Our Outlook for Industrials Stocks
Cautious optimism continues to pervade the industrials universe.
Quarter-End Insights
- The worldwide industrial sector's slowdown continued in the fourth quarter, with challenging conditions in key geographies such as Europe and Asia mitigating surprising strength in the United States.
- With the benefit of hindsight, the third quarter's summer swoon seems to have presented wonderful buying opportunities for high-quality industrial companies. After a sharp rebound, many valuations now look full, in our opinion.
- Even with a more fairly valued sector, we still believe some industries within the sector offer pockets of opportunity, including automotive, transportation, and truck manufacturing.
Cautious optimism continues to pervade the industrial universe. Although it's hard to ignore the weakening manufacturing signs stemming from key geographies such as Europe and China (both of which have seen their Purchasing Managers' Indexes fall below 50), most management teams that we follow do not expect the world to tumble into a renewed recession in 2012. In fact, the U.S. has proved surprisingly resilient, with the ISM U.S manufacturing PMI climbing to 52.7 in November from a low of 50.6 in the third quarter, indicating low-single-digit top-line industrial growth in 2012.
Still, we think some worrying signs lie on the horizon. For instance, several other leading indicators, such as 3M's (MMM) consumer-electronics business lines (easily one of the earliest-cycle businesses in the industrial space) and semiconductor order rates, have weakened materially in recent months, perhaps signaling lower end-market demand to come for the rest of the industrials market. Semiconductors often are good indicators because of their relatively early position in the value chain. Moreover, we need to be cognizant of the fact that some of the positive order rates we've seen from companies tied to the capital spending cycle, such as Rockwell Automation (ROK), might be currently aided by a prebuy effect ahead of changing depreciation rules. Next year, customers can depreciate just 50% of an asset's purchase rather than the current 100% rate currently allowed by The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.
The Industrial Select Sector SPDR (XLI) exchange-traded fund has climbed about 37% from the end of the third quarter, and even though still about 11% off its highs for the year, the index now sits at levels nearly double its 2009 lows. Although we think there are pockets of opportunities for investors, the aforementioned weakening in some of the leading indicators and runup in the shares generally temper our enthusiasm. Our overall sector price/fair value ratio rose to 0.85 in the quarter from 0.78 at the end of the third quarter, suggesting a much slimmer margin of safety among our coverage space today.
Strength Still Evident in Automotive
Some areas of the industrial economy are enjoying healthy rebounds that we think could continue for some time. For example, automakers reported that November's new U.S. light-vehicle sales had the best seasonally adjusted annualized selling rate, or SAAR, this year, the best SAAR since the Cash for Clunkers program's 13.69 million in August 2009, and the biggest year-over-year volume increase since April. It was also the best November since 2007 and the third consecutive month of an SAAR of more than 13 million units, which suggests to us that consumers are finally starting to release pent-up demand.
We have long argued the several years of sales at or below replacement levels was not sustainable, and we think that, barring another major supply shock, we will see our thesis continue to play out next year. Importantly, we expect higher incentive activity in December relative to November, but we also expect solid average selling prices as there is no need for any automaker to drastically overproduce anymore. In short, 14 million units sold in the U.S. isn't out of the question for 2012.
Defense Stocks Still Facing Stiff Headwinds, and Supercommittee's Failure Doesn't Help
The lack of proposed legislation from the U.S. Congressional Joint Select Committee on Deficit Reduction (also known as the supercommittee) for at least another $1.5 trillion in deficit cuts sets the stage for mandatory cuts through a process known as sequestration. The lack of action, and the assumption of no enacted legislation by Jan. 15, 2012, results in automatic cuts totaling $1.2 trillion over 10 years starting in 2013, half of which are expected to be borne by the Department of Defense.
Rumors are already circulating on how to protect the DoD from these Draconian measures. We expect this to be a constant theme next year, but we anticipate little action before the conclusion of the 2012 presidential and congressional elections. Still, Congress could mask the savings by shifting spending from the base budget into Overseas Contingency Operations to soften the blow. In all, we believe low or no growth in the defense sector limits valuation multiples the market is willing to pay, and this is likely to last through 2012. Therefore, we would selectively wait for individual names to discount the worst-case scenario before purchasing shares.
Housing Still in the Doldrums, but for How Much Longer?
Housing remains problematic, with new-home production stuck at or near generational lows and prices of existing structures still declining in the low- to mid-single-digit range annually thus far in 2011. Builders have largely done their part during the past several years by curtailing building such that the current rate of housing completions is now well below any semblance of normal demand. In addition, listed inventories continue to decline, and owning is now cheaper than renting in many regions.
Yet the unprecedented economic stress felt throughout the country has compressed household-formation rates to about half the normal average, and as a result, the glut of homes formed in the bubble years isn't being worked off at anything near a satisfactory rate. After an unprecedented three straight years of new-home sales at well less than half the long-term average, one would think that the market is due for a turnaround. Indeed, we think that some point in the not-so-distant future, investors can count on a sustained increase in housing production and steady prices. Will the inflection point arrive in 2012? At this point, it's still too tough to tell, but we'll get an early hint with the arrival of the spring selling season in the first part of February.
Transportation Still Strong at Home, but Not as Much in the International Routes
Demand for freight shipping remains mixed, with domestic U.S. volume comparisons stronger than international. Truck tonnage seems brightest; with its 5.7% year-over-year improvement in October, the American Trucking Association Truck Tonnage Index was just 4.4% below its all-time high. Also, while comparisons are not as strong as earlier in 2011, railcar volume is still soundly positive year to date. Thus far into 2011, North American intermodal demand is up 4.9% compared with the first 48 weeks of 2010, and cars excluding coal are up 3.4%, despite flat coal car originations and 3.5% fewer grain cars hauled year to date.
We still see weakness in international freight given container import volume comparisons with 2010 at the Los Angeles/Long Beach, Calif., ports have been negative since June, and air-freight tonnage comparisons at both the widely watched Hong Kong Air Cargo Terminal and International Air Transport Association have been weak since the April-May time frame. Although weak demand might seem negative as an economic indicator, the upside for investors with a two- to three-year time horizon is a window in which to buy undervalued shares in some high-quality names (we like Expeditors International of Washington (EXPD), FedEx (FDX), and Union Pacific (UNP)).
Our Top Industrials Picks
Given the large runup in industrials stock prices since their summer slide, it shouldn't be a surprise that nearly every subindustry within the sector has seen its price/fair value ratio climb from the third quarter. In fact, many areas that we thought were somewhat cheap just a few months ago (such as heavy equipment, trucking, and railroads) are now trading at only around 10% discounts to their average fair values. That said, the previously discussed automotive market offers some value, in our opinion, with original-equipment manufacturers trading at a price/fair value ratio of 0.67 (up from 0.57 in the third quarter), and auto-parts manufacturers at 0.76 (up from 0.73). Other notable areas of attractive valuations include diversified industrials (0.81), truck manufacturing (0.70), and shipping and logistics (0.85). Below, we highlight some of our favorite companies from each of these areas.
| Top Industrials Sector Picks | |||||
 | | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Foward P/E(Market Price / 2012E EPS) | |
 | |||||
| Fiat |  | EUR 14.00 | None | High | 10.1 |
| |||||
| General Electric |  | $25.00 | Wide | Medium | 10.2 |
| |||||
| FedEx | | $112.00 | Narrow | High | 12.8 |
| |||||
| PACCAR | | $48.00 | Narrow | Medium | 11.1 |
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| Data as of 12-12-2011. |
Fiat (F) (ITA)
No-moat-rated Fiat stock is not for the faint of heart. Given our expectations for weaker new-vehicle demand in Italy and the rest of Europe, growing contention between management and the Federation of Metallurgical Employees Workers, and hefty financial leverage, we think volatility in the share price will remain high into the first half 2012. Having said this, a year from now, Fiat should begin demonstrating improved financial performance. We maintain that Fiat's integration with Chrysler is in the early stages and that savings from shared vehicle architectures, shared engineering, greater parts commonality, more efficient supply chain management, and supply logistics should materially occur during 2013. However, low-hanging integration fruit should begin to appear by the end of 2012. We believe the total amount of the cost savings from integration with Chrysler could reach well into the billions of euros, and we see significant value in the combined entity's underlying assets, such as Ferrari, Jeep, Mazerati, and Alfa Romeo.
General Electric (GE)
GE remains one of our best ideas in the diversified industrials space, as we think its collection of late-cycle businesses is primed for earnings growth. Although GE Capital has been the primary target for investor pessimism, the business has performed well above expectations. The company has telegraphed its intentions to reinstate the GE Capital dividend to the parent company in 2012, a goal that we think is attainable. But for the uncertainty in Europe, we think that could have taken place in 2011. We also see capacity for a one-time dividend from GE Capital to the parent, as the business recalibrates to keep GE Capital earnings a smaller piece of GE's total earnings mix.
FedEx (FDX)
We consider FedEx to have a narrow economic moat because of its steep barriers to entry, which enable rational duopoly pricing power in its domestic express and ground operations. As the firm's stock is trading at around $81 per share, the market offers a significant discount to our fair value estimate. We believe we're looking out a bit further than the market's focus on current soft express parcel demand to see mix-driven earnings expansion in the midterm, primarily from growth of the high-margin ground segment. Ground contributed $1 billion of FedEx's total $2 billion of earnings before interest and taxes in fiscal 2010, and $1.3 billion of the consolidated $2.4 billion EBIT in fiscal 2011 (surpassing the $1.2 billion of EBIT contributed by express). Last year, ground produced more than triple express's operating margin, and we expect the freight segment performance to continue to improve from the recent past, as well. Freight constitutes 12% of total sales--a material part of the franchise. FedEx is now the largest less-than-truckload player in this recovered segment, and though we consider trucking a no-moat endeavor, FedEx brings bundling of shipping services and its sorting/tracking IT expertise. In addition to market demand and yield improvements, the firm has integrated historically separate national and regional divisions during the past fiscal year and resumed profitable operations during the most recent quarters after making losses for most of the past three years. We believe freight will join ground in making a sound earnings contribution in years to come.
Paccar (PCAR)
Although Paccar's shares are not quite as cheap as we'd like, we recommend investors keep this company on their watchlists. European truck production will likely slow in the coming quarters, but strong North American volumes, market share gains among fleet owners, and continued 25%-30% penetration of its internally manufactured engines bode well for this narrow-moat firm. Moreover, the company has seen recent profitability improvement, stemming from better plant utilization and fewer sales discounts, and we continue to expect midcycle operating margins north of Paccar's historical average.
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