Our Outlook for Industrial Stocks
The U.S. is still a solid growth market for industrial companies.
Quarter-End Insights
- The U.S. manufacturing picture remains relatively positive, with industrial production continuing to increase at a mid-single-digit clip and leading indicators still positive.
- Conversely, European purchasing managers' indexes have turned down sharply. We don't expect most industrial companies to see positive near-term growth in the region. Similarly, China continues to present a critical risk for many manufacturers, although auto sales have rebounded nicely.
- Despite the slowing growth environment, we believe recent stock-price declines have led to sizable margins of safety for long-term investment in high-quality companies.
The U.S. industrial environment is still one of the healthiest growth regions for many manufacturers; industrial production continued to climb at a mid-single-digit clip versus 2011 through the first two months of the second quarter, the U.S. purchasing manager's index, or PMI, remained above the key growth demarcation of 50, and durable goods orders increased at a steady rate in April (the most-recent reading). That said, because the industrial production index is measured as a percentage of 2007's average rate, May's 97.3 reading indicates that we still haven't yet returned to pre-recession levels. We believe industrial companies will enjoy solid growth in U.S. operations over the second quarter, and will likely continue to invest in the region given these growth prospects and improving factory utilization.
On the other hand, the shaky European situation worsened throughout the last several months. The region's PMI fell to 45.1 in May from an average of 48.5 in the first quarter, its lowest reading since mid-2009, as stalwarts such as Germany and France saw readings well below 50. Many industrial company management teams have already planned for this weak situation, and we're encouraged that PMIs haven't yet reached the mid-30s, as they did in late 2008, but we nonetheless expect difficult second-quarter results for firms heavily levered to the area.
China also saw weaker results over the past few months, with the HSBC manufacturing PMI down to 48.4 in May from a 50.6 average in the first quarter and with former growth areas--such as construction equipment--now seeing negative year-over-year growth rates. Still, auto sales have provided one bright spot in April and May, as passenger vehicles climbed 12.5% and 22.6% in the months, respectively, from 2011 figures. These rates reflect a rebound from the 1.3% decline in the first quarter, and year-to-date sales are now up 1.7% from a year ago. Foreign manufacturers have strongly benefited from this turnaround, especially in the luxury segment, and we note that government policies to spur purchases of smaller vehicles in rural areas may further benefit manufacturers going forward.
With concerns abounding for the global economy, we're not surprised that the Industrial Select Sector SPDR (XLI) exchange-traded fund has fallen 6.4% since the end of the first quarter. That said, we believe companies with a higher amount of U.S. exposure--in particular, transports, automotive firms, and farm equipment manufacturers--could offer long-term investors above-average returns once the dust has settled.
U.S. Auto Sales Still Look Too Low
We continue to believe there's significant growth ahead in U.S. light-vehicle sales. With tremendous pent-up demand, improving inventory, and terrific new product coming (such as the 2013 Ford Fusion and Toyota's (TM) release of 19 new or refreshed models this year), we see far more reasons to be optimistic than pessimistic about auto sales.
The data also support this claim. The U.S. light vehicle SAAR, or seasonally adjusted annualized selling rate, was about 13.6 million in November and December, then jumped considerably in January to 14.2 million. February's 15.1 million was the best SAAR of any month since February 2008. Although the SAAR has come down to 13.75 million as of May, the reading is still 17.5% higher than a year ago. We continue to project a full-year SAAR in the low- to mid-14 million range, which would represent a high-single-digit or low-double-digit percentage climb from 2011.
We're particularly encouraged that GM (GM) had its best May in four years, climbing 11% from May 2011, and that Ford (F) saw volume increase nearly 13% year-over-year in the month. We think both companies have competitive product in all segments and now operate in a demand-pull model instead of the production-push model that characterized the pre-crisis Detroit Three. Both automakers also have good balance sheets and break-even points dramatically lower than before the crisis, and we think the market is not giving either company enough credit.
We also think automotive parts manufacturers will enjoy improving sales alongside vehicle OEMs. For example, Gentex's (GNTX) debt-free, cash-rich balance sheet is another way to invest in autos without the legacy concerns of General Motors and Ford. We think this narrow moat, mid-cap, auto-dimming mirror firm is another route to invest in the top-down auto recovery without worrying about pensions, unions, and large temporary government owners.
Railroads Are Executing Well, but Still Realizing Low Steam Coal Demand
Volume is mixed among railroad commodities. North American railroads continue to benefit from improving intermodal container demand, with mid-June year-to-date volume up 4% from the prior-year period, but other goods are not so favorable. Indeed, grain carloads declined nearly 10%, coal slid 10%, and total carloads are off 2% compared with cumulative volume at this point in 2011. However, year-to-date automobile and petroleum-related carloads are up year over year by a steep 17% and 30%, respectively. In fact, excluding coal, carloads are up 3% in North America.
Even after we project sharp declines in coal volume this year and continuing into the future, we think shares of several railroads look undervalued at this time. In particular, eastern railroads CSX (CSX) and Norfolk Southern (NSC) look hardest hit, as they are highly exposed to troubled Central Appalachian coal. High coal stockpile levels remaining after the mild winter and, more importantly, extremely low natural gas prices have cut demand for Central Appalachian coal. We model 20%-25% declines in 2012 coal volume at the eastern rails, then continue to drop volume 5% per annum during the next five years of our discrete projection period, based on our assumption of continued favorable natural gas prices. We project more modest declines at Union Pacific (UNP), as this western rail hauls principally cheaper Powder River Basin coal.
As railroads demonstrated by yielding strong (even record) margins during plummeting demand in the recent recession, though, this old industry can remove capacity nearly in real time. Many coal cars belong not to the railroads, but to their customers, the utilities, constraining the extent of rail assets exposed to the full brunt of declining demand. Also, coal trains typically comprise only coal cars (a "unit train"), not a mix of other types of goods that might still need to move regardless of coal demand, so rails can reduce train starts and adjust crewing via attrition and furloughs if needed, then redeploy or store locomotives to match demand. No doubt coal demand is weak--we're modeling weakness ourselves--but we believe continuing single-digit percentage price expansion plus growing volume in intermodal, auto, sand, and other gas- and oil-related shipments can help shelter rails' top lines from the full brunt of crashing coal demand. We think the coal-related pessimism may be overdone, punishing (especially the eastern) rails excessively for weak demand in one admittedly large and profitable sector.
We believe all Class I rails will continue to improve operating ratios during 2012 and beyond. Through rate increases and operating improvement (chiefly more effective use of manpower), we expect new margin records at all but longtime leader Canadian National (CNI). Not only do we expect CSX, Norfolk Southern, and Union Pacific to reach for 65%-67% operating ratios within the next five years, we also believe Canadian Pacific (CP) will also shore up its margins during this period. Both CP's chairman and CEO resigned the morning of the recent annual meeting, and the director slate nominated by activist investor Bill Ackman of Pershing Square Capital was elected. We consider this a referendum on poor relative performance compared with the other Class I railroads; we expect Ackman's preferred CEO candidate (former CN CEO Hunter Harrison) will take the CP helm for a few years. In fact, we think shares of CP benefit from a Hunter Harrison halo at present, even in advance of operational turnaround and even in advance of Harrison's installation as leader of CP.
Falling Crop Prices Yield Attractive Margins of Safety for Farm Equipment Manufacturers
We've seen early planting of corn and soybeans along with healthy wheat crops, which could substantially improve yields versus the difficult situation seen in 2011. In fact, the USDA expects a massive increase in corn plantings and a return to better yields after last year's difficult season. Barring renewed adverse weather conditions, the agency forecasts ending U.S. stocks to double in 2012-13 for this commodity. Although the resulting stocks/use ratio of 13.7% is still historically low, it is far healthier than the 6.7% seen in the 2010-11 planting season. While some of this increased planting will likely steal some acreage from soybeans, leading to lower ending stocks this year and next, we expect overall supply growth to outpace demand increases over the long run in our base-case scenario, likely pushing down crop prices and subsequent cash receipts for farmers.
While this base case would present challenges for equipment manufacturers such as Deere (DE) to grow their unit sales, we acknowledge that several scenarios exist in the short and medium term that could have incremental effects on our valuations, particularly regarding potential weather patterns that could help or hurt crop yields. Even after examining several alternative scenarios, however, we think Deere could most strongly benefit compared with its peers because of its solid North American presence and an increasing share in international markets. Moreover, our discounted cash-flow valuation suggests that the recent weakness seen in the company's share price currently offers a decent margin of safety in this narrow-moat firm.
Our Top Industrials Picks
After the market's recent sell-off, we think many industrial sectors offer much better margins of safety than just a few months ago. The aforementioned automakers and parts manufacturers continue to be two of our favorite areas, with a price/fair value ratio of 0.63 (compared with 0.72 at the end of the first quarter) for OEMs, and 0.68 (down from 0.86) for auto parts. In addition, we think farm and construction equipment manufacturers (0.78 price/fair value versus 0.92), railroads (0.83 compared with 0.84), and waste management firms (0.92 price/fair value versus 1.08) could offer value for long-term investors. Notably, many of our preferred names in each of these industries derive a substantial portion of their sales from U.S. operations, allowing them to participate in one of the faster-growing regions of the world.
| Top Industrials Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
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| Deere |  | $87.00 | Narrow | Medium | $60.90 |
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| CSX Corp | | $31.00 | Narrow | Medium | $21.70 |
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| Republic Services | | $35.00 | Narrow | Medium | $24.50 |
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| Delphi | | $45.00 | None | High | $27.00 |
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| Data as of 6-19-12. |
Deere (DE)
Deere's core agricultural equipment segment will likely see slowing top-line growth in 2012 due to improved crop yields and difficult year-over-year comparisons, but international share gains, solid cost control, and likely improving U.S. construction markets should mitigate this concern. We also like that the company continued to get mid-single-digit growth from pricing in the most recent quarter, while operating profitability remained robust. In all, we think the recent sell-off in the name has priced the stock much closer to a bear scenario, offering a decent margin of safety to our $87 fair value estimate.
CSX (CSX)
CSX reached record earnings in the first quarter, even as coal demand dropped significantly. CSX's margins had lagged its peers' after the rail renaissance began in 2004, but we believe the firm's surprisingly strong profitability during the recession marked the end of its perceived second-class status. We expect this solid operating performance to continue. Given CSX's coal-rich mix (32% of consolidated 2011 revenue--the highest proportion of any Class I rail), the firm rail will be hard hit by plunging utility coal demand during the next several years. Export coal, autos, and intermodal growth, plus continued margin improvement, should preserve earnings despite deep domestic coal declines. While export coal, automotive, and intermodal traffic will help back-fill lost Central Appalachian steam coal volume, there's no denying the fact that less coal means less income for CSX. Still, we expect the rail to continue to improve (raise) prices and to deliver continued improvement in margin, sticking to the path on which its leadership team set the rail around 2003.
Republic Services (RSG)
Republic Services' operational discipline amid a large acquisition and difficult recession supports our conviction in this narrow-moat company's high quality. As the waste services sector has historically been late-cycle, we expect a stronger U.S. economy should drive low- to mid-single-digit organic top-line growth as trash volumes continue to normalize. In our view, the latest economic downturn delayed RSG from realizing the full benefit of its recent acquisition of Allied Waste, which we expect will lead to future margin expansion as the company enjoys increased operational leverage from an expanded landfill base.
Delphi (DLPH)
Although auto parts supplier Delphi has one of the higher European exposures compared with the other highlighted names this quarter (approximately 45% of revenue), the firm typically gets a modest measure of pricing power from customers in an otherwise brutally competitive market due to consistently developing new technologies. Moreover, owing to volume from new business, growth in global vehicle production, greater average penetration per vehicle, and pricing from innovative technologies, we expect Delphi's margins to be at the upper end of the auto supplier sector. As volumes continue to rebound, we expect to see further operating leverage, the fruit of several years of substantial restructuring. The stock currently trades at a sizable discount to our $45 fair value estimate.
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