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Quarter-End Insights

Our Outlook for Industrials Stocks

Slowing demand and dollar strength will hurt 2009, but values remain.

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Next year will be a tough one for the industrial companies we cover, there's no doubt about it. Both the number of announcements regarding 2009 earnings forecasts and their magnitude of downward adjustment suggest that the majority of companies in our coverage universe are bracing for conditions not seen in several years. Nobody will be spared, as companies throughout the value chain, from those who mine the raw materials to the shippers that deliver the goods, are all affected.

The reasons are myriad but can be summed up most succinctly in two areas: Demand is falling off a cliff, both domestically and abroad; and currency has reversed from a strong tail wind into a stiff head wind. Take  3M (MMM),whose management team recently outlined conditions by stating that business was "soft but in line with guidance in October" but then suffered a "rapid volume slowdown" in November, with "organic local currency sales down 17%."  Illinois Tool Works (ITW) suffered a similar trend, with base (internal) revenue up 1% in October, but falling 14% year over year in November and 15% year over year through the first week or so of December.  Eaton (ETN) was also tripped up, as management had to recently lower a forecast it produced in late October. Finally, equityholders of  FedEx (FDX) suffered their worst day since the 1987 crash in early December when management disclosed that the low end of its fiscal 2009 (ended in May) earnings forecast would be 26% lower than the company had thought as recently as September. The list goes on and on, such that our analysts are expecting those companies that haven't already warned about a significant slowdown to do so in the not-so-distant future. Quite simply, business has shut down this fall, and virtually every company in our industrial universe will be affected.

On top of that, the world's banking crisis and resulting global recession has had a beneficial effect on the dollar, which has become a destination in the flight to quality. The trade-weighted dollar index is up 11.6% as of Dec. 17 since bottoming in March (although this trend may be reversing as we write). Importantly, the move reverses a trend that left the dollar 39% lower than its 2002 high (according to that index). The happy situation that enhanced the top lines of many of our multinational industrial names during the years of dollar weakness has now reversed, and U.S.-based corporations will suffer the consequences of exchanging their foreign currencies for fewer dollars than at the last reporting date. In some instances, the effect will be severe. A case in point is  Tyco International (TYC), whose management indicated that if exchange rates remained where they were in early November, the company would need to overcome an 8%-10% currency head wind. Although the dollar has displayed some weakness since the latest Fed rate cut in mid-December, we're still taking a conservative view toward revenues for next year throughout our coverage universe.

Notwithstanding these problems, we're actually quite bullish on the share prices for many industrials stocks. Equities are long-dated assets, and therefore they should be evaluated not just on 2009's prospects but on an estimate of normalized results. On this basis, many of the stocks we cover are downright cheap. For those companies that enjoy strong balance sheets and sustainable competitive advantages, one or two years of relatively weak earnings aren't the end of the world. On the contrary, the prices afforded in these times of stress offer excellent opportunities to those investors smart enough to properly evaluate what they're buying. Industrial stocks are no exception.

Valuations by Industry
Industries that looked cheap in September are now even more so, thanks to the October/November equity swoon. In particular, manufacturing, land transport, and agricultural machinery prices look attractive relative to our current intrinsic value estimates, while environmental control and diversified manufacturers look to be a bit more expensive than in September. No groups, however, are significantly overvalued according to our methodology. 

 Industrials Valuations
Segment

 Price/Fair Value*

Three Months
Prior
Change
(%)
Aerospace & Defense 0.73 0.91 -20
Agricultural Machinery 0.67 0.70 -4
Air Transport 0.95 1.28 -26

Automakers

0.57 0.76 -25
Auto Parts 0.61 0.86 -29
Auto Retail 0.81 0.89 -9
Building Materials 0.62 0.64 -3
Construction Machinery 0.59 0.77 -23
Distributors 0.67 0.83 -19

Diversified

0.66 0.64 3

Electric Equipment

0.59 0.72 -18
Environmental Control  0.74 0.58 28
Homebuilding  0.56 0.78 -28

Land Transport 

0.58 0.88 -34

Machinery

0.60 0.76 -21

Manufacturing

0.50 0.97 -48
Metal Products 0.62 0.83 -25
Packaging 0.69 0.87 -21

Paints/Coatings

0.92 0.96 -4

Transportation-Misc

0.65 0.86 -24
Truck Makers 0.64 0.75 -15
Water Transport 0.53 0.72 -26
Data as of 12-16-08. *Market-Weighted Harmonic Mean

Industrial Stocks for Your Radar
For this quarterly review, we're going to point out some deep-value stocks. None enjoy quite the business quality of the more high-profile industrial companies we cover, but they nonetheless have attributes sufficient to get them through the current downturn in relatively good stead. All have strong balance sheets and operate in niches that will help insulate against competitive attacks. Importantly, all are extremely cheap.

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

Price/FV

Terex  (TEX) $45 None High 0.39
Pacer (PACR) $28 Narrow Medium 0.34
SPX Corp (SPW) $100 None Medium 0.37
Crane (CR) $34 Narrow Medium 0.46
Data as of 12-17-08.

 Terex (TEX)
Although it's pitted against the likes of  Caterpillar (CAT),  Deere (DE), and Komatsu in the highly cyclical and competitive construction equipment industry, Terex has secured itself a sizable share of the capital equipment market. Instead of going head-to-head with the industry heavyweights, Terex has built share and competed in other equipment categories such as cranes and aerial work platforms. In fact, Terex boasts more product breadth and depth than any other firm in the industry, while trading at a cheaper multiple of sales, earnings, or cash flow.

 Pacer (PACR)
Pacer profitably operates one of the largest intermodal shipping networks in North America by buying bulk space on all major rail lines. We expect margins to deteriorate some when the firm renews critical contracts with  Union Pacific (UNP) and  CSX (CSX) in 2011 and 2015. Current rates were established when rails were looking to fill excess capacity, which is no longer the case as rails now enjoy tremendous pricing power due to their cost advantage over competing modes of transport. Nonetheless, Pacer's margins aren't going to zero, and the company will likely have the ability to pass along at least some of the cost increase. We think the market is a bit pessimistic on this name, as fuel costs, labor costs, and environmental concerns will all favor rail transport over straight trucking. Pacer is a big beneficiary, as it is the largest player in intermodal marketing, a service integral to the ongoing rail renaissance.

 SPX Corporation (SPW)
Perceived exposure to automotive markets, municipal spending, and emerging-markets infrastructure have crushed this name. Fortunately, its auto exposure is in the service area, as SPX sells the diagnostic equipment used in diagnosing and servicing an aging automotive fleet. Its cooling tower business is heavily levered to power plant spending in China, an area likely to receive at least some of the nearly $600 billion stimulus likely to be unveiled next year. We think normalized cash flows support a price much higher than the current quote.

 Crane (CR)
This company operates in several markets that have been ravaged by the current market downturn. Exposure to aerospace, recreational vehicles, and energy markets will likely make 2009 a tough one. Asbestos exposure is also inherent to the story. Nonetheless, at current prices, investors are paying a fraction of the price the company commanded last summer. We think Crane is capable of generating normalized earnings in the $2 per share range, and we note that it posted over $3 per share of EPS in 2007. Asbestos exposure is well contained, as claims are no longer growing. Fraudulent practices rampant among litigants several years ago have been exposed, which suggests that the company no longer faces an ever-expanding roster of claimants.

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