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Stock Strategist Industry Reports

Industrials Seeking to Energize Margin Growth

Several companies in the sector, with their constant portfolio pruning and operations improvements, are apt to withstand oncoming headwinds.

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We have reached a point in the economic cycle where top-line growth for industrial companies will be harder to come by, forcing firms to tighten operations and rely heavily on their core competencies. We think  Emerson Electric (EMR) and  Honeywell (HON) have solid opportunities to increase earnings as well as returns on invested capital. Both firms benefit from a growing focus on energy efficiency as well as management teams aiming to drive margin expansion beyond prior midcycle levels. While current margins are near all-time highs, we see room for further growth. Emerson and Honeywell have managed to alter their respective margin profiles by selling underperforming noncore businesses, improving the cost structure of international operations, and shifting away from pure component sales and moving toward designing systems.

Our long-term thesis around economic moats for diversified industrial firms depends on a company driving internal synergies that allow it to deliver products at a lower cost than competitors and differentiated technologies that otherwise would be uneconomical for a stand-alone firm to produce on its own. Over the past decade, one of the emerging trends among manufacturers has been to shift away from traditional component sales to actually designing and engineering complete systems and selling those direct to customers. Instead of having a few parts being included on the bill of materials, the manufacturer actually builds the kit itself, allowing it to put its own content into the final product and source other items. Ideally, the manufacturer can add more technology and value to the customers while also capturing a larger piece of the profit share. Side benefits for the customer include tighter inventory management and more timely resolution to engineering issues.

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

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