Our Outlook for Industrial Stocks

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Our outlook for U.S. industrial activity for 2010 is decidedly better than 2009, as several metrics within the industrial space suggest activity that bottomed in early summer is on the upswing. We look for further recovery next year, as current production levels of several key sectors are still far below normal demand.

In past outlooks, we concentrated on macro data such as industrial production and the Institute for Supply Management's purchasing managers index to make the case that the industrial economy bottomed in mid-2009. This is still the case. November activity in the nation's industrial sector increased by 0.8% from October. The increase, while relatively subdued, was the fifth consecutive gain, and puts the index 3.7% above its June low (but still 11.6% below peak levels set in December 2007).

Encouragingly, manufacturing output advanced a relatively strong 1.1% in November. It was the strongest increase in three months and featured broad-based gains among both durables and nondurables. As far as modern recoveries are concerned, this one is proceeding at about an average pace, at least with regard to industrial activity. The 3.7% increase thus far compares favorably to recoveries in 1991 and 2001, which were both about 2% off their lows five months into recovery, but trails both recoveries staged in the early 1980s as well as the one in the mid-1970s. Each of those enjoyed 4%-5% higher production levels five months into recovery. Even with recent gains, however, production levels in several key areas of the economy are bumping along at unsustainably low levels, meaning increases are inevitable at some point. Three that we'll tackle here are housing, and auto and truck manufacturing.

Housing
Total annual housing production for 2009 will come in around 550,000 units, which is a 40% decline from 2008 and marks the fourth consecutive annual decline. This year's production will be almost 75% below peak annual levels set in 2005, and less than the amount of households likely formed.

It's highly likely that next year will show improvement in both total and single-family starts, as the bottom in production occurred in late spring and has been trending mildly higher since. In fact, single-family production actually grew year-over-year in November (by 5%) for the first time since March 2006.

Most forecasts we've seen thus far are calling for an increase in total starts in the 20% range next year. While this may be the case, we think a 30%-50% increase isn't out of the question. The upper end of that range puts next year's production at a scant 825,000 units, which would be the third straight year with less than 1 million units produced. Prior housing bottoms of 1975, 1982, and 1991 never had any calendar years with production of less than 1 million units, nor has any year since at least 1959. Additionally, the reduction in new home standing inventory has largely run its course. The amount of empty new homes now sits at the same level as 1972. As a percentage of households, the metric hasn't been lower in more than 50 years.

Autos
2009 witnessed auto sales of about 10 million units. Normal annual replacement demand of about 5% to 6% of the existing fleet (250 million units) indicates normalized replacement sales levels of at least 12.5 million units. Add to this the annual net number of new drivers, which we estimate is in the 1-2 million range (though not all of these folks will utilize a dedicated vehicle), and there's evidence strongly suggesting that normal auto demand lies well north of current production.

As a result of 2009's abnormally low sales rate, a domestic light vehicle fleet that was already the oldest in at least 10 years at the beginning of 2009 got significantly older. This cannot go on forever. Already, used auto prices are at their highest levels since at least 1995 (according to the Manheim Used Vehicle Value Index), as a result of a dearth of supply of trade-in vehicles. As used vehicle prices trend upward, new vehicle purchases gain attractiveness. Several forecasts are suggesting a 10% increase in North American auto builds in 2010. We wouldn't be surprised if that turns out to be conservative.

Trucks
As a result of more homes and autos being built over the coming years, shipping volumes of heavy materials and components are likely to expand, leading to increased demand for trucks. Estimating normal heavy-duty truck demand is a bit trickier than auto and housing demand, as changing emission standards lead to some years being significantly above or below others.

Nonetheless, 2009 will go down as an abnormally weak year for heavy-duty truck production, as last year's less than 95,000 units produced is less than two-thirds average annual production over the past couple of decades.

2007 witnessed a surge in buying due to impending emission standards, so there may still be a bit of a surplus given historically low levels of shipping demand over the past couple of years. Even so, we're forecasting a significant increase in truck production for the next two years.

 

Valuation by Industry
Valuations in industrials have gotten richer for the most part during the fourth quarter, and few names offer outstanding value at current prices.

The  Industrial Select Sector SPDR (XLI) ETF increased about 10% in the three months ending in December, and now sits 88% above its March lows.

Even so, valuations have become more compelling in a couple of sectors likely to benefit from the increased activity we anticipate in housing and autos, as homebuilding/construction and auto dealerships are currently among our highest-rated sectors.

Airlines and electronic equipment are among our most expensive industries.

Industrials Industry Valuations
	Star Rating	Price/Fair Value*	P/FV Three Months Prior	Change (%)	Industry FV Uncertainty**
Aerospace & Defense - Maj Diversified	2.94	1.01	1.01	0	40.9
Auto Dealerships	3.36	0.82	0.98	-16.3	64.8
Airlines	2.63	1.33	1.31	1.5	100.0
Auto & Truck Manufacturing	3.53	0.79	0.82	-9.7	78.4
Auto Parts Manufacturing	2.98	0.93	1.03	3.8	62.5
Diversified	3.22	0.81	0.78	2.5	46.6
Electronic Equipment	2.37	1.22	1.19	2.3	56.8
Farm & Construction Machinery	2.96	0.97	0.94	3.2	36.4
Homebuilding & Construction Products	3.52	0.71	0.83	-14.5	85.2
Industrial Distribution	2.36	1.10	1.01	8.9	2.3
Industrial Products	2.89	1.00	1.05	-4.7	35.2
Logistics	3.59	0.84	0.86	-2.3	22.7
Railroads	2.78	1.04	1.02	2.0	18.2
Trucking	2.81	1.03	1.00	3.0	34.1
Data as of 12-14-09. *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.

Our Top Industrials Picks
An industrial 5-star list that numbered more than 140 in March has shriveled to near zero today. However, we still have a few names that are attractively priced, though not the screaming buys they were earlier in the year.  

Top Industrials Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Price/Sales
St. Joe Corporation		$50.00	Wide	High	18.0
Mohawk Industries Inc.		$56.00	Narrow	Medium	0.6
Lithia Motors		$18.00	None	Very High	0.1
AutoNation Inc.		$25.00	Narrow	Medium	0.3
Data as of 12-23-09.

 St. Joe (JOE)
Though tough to model, St. Joe offers what we believe to be pretty compelling value at current prices. The company owns significant amounts of land in the Florida panhandle, bought at prices far below even today's depressed values. The opening of a new international airport in Panama City this coming May should provide the catalyst toward a long period of economic development in the region. Investors can be sure that any development in the area will most likely be done on St. Joe land, and with St. Joe's assistance in the entitlement process. Over the past three years, management has done a good job of reducing the company's capital intensity to very attractive levels, while at the same time shoring up its balance sheet.

 Mohawk Industries (MHK)
Mohawk has seen its business shrivel right alongside the collapse in the construction/renovation industry over the past three years. Tough days still lie ahead for sure, as the flooring industry will be dealing with overcapacity for several more years. Even so, there's reason to believe that the company may enjoy brighter days in 2010. Mohawk derives about half of its business from replacement and repair, a segment that may see an uptick even if new construction remains stagnant. As foreclosures sales ramp up, it's likely many buyers of these units will find them in rough condition and in need of new flooring to be inhabitable. We still maintain the company enjoys more than $5 per share in earning power once normalcy returns.

 AutoNation (AN)
AutoNation is the best light-vehicle dealer we cover. Management recently announced the company is going back on the offensive and looking to acquire stores rather than continue to pay down debt. We like this strategy since U.S. light-vehicle sales bottomed out in February, and the company has already reduced its debt load by about $1 billion over the past 12 months. If, however, sellers continue to ask too much for their stores, AutoNation will likely resort to repurchasing its cheap shares. The best operator in the business, AutoNation consistently enjoys better SG&A efficiency than its peers. We don't think the market adequately appreciates this, nor the firm's coming margin expansion.

 Lithia Motors (LAD)
We think Lithia has made it through the worst of its distress and is poised to record much higher operating margins in the near future. The value-line strategy of selling older model used vehicles is boosting used vehicle gross margin by nearly 500 basis points. And like many firms, Lithia has done plenty of cost-cutting during the recession. On top of this, a $43.5 million October equity offering has provided management with ammunition to resume acquisitions. Management is clearly pretty optimistic about the firm's prospects, as the most recent conference call displayed more optimism about the future than we've heard since the recession began. A critical caveat for investors however is that about 30% of new vehicle unit sales come from Chrysler brands. Yet if the U.S. economy is beginning its recovery and Chrysler stays alive (which it should at least in the short run), we think Lithia is well positioned to report heady earnings growth over the next few years.

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Other Sector Outlook Articles

• Banks
• Basic Materials
• Business and Financial Services
• Consumer
• Energy
• Health Care
• Tech & Telecom
• Utilities

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