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Stock Strategist Industry Reports

Industrial Products Firms Use Recession to Reload

Near-peak margins from industrials warrant scrutiny, but the space bears some gems.

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Earnings continued to impress during the second quarter. A number of industrial companies delivered strong revenue growth and operating margins at or above our midcycle assumptions. The strength in earnings, while welcome, is unlikely to be broadly sustainable over the long term, as manufacturers add capacity to meet burgeoning demand. However, we think some companies have made fundamental changes which will buoy ongoing profitability, and we highlight a few of these below.

A Healthy Dose of Restructuring Goes a Long Way
In 2008, signs of a looming recession forced many manufacturers to slash workforces and shut down plants abruptly to mute the impact of rapidly declining volumes. In doing this, many manufacturers were able to retain solid profitability in a shrinking economy. Because the recovery has stretched over several quarters, manufacturers have had the luxury of satisfying demand with a dramatically lower cost base. New revenue is coming on with little associated fixed cost, resulting in robust operating margins. For most companies, we think these margins are unsustainable, because companies eventually will have to add capacity--more people and more machines--to satisfy demand, thereby dampening operating performance. We view this as less of a setback than a return to a normal environment with fewer strains in the supply chain.

Daniel Holland does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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