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Morningstar
Quarter-End Insights

Industrials: Pockets of Value in Automotive

Bargains are currently scarce in the sector, but industrials continue solid execution and segment portfolio refinement.

Keith Schoonmaker
  • We consider industrials to be fairly valued, generally speaking, but see pockets of value in the automobile manufacturing sector. 
  • Industrials are benefiting from healthy midcycle demand and are producing solid margins.
  • Flush with cash and having refinanced high-interest-rate debt during recent years, some industrials have turned to refining their portfolios to better match long-run targets.

We see a paucity of cheap stocks among industrials, but this is common across much of the broader market, as reflected in the near-record levels of many indexes. At the time of our writing, the ratio of market price to Morningstar fair value estimate was 1.02 for all Morningstar-rated stocks and 1.06 for industrials. That is, on average industrials are 6% overvalued via our methodology. Most industrial subsectors (airlines, conglomerates, distributors, railroads, and so on) are overvalued by 3%-36%, with trucking at the latter extreme. We rate staffing and auto dealers as fairly valued and consider only two industries, auto manufacturers and farm and construction equipment, to be undervalued, at 12% and 5%, respectively.

However, some individual values can still be found here. Turning to the approximately 160 stocks we cover in industrials, about a third are valued less than our fair value estimate, but just 20 have a margin of safety greater than 10%. Of these, six are unrelated and seven are the aforementioned automakers. We include  Fiat  and  General Motors (GM) in our highlighted names below as the cheapest among industrials, trading at 56% and 63% of fair value, respectively. In fact, Fiat is one of only nine 5-star stocks in Morningstar's coverage universe today. Three are heavy equipment manufacturers; we mention farming equipment builder  AGCO (AGCO) below, but  CNH Industrial (CNHI) and lift manufacturer  Terex (TEX) are also undervalued. A pair is homebuilders ( NVR (NVR) and  Pulte (PHM)) and another pair is aircraft manufacturers ( Airbus (AIR) and  Bombardier (BBD.B)).

Recent demand has been quite strong for most firms we cover, and we expect this to continue for multiple quarters. We believe firms rationalized assets and purged expenses during the crucible of the recession, then added capacity conservatively and hired employees slowly because of concerns about health-care regulations and costs. Consequently, many firms are near peak margins, and we don't model much margin expansion going forward, excluding firms in the midst of secular operating betterment (railroads) or latent demand recovery (automakers). Concerning the latter, the August seasonally adjusted annualized selling rate came in at 17.5 million, according to Automotive News, up 5.5% from August 2013--the highest of the year and best since 17.63 million in January 2006. The fleet is still aged, and we expect additional demand rebound. 

Industrial production has been flat during the past three months, but is up 4% from prior-year levels. In August, manufacturing improved 3.6% and business equipment was up 5.7% year over year. U.S. August PMI increased to 59%, marking a 1.9-percentage-point increased from the prior month and the highest reading since March 2011, the 63rd consecutive month of expansion.

In other indicators, the HSBC Markit Flash report for September PMIs for China increased slightly sequentially, from 50.2 to 50.5, but remains barely above the 50 demarcation indicating expansion. The September Markit Flash Eurozone PMI was 50.5 (a 14-month low) in manufacturing and 52.8 (a three-month low); similar to China, the signal is only moderate expansion.

The U.S. Architecture Billings Index declined in August after hitting a seven-year high in July, but we remain optimistic on a larger resumption of commercial construction. Rail volume is decent, with total carloads year to date improving 3%. Grain and petroleum are the big percentage gainers this year, up 14.9% and 11.6% year to date versus last year. Intermodal units continue to be strong, up nearly 6% from prior-year levels and at least twice the GDP growth level. The American Trucking Associations indicated its tonnage index increased a respectable 4.5% over August 2013 to reach a new high of 132.6. Year-to-date tonnage increased 3.1%. Altogether, these indicators are encouraging, and we believe the current plow-horse economy will continue to plod forward.

Armed with healthy balance sheets in addition to decent demand and solid margins, some industrials have turned their focus to refining their portfolios to better match long-run targets. Industrial stalwart  General Electric (GE), perhaps the most visible example, continued its portfolio composition refinement efforts during the third quarter by announcing the intention to sell its home appliance business to Swedish manufacturer Electrolux for $3.3 billion in cash. In our opinion, the strength of the GE appliance brand combined with favorable expectations for a rebound in housing at this point in the economic cycle support a valuation of nearly 8 times trailing 12-month EBITDA. When the deal closes in 2015, GE expects to net a gain of approximately $0.05-$0.07 per share. In our view, the deal makes sense for both parties. Adding GE's storied appliance brand to its set of higher-end appliances broadens Electrolux's reach in the United States, where it competes head to head against Whirlpool (WHR). For GE, shedding the cyclical appliance unit monetizes a valuable consumer brand, while liberating the company to focus on supporting business segments that serve faster-growing industrial end markets. Together, the consumer-oriented appliance and lighting segments constitute less than 10% of industrial revenue, and we believe GE's truly industrial products typically support lucrative parts and service contracts that deliver high-margin returns on original-equipment manufacturer sales for years to come. The recent  Alstom (ALO) acquisition is this type of attractive business and helps position the firm's annual revenue to move toward a composition concentrating more on industrials and less on financials.

GE is not the only titan rebalancing its holdings. Near the end of September, narrow-moat  Siemens (SIEGY) announced it is buying Dresser-Rand , which makes compressors and turbines for the oil and gas industry. We believe this makes strategic sense because it strengthens Siemens' oil and gas offering, especially in the U.S. Given current low U.S. gas prices, the ongoing shale gas boom, and the steady trend toward the retirement of coal, we expect gas power plants to gradually increase as a percentage of U.S. installed capacity, thus participation in this end market boosts Siemens' growth prospects.

Earlier this year, Siemens bought the bulk of  Rolls-Royce's (RR.) energy business and unsuccessfully competed with GE for Alstom's gas turbine business. Dresser-Rand gives the company ammunition to compete more effectively in the oil and gas industry and gives the company a lock on lucrative, long-term service contracts. Siemens also announced the sale of its 50% stake in the joint venture BSH Bosch und Siemens Hausgeräte. This sale requires regulatory approval and is targeted to close in the first half of 2015. These acquisitions and divestitures are in line with management's focus on the core business.

Top Industrials Sector Picks
Star Rating Fair Value
Estimate 		Economic
Moat 		Fair Value
Uncertainty 		Consider
Buying
AGCO $57.00 None High $34.20
Fiat Group SpA $19.00 None High $11.40
General Motors $53.00 None High $31.80
Data as of 09-23-2014

 AGCO (AGCO)
AGCO, as an agricultural equipment manufacturer, is exposed to the high-profile U.S. agricultural downturn, but that market constitutes only 26% of sales, and the company has nearly 50% share in the fast-growing Brazilian market, plus attractive market share positions in Europe and Africa. In a weak near-term operating environment, cost-saving opportunities should emerge from a 2015 small-tractor platform launch, while relatively low debt levels should allow the firm to pursue share repurchases or acquisitions to increase shareholder value. In our opinion, industry sentiment seems to be slightly more negative than when most agricultural equipment companies reported last quarter. Farmers are generally delighted with high crop yields, but this has created lower year-over-year pricing in most crops, and we believe farm income will decline this year. We suspect this weakened sentiment is translating into weaker equipment orders, and both strong sales last year and a record-low equipment age make it unnecessary for some farmers to be buyers in this environment. However, this same weak sentiment may make acquisitions more affordable for AGCO, for example in the spraying and planting equipment product lines.

 Fiat Group SpA ()
Automaker Fiat currently trades at greater than a 40% discount to our $19 fair value estimate. We consider the stock appropriate for investors willing to accept the risks of a turnaround situation with a leveraged balance sheet in a cyclical, capital-intense, highly competitive industry. In our valuation assumptions, we project Italian demand will remain in a protracted recovery into the second half of this decade; we assume Fiat retains its top market share in Brazil, albeit on an 18% slump in Fiat Latin America revenue for 2014; and we model revenue and EBITDA conservatively--roughly 20% below management's five-year plan. 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 plans to incorporate in the Netherlands and have its corporate address in the United Kingdom. Fiat Chrysler will exchange 1 for 1 new common for old shares of Fiat SpA. New shares will trade on the NYSE and Milan exchange, likely in October.

 General Motors (GM)
Automaker GM is poised to see the upside to high operating leverage, thanks to rising volume and a reduction in its vehicle platforms. We believe many investors are focused on pension 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 thanks 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 a quarter, equivalent to about a 3.5% yield. Europe is likely to remain challenged for several more years, but the region is improving rapidly. Holes in the U.S. product lineup (full-size sedans, full-size trucks, and SUVs) are now filled. And here's a compelling statistic: 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 18%-19% share of a much smaller 10.5 million-11 million in U.S. market sales. The ignition switch recall increases headline risk and litigation risk, but we think GM can pay any fines/judgments that come its way, thanks to nearly $39 billion of liquidity. In early June, we reduced our fair value estimate by $4 per share for a $7 billion reserve estimate for fines, lawsuits, and the compensation program related to the ignition switch recall. We still think this accrual will probably prove too high. GM said in July that the compensation program could cost it as much as $600 million, but many uncertainties on this fund and government fines remain.

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