Put These Firms on Your Industrials Watchlist

• North American sales rates of new autos hit eight-year highs, even in the face of massive recalls, but auto manufacturers lack the economic moats that surround the auto dealers.
• Large commercial aircraft manufacturers are taking actions to improve margins in the coming years.
• An airline passenger traffic rebound will benefit wide-moat Mexican airport operators.

 

U.S. automakers reported a strong seasonally adjusted annualized selling rate of 16.8 million for May 2014, the best May SAAR since 2005 and the highest SAAR since 17.2 million in July 2006. Total sales rose 11.3% from May 2013 to about 1.6 million. May's acceleration from early spring is good news, but the month had certain nuances worth considering--five Saturdays, a major holiday, an extra selling day, and possible deferred purchases because of severe winter weather in early 2014. Nonetheless, the consumer appears to have taken recent recalls in stride. Our expectation for 2014 sales remains at 15.9 million-16.2 million units.

We think the dealer sector--including Lithia Motors (LAD),  CarMax (KMX), and  Asbury Automotive (ABG)--is the most competitively advantaged business in the automotive supply chain. Parts and service operations gives the dealer an intangible advantage over an independent garage. Many customers bring their vehicle to the dealer for servicing because the vehicle is either under warranty or because the dealer has the factory parts and expertise to service the vehicle. The recent recall activity should provide a near-term surge for dealers, although we think current dealer share prices are rich.

Additionally, large dealers centralize back-office operations and generate far more volume than a small dealer, which brings scale. Dealers have no burdensome retiree expenses, and the large public dealers do not depend on the health of one brand; original equipment manufacturers must contend with both of these challenges. The dealers enjoy mid- to high-single-digit gross margins on new vehicles and 100% gross margin on financing and insurance. We believe continued consolidation will enable the public dealers to enjoy further cost advantages and working capital efficiencies from moving vehicles within their growing store networks.

Turning our focus to another transportation industry, we note large commercial aircraft (LCA) sales remain buoyant, and undelivered backlog has swelled to more than 10,500 units. Significant barriers to entry fortify the protection that  Airbus (AIR) and  Boeing (BA) enjoy in the LCA marketplace, with no global players able to dent the duopoly. Intangibles include engineering resources and know-how, financial strength, political connections, and supply chain management. Switching costs provide an additional, although weaker, source of advantage, as airlines prefer products that their personnel are already trained on or familiar with. Still, we are perplexed that the duopoly is not more profitable, considering the moat that surrounds the business.

We see the following avenues as enhancing profits in the years to come: reduced price competition, shared profit with suppliers, optimized labor, and targeted research and development spending. We find that Airbus has more opportunity, because Boeing has already bulked up its margins from lower R&D and has begun a round of improvements from supplier discussions and staffing adjustments.

Airport operations are a wider-moat transportation business. Passenger traffic across Mexico remained nearly stagnant from 2001 to 2009 following rapid increases from low-cost carriers during the middle of the past decade. Following the worldwide recession, traffic has nicely rebounded to reach a new high of more than 93 million passengers in 2013. Airline fleet expansion plans combined with more seats per plane and a growing middle-class population clear the runway for high single-digit annual capacity growth over the medium term in Mexico's aviation industry. Wide-moat airport operators with rights to operate airports across Mexico for decades to come are well positioned to profit from the improving traffic dynamics.

Historically, the three private Mexican airport operators ( OMA (OMAB), GAP (PAC), and  ASUR (ASR)) have each increased the proportion of sales that come from commercial sales during the past 10 years. The basic logic is sound: Travelers are a captive audience within the terminals or nearby facilities and will pay for convenience. Additionally, terminal improvements that increase traveler browsing time, such as automatic baggage screening, will further increase high-margin commercial sales from duty-free stores, VIP lounges, or other such venues.

Top Industrials Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Fiat Group SpA		$19.00	None	High	$11.40
General Motors		$53.00	None	High	$31.80
Actuant		$41.00	Narrow	Medium	$28.70
Data as of 06-23-2014

 Fiat Group
We believe shares of Fiat are appropriate for investors who are willing to accept the risks of a turnaround situation with a leveraged balance sheet in a cyclical, capital-intensive, highly competitive industry. Our fair value estimate includes the expectation that Italian demand will remain in a protracted recovery well into the second half of this decade; that Fiat retains its top market share in Brazil, albeit on a 6% slump in Fiat revenue for 2014; and estimated revenue and EBITDA that are roughly 20% more conservative (below) management's five-year plan.

At the beginning of 2014, the company purchased the remaining 41.5% stake in Chrysler that it did not already own. Fiat's ownership in Chrysler will enhance margin and returns as the two companies integrate common vehicle architectures and parts while making more efficient use of capacity, engineering, and corporate functions. The new entity will incorporate in the Netherlands and have its corporate address in the UK. Fiat Chrysler will exchange 1:1 new common shares for old shares of Fiat SpA. New shares will trade on the NYSE and Milan exchange. Management expects the share exchange to be completed by the end of 2014.

 General Motors (GM)
GM is poised to see the upside to high operating leverage thanks to rising volume and a reduction in the number of its vehicle platforms. We believe many investors are focused on the large pension/OPEB underfunding and the overhang of government and VEBA ownership. However, the pension will not be due all at once and is closed to new participants. Global pension underfunding at the end of 2013 fell by $7.9 billion, or 29%, compared with year-end 2012 due to a rise in interest rates.

The U.S. Treasury exited GM last year, and we expect the Canadian government to exit this year. GM also has a cash hoard that it could use for share buybacks or discretionary pension funding, and we like the announcement of a significant initial dividend in January of $0.30 per quarter, equivalent to about a 3.3% yield.

Europe and the GMIO segment will likely remain challenged for several more years, but Europe is improving rapidly while key holes in the U.S. product lineup (full-size sedan, full-size trucks, and SUVs) 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 depending on mix at just 10.5 million to 11 million U.S. industry units with 18%-19% share.

The ignition switch recall increases headline risk and litigation risk, but we think GM can pay any fines and judgments that come its way thanks to over $37 billion of liquidity. We are reserving $7 billion for future fines, lawsuits, and victim fund payouts, which we think will likely prove far too high of an estimate. Even after this accounting for this reserve in our model, GM shares look undervalued.

 Actuant (ATU)
Actuant's sluggish organic growth has deterred investors, but we believe shares are attractive. Management has taken two key steps over the last couple of years that we think will result in improved shareholder returns. First, the divestiture of the legacy electrical business frees Actuant from its lowest margin and most competitive segment; we think the company will be able to better focus on core growth initiatives and invest in new technologies in the energy and industrial end markets. Second, management is using share repurchases to return excess cash to shareholders. While the initial mention of a repurchase program was not received well by the Street, acquisition hiccups--such as recently acquired and subsequently divested Mastervolt--reveal that it is better to buy Actuant stock at a discount than to stretch on an acquisition. The company wrapped up its initial repurchase plan in the second fiscal quarter of 2014 (ending Feb. 28, 2014) and has authorized an additional repurchase of 7 million shares (~10% of shares outstanding). The rebound of European automobile demand coupled with a normalized industrial cycle should allow for modest top-line growth over the coming years.

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