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Quarter-End Insights

Our Outlook for Industrials Stocks

Most industrials are fairly valued at present, with a pocket of value in automakers.

  • Indicators of economic health and sentiment remain positive. The housing and automotive industries continue to rebound from recession lows. U.S. industrial production increased 1.1% sequentially and 3.2% year over year in November, and PMI is above the 50 positive demarcation in the U.S., eurozone, and China.
  • Three automotive manufacturers offer a rare pocket of value within industrials. Fiat is 5 stars, and General Motors and Ford are both 4 stars. Encouragingly, the latest U.S. light-vehicle seasonally adjusted sales of 16.4 million marks the highest for November since 17.1 million in 2003, and it's the high-water mark so far in 2013.
  • Outside of select automakers, we consider shares of most industrials to be fairly valued, putting individual stock-picking in demand.

Most relevant macroeconomic indicators are positive, albeit not glowing, for industrials. Broadly speaking, industrial firms seem to have adjusted to the modest growth environment and are producing strong margins to top off healthy balance sheets. We expect housing and auto demand to continue driving recovery, but at a more modest pace than previously. The auto industry in particular contains several names we consider to be undervalued at present.

November industrial production increased 1.1% sequentially and 3.2% year over year, representing the largest sequential jump since November 2012 (up 1.3%). This gap upward is more in line with the recent persistently optimistic sentiment metrics, like the U.S. ISM Purchasing Manager Index. Moreover, industrial production improved in most categories. Manufacturing output rose 0.6%, demand for durable goods rose 0.8%, and motor vehicle and wood product demand rose 3.4% and 1.0%, respectively. Nondurable goods demand rose 0.5%, with strongest gains in textiles (up 1.7%). Mining output increased an impressive 1.7%, primarily due to increased production after Tropical Storm Karen left the Gulf of Mexico. Utility output rose 3.9% with similar-size gains in the electric and natural gas categories.

Among broad measures, we note that the Bureau of Economic Analysis revised its third-quarter U.S. GDP growth estimate upward 80 basis points to 3.6% due to better-than-expected consumer expenditures and higher private inventory levels. The November employment situation report was better than expected, with 203,000 new jobs relative to a 180,000 consensus forecast. The unemployment rate declined to 7.0% and also was better than the 7.2% consensus expectation. The Bureau of Labor Statistics upwardly revised September (revised up 2% to 204,000) and October (up 7% to 175,000) new jobs data. Most categories showed year-over-year growth, with government jobs continuing to shrink. In the past 12 months, federal government employment has contracted by 92,000.

One of the most positive indicators of late is the American Trucking Associations truck tonnage index, which soared to all-time highs in August and September. The ATA index expanded year over year from 2012 levels by 4.5%, 6.9%, and 8.4% during the three months of the third quarter, then surged 8.0% in October. Year-to-date truck tonnage is 5.5% higher than 2012 levels. That said, the tonnage index overstates broader growth among the trucking firms we cover. This is because the robust tonnage trends are being driven in large part by strength in specialized heavy-haul freight related to the housing and energy end markets (including hydraulic fracturing). More traditional dry van trucking, like most companies we cover, is a bit more subdued, with most carriers reporting choppy demand and flattish miles per truck in recent quarters. In fact, trucking industry loads are up less than 1% year to date (relative to the same period in 2012). Part of the sluggish utilization performance this year relates to limited driver availability and lost productivity from the government's recently revised more restrictive hours-of-service rules.

Rail volume growth is mixed, as North American rail traffic through the first week of December is up 200 basis points from prior-year levels. Petroleum products continue to lead year-over-year gainers, up 24.9% from year-to-date 2012 levels due to growth in crude by rail. Intermodal units are up 4.3% thus far in 2013. The latter supports our expectation that railroads will continue to increase intermodal via highway conversions throughout the economic cycle, thanks to more attractive rates and lower environmental impact. Coal remains weak (down 3.6% from last year), but declines appear to be slowing. Grain is improving as the more normal harvest is collected this year, but remains 4.5% below year-to-date 2012 levels because of the lingering drought effect dragging on 2013 shipments during the first three quarters of the year.

Sentiment indicators outside the United States remain in positive territory. The eurozone manufacturing recovery appears to be continuing, for the Markit Flash Eurozone Manufacturing PMI December data reached a 31-month high of 52.7 (versus 51.6 in November). New orders and output lifted the index as both showed their highest readings since spring 2011. Growth is uneven across the eurozone. Commenting on the data, Markit's chief economist noted that France "looks increasingly like the new 'sick man of Europe,'" while Germany is reflecting solid growth. The China Flash Manufacturing PMI (based on 85%-90% of final data points) was modestly lower sequentially and barely above 50 (50.5 December reading versus 50.8 in November). Shorter supplier delivery times (these were previously increasing) and lower purchase quantities hindered the index in December.

Housing Sales and Starts Well Below 50-Year Averages, Recent Prices Healthy
Recent quarterly results from the homebuilders indicate that the demand response to higher mortgage interest rates was significant. Toll Brothers' net new order growth decelerated from 49% in the January quarter to 36% in the quarter ending in April, 26% by July quarter-end, and just 6% growth in the October-ending quarter. However, the housing recovery has not been derailed; industry orders should rebound as the sticker shock effect wears off and interest rates stabilize. Long-term housing fundamentals still support sales growth, given population demographics, recovering household formations, low housing inventories, and still-supportive housing affordability. In population demographics, echo boomers reach 29 years of age next year. For inventories, new homes are 4.9 million versus a historical mean of 6.1 million, and existing single-family residences are at 5.0 million versus a historical mean of 6.5 million. Concerning affordability, we believe the 30-year fixed mortgage rate would need to increase to about 7% to bring affordability in line with 1990s levels compared with rent rates. Importantly, new home sales are still one third below the 50-year average and housing starts are 39% below the 50-year average.

Concerning home prices, the limited inventory of existing and new homes is helping prices to recover. Some examples: CoreLogic home prices increased 0.2% from September to October (and are up 12.2% year over year), the Case-Shiller 20-city index increased 13.3% in September, the National Association of Realtors existing home median price gained 12.7% in October, and the Federal Housing Finance Agency existing home price gauge increased 8.5% in September. Solid sale prices of low-cost-basis land have boosted margins, but we think gross margins could peak in the next 12-18 months. Among homebuilders, we still appreciate  NVR's (NVR) land-light model and still consider the shares to be undervalued.

Auto SAAR Best November Since 2003
U.S. light-vehicle sales increased 8.7% year over year to more than 1.2 million in November. Automotive News put the seasonally adjusted annualized selling rate at about 16.4 million compared with 15.3 million in November 2012. This year's SAAR was the industry's highest for November since 17.1 million in 2003, as well as the best SAAR yet this year. Given a strong November, we expect full-year sales to finish around 15.7 million units. December is often one of the highest unit sales months of the year, and the industry year to date through November is at more than 14.2 million. Credit remains readily available to consumers at very low rates, so we expect the industry to continue its momentum into 2014.  General Motors' (GM) November U.S. sales climbed 13.7% year over year to 212,060 units with retail channel sales up 19%. Fleet volume declined 3%, but this was due to lower rental deliveries, which we think is a positive for residual values. GM's commercial fleet sales increased 18% and small-business owners increased pickup purchases 76%.  Ford's (F) November U.S. sales climbed 7.2% to 190,449. Retail sales grew 9% and gave Ford its best November retail month since 2004. All vehicle segments increased year over year, but trucks were the big winner with a 17% retail gain for Ford compared with 6% for its cars and 3% for utilities. The F-Series pickup exceeded 60,000 units for the seventh straight month, including fleet, with total sales for the pickup up more than 16% to 65,501 units.

We Initiated Coverage of Two New Share Classes in 4Q:
Ingersoll Rand Spun Off Allegion, and Aramark Returned to the Public Market

 Allegion (ALLE) is the number-two player in the $25 billion global mechanical and electronic security product market, behind Swedish firm Assa Abloy. The  Ingersoll Rand (IR) spin-off has earned a narrow economic moat due to intangible assets from its strong brand names and its depth of experience in marrying functionality with adherence to complex building codes. Allegion's well-known and respected brands afford it premium pricing. Perceived quality of a security product is a critical consideration in such applications as schools, hospitals, and government buildings, since the cost of failure is particularly high. These end markets are where Allegion has been especially successful, since many of its brands have a reputation for superior quality and durability. Schlage is the most significant brand in terms of revenue contribution and consumer awareness and is the largest commercial and residential cylindrical lock provider in North America. Allegion's most strategic other brands, namely Von Duprin in exit devices, LCN in door closers, and CISA and Interflex in electronically controlled locks, carry similar cachet among prospective, mostly commercial customers. They also happen to carry leading market share positions in their geographies, with the exception of Interflex (second largest). Allegion's pricing power shows up in its superior margin profile--EBITDA margins were 20.5% in 2012 versus 15.2%-18.3% for its closest public competitors.

 Aramark (ARMK) has been providing food and clothing for a range of corporate and institutional clients since 1959. Following a leveraged buyout in 2007, Aramark's recent initial public offering is the third time the food, facilities, and uniform services provider has offered shares to the public. Food service represents nearly 90% of the company's sales, with North America constituting its largest market. This asset-light outsourcing business generates recurring revenue streams by promising customers more efficient methods of managing costly noncore functions, such as kitchen operations. In addition, uniform rental contributes nearly $1.5 billion in revenue. Aramark's weaker operating performance relative to peers combined with inconsistent returns on invested capital makes us hesitant to award the company a moat. Low barriers to entry have supported the fragmented nature of food-service markets, and we believe it is difficult for players to differentiate themselves in this relatively commodified industry. Peers  Compass Group (CPG) and  Sodexo (SW) have managed to leverage scale to sustain lower costs and derive customer switching cost advantages; however, Aramark's historical underperformance suggests less bargaining power against both customers and suppliers. Aramark's scale should provide the company with a purchasing advantage; however, the company's margins have underperformed its moatier peers'.

Industry-Level Insights
We consider most of the industrials sector to be fairly valued; the median ratio of market price to our fair value estimate is a slightly overvalued 1.08. The most highly overvalued industries are auto dealerships (1.29 median price/fair value), trucking (1.27), and staffing services (1.23). Not far behind are residential construction names, with a median of 1.20, but we consider NVR shares attractive. While integrated shipping and logistics as a sector is fairly valued on average, with a 1.05 price/fair value, we find  C.H. Robinson (CHRW) a standout for its valuation and its high quality as well. In fact, both NVR and C.H. Robinson use asset-light business models to generate leading returns on invested capital in their respective industries. The only industrial sectors with a median price/fair value greater than a couple percent below 1.00 are farm and construction equipment (0.97) and auto manufacturers (0.91). In autos, GM and  Fiat are much more undervalued than the median for this industry. In this mostly fairly valued market, stock-picking is essential in discovering names that we believe will offer the most upside.

Our Top Industrials Picks
This quarter we highlight our only 5-star name, Fiat, plus Ford and GM because we still consider both of these automakers undervalued. We also point out Eaton and Schneider Electric as names for investors to keep on their radar. Of these, only Eaton and Schneider have economic moats (narrow), but we consider valuation attractive for all.

Top Industrials Sector Picks

Star Rating Fair Value
Fair Value
Eaton Corporation, PLC $84.00 Narrow Medium $58.80
Fiat Group, S.p.A. $19.00 None High $11.40
Ford Motor Co. $26.00 None High $15.60
General Motors Co. $56.00 None High $33.60
Schneider Electric EUR 71.00 Narrow High EUR 42.60
Data as of 12-16-2013.

Eaton (ETN)
Eaton's 2012 acquisition of Cooper Industries transformed the company from being a play on the heavy truck cycle to including the nonresidential construction and utility capital spending cycle. In addition to some natural synergies between the companies' electrical businesses, a more balanced earnings and cash flow stream should help the company navigate economic cycles. The market continues to discount Eaton due to a weak (but improving) truck cycle and exposure to Europe, but we think as the market understands the company's new operating structure, long-term investors will be rewarded.

Fiat remains the most undervalued stock in Morningstar's industrials coverage, even though the shares have gained 43% year to date. This no-moat 5-star stock is a great value for investors who are willing to patiently wait and to accept the risk of a turnaround situation in a cyclical, capital-intensive, and highly competitive industry. Despite the economic uncertainties of new car demand in Italy, Fiat will benefit from number-one share in Brazil and the launch of several new models beginning at the end of this year and running into 2016. Fiat's ownership in Chrysler will enhance margins and returns as the two companies become more integrated with common vehicle architectures and vehicle parts while better utilizing capacity, engineering, and corporate functions.

Ford Motor (F)
Ford's revamped small-car lineup means the company has competitive vehicles in every segment and no longer has to rely on trucks and sport utility vehicles to make money. The company derives nearly all of its profit from the U.S., and this market is poised to grow to at least 16 million annual unit volume from 10.4 million in 2009. This top-down recovery complements tremendous bottom-up change at Ford thanks to Alan Mulally's embrace of common vehicle platforms. Ford is well ahead of GM in moving 87% of its annual global volume to common platforms by 2013 versus 96% by 2018 at GM.

General Motors (GM)
GM made a flurry of changes and announcements in early December. On Dec. 5, the company announced that the Chevrolet brand will mostly be pulled out of Europe starting in 2016. The brand will still be sold in Russia and many former Soviet Bloc nations, but in Europe its presence will be limited to halo cars such as the Corvette. According to data from the European Automobile Manufacturers' Association, Chevrolet had only 1.2% of EU27 registrations through October this year. We think GM Europe will become a more efficient segment by focusing its marketing efforts on Opel/Vauxhall and then gradually expanding Cadillac's presence in Europe.

Next, the U.S. Treasury announced Dec. 9 that it has sold all of its remaining common shares of GM, recouping about $39 billion of its roughly $50 billion loan to the automaker. We see this announcement as extremely good news for GM's stock, as the end of U.S. government ownership removes an overhang on the shares. A Canadian government entity still owns about 7.9% of actual shares outstanding on Oct. 25, as well as 16.1 million of GM's 9% Series A preferred shares (GM can redeem the latter at the end of 2014). The United Auto Workers' voluntary employee beneficiary association owns a 10.1% stake of common shares, as well as 140 million Series A preferred shares. We expect the Canadians to exit in 2014 and the VEBA to sell its shares more gradually in order to diversify its asset base as well as meet retiree health-care claims.

Just a day later, GM announced that CEO Dan Akerson will retire Jan. 15 and be succeeded by the current head of product development, Mary Barra. We think Barra, 51, is a fine choice, and her promotion is not a surprise.

GM intends to sell its remaining stake in Ally Financial for about $900 million, or about a $0.50 per diluted share increase to our fair value estimate. The Ally sale makes sense to us as the holding is a noncore asset for GM, since GM Financial is now the company's captive finance arm. GM shares remain undervalued, and we have more reason than ever to be optimistic about the company's performance.

Europe is likely to remain challenging for several more years but is improving rapidly, while key holes in the U.S. product lineup (full-size sedans and full-size trucks) are now filled. Old GM broke even with 25% U.S. share and a U.S. industry sales level of 15.5 million units while new GM breaks even with 18%-19% of just 10.5 million units. Furthermore, we think GM will soon initiate a dividend on its common stock, as it had $26.8 billion of automotive cash as of Sept. 30 and management intends to return cash to shareholders. To match Ford's 2.4% dividend yield, GM would have to pay an annual dividend of about $0.98 per share. Based on the actual shares outstanding of roughly 1.39 billion, we calculate a cost of nearly $1.4 billion--a manageable figure, in our opinion.

Schneider Electric (SU)
Schneider Electric has a collection of businesses geared to helping companies manage energy use ranging from building and factory automation, backup power, and power distribution. The market has taken a dimmer view of Schneider's businesses relative to peers because of the company's exposure to Europe, a concern that is merited when assessing near-term earnings growth, but less of a factor when considering long-term valuation. The company has a narrow economic moat driven by high customer switching costs, and its strong balance sheet should enable both internal investment and the return of cash to shareholders.

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