Our Outlook for Industrial Stocks

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• Upcoming third-quarter industrial-company results are likely to be very impressive
• Coming quarters will likely suffer slowing growth in industrial activity
• Long-term drivers remain in place for sustained growth once the expected lull passes

We started last quarter's outlook three months ago by commenting on the strength of the then-current conditions in the industrial space. Our outlook was contrary to what appeared to be weakening economic data starting to trickle in at the time, and definitely counter to the then- (and still-) prevailing sour sentiment around global economic activity.

As it turned out, the just-finished third quarter was almost assuredly a very good one for almost all industrial companies. Recent comments from several CEOs suggest industrial companies enjoyed strong demand throughout the summer. As a result, we expect very good results when all these companies report third-quarter earnings in October. Demand has rebounded from last year's levels in almost all sectors, while cost containment has been outstanding as the fruits of 2009's massive restructurings flow through the income statements. In fact, one of the reasons that employment in general has stayed so soft compared with many past recoveries is that many companies are enjoying significantly increased productivity due to these recently enacted changes.

As we peer out into the fourth quarter and beyond, however, we're picking up some very strong signals that conditions in the short  to medium term for our industrials universe aren't going to match the near-perfect conditions of the past several quarters. Most of our indicators are pointing to a significant slowing of industrial growth over the next couple of months, as the weakness felt at the consumer level in early summer will likely be filtering through to industrials in the fall and early winter.

Looking out a bit further, however, we're still optimistic about industrial demand in the years ahead, as the amount of underinvestment in many of the nation's industrial and capital investment accounts during the great recession was so large that a significant amount of pent-up demand is likely to be unleashed over the next several years. Overseas activity is even more difficult to forecast, and China remains a wild card in this analyst's opinion. Its current rate of infrastructure spending is likely unsustainable. If this slows down, there's uncertainly as to whether the much-anticipated emergence of the Chinese consumer will be enough to pick up the slack.

Inventories, Though Still Low, Won't Provide Much Fuel to the Industrial Space for  a While
We specifically called out inventories as a reason to be optimistic three months ago, as inventory-to-sales ratios were looking lower across the entire value chain. We're not so sanguine on this subject today, as recent data suggest the inventory rebuilding dynamic so prevalent in recent quarters isn't going to be of much help in the next few months, and very likely, the next few quarters. Specifically, two indicators have us a bit worried--the Institute for Supply Management's PMI report on manufacturing, and recent business inventory data.

There's been a lot of attention focused on the PMI report for the past several months, and for good reason. It's historically been a very good leading indicator not only of industrial activity, but of economic activity in general. The August reading was encouraging on the surface, as the diffusion index actually increased a few ticks against a widespread belief it would fall.

Unfortunately, some of the internal data contained in the report hasn't been as encouraging for a couple of months now. Inventories relative to new orders are a handy leading indicator of the overall PMI's direction several months hence. As the chart below shows, the indication is for a lower PMI reading very soon, as a drop in this ratio is virtually always followed by drop in the overall index several months later. Unfortunately, as a leading indicator itself, a drop in the overall PMI generally presages lower industrial production.

In addition to the ISM data, subtle changes in the inventory-to-sales data found in the monthly factory data are often excellent leading indicators of overall domestic production. In the chart below, we plot the annual rate of change in the total business inventory-to-sales ratio (on an inverted scale) against industrial production.

Here too, the indication isn't great, as it appears the inventory dynamic is no longer the ally of the production cycle that it was just a few months ago.

Finally, our composite leading indicator, which is made up of a number of wide-ranging data points from many sectors is flashing the same signal as the above two charts. As seen below, its annual growth rate rolled over starting in June and has declined since, indicating the odds for continued strength in industrial activity during the next few months are long.

In summary, the best leading indicators that we can find seem to suggest there's a slowing afoot in the industrial space. Though consistent with much other economic data, it's in contrast to very recent comments from CEOs within the space, who, nearly to a person, strongly indicate that their businesses have remained strong through August. Perhaps there are better indicators we've not learned of that are showing the opposite from what we're seeing, but we doubt it. In addition, the year-over-year indicators are being heavily influenced by anomalous situations in the year-ago data that make the comparisons look weaker than they really are. All of this could be, but the pervasiveness of the signals makes them hard to ignore. For all intents and purposes, it looks to us like industrial activity is in for a slowing in the months ahead.

 

Looking around the globe, strength is mixed in Europe, with France, Germany, and Austria leading the Eurozone recovery, though Germany appears to be faltering a bit. Italy, Spain, and the Netherlands remain weak, while Greece is still mired in recession. In total, the Eurozone manufacturing PMI output sank to a six-month low of 55.1 from 56.7 in August, indicating growth in the industrial sector remains, but at a slower rate. Encouragingly, the new order component of the report rose for the 13th consecutive month indicating likely positive results going forward.

In China, the manufacturing PMI reports have fallen back considerably in recent months, clouding the outlook for industrial output in that country. After reaching an interim high of 56.6 (like the U.S. PMI, anything above 50 indicates growth) in December 2009, August results were 51.7, or slightly above the growth demarcation. We've been watching the finished goods component of the survey with some angst in recent months, as its steady climb was not a pleasant signal. However, August enjoyed the third-largest drop since the series began five years ago, indicating a build-up of finished goods is not as worrisome today as it was a few months earlier. Bottom line, China appears to still be growing its industrial activity but at a slower rate than several months ago. Longer term, we remain worried that the country's massive investment in fixed assets is unsustainable. When this inevitably slows, there's uncertainty as to whether the Chinese consumer can fill the void.

U.S. Industrial Demand Should Be Strong Over the Coming Years
The question we've been struggling with is whether this expected weakness in the U.S. industrial sector is the start of a new trend or a correction in a sustained upward move. We think there's a case to be made for the latter. It's likely that investors have much to look forward to over the next several years, not withstanding the expected rough patch in the near future.

For instance, we expect a continued uptick in several of the capital spending-centric and durable goods categories manufactured by the companies in our industrial coverage universe. Specifically, below is a chart of gross fixed investment in industrial equipment, transportation equipment, and construction equipment as a percent of real GDP. As can be seen, investment in these items has been extremely limited in the recent past, indicating to us that there's likely to be some material pent-up demand in the not-so-distant future.

Unlike housing, these are not areas where expenditures can be put off for a significant amount of time, as businesses lose competitiveness as equipment ages and wears out.

In addition, many of the issues that would normally make the industrial sector vulnerable to a sustained correction aren't present today. Though the above-mentioned inventory dynamic won't be a tailwind as it's been for several quarters, it's hard to argue it'll be a headwind, as there's not yet enough inventory in the system to necessitate an inventory-led correction. In addition, the extreme amount of restructuring put forth during the past two years means cost structures are already lean, and in little need of adjustment. Wide-scale layoffs, as reported by Challenger Gray, are now virtually nonexistent indicating the industry is unlikely to be hit with another round of massive job loss. Balance sheets throughout corporate America are now in much better condition than at the onset of the Great Recession.

Finally, short-term fears shouldn't keep investors from purchasing cheap stocks that enjoy attractive long-term prospects at prices that are at a discount to intrinsic value. Investors should buy stocks when they're cheap, regardless of the short-term outlook.

Industry-Level Insights
As a group, the industrials space today is priced roughly equal to what it was in our last quarterly outlook back in late June. The aggregate price/fair value now sits at 86%, down negligibly from the 87% level three months ago and considerably from 96% in March.

At the industry level, building materials is our cheapest group, at 64% of fair value. Auto and truck manufacturing, at 72% of fair value is the next cheapest, followed by homebuilding and construction products at 73%. We believe all three groups enjoy a favorable three-year outlook, but they are currently depressed by negative short-term fundamentals and poor sentiment. Our most expensive groups include farm and construction machinery and airlines, at 107% and 105% of their respective fair values.

Top Industrials Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Lennar		$26.00	None	High	$13.00
Ford		$20.00	None	Very High	$8.00
UTi Worldwide		$24.00	Narrow	Medium	$16.80
Honeywell		$60.00	Narrow	Medium	$42.00
Lithia Motors		$16.00	None	Very High	$6.40
Data as of 09-23-10.

 Lennar (LEN)
Homebuilder performance has been lackluster since early May due in part to fears of a double dip in housing now that the Federal Tax Credit has expired and economic growth looks weaker. The market is correct in thinking the next couple of months will be difficult, but we don't think enough investors are factoring in the increase in business quality, nor the brightening long-term picture emerging at all of the large builders. Lennar, in particular, is showing tremendous improvement in its fundamentals, with three of the past four quarters showing net income.

 Ford (F)
We believe U.S. light-vehicle sales will eventually return to a normative demand level of 16-17 million units a year, and Ford is one of the best ways to play that recovery. The United States is by far the largest contributor to Ford's earnings, so we think the stock will eventually rise when auto sales get well above present levels. The firm is continuing to de-lever its balance sheet such that it may enjoy an investment-grade credit rating in the not-so-distant future. Ford now makes car models that people really want to buy rather than in past years when consumers bought a Ford Escort because it was cheap. A full line of competitive vehicles is likely going to help Ford outsell  Toyota (TM) in America this year and keep generating cash to pay off more debt. Ford also benefits from a halo effect of being the only American automaker to not take taxpayer bailout loans.

 UTi Worldwide 
Much cheaper than its better-known competitor, we think UTi Worldwide presents investors an opportunity at current prices. Second-quarter results confirmed our thesis that while UTI still suffers with rapidly expanding costs due to the inability to pass through capacity price increases in real time, its three-year operational improvement program remains on track. As a result, we expect better margins going forward as these cost increases taper off and operating improvements take hold.

 Honeywell (HON)
A significant portion of Honeywell's portfolio is aimed directly at helping customers decrease energy consumption, an area where we expect solid growth in the coming years. In addition, the company is in the early stages of a lean six-sigma initiative, which has proven to both improve operating margins and reduce working capital at Honeywell sites that have already implemented the system. Trading at less than 14 times our 2011 earnings projection, we think Honeywell is attractively priced as the market appears to discount the possibility of additional margin lift coming from operating improvements.

 Lithia Motors (LAD)
Lithia should provide good returns for those looking for a small-cap opportunity. We think the market does not appreciate that most of the firm's Chrysler exposure is tied to pick-ups, SUVs and vans, which would have a buyer if Chrysler were to ever liquidate. The company's earnings are recovering from severe lows in 2009, and the firm's move into older used vehicles is paying off with higher margins. Lithia is very Chrysler heavy in sales mix so Chrysler's September announcement of products such as a new 300 sedan and a mid-size 200 model should increase profits in 2011. Lithia is also the only dealer to have reinstated its dividend. The firm raised its 2010 adjusted earnings guidance at its second-quarter earnings release to $0.72-$0.77 per diluted share. We think earnings power is well north of $1 per share.

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