Our Outlook for Industrials Stocks
Valuations climbed in the third quarter amid a steady, though still weak, end market backdrop.
Quarter-End Insights
- The U.S. industrial economy muddled along in the third quarter, with weakening industrial production growth and leading indicators. Construction spending remains an area of continued gains, however, and year-to-date U.S. light-vehicle sales are 14.7% higher than in 2011.
- The Chinese construction markets continue to suffer, though stimulus spending could help in the short run for companies like Joy Global and Caterpillar (CAT). Conversely, most industry companies don't expect much positive news from Europe in the near team.
- After a stellar planting season for U.S. farmers, the worst drought in 25 years hit the region. We expect the environment to create some headwinds for farm equipment manufacturers, but the situation doesn't substantially alter our long-run projections for the firms.
The industrial environment remained relatively steady in the third quarter. The U.S. continued to plod along (albeit at slightly weaker levels), Europe remained difficult, and China slowed further, but these themes largely carried over from the prior period. Indeed, the lack of new negatives--combined with additional government action--seemed to spur this sector's market performance, with the Industrial Select Sector SPDR (XLI) climbing 5.4% since the end of June; the exchange-traded fund has now jumped 12.4% year to date, but is still trailing the broader S&P's 18% gain.
But not all is well. U.S. industrial production growth slowed to low single digits in August, while the Institute of Supply Management's Purchasing Managers' Index fell below 50 (a key demarcation that suggests positive growth expectations) for the first time in three years. Moreover, companies such as FedEx (FDX) and Cummins (CMI) have issued cautious outlooks for the remainder of the year. As such, the near term will probably bring some headwinds, but we think some areas of growth remain, particularly in automotive and construction. In the former, we think pent-up demand is substantial, and U.S. auto sales climbed to a seasonally adjusted annual rate of 14.5 million in August, one of the best readings since the cash-for-clunkers government program in mid-2009. The construction industry has also fared well, posting nine months of year-over-year growth in both residential and nonresidential spending, although the Architecture Billings Index again dipped below 50 during the period, which could pressure some of the high-single-digit growth seen recently.
China and the eurozone also continue to face weakness. In China, the HSBC PMI slipped to 47.7 in August, its lowest level since April 2011, with new orders contracting at an increasing pace in recent months. Sales of hydraulic excavators in the region, a key piece of construction equipment, have fallen year over year for 16 straight months, while electricity demand growth has slowed. Many industrial companies exposed to China's fixed-asset investment received some good news recently with the government's plan to pull forward a number of infrastructure projects, but this may prove to be a short-term alleviation of a longer-term problem.
Similarly, the European industrial situation remained mired in poor PMI readings over the past two months, although things didn't become materially worse; the metric posted a 45.1 reading in August compared with a 45.4 average in the second quarter. Certainly, many firms we cover aren't looking to the region for any growth in the immediate future, and several (especially auto manufacturers like General Motors (GM) and Ford Motor (F)) have outlined restructuring actions due to end market headwinds, but we believe third-quarter results will be again hampered by this geography.
In all, we don't see the same margins of safety in most industrial stocks today as we did three months ago, although several firm-specific issues have presented some attractive investment opportunities.
U.S. Auto Sales Rebounding Nicely
The overall North American automotive picture continued to improve throughout the third quarter. The latest reading (August) of a 14.5 million SAAR was the third month of sequential improvement, and only a bit below February's 15.1 million reading. In our opinion, U.S. pent-up demand is substantial and provides an offset to unfavorable economic conditions, buffering the downside to light-vehicle sales, barring an unforeseen exogenous shock to the fragile U.S. economic recovery. We believe this demand stems from increasing average vehicle age (now about 11 years), increasing miles driven, a historically low ratio of new car sales to new drivers' licenses issued, and used-vehicle pricing near historical highs. As such, we see U.S. light-vehicle sales reaching pre-crisis levels (roughly 17 million units annually) sometime in the second half of the decade. While it's difficult to call a turn in the U.S. unemployment rate or the point at which investors will become convinced that a viable solution is in sight for the European debt crisis, one thing is certain: At current levels, many of the automotive manufacturers' stocks are trading at bargain basement prices, in our opinion.
Housing and Commercial Construction Improving
The U.S. housing picture continued to brighten in the third quarter, as the SAAR of new home sales climbed to 372 thousand units in July, up 4% from June and a stellar 25% improvement from a year ago. Similarly, the National Association of Realtors noted that the SAAR of existing home sales jumped 10% versus July 2011, the seventh straight month of year-over-year increases, with the median price of existing homes sold also climbing 9.4% from last year. In both cases, inventory of for-sale homes remained at muted levels; in fact, new homes for sale again set an all-time record low. We continue to believe that the U.S. housing situation should provide a continued boost to the U.S. economy for the foreseeable future.
Similarly, we still think commercial and other nonresidential construction spending has passed its nadir, although we again caution that poor Architecture Billings Index readings seen in recent months could limit upside beyond the next couple of quarters. Nonetheless, construction equipment companies such as Caterpillar, Terex (TEX), and CNH Global have reported solid North American results in their recent earnings reports, with expectations for further increases in rental activity and fleet replacement to support a higher level of spending.
Drought Creating Short-Term Problems
After a solid start to the planting season (driven by exemplary winter weather), most of the crop-growing United States fell into a monumental drought this summer. In what is now the worst Midwest drought since 1988, per-acre yields of corn, wheat, and soybeans have suffered, driving up the crops' prices substantially. The total estimated cash receipts from these crops--typically a good leading indicator of tractor and combine harvester sales--still represent a 12% year-over-year increase, but we believe poor farmer sentiment will probably create near-term sales headwinds for firms such as Deere (DE), AGCO (AGCO), and CNH Global. We caution that circumstances of increased receipts driven by reduced domestic yields have led to lower demand in the past, as the psychological effect on farmers of a "bad" harvest year can cause reluctance to purchase. Most recently, for instance, the difficult weather conditions in the last marketing year (ending October) led to a massive increase in cash receipts (nearly 30%), but just a single-digit year-over-year climb in high-horsepower tractors. As another example, rapidly declining conditions in 2002 led to poor harvested corn acres as a percentage of planting area, driving down production levels and yields; we saw a similar situation in 2006, with both cases showing positive year-over-year cash receipt growth but declining high-horsepower tractor sales.
That said, higher crop insurance payments and increased planting next year should help to somewhat mitigate this situation beyond the next couple of quarters, and our long-term expectations for these companies aren't materially altered by one challenging year of farm conditions. The upcoming planting season in South America should also help to partially offset potential U.S. weakness. We've factored near-term headwinds into our discounted cash flow models, but have otherwise made few changes to our long-term growth and operating margin assumptions for the original-equipment manufacturers.
Our Top Industrials Picks
After the rapid runup in many industrial stocks over the past quarter, combined with further slowing in many key geographic regions, we now view our coverage universe as more fairly valued than just a few months ago. In fact, only two of our underlying industries (airlines and trucking) saw their price/fair value estimate ratios fall in the period. Automotive manufacturers still offer the greatest value, in opinion, with a P/FVE of 0.67 (up slightly from last quarter's 0.63), though we also see decent margins of safety in auto parts (0.75 P/FVE), truck manufacturing (0.84), and farm and construction equipment (0.82). Below, we highlight our favorite picks in each of these industries.
| Top Industrials Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
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| Ford |  | $20.00 | None | High | $12.00 |
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| Navistar | | $43.00 | None | Medium | $30.10 |
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| Gentex | | $27.00 | Narrow | Medium | $18.90 |
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| Joy Global |  | $75.00 | None | High | $45.00 |
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| Data as of 09-18-12. |
Ford Motor (F)
We believe recent North American light-vehicle sales levels are far below normative long-term demand. With billions in cost savings and improvement in the critical North American market, Ford should continue to report increased earnings as the sector recovers. We caution that outside the U.S., the company's businesses are suffering, and we expect Europe to remain a large negative to Ford's profits this year and possibly next year. Still, we remain confident Ford can weather the continued storm that its foreign operations will bring, given the firm's strong liquidity position, and we still don't think the market is giving the company enough credit for the continued improvement in its home market
Navistar
After running into compliance troubles and sliding market share, this truck manufacturer announced during the quarter that it finally withdrew its futile attempt to use its EGR engine technology to meet 2010 U.S. Environmental Protection Agency emission regulations. The company will now partner with third-party engine supplier Cummins to adapt its SCR product (a technology that Navistar's competitors already employ). In addition, the board of directors recently ousted CEO Daniel Ustian, who had championed the EGR engines. Given his personal attachment to EGR, we believe Ustian may never have become a full supporter of SCR, limiting the necessary attention and resources the technology would need to become viable with the International nameplates--something Navistar could ill afford as it fights to regain lost market share. While this there is still work to be done on installing Cummins' technology in Navistar's engines, we have a favorable early impression of new CEO Lewis Campbell, and we think the company has room to regain some of its lost share.
Gentex (GNTX)
Gentex is the best auto parts supplier that we cover. It consistently holds a dominant market share in auto-dimming mirrors of 88%, and we think this large share is unlikely to be threatened, given the firm's constant innovation and relationships with automakers. A dedication to research and development and innovation are most responsible for this leading position, but excellent financial health and a nonunion workforce also keep Gentex strong. Revenue has grown at nearly a 20% compound annual rate since 1987, and the growth story is not over. During the next 12 years, Gentex estimates the auto-dimming mirror market will grow to more than $3 billion from $1 billion today. Still, the stock looks attractive to us, as there is uncertainty as to how much of the industry will decide to place the camera view in the mirror (Gentex's solution) as opposed to a navigation screen, dashboard, radio, or "infotainment" device.
Joy Global
The mining equipment manufacturer has seen its orders decline compared with a year ago over the past few quarters, owing to lower coal, iron ore, and copper prices that have caused miners to shutter capacity or delay new additions. Although we expect Joy's lofty aftermarket support sales to prevent the company's revenue and earnings from suffering at a similar magnitude, we acknowledge that the near-term picture don't look pretty; the Chinese economy continues to slow, U.S. natural gas prices are still low, and Europe remains in the doldrums. However, we think much of this negative news is already priced into the stock, and we see a decent margin of safety for long-term focused investors.
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