Early Stages of Slowdown for Industrials
How long is the current worldwide lull likely to persist?
Quarter-End Insights
- The world is in the early stages of an industrial slowdown, the effects of which the market has been discounting for several weeks.
- Japan supply-chain problems, which have been highly detrimental to production at Toyota and Honda and have caused intermittent interruptions for other automakers--may abate sooner than expected, which is good news for manufacturing.
- Construction and agriculture equipment makers are likely to see somewhat slower growth.
- Valuations that were stretched last quarter are now less so but not yet overly compelling.
The last several weeks have been tough ones for industrial companies, as Mr. Market has been dutifully discounting the worldwide manufacturing slowdown signaled by virtually every indicator of late. Indeed, the Industrial Select Sector SPDR (XLI) is now about 8% below its April high, compared with a roughly 6.5% decline in the broader market over the same period.
Make no mistake, the slowdown that's been so well advertised is real. Many of the indicators we look at have turned decidedly negative at surprisingly rapid rates. And it's not just one or two of the indicators, but the breadth and synchronized manner of the decline since March that is disconcerting. For instance, in the U.S. many of the regional purchasing manager's surveys that showed warning signs in April have accelerated their declines recently. Both the Empire State Manufacturing Index and the Philly Fed survey have fallen into negative territory as of June from highly positive readings just three months ago. Both these indexes tend to show changes in trend prior to that of the more broadly defined U.S. industrial production index.
In addition, almost all of the worldwide PMI indexes are acting poorly. The widely followed U.S. national ISM report on manufacturing that stood at a strong 61.2 (anything above 50 signifies growth) in March has fallen to 53.5 for May. The 6.9-point drop from April to May was the largest the series has suffered since 1984, indicating the current decline is likely more than just a hiccup. That said, there may be a case for a rebound a few months hence, the reasons for which are outlined later.
The industrial slowdown is evident as well throughout much of the rest of the world, as several of the international PMIs have turned down in unison. Markit's JP Morgan Global Manufacturing Survey dropped to 52.9 in May from 55 in April. Output, new order, new export order, and employment growth throttled back throughout the world. The authors also indicated that production increased at its slowest pace in almost two years, while new orders were the weakest so far in the current 23-month upturn. Most prominent, of course, was the slowing in the U.S., but other large economies have shown weakness as well. For instance, the Markit eurozone manufacturing PMI fell to a seven-month low. At 54.6, the survey was down from April's 58, the largest decline since November 2008, according to the authors. All eurozone countries covered by the survey reported declines in growth rates in May. The rate of decline accelerated in Greece, Spain fell back into contraction, and Italy and Ireland both reported steep slowdowns, according to the authors.
On the brighter side, the HSBC China PMI dropped only modestly and remains just above the growth threshold, as it appears China may be sustaining its recent success in cooling its economic growth and the resulting nettlesome commodity inflation trends. In addition, Japan just enjoyed an increasing PMI for the first time in three months. May's result was the largest sequential increase since the series began in 2001. Production increased substantially in May, according to the authors, reflecting the resumption of factory activity after the March disaster.
So, in sum we know a global industrial slowdown is at hand, virtually throughout the world. The U.S. and the eurozone appear to be fading the most, with China and Japan showing some recent resilience as the latter recovers from what may be the largest disruption in several decades. The question is how long is the current worldwide lull likely to persist?
Auto Production Is Key
Our top economist Bob Johnson has recently surmised that the supply-chain disruptions emanating from Japan in the automotive space may well have had an outsized effect, both on the recent slowdown and the likely ensuing recovery. The reason? Between 40% and 50% of U.S. auto production is from the U.S. factories of Japanese companies, and production from these Japanese plants has been off more than 50% at various points since the crisis began in March. Although the Detroit Three and the non-Japanese transplants have stepped up their game, these plants certainly haven't made up for issues in Japan (they, too, receive some parts from the affected regions of Japan). In fact, car and light truck production in the U.S. tumbled 13% between March and April, a number that likely could have been worse had the damage between the three major Japan producers not been more spread over several months.
Given that automakers buy parts and materials from varying types of vendors (steel, cloth, and plastics to name a few), a slowdown in auto sales has a disproportionate effect on various manufacturing indexes. This is especially true with the PMI indexes that measure the number of firms reporting better or worse results without regard to the magnitude. Auto problems tend to have a minor effect on many firms, and therefore may just have had an outsized effect on many of the PMI results mentioned above, especially those in the U.S.
There's now valid reason for optimism in the automotive space, as it appears that the industry is going to get back on its feet sooner than expected. Toyota (TM) recently stated June North American production will be at about 70% of normal levels, up from 30% in May, while The Wall Street Journal recently reported that Honda (HMC) will be at full production in North America by August for all models except the new Civic. Since auto production is expected to improve in the second half of the year versus the first half, there's a chance that some industrial leading indicators will turn up, improving investor sentiment toward the group and the market overall.
Heavy Construction and Agricultural Equipment to Show Solid but Slower Growth
After strong first-quarter results, construction and agricultural equipment manufacturers are beginning to see signs of weakening through the first two months of the second quarter. In farm equipment, North American tractor sales over 40 hp have fallen 4% year-over-year in April and May, after climbing 5% in the first quarter. The mix shift within this decline is likely positive, as sales of higher-horsepower tractors climbed while lower-powered machines saw some weakness, but slowing combine harvester sales (up 3% over the past two months, versus 37% in the first quarter) may offset this factor.
In addition, Brazilian tractor sales fell 9% in the first quarter, and have continued to slide through May. Here, Deere (DE) may continue to outperform the market due to new product launches and resulting share gains versus rivals AGCO (AGCO) and CNH Global , but the aforementioned North American weakness will most harm the former company. Rebounding European markets, which have enjoyed double-digit growth rates in recent months, could lead to decent results for these manufacturers in the second quarter, but we continue to believe that headwinds in North and South America will likely lead to more-difficult operating environments.
Construction equipment manufacturers will likely also enjoy solid second-quarter results, although we're seeing some slowing metrics here as well. For instance, sales of hydraulic excavators in China fell year-over-year in May for the first time in two years, potentially indicating a slowing of the geography's robust recent growth. Because this product category is dominated by foreign manufacturers such as Caterpillar (CAT), Komatsu, and Volvo, continued declines could drive poor results for these firms. Moreover, Caterpillar's dealers recently reported slowing year-over-year sales of machinery to customers; although these deliveries are facing more-difficult year-over-year comparisons than recent months and are still at a high level, we caution that Cat will likely see further slowing organic revenue growth in coming quarters.
Company-Level Outlooks Haven't Appreciably Changed
At the company level, our modeling hasn't changed much as a result of this latest batch of worse-than-expected economic news. A significant portion of our industrial coverage was modestly overvalued going into the slowdown, so the decline in equity prices across the space has, for the time being, confirmed our prior valuation work.
Across the space, we're modeling for slowing year-over-year growth in most names, due as much to strong comparisons as anything else. We continue to believe our highest-quality names like 3M (MMM) will enjoy organic growth in the mid- to high-single digits over the coming quarters, with margins that remain at least at current levels as volume leverage mostly offsets raw material cost increases.
Other diversified industrials should enjoy slightly slower but still positive organic growth over the coming quarters, with modest acquisition activity enhancing top lines. Valuations in the acquisition arena have been rich of late, so we're taking a cautions approach in our evaluations of any announced deals these days.
Companies heavily exposed to the capital spending cycle likely have several more quarters of growth ahead of them, though we're not anticipating a smooth uptrend. In particular Rockwell (ROK), though not cheap, should have more runway as firms continue to upgrade factory gear throughout the world and the company takes share from competitors.
In some of the service-based industrial sectors like shipping, many of the higher-quality businesses like rails and the large shippers such as UPS (UPS) and FedEx (FDX) will continue to increase prices at a steady clip on top of GDP-plus volume increases. Bottom lines will continue to benefit from improving operating ratios in the case of the rails and an improving business mix at FedEx. Truckers have been enjoying some pricing power for a few quarters now as improving volumes have sopped up much of the excess capacity. We expect modest increases in pricing over the coming quarters.
Finally, we expect those names that derive most of their revenues from the defense department to continue to suffer both top-line and margin pressure as the Pentagon succumbs to a tightening defense budget. That said, we expect some of the large suppliers such as Lockheed (LMT) and General Dynamics (GD) to suffer comparatively less than those suppliers not on one of a few major programs, like the former, or that don't enjoy ancillary revenues streams, like the latter. In addition, a continually constricting defense budget is more than priced into these two names, with each trading well below historical P/E ratios.
Industrials Valuations Getting a Bit More Interesting, but Still Not Highly Attractive
Valuations across the industrials space improved somewhat over the past three months, as the aggregate price/fair value ratio across our industrials coverage universe improved from 0.94 in March to 0.87 today. Bargains, however, remain elusive, so investors need to be picky. Like in recent past outlooks, we still believe auto manufacturers are attractive, at an aggregate P/FV of 0.69 (down from 0.71 in March), as is the building materials group at a 0.72 P/FV (down from 0.77 in March) and residential construction at 0.72 (down from 0.80 in March). The vast majority of our industrial subsectors remain pretty fairly valued, but some mildly attractive opportunities are at hand.
| Top Industrials Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | P/S | |
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| Volkswagen |  | 160 EUR | None | High | 0.3 |
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| Arkansas Best Corporation | | $30.00 | None | High | 0.3 |
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| Textron Inc. | | $34.00 | Narrow | Very High | 0.7 |
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| WMS Industries Inc. |  | $44.00 | Narrow | Medium | 2.3 |
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| FedEx Corporation | | $112.00 | Narrow | Medium | 0.8 |
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| Data as of 06-28-11. |
Volkswagen (VOW)
Volkswagen continues to impress. Our fair value estimate is EUR 160 per share, representing potential upside appreciation of 33%. Global sales year-to-date through May have set a new record for the company, topping 3 million vehicle deliveries, which represents an increase of 14.6% over year-ago results. Volkswagen's sales handily outperformed the world market, which was up by 6.8% over the same time period. Sales increases were across the board for all brands, but most notably, commercial vehicle sales increased by a whooping 31.4% year-to-date. Sales of Skoda vehicles, Volkswagen's low-price, high-volume brand from the Czech Republic, jumped 21.5%. In addition, sales of luxury-brand Audi vehicles increased 17.5% through May, solidly ahead of the global market. Although the company has a stated objective to be the world's largest automotive company, we have doubts that Volkswagen can achieve its sales objectives in the highly competitive U.S. market. However, in our opinion, the company is on a firm trajectory to achieve its objectives in the rest of the markets it serves.
Arkansas Best (ABFS)
We think Arkansas Best enjoys solid upside potential to yields as improvement has lagged that of its peers, due in part to substandard fuel surcharge agreements conceded during the downturn and disproportionate growth among less-profitable accounts. Since pricing execution has become vital to the company's return to consistent profitability, we expect management to be quite aggressive in addressing poorly priced freight and inadequate fuel surcharges over the next year. Low hanging fruit and improved pricing power should support its efforts. That said, Arkansas Best faces persistent wage and benefit inflation as mandated by union contracts. As a result, it needs base rates to rise roughly 10% on a large portion of its business in order to approach normalized profitability levels, and this magnitude of price improvement will take time. A pullback in U.S. economic growth would serve to lengthen the firm's recovery period.
Textron (TXT)
After putting its credit demons to rest, Textron will now look to its aerospace, defense, and industrial products to drive earnings growth. Though Cessna continues to struggle in the midst of poor business jet demand, higher profits in the company's other units will help Textron turn the corner over the next two to three years. Even as defense budgets continue to stay under pressure, the firm's V-22 Osprey and unmanned aerial systems continue to enjoy demand. The firm's industrial systems unit is also moving along nicely, at near record operating margins. While Textron continues to liquidate its noncore financial assets, a marked improvement in the losses at TFC combined with growth in other businesses will push the stock closer to our $34 fair value estimate
WMS Industries
We continue to believe WMS' product portfolio is several years ahead of the competition and management's focus on innovation and value creation from research and development should pay off in the long run. Compared with its competitors, WMS' ability to grow both revenue and earnings in the face of the industry's weakest replacement cycle is impressive. When the replacement cycle picks up, we believe WMS will benefit disproportionally as its recent ship share gains, leading intellectual property, new xD cabinet design, and NXT-CPU3 platform should help the company take an increased share of both consumers' and casino operators' wallets. We believe WMS' valuation looks compelling given its long-term growth potential.
FedEx (FDX)
FedEx is poised to improve margins both by enriching its business mix and via operating leverage. Although domestic Express volume is not likely to increase much over the long run, we believe international markets will propel the Express segment to greater volume and enhanced segment margins through improved parcel density. Perhaps most importantly, though, FedEx's high-margin, flexible-cost model Ground segment continues to expand, spurred on in part by the small but growing Smart Post segment (which uses the USPS for low-cost final mile delivery). Ground contributed more than $1 billion of operating income in fiscal 2010, on $7.4 billion in sales, compared to Express' $1.1 billion EBIT on $21.6 billion of revenue, so Ground has a significant influence on the consolidated bottom line.
We also see Freight making a material income contribution after making losses during eight recent quarters, as FedEx levers the recent integration of two formerly separate less-than-truckload operations into one, and as the LTL market resumes healthier pricing. We base our DCF-derived $112 per share fair value estimate (about 25% greater than the market price at publication) on conservative midcycle margin estimates for Express, somewhat improved Ground margins, and Freight profitability higher than recent performance, but well below margins earned in 2002-07.
We believe our perspective differs from the market's principally in time horizon. While we will not be surprised to see some rapid share price gains when the economy delivers greater volumes, the timing lag in implementing fuel surcharges is likely to constrain earnings during periods in which fuel prices increase. From our perspective, such dips do not disrupt our long-term thesis on this moaty firm, but rather provide buying opportunities for investors looking for value.
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