Industrials: High-Quality Industrials Are on Sale

• Our industrials coverage currently trades almost 3% below fair value, changing course after our prior quarterly update when the sector was overvalued by nearly 4%.
• Increasing concerns about supply imbalance in oil and gas along with a weakening Chinese economy contributed to a sell-off in many industrial names with economic moats.
• Longer term, we believe that near-term headwinds crimping organic revenue growth in the sector will abate; therefore, this recent pullback gives investors an opportunity to buy high-quality names with sustainable competitive advantages at a discount.

Since our last update, heightened concerns of slow global growth driven by a weakening Chinese economy and ongoing supply imbalance in the oil and gas sector caused many blue chip names in our industrials coverage to sell off. As near-term uncertainty roils markets, we believe that the summer's volatility created a better entry point for longer-term investors interested in owning industrial companies with economic moats.

At the time of writing, industrials stocks carry a market price/Morningstar fair value estimate ratio of 0.975 on average (2.5% undervalued compared with our discounted cash flow-derived fair value estimates); whereas in our prior update, the group was about 4% overvalued. In our view, this change of direction opens opportunities for longer-term investors to establish or add to positions at more attractive valuations. From zero previously, we now have one name trading in 5-star territory

Most obvious to us is the battering of industries with significant exposure to the oil and gas sector, with diversified industrials, conglomerates, and industrial distributors all appearing cheap relative to our broader industrials coverage universe. These industries, which also include many wide-moat stalwarts such as

Railroad stock prices have also retreated from recent peaks as investors worry that cheaper fuel may benefit trucking at rail's expense, while diminishing coal and crude-by-rail volumes continue to cause concern. Coal is undoubtedly losing heat as a rail commodity, diminishing from 6.7 million cars and 20% of 2005 volume to 5.4 million and 16% of total 2014 volume at publicly traded North American Class I railroads (excluding BNSF and Ferromex). Crude by rail is the fastest-growing railroad commodity of late, contributing more than one fourth of the volume gains during the past couple of years; yet, crude remains a small part of most railroad cargo and likely isn't enough to offset declines in coal volumes over the years. Nevertheless, we look beyond the shifting mix of rail shipments and continue to highlight that railroads claim quadruple the fuel efficiency of trucking per ton-mile of freight and make more effective use of manpower. Even for goods that can be shipped by truck, we estimate railroads charge 10%-30% less than trucking to move freight over the same lanes. These advantages underpin our wide economic moat ratings, and when quality wide-moat enterprises such as these go on sale, we encourage investors to take notice.

In recent years, many industrial companies looked to China and other emerging markets to boost top-line growth beyond the typical GDP-type cadence expected from developed markets. However, with the spectacular crash of the Chinese markets making headlines in August and economic data coming out of the country failing to provide a silver lining, expectations for growth in this important market began to retreat. In mid-September, the Chinese National Statistics Board reported that the country's industrial output rose 6.1% and fixed asset investment increased 10.9% year over year, arguably robust measures that in actuality missed analysts' inflated expectations. As such, we've witnessed the associated sell-off in subsectors with direct or even indirect exposure to Chinese industrial activity, such as mining equipment manufacturers and shipping companies. Other durable goods manufacturers, which run the gamut from infrastructure equipment necessary for basic economic development to finished building systems to automobile manufacturers, all experienced share price weakness as Chinese economic contraction will negatively impact organic sales growth prospects in each of these product categories.

Although we agree that industrial top lines have shown some stagnation due to this phenomenon, we contend that many of the companies in our coverage list have made significant investments in China and are prepared to stay the course. Over the long run, we still expect this growing economy to generate outsize sales of industrial equipment, and we believe that moaty market leaders with operational entrenchment in the country will ultimately benefit.

To elaborate on China's impact on the auto sector, we've remarked that European automakers, in particular, will experience lower near-term profitability from weakening China vehicle demand. Nevertheless, we would use weakness in stock prices as an opportunity to own shares of European automakers, as our long-term thesis continues to use an annualized long-term demand growth rate in the mid-single digits. Admittedly, our forecast of 26 million-28 million units by 2020 remains more conservative than that of

BMW

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Among our top picks this quarter, we include BMW because of its moat, rather than adding other automakers we've mentioned in prior outlooks that trade at a discount to their fair values (such as

General Electric

GE

After appreciating earlier this year in response to the accelerated disposition of GE Capital, we believe that GE's exposure to both the oil and gas sector and a weakening Chinese economy caused shares to pull back. However, after several years of significant changes to its portfolio, we believe that General Electric is on the verge of a comeback. We acknowledge that investors have been hard-pressed to forget GE Capital's role in the financial crisis, a sentiment that kept GE's shares from recovering as quickly as others in the diversified industrials peer group. Nevertheless, the company used the following years to retrench, choosing to shrink GE Capital considerably, and focus on the legacy industrial core that provides the foundation of its wide economic moat. As GE begins to realize the fruits of an intense period of reinvestment in support of its most moaty industrial businesses, we expect enhanced industrial ROICs and growth in shareholder value. Our fair value estimate of $30 per share reflects our confidence that recent portfolio actions support General Electric's wide economic moat, and we believe the company's competitive positioning is better than ever. While macroeconomic headwinds will always challenge a firm with a global footprint as large as GE's, we believe that the current risk-reward relationship is compelling. In addition, the dividend currently yields close to 4%.

Royal Philips

PHG

We believe the market is undervaluing narrow-moat lighting and health-care equipment manufacturer Philips relative to our fair value estimate of EUR 31 per Amsterdam-listed share and $33 for the ADR shares. In our view, the LED component sale in first quarter of 2015 is a strong indication of management's ability to command a value-enhancing price for the lighting business. The next big catalyst is the separation of the lighting solution unit. We believe the breakup of the company has potential for shareholder value creation and better allocation of capital. Additionally, we expect improving operational performance in 2015-16 for Philips' health-care division and continuation of the strong performance of the firm's Consumer Lifestyle segment. We are particularly pleased with Philips' increased production and shipment ramp-up at the U.S. Cleveland manufacturing facility, although more work remains to be done. In the second quarter, Philips reported strong performance in consumer lifestyle and health care despite a slowdown in Western Europe and a more difficult Chinese market, which represents almost 10% of group sales. On Sept. 15 at Philips' Capital Markets Day, management formalized its previously issued guidance to reflect slightly stronger-than-expected headwinds in these markets, resulting in somewhat lower expectations for both sales and EBITA margins. Regardless, we believe the firm is on track to manage through these challenges, allowing a stronger company to emerge post-breakup.

Union Pacific

UNP

Trading at a greater-than 20% discount to our $114 fair value estimate, wide-moat UP is the largest North American railroad and our most undervalued transport name. Coal constituted 16% of UP's sales last year, and second-quarter coal volume declined 26% versus the year-ago period, as still-low natural gas prices, mild weather, and high utility coal inventories have suppressed demand. We incorporate a 15% full-year coal decline and maintain our expectations of coal declines going forward, offset somewhat by growth in intermodal units. Managing head count is complex, but matching labor to work is key to operating ratio performance. The rail has about 7% annual attrition and needs some head count for capital projects, so while this matter has management's full attention, flexing with demand takes time. In late July, we increased our projection of labor cost as a percentage of revenue by 100 basis points for 2015, but we still believe the rail will continue to make more effective use of manpower, fuel, and machines, attaining a 60% OR next year (2014 was 63.5%, and we now model 63% for 2015). In sum, we like UP for its diverse portfolio (PRB coal, intermodal franchise at L.A./Long Beach and fast-growing domestic, high auto exposure, and frac sand), room to improve OR a bit, conservative management, and 2.5% dividend yield--among rails, only

More Quarter-End Insights

• Stock Market Outlook: Minor Correction Not Enough to Make Stocks Cheap
• Economic Outlook: As World Growth Falters, the U.S. Consumer Rolls Along
• Credit Markets: Plummeting Commodity Prices Take Their Toll
• Basic Materials: U.S. Construction Activity Provides Shelter From the Storm
• Consumer Cyclical: Near-Term Concerns Over China Create Buying Opportunities
• Consumer Defensive: Upside in Staples Companies With Long-Term Cost-Cutting Opportunities
• Energy: No Rapid Rebound for Oil Prices
• Financial Services: Re-Analyzing Banking Systems and Bank Moats
• Health Care: Recent Pullback Opens Door to More Compelling Valuations
• Real Estate: For the Strong Stomached, Commercial Real Estate Looking More Attractive
• Tech and Telecom: Still Watching Foreign Exchange Headwinds and the Cloud
• Utilities: Low Rates Keep the Sector's Lovefest Raging