Our Outlook for Industrials Stocks
Prospects look positive for autos, railroads, and staffing, while possible sequestration could bode ill for defense.
Quarter-End Insights
- Macro industrial indicators are mixed but slightly positive in our view: Domestic industrial production rose 2.5% in November, but PMI remains below the critical 50 mark in both the U.S. and eurozone, though the latter increased to a nine-month high.
- Domestic auto demand remains robust: November was the best month this year for U.S. light-vehicle seasonally adjusted sales; General Motors (GM) and Ford (F) are still 5-star buys.
- The fourth quarter brought a flurry of dividend activity ahead of potential U.S. income tax rate changes.
The quarter's overall industrial climate was mixed but slightly positive in our view. The November U.S. industrial production index improved 2.5% from the prior-year period, following 1.7% and 2.8% year-over-year gains in September and October. However, the past four months mark the weakest percentage growth rates since February 2010. Within the Federal Reserve's industrial production report, November manufacturing expanded 2.7% year on year, and comparisons with 2011 are positive but also slowing.
The Institute for Supply Management reported the U.S. manufacturing PMI dipped below 50 again in November, to 49.5 from 51.7 in October and 51.5 at the end of the third quarter. The 12-month mean domestic PMI of 51.9 is elevated due to stronger indications in the first half of 2012. Providing some encouragement, however, new orders remain above 50 (at 50.3) and the new order/inventory ratio again climbed due to the inventory reading falling five points to 45. Turning to overseas surveys, the Dec. 14 HSBC flash China factory PMI rose to 50.9--the fifth consecutive monthly gain and the highest mark since October of last year--and the Markit eurozone flash estimate PMI rose to a nine-month high in December, but at 47.3 remains below the 50 demarcation.
In addition to broad indicators and survey results, we look to transportation volumes for near real-time insight into the health of the economy. North American trucking and rail volumes remain positive overall, but plenty of commodities are also weaker than the year-ago cumulative volumes. The ATA Trucking Tonnage Index slipped 2.2% in October from the prior-year period, but a fraction of this decline might be due to disruption from Hurricane Sandy during the final days of the month. Prior to October, the truck tonnage index had increased year over year in every month since December 2009. The Association of American Railroads reported that through early December intermodal volume was up 4.3% from the prior-year period and carloads were down 1.8%; excluding coal, cumulative carloads improved 2.6%. Among major commodity classes, year-to-date coal is down 9.6% year over year, grain is off 6.8%, and chemicals declined 1.9%. The sharpest gainers are autos (up 14.1%) and petroleum products (up 37.4%).
U.S. Auto Sales Remains Robust
Automakers reported November U.S. light-vehicle sales that were the best of the year so far on a seasonally adjusted annualized basis. Total vehicles delivered to consumers increased 15% from the prior-year period to 1.13 million. Automotive News reported that the seasonally adjusted annualized selling rate, or SAAR, was 15.56 million, above 13.57 million in November 2011 and 14.31 million in October 2012. The trade journal stated that was the best SAAR since 15.59 million in January 2008. Ford estimated that Hurricane Sandy contributed 20,000-30,000 units of industry volume, mostly October sales that the storm delayed until November. General Motors estimated that the storm increased the SAAR by 400,000 units and that in total, the storm will require 50,000-100,000 vehicles to be replaced. Although management at major automakers would like to see the uncertainty of the fiscal cliff be resolved, we do not detect a major slowdown in automotive demand.
Indeed, we remain optimistic about the continued recovery of the U.S. auto industry from its severe low of 10.4 million vehicles sold in 2009. Consumer credit is readily available, the fleet age remains at record highs, and the Japanese automakers have inventory. Additionally, GM will have plenty of key product launches next year, including the next generation of full- and midsize pickups trucks, the Chevrolet Impala full-size sedan, and the Buick Encore small crossover. We expect new high-volume vehicles, such as trucks and crossovers, to drive traffic to showrooms next year. We maintain our Morningstar Ratings for Stocks of 5 stars on both Ford and GM. Adjacent to the consumer vehicle space is another of our other strong buy recommendations, RV manufacturer Winnebago (WGO). The stock has appreciated 85% year to date and thus ratchets to a 4-star rating on valuation, even as we slightly increased our fair value estimate.
The Fourth Quarter Brought a Flurry of Dividend Activity
Unusual return of cash to shareholders was a phenomenon hard to miss in industrials this quarter. Trucking in particular is rife with high cash balances and significant founding family share ownership--a recipe for special dividends in the face of potentially higher dividend income tax rates if we've ever seen one. Heartland Express (HTLD) and Knight Transportation (KNX) paid special dividends in 2010 and announced another this quarter, along with Marten Transport (MRTN) and Werner Enterprises (WERN). A handful of firms in other sectors (such as Fastenal (FAST), Kforce (KFRC), and Paccar (PCAR)) announced specials, too, and some companies ( Johnson Controls (JCI), for example) pulled normal first-quarter payments into the fourth quarter to spare shareholders the uncertainty of 2013 dividend tax-rate changes. Landstar System (LSTR) pulled forward anticipated 2013 and 2014 quarterly dividends into December 2012 and will evaluate its payout policy in late 2014. In addition to changes in normal dividend-payment schedules, several firms (including Delphi Automotive (DLPH) and TRW Automotive ) indicated that uncertainty on dividend tax policy will likely increase emphasis on share-repurchase programs. We're no fans of higher taxes, but recognize that even in the likely worst-case scenario, many personal investors may realize lower than the peak (low-40% range) income tax rate being bandied about for 2013 dividends because of less severe actual legislation, the fact that they're holding investments in tax-sheltered retirement accounts, or the fact that they're falling below peak progressive income tax rates. Still, these special dividend payments reduce our ex-dividend per-share valuation slightly because they reduce the enterprise value. This aside, we consider the sector as a whole to be slightly undervalued and maintain interest in individual stocks that we think offer material upside potential.
Near-Term Prospects for Diversified Industrials Mixed by Geography
We see two overarching themes driving near-term growth for diversified industrial companies: stagnant activity in Europe and Asia, and a rebound in residential construction activity in the U.S. Corporate executives and industry participants continue to voice long-term concerns about Europe to the extent that even at bargain prices available in the market right now, management would be reluctant to buy any new assets in that region. In China, the broader concern is the change in top leadership and resulting changes that will come at major corporations. With so many moving pieces, it is quite possible that the country muddles along in the short term before regaining its footing.
After more than five years of weakness, U.S. residential construction looks positive going into 2013, supported by homebuilder confidence, consumer confidence, and, importantly, actual construction. We expect electrical products companies such as Hubbell HUB.B, as well as an assortment of building products firms such as Stanley Black & Decker (SWK), Mohawk Industries (MHK), and Masco (MAS), to deliver meaningful top-line growth in these markets next year. Although commercial construction has yet to show similar signs of recovery, that market typically lags the residential market by 12 to 18 months.
Railroads: UP and Kansas City Southern Benefit From Mexican Manufacturing
We think shares of all U.S. Class I rails are undervalued at present and point to Union Pacific (UNP) as a low-risk option. Its coal exposure is lower than that of the eastern rails, CSX (CSX) and Norfolk Southern (NSC)--each have about 30% of revenue from coal versus 22% at Union Pacific--and the coal it carries is cheap-to-mine Powder River Basin coal, not the hard-to-retrieve Central Appalachian variety. UP is also the only rail that still has a legacy contract repricing benefit, and price is a powerful lever. If manufacturing accelerates in the U.S. and Mexico due to relative attractiveness of total cost in wages and transportation (versus Asian plants), UP's attractiveness increases, as it operates a material intermodal business at Los Angeles/Long Beach for importing parts for U.S. production and earns 10% of its revenue on traffic to/from Mexico via multiple interfaces at the border. UP also owns 26% of the Ferromex Mexican railroad. Even more exposed to Mexican nearsourcing is Kansas City Southern , which derives about 45% of sales from its Mexican operation. Kansas City Southern has some additional powerful growth drivers in highway conversions to intermodal at Laredo, Texas, where it has exclusive rail passage at this busy crossing, and in several new auto plants developing in Mexico. Video of our conversation with Kansas City Southern is on Morningstar.com.
Canadian Pacific Railway (CP) during the quarter hosted an investor meeting to lay out the plans its new CEO has for this ripe-for-turnaround rail, the only remaining margin laggard. We believe iconic CEO Hunter Harrison (at the helm since summer) has begun to catalyze significant change at CP. We hear great progress and plans, but it's still early to credit the rail with an operating ratio near its peers within a few months of Harrison's arrival. That said, Harrison's history of turning around two railroads make him the low-risk leader for this rail with strong potential for operating improvement and commensurate earnings-per-share growth.
Defense Sell-Off Possible Without Sequestration Resolution
The Budget Control Act of 2011 outlined cost reductions to offset debt-ceiling increases of up to $2.1 trillion in multiple steps. In late November 2011, a bipartisan "supercommittee" tasked with identifying reductions announced it had failed to do so, paving the way for across-the-board cuts to begin Jan. 2, 2013. This messy and illogical process, called sequestration, could cut the Department of Defense's budget by nearly $1 trillion over 10 years, unless Congress takes action to avert it. We note the exposure to short-cycle IT services is a headwind, while international sales has been a tailwind for sales growth. Of the prime contractors, General Dynamics (GD) and Northrop Grumman (NOC) have high IT exposure, while Raytheon is tops in international exposure.
Looking at our fair value estimates that attempt to embed significant cuts to the DoD budget and comparing them with current market prices, the market seems to believe Congress will take some action to avert the planned cuts, which are currently law. Should sequestration occur, we think the defense sector would likely experience a knee-jerk investor reaction to sell shares. However, we believe that the companies could manage their businesses to the new revenue opportunity. Although the $160 billion of sales that are expected in 2012 would likely fall in 2013, we expect the companies to aggressively right-size their footprints, in concert with historical practices. Prime contractor operating margins have averaged 10.5% during the past five years, and we think that is a reasonable estimate in three to four quarters following sequestration.
Staffing
Since the beginning of 2010 through November 2012, nonfarm payrolls have increased by more than 4 million jobs. We believe growth for the U.S. employment market should remain moderate during the next several months, but we also expect this trend to accelerate during the course of 2013. Given the Federal Reserve’s stated goal of easy monetary policy until unemployment reaches 6.5%, and barring another steep economic downturn, an accelerating trend is in the cards for job growth, in our opinion. This dynamic will benefit firms that provide employment services to businesses.
The employment-services industry has rebounded sharply from recessionary levels with many players experiencing solid operating improvement. Businesses have used human resources outsourcing services to a greater degree in order to build efficiency. We believe this trend is a long-term positive for our employment-services coverage list. Secular tailwinds for the employment-services industry should especially benefit payroll processor Paychex (PAYX). The firm has produced returns on invested capital averaging above 70% during the last 15 years--its triumvirate of high customer switching costs, solid scale advantages, and a respected brand image constitute a wide economic moat. We believe the stock is currently undervalued, and investors have an opportunity to gain a decent return from a top-tier business.
Our Top Industrials Picks
We consider most of our industrials coverage universe to be fairly valued. Since last quarter, the ratio of industrials sector prices to Morningstar's fair value estimates crept upward from 0.91 to 0.93; as price/fair value approaches the value of 1.00 in this manner, we find less margin of safety below our estimated intrinsic value. Auto manufacturers and auto-parts suppliers remain the greatest pockets of value in our opinion (0.71 and 0.77 respective current price/fair value), and heavy farm and construction equipment manufacturers, logistics, and staffing sectors offer the next most attractive valuations by our metric. We have picked several individual stocks that we consider to be on sale at this time and suggest investors keep these names on their radar.
| Top Industrials Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
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| Caterpillar |  | $106.00 | Wide | High | $63.60 |
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| Expeditors Intl. of Wash. | | $51.00 | Wide | Medium | $35.70 |
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| Gentex |  | $27.00 | Narrow | Medium | $18.90 |
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| WMS Industries | | $33.00 | Narrow | Medium | $23.10 |
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| Data as of 12-18-12. |
Caterpillar (CAT)
Cat holds sizeable exposure to mining equipment (25%-30% of total sales), and the firm is still heavily leveraged to the ongoing North American recovery in both residential and nonresidential construction. Near term, the company will face headwinds in its European and Asian operations (about half of sales), but we expect U.S. operations to enjoy strong results in the coming quarters. The long-term potential remains strong for this market leader. In addition, the recently declining stock price (off about 3% year to date, versus about 15% positive year-to-date performance for the S&P 500 Index) offers a decent margin of safety for this wide-moat firm, in our opinion.
Expeditors International of Washington (EXPD)
We maintain our opinion of Expeditors as one of the highest-quality transport stocks we cover, and we believe shares are attractively priced at this time. This non-asset-based, third-party logistics firm produces fantastic 25%-plus ROICs by arranging international air and sea shipping and handling customs brokerage so clients can focus on core operations. Although the firm has faced demand headwinds for more than a year, we think expectations of modest or no near-term airfreight volume growth are already incorporated into the share price. We believe shares of well-managed, well-capitalized Expeditors are trading at recessionlike multiples and at a significant discount to our fair value estimate. Expeditors owes no debt, holds more than $6 per share in cash, and yields about a 1.5% dividend.
Gentex (GNTX)
We highlighted Gentex in our prior quarterly commentary but reiterate our interest to point investors to a pending government ruling that might affect the share price. Gentex holds a commanding 88% global market share in auto-dimming rearview mirrors, and we consider this nonunion technological innovator to be a top-shelf auto supplier. Weak European demand is a present headwind--and Germany constitutes about a quarter of total sales--but we think that the firm's fortress balance sheet (debt free and boasting about $4 per share of cash and investments) can weather a storm. Dec. 31 is the deadline for the National Highway Traffic Safety Administration to issue a final ruling on automaker compliance with the Kids Transportation Safety Act of 2007 signed by President Bush. That's right: 2007. Clearly "deadline" means something different to the government than it does to us mere mortals, as this due date has been pushed back multiple times, but share-price movement surrounding this scheduled announcement date could afford alert investors an opportunity to buy Gentex at a discount (it's already attractive at 5 stars and pays a 2.8% dividend yield). This ruling will specify details about the timing of mandated compliance and possibly the placement of a rear camera display (could be in Gentex RCD mirrors, or in a navigation screen or dashboard). We model just 10% of the industry to use RCD mirrors to comply with this act, but emphasize that the actual rate is highly uncertain. That said, our valuation relies more heavily on general industry health than on the NHTSA ruling.
WMS Industries
Overexpansion by gaming operators during the early 2000s created a lackluster operating environment for the gaming manufacturing industry. The confluence of this secular dynamic and recent operational missteps have hampered WMS. The firm has reported disappointing results for most of the last few years as a result of poor gaming development and production execution. However, WMS has recently started to correct these problems and its business seems to be operating at a healthier level. We believe customers will eventually need to replace aging machines as gambling patrons seek the most entertainment per dollar spent. This variable will drive accelerating demand for WMS beyond the near term, and with an improved operational structure, we expect the firm to expand its revenue and operating margins materially over the medium to long term. Shares of the gaming-machine manufacturer have been decimated during the last two years, falling from a high of approximately $50 per share to its current low of approximately $16. However, negative trends are limited to the near term, in our opinion, and we believe improving operational conditions will boost the firm's results.
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