Our Outlook for Industrials Stocks
Activity in the industrial space is likely to remain in growth mode.
Quarter-End Insights
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- Activity in auto production is picking up in March, but housing and truck production are still a bit slow.
- The Institute for Supply Management's PMI survey points to continued strength in manufacturing.
- Industrial data points to growth in overall employment coming soon.
Our outlook for industrial activity in the United States remains upbeat, as a recovery in the goods-producing space that started last summer remains intact, albeit with a few recent bumps in the road. In last quarter's update, we talked about three areas of the industrial economy that absolutely had to get better, simply because they could hardly get worse. These were residential construction, automotive production, and heavy-duty trucks.
Trends don't change that quickly in industrials, so we believe our thesis still holds. Housing and auto production saw some weakness in February, largely because of weather and a production halt at Toyota. March data will be better, especially in regard to the latter. Production figures for individual automakers suggest March auto production is humming right now as a result of incentives put forth by Toyota to win back customers in the aftermath of its recent safety issues. Other makers are following suit, luring consumers back to the showrooms.
As for housing, we expect a production lift into the April expiration of the tax credit. After that, we think some job growth will support what's still a very anemic pace of building.
With regard to truck production, numbers through the first two months of 2010 suggest the market needs to gain a bit of momentum for our 2010 estimate of 120,000-130,000 heavy-duty truck sales in the U.S. to be met. Nonetheless, we're not apt to change our forecast until we see a few more months of data. Here too, we think the environment will brighten.
Manufacturing Vital Signs
After a relatively strong January, February industrial production was lackluster, owing mainly to the above-mentioned items. We look for a relatively strong bounce going forward, as the leading indicators are still pretty positive. The Institute for Supply Management's purchasing manager's index, or PMI, far and away one of the most accurate leading indicators of industrial activity (and overall economic growth), continues to indicate expansion. It's been above the critical "50" demarcation, or the dividing line between expansion and contraction, since August 2009. As can be seen from the chart below, it always leads actual industrial production by a few months.
February's PMI number of 56.5 was down slightly from January's 58.4 (thus far the cycle high), indicating a possible slowing of momentum. We're reasonably confident this isn't the case, however. Inventories remain very lean throughout the entire value chain, giving us confidence that we're in for several more months of strong PMI data as manufacturers supply products to retailers and distributors to satiate final demand as well as restock inventories. In fact, both inventory components contained in the PMI survey, "overall inventories" and "customer inventories," remain near cyclical lows, indicating there's much to be done. Furthermore, the business inventory/sales ratio, tabulated by the Census, is now back to all-time lows. In short, any uptick in final demand isn't going to be supplied from inventory from here on out, necessitating an increase in production.
Until February, industrial production was tracking closely with the most impressive recoveries in recent history. Through January of this year, industrial production was 5.4% above it's June 2009 bottom, putting it just below the impressive recoveries of 1975 and 1982. These recoveries, by far the most powerful of the past four decades, enjoyed advances of a bit more than 6% seven months into their upswings.
February's weak 0.1% sequential growth in industrial production put the current recovery noticeably behind both the above-mentioned historical recoveries, which were both well into the 7% growth range after eight months compared with current industrial production that sits only 5.5% above its nadir after the same amount of time. If this keeps up, the current situation will be quite disappointing. Yet we think the current recovery should make up some ground soon. As mentioned above, weather and auto production undoubtedly had material effects on February production, with the former crimping construction projects and the latter hurting durable-goods production. We're expecting a strong bounce in industrial production in the next couple of months as automakers increase production.
Industrial Production as a Window on Overall EmploymentIf our industrial indicators remain true to form, it appears the economy is on the verge of a long-awaited revival in job growth. A common misnomer bandied about in the press and investment community is that employment is the critical ingredient needed to restore economic growth. Without it leading the way, the theory goes, growth will not resume.
The data paints just the opposite picture. Recovery of just about everything (industrial production, housing, gross domestic product, and so on) starts well before any turnaround in overall employment. In essence, growth in employment is a byproduct of growth in manufacturing, services, consumer spending, and many other areas of the economy, not the driver of it. As can be seen from the chart below, industrial production clearly leads employment by several months.
Industrial production's rate of decline bottomed in June of last year, four months before that of overall employment. The same thing occurred in the prior recession: Industrial production bottomed three months ahead of employment and was back into positive growth territory two months before total employment. The three-month moving average of the growth in industrial production turned positive this last February. We think there's an excellent chance of employment following suit in the very near future. Charts in several other sectors of the goods-producing market, such as housing and the PMI employment index, look very similar. Year-over-year growth rates that bottomed last year are now positive, with employment hot on their trails.
Industry-Level Insights
Unfortunately, valuations are not all that compelling today in industrials, as the group has been discounting a recovery for several months. The XLI industrial exchange-traded fund has rallied roughly 100% through mid-March from its lows last year, compared with a roughly 70% rally for the broader S&P 500. As a result, many industrial sectors sit at or near fair value. As a whole, our industrial universe sits about 107% of our estimated intrinsic value. Our cheapest sectors are the building-materials sectors, at less than 70%-80% price/fair value ratios, though very high uncertainty ratings keep us from outright buy recommendations in this sector. We also think auto dealerships are slightly undervalued. On the expensive side are airlines, at more than 150% price/fair value ratios. Industrial distribution is also a bit pricey at current levels, at slightly more than 120% of our fair value estimates.
Our Top Industrials Picks
| Top Industrials Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/Sales | |
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| St. Joe |  | $50.00 | Wide | High | 20.81 |
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| UTi Worldwide | | $24.00 | Narrow | Medium | 0.49 |
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| General Electric | | $25.00 | Wide | High | 1.23 |
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| Rush Enterprises | | $18.00 | None | Medium | 0.38 |
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| Data as of 3-24-10. |
St. Joe (JOE)
Although 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, Fla., this coming May should provide a 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. During 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.
UTi Worldwide
Nonasset freight forwarder UTi Worldwide is well positioned for escalating returns when global trade resumes in force, and we expect margins to recover from last quarter when the firm was unable to keep up with rapid supplier price increases. Though not as profitable as its competitor, the venerable superstar Expeditors International (EXPD), UTi also isn't as expensive. This company trades at a modest multiple of the $1.00-$1.50 in per-share earning power inherent in the model. We think this is pretty cheap for a company that requires very little capital investment, and UTi enjoyed 15% annual growth under normal conditions
General Electric (GE)
Things are looking up for this wide-moat diversified industrial firm. Dividends that were sliced by nearly 70% in 2009 are likely to start climbing from their current $0.40 per-share figure as early as next year as a result of much better health at the company's capital services business. A combination of a recovering economy and a smaller, more conservative loan book should help to lower provisions, thereby raising income for GE Capital. The unit's rising pretax, preprovision income on a trailing-12-months basis is encouraging, given the shrinking asset base, and gives us confidence that GE's finance unit has made it through the worst of the current cycle. We think the $1.00 in per-share earnings that GE will likely generate this year is the low of the cycle.
Rush Enterprises (RUSHA)
Rush should benefit from what we see as a potential surge in truck sales that should commence in the coming quarters and gain significant momentum during the next two years. We think the company will enjoy earning power of at least $1.50 per share during the coming years, against a current price of around $13 per share. If our thesis doesn't play out, the stock should be buoyed by a parts-and-service business that is on par today with what it was during the boom years of the last cycle.
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