Industrials: A Few Bargains Still Remaining

• Our industrials coverage currently trades at about fair value, with many subsectors lingering in overvalued territory. Nonetheless, pockets of opportunity exist in select stocks.
• Industrials have enjoyed relatively healthy macroeconomic conditions in the U.S., and investors seem to be extrapolating those trends out over the long run. Even so, a strengthening U.S. dollar may blunt 2015 export growth as manufactured U.S. goods become relatively more expensive.
• Global trade has seen healthy expansion since the middle of 2013, providing a boost to many industrial stocks, especially those in transportation. Lower fuel prices could support consumer spending and reduce industrial transportation costs in 2015.

Continuing the theme of recent quarters, we find few bargains throughout our industrials coverage. No stocks trade in the 5-star range, and only about 14 (out of 163) trade in 4-star territory. That said, this dynamic doesn't deviate too far from the broader market. At the time of writing, industrials stocks carried a market price/Morningstar fair value estimate ratio of 1.08 (8% overvalued compared with our discounted cash flow-derived fair value estimates), while the price/median fair value of all stocks that Morningstar covers was 1.03 (3% overvalued).

Among the most expensive subsectors are airlines, auto parts, tools and accessories, and trucking, ranging from 27% to 42% overvalued--the asset-based truckload and less-than-truckload carriers hover at the high end of that range. Other subsectors such as business services, infrastructure operation, rental and leasing services, and staffing and outsourcing also carry healthy market valuations, with premiums to our fair values in the midteens, but they aren't quite as lofty as the former group.

Despite generally rich valuations across the industrials space, some pockets of value still exist. As highlighted in the top picks section below, our best ideas include industrial distributor

Naturally, idiosyncratic influences vary by company, but broadly speaking, we suspect that rich industrials-sector valuations reflect healthy macroeconomic conditions and related optimism. Economic tailwinds have supported decent demand and pricing in most industries. Firms have also become leaner and more efficient since the 2008-09 downturn, providing fertile ground for incremental operating leverage and margin gains. In many cases, we suspect investors are extrapolating these positive operating trends out over the long run.

Overall, U.S. real GDP grew at an annual rate of 2.2% in the fourth quarter of 2014, bringing the full-year total to 2.4%, 0.2 percentage points higher than 2013. Industrial production has also been quite favorable, increasing 4.1% for full-year 2014 versus a 2.9% rise in the previous year, and about 4.4% in the fourth quarter. Manufacturing output rose 3.4% for all of 2014, up 1.2 percentage points from 2013. However, December, January, and February have shown declines of 0.1%, 0.3%, and 0.2%, respectively.

Exports of U.S. goods have supported the domestic economic recovery, increasing 2.7% to a record $1.64 trillion in 2014. Even so, January exports of goods declined 3.9%, the largest monthly year-over-year decline since October 2009. The decline comes as the Federal Reserve Board trade-weighted U.S. dollar index hit 116.6, increasing 13.5% versus the same period a year ago. The current index level is the highest since May 2004.

Beyond the United States, the Markit Eurozone Composite PMI continues to signal expansion (above 50) since mid-2013. That said, the reading peaked at 54.0 in April 2014 and has remained below peak ever since, but at 53.3 for February, the index signaled expansion for the 20th month in a row. Thus, like trends in the United States, there are hints of a prolonged eurozone manufacturing recovery.

In terms of other key indicators, the architecture billings index reflects an approximate nine- to 12-month lead time between architecture billings and construction spending. The ABI has been positive 10 times out of the past 12 months. The February index score was 50.4, up from the negative reading of 49.9 in January. A showing above 50 indicates increased billing activity. But one month does not a trend make, and concern may arise if index scores were to deteriorate again in the next couple of months. Conversely, residential new housing starts dropped a surprising 16% in February and are up 1% for first two months of the year. The decline seems to indicate weakness beyond what might have been expected from the frigid temperature experienced during the month throughout much of the country, but weather effects are difficult to parse out from economic factors.

In the auto sector, we think 2015 global demand for new light vehicles will increase approximately 3%, favorable for global original equipment manufacturers and for suppliers with a worldwide operational footprint. U.S. February light-vehicle sales volume increased 5.3% compared with the same month last year, with the seasonally adjusted annualized selling rate at 16.24 million, according to Automotive News. This was the third monthly sequential decline since November. However, we think 2015 U.S. light-vehicle demand will increase roughly 3% to about 17 million units. Desirable new product, an aging fleet of vehicles on the road, readily available credit, and higher usage as measured by average miles driven should continue to have a favorable effect on demand.

European unemployment and austerity measures, among other industry fundamentals, will make for a protracted period of auto demand recovery. We look for European light vehicle registrations to increase between 3% and 5% in 2015. The rate of demand recovery in the region should perk up more in 2016 as the unemployment picture improves. In other world markets, we expect demand growth to slow to a 7% increase this year in China and for economic recovery in India to support a 3% rise in demand. High inflation and weak economic conditions reduce demand in South America. The Ukraine conflict along with economic sanctions, plummeting oil prices, and the substantially devalued ruble stifles Russian new vehicle demand.

With respect to transportation, world trade rose 0.9% in December after a 0.6% decline in November, as measured by the CPB World Trade Monitor. Fourth-quarter world trade increased 1.1% after a 2.0% bump-up in the third quarter last year. World industrial production had a slight 0.4% monthly sequential increase in December from November after a 0.5% sequential rise in November. However, volume of U.S. imports increased from 114.5 in November to the 2014 peak of 119.4 in December (2005=100), while export volume peaked at 150.3 in October and decreased to 149.3 and 148.5 in November and December, respectively. According to the CPB World Trade Monitor, world exports were at 140.4 in December, down only slightly from the October peak of 140.7, while imports reached the 2014 peak in December at 138.1.

Freight demand remains solid for the trucking industry within the U.S., as the ATA truck tonnage index showed an increase of 3.5% for full-year 2014. For January, the index inched higher by 1.2%. Further, highway brokers and carriers are both seeing robust pricing power thanks to secular truckload-capacity constraints. Rail carload volume remains positive, increasing for full-year 2014 by roughly 4.5% over 2013. However, carload traffic for February declined 1.1% after a year-over-year January increase of 5.6%.

Lower fuel cost should be a tailwind for transportation in 2015. West Texas Intermediate crude fell from $109 in July 2014 to its current trading range just below $45. During the third quarter of 2014, the International Air Transport Association forecast that global airlines' profit would be $19.9 billion in 2014 but increase to $25 billion in 2015 due mainly to lower fuel cost net of ticket pricing. We expect reductions in rail fuel costs, which account for roughly 15% to 20% of annual expenses, to have a mostly neutral midterm impact due to effective fuel surcharges, but the loss of oil shipments is likely to reduce volumes slightly. According to the U.S. Department of Transportation, if truckers' average fuel economy is between 5 and 7 miles per gallon with the price of a barrel of oil between $60 and $80, the cost per mile would be around $1.82. At current levels, the price of a barrel of oil might imply 30% to 50% savings in fuel cost. Because of the aforementioned truck capacity constraint, however, we don't expect to see a major shift from railroad intermodal to trucking.

MSC Industrial Direct

MSM

Within the industrial distribution industry, MSC dominates the $10 billion metalworking segment and is roughly 5 times larger than its nearest competitor. MSC differentiates itself by competing on deep metalworking expertise, quick product delivery, and automated inventory stocking and ordering solutions for customers. MSC also differentiates its business from the competition through aggressive information technology investment, which has helped the company increase the ways it can service the customer, including vendor-managed inventory and vending machine systems. These solutions make the purchasing process completely automated, so customers waste little time refilling orders. This emphasis on IT investment has raised website and electronic portal sales to 44% of the overall corporate sales.

MSC's vendor-managed inventory capabilities and its vending machine initiative increase switching costs. These offerings broaden MSC's distribution capabilities and create another sticky element to the distributor-supplier relationship, making it more problematic to switch to another distributor and away from MSC. Additionally, the company's suppliers prefer to sell via distributors because selling directly to end users often is prohibitively expensive and outside of manufacturers' core competency. In total, MSC performs the selling function for nearly 3,000 suppliers and sells to 325,000 customers. It provides value to each constituency and has generated an 18% average return on invested capital over the past 10 years.

General Motors

GM

GM is poised to see the upside to high operating leverage thanks to rising volume and smarter manufacturing than in the past, including a reduction in its vehicle platforms. 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 10.5 million to 11 million U.S. industry units.

We believe many investors are focused on the large underfunding of pension and other postemployment benefits, the recall, and the overhang of government and VEBA ownership. However, the pension will not be due all at once and is closed to new participants. The U.S. Treasury exited GM in late 2013, and we expect the federal Canadian government to exit soon now that the Ontario government sold in early 2015. 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 2014 of $0.30 a quarter, which is going to increase this year to an annualized rate of $1.44, equivalent to about a 3.8% yield. In March, GM announced a clear capital-allocation policy that will see the company buy back $5 billion of its stock before the end of 2016. The company also reduced its cash target to $20 billion from $20 billion-$25 billion previously.

The ignition switch recall increases headline risk and litigation risk, but we think GM can pay any fines or judgments that come its way thanks to $37.2 billion of automotive liquidity at year-end 2014, including $25.2 billion of cash. Last 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 think this accrual will prove too high, but we factor a conservative penalty into our valuation. It would take a lot more bad recall news for us to materially decrease our valuation further.

Joy Global

JOY

We believe that mining equipment manufacturer Joy Global is undervalued by the market. Although we do not think the mining equipment industry is on the cusp of a dramatic recovery, we do believe that Joy stock, which is trading between 11 to 12 times our 2015 free cash flow estimate, is inexpensive for a business where conditions are stabilizing. Joy Global is unique relative to its peer group, in that roughly 70% of sales come from aftermarket parts and service. Most competitors have given this business to their dealers.

While mining capital expenditures are clearly inclined to fall in 2015 and potentially in 2016, mining customers have finally reached a point where they have to begin rehabbing their fleet of equipment, which should benefit Joy Global. Joy is also unique because roughly 60% of the company's business is exposed to coal (predominantly in the U.S.). While most major commodity prices have continued to plummet, U.S. coal consumption ticked up in 2014, while thermal coal prices actually stabilized. Even though our long-term outlook for U.S. coal consumption is not for growth, our basic materials team sees upside in Powder River Basin coal prices and stability in Illinois Basin coal prices beyond 2015.

We think these conditions mean that Joy Global is inexpensive relative to near-term earnings with share price upside to a future recovery in new equipment sales. Lastly, Joy is not solely captive to its environment. Over 2014, management pulled $80 million of cost out of the business and in 2015 plans to remove another $25 million of expenses. The company's attractive free cash flow has been used to buy $483 million of stock over the past 18 months, and it is authorized to buy back another $517 million through August 2016. We believe this cash deployment is particularly attractive relative to Joy's $4.3 billion market capitalization.

More Quarter-End Insights

• Stock Market Outlook: Proceed With Caution
• Economic Outlook: More Slow Growth but Labor Scarcity
• Credit Outlook: Demand Rises for Higher-Yielding U.S. Dollar-Denominated Debt
• Basic Materials: China Will Keep a Lid on Most Commodities
• Consumer Cyclical Investors: Shop Carefully in 2015
• Consumer Defensive: Attractive Companies, Top-Shelf Valuations
• Energy: Coping With Lower Oil and Gas Prices
• Financial Services: Bank Worries Are Overdone
• Health Care: 3 Picks in a More Expensive Sector
• Real Estate: REITs That Can Weather a Rising Rate Environment
• Tech and Telecom Sectors: Time to Be Selective
• Utilities: Bloody February Brings Valuations Back In Line