Our Outlook for Industrial Stocks

• Positive global purchasing manager surveys suggest strong industrial production growth in the coming quarters.
   
• Inflationary pressures are becoming more evident and could threaten firms' gross margins if not offset by price increases.
   
• The recent Japanese disaster could boost near-term results for U.S. and European automakers, construction equipment manufacturers, and power generation equipment providers.

We wrote in our December outlook that it appeared the domestic industrial economy was about to awaken from the funk it had been in for the prior few months. Indeed, that turned out to be the case, with the manufacturing component of U.S. industrial production enjoying solid growth in December, January, and February. As we look forward, we expect continued strong performance in this critical metric, as well as from the later-cycle capital spending industries.

We're currently very encouraged by the leading indicators of industrial activity, as just about everything we follow is pointing toward strong activity in the next several quarters. For instance, many of the regional purchasing manager surveys are currently robust, to say the least. The Empire State Manufacturing Index has turned up over the past couple of months, while the Philly Fed regional manufacturing survey is sitting at all-time highs. Both lead industrial production by a couple of months, giving us a heads-up regarding future activity.

In addition, the national purchasing manager survey undertaken by the Institute for Supply Management is indicating strong growth both in regard to the headline number and its internals. An overall reading of 61.4 in February was the highest the survey has been since the early '80s, while the important inventory-to-new orders ratio is once again climbing.

The chart below aggregates all the indicators into an easier-to-analyze composite index plotted against industrial production. Generally a very accurate indicator, it's currently pointing to solid year-over-year growth in domestic manufacturing activity. As a result, we wouldn't be surprised to see overall industrial production up a mid- to high-single digit percentage at the end of 2011.

We're looking for similarly strong growth in worldwide manufacturing. The Markit/CIPS U.K. manufacturing survey remained at 61.5 in February, implying very strong activity in England going forward. New orders, output growth, and production all posted impressive results. Within sectors, both consumer and intermediate-goods demand remained strong.

As for the Eurozone, it has posted its strongest growth in 11 years thus far in 2011. The Markit Eurozone PMI index, now at 59, was driven once again by strong activity in Germany but is now also being helped by countries on the periphery. In fact, only Greece posted results below the 50 demarcation line delineating growth from contraction.

PMIs in Germany, Austria, and the Netherlands all now sit at record levels, while Italy, Ireland, and Spain all showed improved "vigor" according to the survey. New orders throughout the zone rose to the second-highest rate in 10 1/2 years in February, while new export growth hit a 10-month high. All in all, we find the global purchasing manager surveys to be highly positive, and more indication of very healthy manufacturing activity throughout the developed world.

China, on the other hand, appears to be cooling down somewhat, which may not be such a bad thing. The HSBC China Manufacturing Index eased to 51.7 in February from 54.5 the previous month, mostly due to an easing in new business growth and new export orders. The latter fell for the first time since August, while the overall index now sits at a seven-month low. In addition, the survey points to the first sequential reduction in employment since last October.

 

The Threat of Inflation Will Likely Test Companies' Ability to Increase Prices
We're not so disappointed to see a slowdown in China because of the potential positive effects on global commodity cost inflation, as slower manufacturing activity may ease some inflationary pressure in one of the most affected regions in the world. However, cost pressures are highly evident everywhere, with just about every survey, index, and individual comment indicating material cost pressures. Some developed regions are even suffering record rates of increase in input prices of late. A cooling in China is a good place to start if the world is to get this material cost inflation under control.

We're confident the railroads--such as  Canadian National (CNI),  Canadian Pacific (CP),  CSX (CSX),  Norfolk Southern (NSC),  Union Pacific (UNP), and Kansas City Southern --will recoup virtually every penny of fuel cost inflation, as will  United Parcel Service (UPS) and  FedEx (FDX). Most of the truckers will enjoy less success because of the tougher market dynamics, but they will still be able to pass through a large percentage of fuel cost increases. Perversely, the short-term earnings impact will be most pronounced for the rails and integrated shippers due to the relatively slower implementation of surcharges.

However, we're not so constructive on most of our industrial names' abilities to pass these costs on. Many of the companies that make components and sell to large powerful customers (like automakers, heavy equipment makers, etc.) will have considerably less success in passing along material cost increases. Most will choose to offset the increases through attempted efficiency gains and material substitution. However, we're bracing for some modest margin pressure throughout the manufacturing space in the quarters ahead.

Capital Spending Still Looking Solid
We're still expecting good growth in capital spending for several quarters. As we've mentioned in prior outlooks, 2009 was a disastrous year for capital spending. The category started to recover in early 2010 and is now in the midst of what we believe could be a multi-year run of strong growth.

Aggregate nominal growth in gross fixed investment in industrial equipment, transportation equipment, and construction equipment topped 20% in each of the last two quarters of last year. Because the trough was so deep, the amount of underinvestment in the system likely necessitates similar growth rates for several more quarters. Indeed, growth rates in orders for names like  Emerson Electric (EMR),  Caterpillar (CAT), and  Parker Hannifin (PH) remain impressive but are now cycling against tougher comparables. Some moderation is likely, but we think the performance of these categories may surprise some people.

Automotive Companies Most Affected by the Japanese Tragedy
Of the names in our industrial coverage, the most affected by the disaster in Japan are the automotive names. Morningstar analysts Dave Whiston and Richard Hilgert have commented extensively on the matter, some of which is paraphrased here.

The good news for the three Japanese automakers we cover is that their assembly plants are, for the most part, unharmed. Unfortunately, there is major uncertainty regarding the impact of the supply base in Japan, the ability of infrastructure to transport parts around the country, and the amount of damage to ports where vehicles are shipped overseas.

For the markets outside of Japan, the near-term implications are more positive for competitors to the Japanese OEMs to the extent that Japanese exports are limited and Japanese facilities located outside of Japan become capacity-constrained as production is shifted from Japanese facilities. This will likely lead to restricted dealership inventories, which may cause consumers to look elsewhere if they are unable to find desired models on dealers' lots. This issue could especially apply to compact and luxury vehicles since nearly all hybrids, most Lexuses, and the Toyota Yaris and Honda Fit sub-compacts are made in Japan. A shortage in fuel-efficient models would be well-timed for the Detroit Three, who now have very competitive compact and sub-compact vehicles.

We see  Toyota (TM) as the most exposed to the earthquake's damage due to its reliance on Japan as a production base. Roughly 44% of its global passenger vehicle production is in Japan compared to only about 27% at  Honda (HMC). Furthermore, it is likely Toyota makes over 1 million vehicles in Japan for export to other nations.

The majority of Toyota's 16 parts and assembly plants are near Nagoya, far south of Sendai, but in January the company opened a Yaris plant with 120,000 units of capacity in Miyagi, near Sendai. It also has a parts plant in Tohoku in the north and a transmission and wheel plant in Hokkaido. However, we suspect the plants are not going to be significantly damaged. Complete Japan plant shutdowns impact many models, most notably hybrids and Lexus. The Lexus impact is most troubling since these are higher-margin vehicles. All but one Lexus model is made in Japan, the exception being the popular RX crossover made in Canada.

We are not going to reduce our fair value on any Japanese automaker at this time, but one concern we have on profits going forward is the strong yen. Toyota is far more exposed to a strong yen than Honda due to exporting more of its production outside Japan.

As discussed above, Honda is not as exposed to Japanese production shocks and the strong yen relative to Toyota. Honda's most important market is the United States, and in calendar 2010 the company produced 87% of its U.S. auto unit sales in North America, by far the most of the major Asian automakers. Still, the company has its own issues following the quake. The company has four Japanese plants (two auto, one motorcycle and one power product), but that does not include an unspecified number of parts plants.

Even though its sales and profits may be negatively impacted in the near term,  Nissan (NSANY) has the potential to quickly recover from the impacts of the local devastation from the natural disasters currently affecting all of Japan. Historically, one-third (approximately 1.0 to 1.3 million units) of Nissan's production has come from Japan. However, the company usually sells about one-quarter (roughly 500,000 to 750,000) of its units domestically. While the company may not be able to completely recoup lost Japanese volume in other regions of the world, it should be able to produce a substantial portion of its overseas sales requirements at its foreign facilities.

 

As far as other affected names in the industrials space, we believe any postponement of the nuclear renaissance would have a mostly neutral effect on the power generation manufacturers  Alstom ,  General Electric (GE), and  Siemens (SI). Each of these companies is diversified across fuel sources, meaning a shift in demand will have a less material impact on the companies as a whole. If anything, operating margins may improve with less nuclear installations since nuclear plants tend to be lower-margin businesses. In the near term, manufacturers of smaller scale petrol-based generators--like  Cummins (CMI), Caterpillar, and General Electric--should benefit from quick-fix solutions. Down the road, we expect traditional power generation manufacturers Siemens, General Electric, and Alstom will compete to fill the capacity void left by discarded nuclear power.

Lastly, the rebuilding of affected parts of Japan will be a modest positive for Caterpillar. Japan is home to a robust construction equipment industry, led by domestic players Komatsu and  Hitachi (HIT), who together generate revenue upwards of $7 billion annually in the country. However, U.S.-based Caterpillar has made in-roads over the past several years, and garners about $1.2 billion in revenue in Japan. In the wake of the recent tragedy, we think Cat could see some opportunity at the expense of its Japanese peers. Komatsu is Caterpillar's principal global competitor, and currently leads the growing Chinese construction equipment market with midteens market share. If Komatsu finds itself with tight capacity due to domestic rebuilding, U.S. firms such as Cat,  CNH Global  and  Deere (DE) could see a chance to increase their share of the emerging market. We see this possibility as a shorter-term issue, however, as Komatsu holds a sizable manufacturing base in China.

We're Seeing Only Select Pockets of Attractive Valuations
Given the aforementioned near-term headwinds for the automotive industry, it should come as no surprise that we think auto OEMs are among our cheapest names (with a price/fair value estimate ratio of 0.71). We also continue to see some value in residential construction (price/fair value estimate of 0.80) and building materials (0.77), due to our expected medium-term upturn in housing.

Conversely, we think truck manufacturers are overvalued with a price/fair value estimate of 1.14, especially since we expect  Navistar  to lose share as a result of a shift in engine technology within the industry.

Top Industrials Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Price/FVE
Ford		$24.00	None	High	0.60
General Electric		$25.00	Wide	Medium	0.78
LKQ Corporation		$33.00	Narrow	Medium	0.70
Masco		$25.00	None	High	0.57
Data as of 3-21-11.

 Ford (F)
U.S. automotive demand has picked up recently, and Ford enjoys the goodwill of not having taken U.S. government money during the recent recession. Not wanting to squander this position, the company continues to roll out high-quality new models that compete strongly with both imports and American manufacturers. Although the firm's balance sheet is not as solid as rival  General Motors (GM) after its emergence from bankruptcy, we think Ford's financial position is nonetheless the strongest it has been in years. We expect the company to continue to reduce debt through free cash flow, and we've assigned an investment-grade credit rating to the firm as a result.

 General Electric  (GE)
GE's mostly late-cycle portfolio is ready to resume growth. Fourth-quarter orders increased 12%, led by nearly 14% growth in equipment orders. In addition, GE Capital is once again producing earnings, the company's balance sheet is improving, and backlog remains strong. With a much-improved balance sheet after the sale of NBC Universal, GE is also likely to embark upon a major share repurchase.

 LKQ Corporation (LKQX)
LKQ is the only recycled, refurbished, and aftermarket replacement parts distributor with a national network and presence. Primarily serving collision repair shops, the company is well positioned to capitalize on the insurance industry's demand for low-cost, collision-repair products. A strong balance sheet and solid cash flow generation enable acquisitive LKQ to continue to penetrate the alternative replacement parts market. After acquiring its largest rivals in 2007 and 2009, respectively, the company has very limited competition in this highly fragmented market.

 Masco (MAS)
This housing-related manufacturing firm looks to enjoy strong earnings growth prospects over the next few years and is attractively valued, in our opinion. The company has removed $500 million in structural costs and better integrated its disparate legacy acquisitions under operationally focused CEO Timothy Wadhams, who took leadership of the firm in 2007. Now, with housing likely to bottom over the intermediate term, the firm's sales and earnings should rise materially. Though Masco currently sits at roughly breakeven profitability, we estimate the company can generate somewhere around $1.50 to $2.00 per share in normalized earnings per share.

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