Three Stocks to Play the Global Infrastructure Buildout

Over the last month, we significantly upped our fair value estimates for some of the largest companies in the global industrial equity markets, namely the multi-industry conglomerates  General Electric   (GE),  Siemens (SI), and  ABB Ltd (ABB). These companies rank 2, 42, and 164, respectively, in terms of market cap on the global equity stage. The stocks have soundly trounced the global equity indexes over the last 12 months with ABB and Siemens rocketing up 104% and 88%, respectively, compared with 37% for the MSCI World Index. GE has turned in a 28% total return, a respectable rise for the second-largest company in the world by market cap.

Despite the runup, we think the stocks still offer attractive value to investors. We've identified four key factors among our industrial infrastructure suppliers that are fueling substantially higher cash flows and improved financial results: 1) productivity benefits from business restructuring; 2) a favorable sales growth outlook due to massive investment in global industrial infrastructure; 3) more shareholder-friendly business decisions driven by increased attention to return on invested capital, and 4) relatively new management teams taking fresh looks at the strategic positioning of their businesses. In this article, we examine these factors and make the case that restructuring actions coupled with favorable macro trends will boost returns on investment at global industrial infrastructure companies and drive above-average returns for equity investors.

Industrial Infrastructure Buildout Fueling Sales and Earnings Growth
Our three industrial infrastructure stocks all boast market-leading positions producing industrial capital goods for fossil fuel power generation and electrical power transmission and distribution equipment. We expect an extended long-term cycle of surging global spending on energy and power infrastructure. The rapidly growing Asian economies are vigorously investing in electrical power generation and power transmission infrastructure. China is a particularly voracious investor in power generation and transmission infrastructure; the Chinese government estimates that it will spend a total of $40 billion this year on power generation, or more than 10% of total global spending. We project spending on Chinese power infrastructure will continue to increase at a compounded rate of about 10% for the next five years. Furthermore, we forecast robust spending by European nations due to deregulation in the electrical power industry.  In the United States, spending on an archaic power infrastructure should also fuel robust sales growth. We think the infrastructure buildout expansion will extend through 2020. We estimate that total investment for power generation and power transmission equipment is currently running at approximately $150 billion per year. As shown in the chart below, we estimate that the total market will grow at a compounded rate of approximately 6% for the next five years reaching $200 billion by 2012. GE, Siemens, and ABB are the three largest suppliers of energy and power infrastructure worldwide. We think the companies' massive installed bases and superior distribution capabilities will enable them to expand market share and increase sales in this market at 12% on a compounded basis, twice the market rate.

Trimming Business Portfolios and Sharpening Business Focus
While GE, Siemens, and ABB manage a variety of businesses serving a vast array of industrial end markets, over the last three years they've slimmed down their industrial business portfolios, shedding underperforming units. Each company has also taken meaningful steps to restructure lines of business to more vigilantly focus on core markets where it enjoys market leadership. ABB divested its upstream oil and gas business and other smaller businesses in 2004. Since then, the company has made no major acquisitions and has concentrated on improving the performance of its existing lines of business. GE recently sold its plastics business and two large financial businesses, Genworth and GE Insurance Solutions. GE has targeted infrastructure markets for acquisitions, acquiring Smiths Aerospace, Vecto-Gray, and Ionics, serving the aerospace, oil and gas, and water markets, respectively. Siemens has been the most aggressive at trimming its portfolio of businesses, selling its telecom handset business in 2005, combining its communications networking business into a joint venture with Nokia (where Nokia is taking a dominant management role), and this year announcing a spin-off of its automotive supply business VDO Siemens. Annual sales of businesses that Siemens has divested over the past two years and businesses it plans to divest from its core portfolio sum to approximately EUR 23 billion, or 25% of our forecasted sales for 2007. Now that's some serious corporate downsizing!

Emphasizing Returns on Invested Capital (ROIC) and the Impact of Private Equity
We think the active restructuring reflects an increased focus by the CEOs and their boards on returns on investment to shareholders. This trend has been particularly manifest at the Europe-based ABB and Siemens. Each has weathered substantial upheaval and losses in a variety of businesses between 2001 and 2004. Management routinely made strategic decisions that sacrificed operating profits in order to maintain market share in highly competitive markets. The result was poor financial performance and intermittent charge-offs that distracted management and contributed to underperformance at many other lines of business. Starting around 2004, new management was less tolerant of poor performance and took decisive actions to restructure or sell underperforming units.

We also think the aggressive activity of private equity firms in buying up poorly managed industrial companies played a role in changing the industrial investment landscape. By providing an attractive market to sell off underperforming units, private equity firms have helped facilitate restructuring as well as stimulate management changes to improve operating efficiency.

New Management Talent in Place
In keeping this renewed focus on return to shareholders, we point to relatively new management teams willing to take a fresh look at the structure of these global industrial companies. At Siemens, Klaus Kleinfeld took over as CEO and implemented most of the restructuring actions outlined above. Kleinfeld has recently been replaced by former Merck finance executive Peter Loscher, but we expect Loscher to pick up where Kleinfeld left off and continue to slim down Siemens. Fred Kindle has been at the helm of ABB since 2004 and has determinedly sought to improve manufacturing efficiency, delivering excellent results. GE's Jeffrey Immelt is the longest-serving of our global industrial infrastructure CEOs, but in his sixth year at the helm, he is in the early part of his tenure as GE CEOs go. He has installed new managers at most of the company's major divisions.

Upward Trajectories on Financial Returns Forecast
Due to aggressive business restructuring actions and substantial growth opportunities driven by the global infrastructure buildout, we expect earnings growth and returns on invested capital to rise sharply at our large global industrial infrastructure suppliers. Over the next five years, we forecast that ABB earnings will grow at a compounded rate of 18%, while returns on invested capital will jump to 50% by 2011, from 30% last year. At GE, we forecast that earnings will grow at a compounded rate of 12.5%, while ROIC will jump to 22% from just 12% last year. Finally, at Siemens, we think that earnings will grow at a remarkable rate of 33% over the next five years, while ROIC will jump to 31% from just 6% last year.

Our bullish forecasts are reflected in our investment ratings; Morningstar currently rates Siemens 4 stars and GE and ABB 3 stars, reflecting our view that healthy returns are available to equity investors in these companies.