Our Outlook for Industrials Stocks

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As expected, industrial firms entered 2009 with a whimper. Continued weakening of the global economy has led to sharp industrial-production declines and massive employee layoff announcements from many of the major names we cover. We expect the near-term environment to remain dreadful for industrial companies. Still, there are some positive signs, but it's too early to say for certain whether the sector will finish the year with a bang, and we're definitely not ready to call a bottom.

By most measures, the worldwide economic picture worsened through late 2008 and early 2009, as the gross domestic product (GDP) of most industrialized nations fell or slowed. The United States saw a 6.2% annualized fourth-quarter GDP drop, and the first quarter isn't shaping up much better. Critical to our coverage space, industrial production fell 1.4% sequentially in February (after dropping 1.9% in January), and dropped below 2002 manufacturing levels. Key components of this index include automotive production, new home starts, and aircraft construction, all of which continue to suffer from slackened consumer demand. Retail sales of new cars fell in February to an annualized level of 7.5 million from over 8 million in the last quarter, housing starts remain at unprecedentedly low levels, and Boeing (BA) has suffered immensely from a worker strike during the fourth quarter.

The pain hasn't been isolated to the U.S., either. Eastern Europe--until recently a hotbed of economic growth--is facing enormous challenges and threatens to upset Western Europe's already-struggling economic circumstances. Asian stalwart China even saw its seemingly immune GDP growth slow recently, and precipitously declining iron-ore shipping rates suggest that the country's industrial production hasn't meaningfully rebounded in the first quarter. To make matters worse for U.S.-domiciled companies selling overseas, the dollar has maintained its strength over the past several months. These firms will report less dollar revenue per local-currency sale as a result, further challenging year-over-year comparisons.

In response to the deteriorating economic condition and still-muted outlook, several of the largest companies we cover have announced major layoff plans. For instance,  United Technologies (UTX) plans to let go of 11,600 employees over the year,  Caterpillar (CAT) looks to shed 22,110 people, and  FedEx (FDX) will trim 900 jobs, (2.6% of its workforce). As these and other job cuts filter through the economic system, we expect consumer spending to continue its downward trend, further impacting firms such as  3M (MMM) and  General Motors (GM).

Moreover, many of the firms on our coverage list are incredibly capital-intensive, and they have a hard time spreading less revenue over a fixed cost base. As a result, operating margins are likely to continue their downward march; it's likely that the profitability seen over the past few years won't be generated again for years to come. Some companies--such as shipowner  DryShips  and autoparts supplier  American Axle (AXL)--have blown through financial covenants. Although banks have thus far been willing to renegotiate debt agreements, they may not be so kind if conditions worsen materially. As it is, these high-debt companies will likely face substantially higher interest costs, accelerated principal payments, or both. For several companies we cover, we factor a high degree of insolvency risk into our discrete scenario analysis.

Nonetheless, some positive trends have appeared on the horizon. For one, lower oil prices have benefited consumers at the fuel pump. If drivers continue to shell out less for gasoline, they will likely have more in their wallets to spend. Another positive,  Boeing's (BA) production rebound after its fourth-quarter strike could boost first-quarter numbers. Continued global governmental stimulus packages--if successful--could also generate demand for construction and the infrastructure to support it. However, any potentially meaningful benefit is likely several quarters out.

Valuations by Industry
Considering our multiyear focus, it should come as no surprise that we view most of our coverage list as attractively valued even though near-term results will likely remain dim. Overall, the sector's average price/fair value ratio is 61%. The majority of the companies we follow operate in violently cyclical industries, and the current downturn has been exacerbated by the worldwide recession. Although demand will inevitably again return, uncertainty abounds. That said, as demand picks back up, we think the machinery, transportation, and materials necessary to support infrastructure projects will strongly benefit; these industries are amongst the cheapest for long-term investment.  

Industrials Industry Valuations
	Star Rating	Price/Fair Value*	P/FV Three Months Prior	Change (%)	Uncertainty Percentile**
Aerospace & Defense	4.4	0.59	0.73	-19	56.7
Agricultural Machinery	4.3	0.59	0.67	-12	22.0
Air Transport	3.2	0.69	0.95	-27	96.9
Automakers	4.0	0.59	0.57	4	62.2
Auto Parts	4.0	0.59	0.61	-3	55.1
Auto Retail	3.0	0.93	0.81	15	29.9
Building Materials	4.0	0.57	0.62	-8	65.4
Construction Machinery	4.7	0.49	0.59	-17	40.9
Distributors	4.3	0.73	0.67	9	26.8
Diversified	4.6	0.52	0.66	-21	33.9
Electric Equipment	4.0	0.69	0.59	17	47.2
Environmental Control	3.7	0.61	0.74	-18	52.0
Homebuilding	4.1	0.53	0.56	-5	85.8
Land Transport	4.9	0.57	0.58	-2	12.6
Machinery	4.8	0.53	0.60	-12	24.4
Manufacturing	5.0	0.48	0.50	-4	50.4
Metal Products	3.8	0.62	0.62	0	72.4
Packaging	4.2	0.65	0.69	-6	29.1
Paints/Coatings	3.0	0.87	0.92	-5	60.6
Transportation-Misc	4.9	0.55	0.65	-15	15.7
Truck Makers	4.6	0.58	0.64	-9	25.2
Water Transport	4.5	0.46	0.53	-13	67.7
Data as of 03-13-09. *Market-Weighted Harmonic Mean **Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of all industries under coverage.

Industrials Stocks for Your Radar
Given the current economic malaise, we think it's critical to keep strong companies with pristine balance sheets on your radar. Even though economic activity will eventually again pick up, some companies may not make it to the other end of the tunnel due to high degrees of financial leverage. These firms, which have very little debt, are worth keeping on your watch list.

Top Industrials Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Open
Aptar		$47.00	Narrow	Medium	$27.96
Expeditors International of Washington		$44.00	Wide	Medium	$28.75
Ritchie Brothers Auctioneers		$20.00	Wide	Medium	$16.98
St. Joe		$50.00	Wide	High	$15.46
Data as of 03-18-09.

 Aptar (ATR)
As a custom dispenser-pump designer and manufacturer, Aptar's product offering is typically more recession-resistant than many other firms we cover. Although the firm's volume has suffered from the "empty-pantry" effect (in which consumers slow their own replacement cycle of dispensable products such as creams, condiments, and medicines), we think staple items such as ketchup and shampoo will generally remain in demand throughout the downturn. With a paltry $100 million in net debt, Aptar looks to maintain its market-leading share.

 Expeditors International of Washington (EXPD)
Featuring a dynamic business model and stellar execution, this third-party logistics firm has consistently generated terrific returns on its invested capital. Although volume head winds will likely challenge the firm's top line for several quarters, Expeditors' variable cost structure should preserve profitability during the downturn. With zero long-term debt and nearly $750 million in cash at the end of 2008, we think the company is well-positioned to outlast continued weakness.

 Ritchie Brothers Auctioneers (RBA)
The world's largest industrial auctioneer, Ritchie Bros. has carved a profitable network for the sale of construction, agriculture, and other industrial equipment. The firm's terrific working capital management and net cash position (more cash than long-term debt) should serve the company well as it continues to expand within the highly fragmented industrial-equipment resale market. On top of that, Ritchie Bros. has a history of producing solid performance throughout economic cycles. In fact, the company has failed to achieve year-over-year top-line growth only once during the last 40 years.

 St. Joe (JOE)
As a real estate developer with substantial land holdings in Florida (one of the weakest real estate markets in the country), St. Joe doesn't immediately seem like a prime investment candidate. However, the company dominates the state's northwest coast, and holds its land at near-zero cost. With $116 million in cash and only $50 million in debt, the firm has lots of time to wait for the eventual rebound in land value.

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Other Sector Outlook Articles

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