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Our Outlook for the Industrials Sector

The global economy remains robust.

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Despite mixed signals on the health of the U.S. economy, global growth remains robust, and many of the companies in our industrials coverage universe should continue to benefit.

After slowing earlier this year, several key economic indicators, such as capacity utilization and the Institute of Supply Chain Management's (ISM) survey of purchasing managers, pointed to a rebound in U.S. manufacturing during the second quarter. Conditions varied widely by industry with strong activity in the basic materials, transportation, and aerospace sectors standing in stark contrast to sharp downturns in the housing and domestic automotive industries. It remains unclear if falling demand, job losses, and bankruptcies in these sectors will impact the broader economy, but so far the effects have been muted.

The widening U.S. trade deficit continues to cause concern in Washington, with numerous anti-trade bills under consideration, but it's worth noting that U.S. exports have also risen over the past year. Domestic firms have benefited as the weak dollar has made U.S. exports more competitive overseas while also increasing the value of profits earned abroad.

Elsewhere, the rapid economic growth in China, India, and other emerging markets continues to generate headlines. Less heralded, though, is a notable resurgence in the long-dormant economies of Western Europe and Japan. Official and anecdotal data from many of the companies in our industrials coverage universe point to an acceleration in growth in these regions. Policy reforms in banking, labor, and trade should help promote further recovery. While economists continue to debate what, if any, impact a slowdown in the U.S. would have on the surging global economy, many of the firms we cover are well-positioned for long-term global growth.

No summary of the industrials sector would be complete without mentioning the impact of robust merger-and-acquisition activity. Dealmaking remained strong during the second quarter with both financial and strategic buyers taking a turn at the dance. A general rise in valuations and interest rate volatility seem to have slowed the pace of buyout announcements in recent weeks, but activity remains brisk. Even if conditions in the capital markets make it more difficult for private equity firms to work their financial engineering magic, we think many strategic buyers, often global companies with access to cheap capital, will remain active as they aggressively try to lock up natural resources, consolidate industries, and expand their global presence.

Valuations by Industry
Our industrials coverage universe encompasses a broad range of industries with different competitive dynamics. To narrow our focus, the table below presents our star-rating and median price/fair-value estimate by industry.

 Industrials Industry Valuations
Segment

Average
Star Rating

Median
Price/Fair Value
Stocks Covered
Aerospace and Defense 2.59 1.08 22
Agricultural Machinery 2.33 1.15 3
Agriculture 1.67 1.50 3
Agrochemical 3.00 1.01 4
Aluminum 2.50 1.04 4
Automakers 2.86 0.98 7
Auto Parts 2.80 1.01 16
Auto Retail 3.14 0.98 14
Building Materials 3.25 0.91 9
Chemicals 2.61 1.08 34
Construction Machinery 2.40 1.11 5
Diversified 3.17 0.97 6
Electric Equipment 2.53 1.10 20
Machinery 3.00 0.99 11
Manufacturing--Misc. 4.00 0.86 1
Metal Products 2.33 1.03 11
Packaging 2.89 1.08 9
Paints/Coatings 3.00 1.05 1
Plastics 3.00 1.08 1
Recreation 3.13 0.95 9
Rubber Products 1.50 1.15 3
Steel Iron 2.63 1.11 21
Transport Equipment 4.00 0.80 1
Truck Manufacturers 1.50 1.52 6
Data as of 06-15-07.

Many of the industrial companies we cover have seen their market valuations soar over the past year. In fact, the median price/fair-value is greater than one for all but a few subsectors, and there are few 5-star names at the moment in our industrials universe.

The runup in valuations appears to be driven by three broad factors. First, in many sectors, investors have driven up valuations with the expectation that global growth will continue and that demand for items such as agricultural commodities, basic materials, and capital equipment will remain robust. Second, in sectors such as auto manufacturing and auto parts, investors believe many firms will see profits rebound as their restructuring efforts pay off. Finally, many valuations include a control premium based on the expectation of continued merger-and-acquisition activity.

Industrials Stocks for Your Radar
Although the recent runup in valuations makes many companies with solid business prospects appear expensive, we've been able to identify a few companies worth considering, as well as numerous watch-list candidates to consider when a market pullback offers the opportunity to purchase them with a sufficient margin of safety.

 Stocks to Watch--Industrials
Company Star Rating Fair Value Estimate Economic
Moat
Risk

P/FV

SAIC  $25 Narrow Average 0.72
3M $103 Wide Below Avg 0.84
ABB $26 Narrow Average 0.86
Georgia Gulf $24 None Above Avg 0.76
Sealed Air $38 Narrow Average 0.82
Data as of 06-22-07.

 SAIC (SAI)
This company's shares took a hit earlier this month after reporting lackluster second-quarter financial results. We think the sluggish results were driven by temporary factors such as delays in the government purchasing process, and we like the firm's long-term prospects. SAIC should benefit as the government continues to spend heavily on upgrading intelligence and military capabilities. In addition, changing demographics should allow the trend toward outsourcing to continue. From the  Analyst Report: "Since 1990, the number of federal civil servants has actually declined 20% while the ranks of contractors have swelled by 50%. With more than 30% of federal civil servants expected to retire in the next 10 years, the government will struggle to keep pace with hiring requirements, especially for highly technical positions, and will likely continue to outsource to meet immediate needs while gaining more operating flexibility."

 3M Company (MMM) 
3M should continue to benefit from strong global growth while recent cost-cutting efforts should also boost the bottom line. From the  Analyst Report: "3M has also been making a number of bolt-on acquisitions in growth sectors that take advantage of 3M's already-existing strengths in research, manufacturing, and distribution. One of our favorites was the company's acquisition of water-filtration company Cuno. Cuno had 30 sales people in China, while 3M has more than 3,000. Plugging Cuno's product line into 3M's sales network produced immediate positive results, and the business has experienced double-digit growth since the transaction.

 ABB ADR (ABB)
Infrastructure spending will likely remain strong in Asia for the next several years, and ABB is poised to benefit. From the  Analyst Report: "ABB has done an impressive job of stripping out noncore and nonperforming lines of business over the past four years and has transformed itself into a leaner, more-focused company. The firm has made significant strides in improving its profitability and controls leading market positions in key end markets in Asia."

 Georgia Gulf (GGC)
The slump in residential construction has hurt Georgia Gulf's business, but we think the firm can withstand the downturn and prosper in the long run. From the  Analyst Report: "The acquisition of Royal Group Technologies, completed early in the fourth quarter of 2006, made Georgia Gulf a fully integrated PVC producer, from salt to siding. While we remain concerned that this no-moat firm may have bitten off more than it can chew in pursuing this deal, we believe leveraging its product portfolio away from commodity chemicals and toward finished PVC products bodes well for its long-term prospects."

 Sealed Air (SEE)
Like many industrial firms, Sealed Air is poised to benefit from the strong global economy. From the  Analyst Report: "Sealed Air generates half of its sales in the U.S. and Canada and is expanding its worldwide footprint. The company is already well established in Western Europe and is adding capacity in developing markets like China and Eastern Europe. While the domestic business has been stable, growing at an average of 4%, the international operations offer much greater potential for growth. Additionally, as manufacturing becomes more global and specialized, a greater need for Sealed Air's products continues to develop among industrial customers."

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John Novak does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.