% of the 60 economists surveyed said they think the economy will get better during the next 12 months. Another 27% expect it to stay the same.

But even if the economy does not turn south in 2007, we are already seeing signs that economic expansion has more legs internationally than domestically. Our favor among industrial stocks accordingly falls on firms with greater global exposure.

Valuations by Industry
The industrial-materials sector has again clocked in with the lowest average star rating--2.60--of the 12 sectors that constitute our coverage universe. That's partly due to our generally cautious stance on commodity prices, which are major inputs to many of the companies in the sector. It's also a function of our abovementioned expectation of an economic contraction and of the way we incorporate that into our valuations.

Industrials Industry Valuations
Segment	Average Star Rating	Average Price/Fair Value	Stocks Covered
Aerospace and Defense	2.76	1.09	21
Agricultural Machinery	2.00	1.20	3
Agriculture	2.25	1.41	4
Agrochemical	2.25	1.18	4
Aluminum	3.20	0.97	5
Automakers	3.00	0.95	7
Auto Parts	2.62	1.02	16
Auto Retail	3.20	0.94	15
Building Materials	3.43	0.95	7
Chemicals	2.75	1.14	34
Construction Machinery	2.60	1.11	5
Diversified	3.50	0.97	6
Electric Equipment	2.65	1.14	21
Machinery	2.90	1.04	11
Manufacturing--Misc.	4.00	0.84	1
Metal Products	2.67	1.15	12
Packaging	2.62	1.08	8
Paints/Coatings	3.00	0.99	1
Plastics	3.00	1.10	1
Recreation	3.00	1.00	10
Rubber Products	2.00	1.29	3
Steel/Iron	3.00	1.04	22
Transport Equipment	4.00	0.77	1
Truck Manufacturers	2.00	1.60	6
Data as of 03-15-07.

As the above table shows, we have a bullish outlook for three areas: the amorphous and unwieldy group of companies known as diversified industrials (aka, conglomerates) and the much more straightforward aluminum and building materials industries. It may not seem particularly meaningful to be bullish on conglomerates since they tend to operate in multiple industries. However, these companies also tend to be large and to have significant international exposure to the robust global economy. Although we may find ourselves at a precarious point in the domestic U.S. economic cycle, global demand for capital goods remains quite strong. Specifically, overall economic growth and spending on infrastructure projects in emerging Asian economies such as China and India, as well as in the Middle East, are driving continued solid growth of industrial and capital goods products.

Aerospace continues to be arguably the hottest industry in this segment, and yet we think that group trades very close to its fair value. Importantly, the market and Morningstar have probably arrived at this same place in very different ways: the market on the momentum of two consecutive years of massive airplane orders, and Morningstar on a strong next decade of aircraft deliveries complete with a muted downcycle. The aluminum industry, which serves aerospace, is hot largely by extension, and the market may be slower to give those firms credit for the mounting aircraft backlogs.

Building materials is an industry with a more turbulent future, particularly given its exposure to the U.S. homebuilding market. Still, while shipments in the U.S. could be weak over the next several quarters, we expect pricing to remain strong in the aggregates space and relatively stable for cement. And like conglomerates with global reach, basic material firms like  Cemex (CX) and  Lafarge (LR) should offset much of the weakness in the U.S. with strength in other parts of the world.

Industrials Stocks for Your Radar
Three of our favorite industrial stocks right now are highly correlated to the themes discussed above, while two are significantly smaller and more focused.

Stocks to Watch--Industrials
Company	Star Rating	Fair Value Estimate	Economic Moat	Risk	Mkt Cap (bil)
United Technologies		$78	Wide	Below Avg	$65.9
3M		$89	Wide	Below Avg	$56.6
Cemex		$45	Narrow	Average	$26.4
Ecolab		$50	Narrow	Below Avg	$10.8
SAIC		$25	Narrow	Average	$7.4
Data as of 03-22-07.

 United Technologies (UTX)
We have considered United Technologies a wide moat company for as long as we have assigned such ratings based on its world-class market positions, outstanding management and operations, and consistent economic profits. The company is enjoying healthy sales growth due to its significant exposure to the expanding aerospace sector and to surging infrastructure spending in emerging Asian and Middle Eastern economies. The firm operates three leading aerospace franchises: Pratt & Whitney, Sikorsky Helicopter, and Hamilton Sundstrand avionics (40% of sales). International sales now constitute 60% of the company's total and are growing at a disproportionately rapid rate, particularly in China and India.

 3M (MMM) 
Last year was a transition year for 3M as it invested in much-needed capacity expansions and jettisoned noncore businesses. On top of that, the company experienced some atypical earnings volatility as a result of issues in its flat-screen film business and its exposure to residential housing. The operational issues were a bit of a surprise, but we believe that the company has dealt with both of them. Further, we approve of the expansion projects and think that they will eventually provide a springboard for the company's performance going forward. Meanwhile, the divestitures will allow the company to focus its attention and its capital on programs that have the most potential and that best fit in with the rest of the 3M product pipeline. This extremely diversified firm generated more than 60% of 2006 revenues internationally with its six operating segments.  

 Cemex (CX)
Based in Mexico and with a significant presence in the U.S., Cemex still generated about 57% of 2006 sales from outside these two countries. Here is an increasingly global firm with a collection of assets that is simply not replicable. The firm's strategically located cement plants, because of the importance of transportation costs in this business, help make it one of the lowest-cost producers in each of its markets. Banking on the fact that consolidation would be beneficial over the long run, Cemex recently made an opportunistic bid for  Rinker (RIN) after that firm's key end markets came under severe pressure from the housing downturn. Given management's impressive track record with prior acquisitions, we are quite certain that it will extract enough additional profitability out of the combined assets to easily justify the currently proposed deal price.

 Ecolab (ECL) 
Although this firm produces almost all of the cleaning chemicals it sells, the main source of its narrow moat is its scale, salesforce, and distribution network. The company provides dispensing and assorted equipment to restaurants and other businesses, and then sells the corresponding chemicals to those businesses on an ongoing basis. We think the firm has about 11% of global market share. International sales represented 46% of 2006 revenues, though associated operating margins are some 400 basis points less than domestic margins largely because the distribution network is significantly less dense.

 SAIC (SAI)
This medium-sized defense contractor issued its initial public equity offering only last October, but it has a 38-year history of providing high-technology solutions to the government. The stock has done little since its IPO, with the market concerned about overhang from employee shareholders selling out, stock option dilution following the IPO, and slower revenue growth. This is an extremely trusted government partner, however, and one that knows how to identify and capitalize on emerging technologies that would be valuable to the government. The firm has developed substantial technological expertise and employs 23,000 people with national security clearances--significant sources of competitive advantage. And, after 37 consecutive years of revenue growth, SAIC now has a backlog that is roughly twice its 2006 sales.

If you'd like to track and analyze the stocks mentioned above, click here to create a watch list. Then simply click "continue," name your watch list, and click "done." (If this link does not work, please register with Morningstar.com--registration is free--or sign in if you're already a member, and try again.) This will allow you to save and monitor these holdings within our Portfolio Manager. And you can get Morningstar's complete take and regular updates on these and more than 1,900 other stocks, as well as our complete list of 5-star stocks, by taking a free 14-day Premium Membership trial.

Other Sector Outlook Articles

• Business Services
• Consumer
• Energy
• Financial Services
• Hardware
• Health Care
• Media
• Software
• Telecom
• Utilities

<< Return to Main Market Outlook Page