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Quarter-End Insights

Our Outlook for the Industrials Sector

Macro headwinds stiffen across the industrials sector.

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The industrials sector has experienced a mixed bag of results since our last sector outlook in September. Those firms heavily exposed to residential housing and/or soaring fuel costs have continued to take their lumps. Not only are the usual suspects such as homebuilders and auto manufacturers suffering, but we're seeing the negative impact of these macro headwinds spilling into other industries as well. Many of the transportation firms we cover are blaming the depressed housing market for lower freight volumes. In the chemicals industry, companies such as  Dow (DOW) and  Du Pont (DD) are being pinched by higher input costs with oil hovering around $100 a barrel.

On the other hand, firms with a relatively diversified revenue base or concentrations in secularly strong markets such as defense, aerospace, and agriculture continue to perform well. Diversified industrial manufacturers such as  Illinois Tool Works (ITW),  Eaton (ETN), and  United Technologies (UTX) have seen their international profits soar as a weak dollar has made for more price-competitive products and a favorable currency conversion environment--helping to offset domestic sales declines. Agricultural firms such as  Deere (DE) and  Monsanto (MON) continue to benefit from the global ethanol boom that is enriching their customers. And the outlook for  Boeing (BA) and other aerospace/defense firms remains bright, as strong commercial aerospace demand and increased defense spending show no signs of waning.

We are reluctant to make macro predictions about the future direction of the economy, but we certainly believe the industrial sector could be approaching a tipping point as we move into 2008. Pockets of strength in agriculture and aerospace/defense appear to have some staying power, but other industrial markets could start to feel increasing pressure if the surge in oil prices and the turmoil in the housing market persist. It's too early to assume a pronounced pause will reverberate across the industrials sector, but that scenario is certainly well within the realm of possibilities.

Valuations by Industry
We've outlined below how our universe of industrials stocks stack up from a current price/fair-value perspective. We've also included the price/fair-value ratios from our last quarterly outlook to illustrate the relative changes in sector valuations. 

 Industrials Industry Valuations
Segment

Current Median
Price/Fair Value

Three Months
Prior
Change
(%)
Aerospace and Defense 1.03 1.04 0
Agricultural Machinery 1.00 1.18 -15
Agriculture 1.12 1.11 0
Agrochemical 0.91 0.97 -6
Aluminum 1.00 0.98 2
Automakers 0.98 0.96 2
Auto Parts 0.95 0.98 -3
Auto Retail 0.84 0.94 -11
Building Materials 0.69 0.73 -5
Chemicals 0.92 1.04 -12
Construction Machinery 1.20 1.18 2
Diversified 0.87 0.97 -10
Electric Equipment 1.00 1.05 -5
Machinery 0.95 1.00 -5
Manufacturing--Misc. 0.85 0.95 -11
Metal Products 0.88 1.00 -12
Packaging 0.90 1.01 -11
Paints/Coatings 0.96 1.04 -8
Plastics 0.83 1.08 -23
Recreation 0.81 0.84 -4
Rubber Products 0.70 0.91 -23
Steel Iron 0.93 0.95 -2
Transport Equipment 1.05 1.00 5
Truck Manufacturers 1.00 1.29 -22
Data as of 11-19-07.

In general, we're seeing better values across our industrials universe this quarter compared with last. The average price/fair-value of the industrial sector as a whole is 0.97, which suggests the space is modestly undervalued. At the time of our last industrials outlook, the sector looked slightly overvalued based on our prevailing fair value estimates.

Construction machinery companies look to be the most expensive names among the group right now, as overpriced and lower-quality operators appear to be disguising our belief that names such as  Caterpillar (CAT) and  Terex (TEX) remain undervalued. On the other hand, building materials remains the most undervalued slice of our industrials universe as the drop in the housing market continues to put downward pressure on these stocks. That said, we think firms such as  Cemex (CX) and  Eagle Materials (EXP) offer attractive long-term opportunities at these prices. Both companies have the ability to muddle through a challenging short-term market, and they should be opportunistically positioned once market conditions improve.

Industrials Stocks for Your Radar
We continue to see a number of compelling investments within the industrial space at current valuation levels. In particular, we think the following names are worth putting on your radar screen.

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

Mkt Cap
($bil)

Granite Construction  $62 Narrow Average 1.7
3M $103 Wide Below Avg 60
Terex $105 None Average 6.9
Siemens AG $190 Narrow Average 142
ITT Industries $83 Narrow Average 12
Data as of 12-07-07.

 Granite Construction (GVA)
Granite shares took a hit in late October after the firm reported disappointing third-quarter results and released lower-than-expected full-year earnings guidance. However, with its most problematic construction contracts nearing completion and a substantial amount of increased infrastructure funding being injected into its core markets, we believe this firm's long-term prospects remain bright. From the  Analyst Report: "Granite Construction is in the midst of an organizational restructuring that we believe will better position the company for the recent surge in local, state, and federal infrastructure construction spending. We believe Granite's unparalleled ability to take on projects of varying scope and diversity, combined with the synergies it can capture through the vertical integration of its construction materials and services businesses, provides this firm with a defensible economic moat in what has largely been a no-moat industry."

 3M (MMM)
With 20%-plus operating margins and an average free cash flow margin of more than 15% the past few years, 3M boasts some highly impressive and enviable financial metrics. We believe the company's innovative culture can continue to generate healthy results for the firm over the long term, and we'd look for its global footprint to offset any short-term domestic weakness. From the  Analyst Report: "The company still boasts top-of-the-line research-and-development capabilities, the ability to leverage technology across different platforms, and its fierce dedication to production excellence."

 Terex (TEX)
Terex should not only benefit from continued operating improvements, but also from its exposure to late-cycle end markets that are being propelled by a strong nonresidential construction environment--particularly overseas. From the  Analyst Report: "Terex has minimal exposure to the U.S. housing market (5%-7% of revenue), and its late-cycle businesses (like the crane business) are just starting to heat up. While a cyclical slowdown will eventually ensue, we think an acute focus on costs will allow Terex to create shareholder value throughout the economic cycle."

 Siemens AG (SI)
We think Siemens is a stock worth watching as the company's ability to tap the global infrastructure build-out will position it well for decades to come. In 2007, Siemens was embarrassed by a pay-for-play scandal that led to the replacement of its CEO, but we think the scandal is largely behind the firm. From the  Analyst Report: "Siemens is a highly diversified industrial company, but it's among the best-positioned companies in the world serving the once-in-a-lifetime industrial infrastructure construction in emerging markets. Furthermore, Siemens is in the middle stages of a productivity overhaul that is driving extraordinary gains in profitability."

 ITT Industries (ITT)
ITT generates 80% of its revenues from the defense and fluid technology markets--both of which we believe will benefit from positive secular trends in the coming years. Additionally, these markets should prove relatively resistant to any near-term economic pressure as they are both relatively immune from the housing malaise and consumer spending. From the  Analyst Report: "ITT's strategy in fluid technology is to position itself as a total-solution provider for municipal governments looking to build or revamp water or waste water treatment plants. In the defense sector, ITT serves as a key outsourcing partner for the U.S. government, increasing its importance, as well as its leverage."

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John Kearney has a position in the following securities mentioned above: CX. Find out about Morningstar’s editorial policies.