Industrials: Baking In Too Much Optimism

• U.S. auto sales may be done growing on a full-year basis for this cycle, but we remain upbeat on demand. Even if sales fall considerably from the mid-17 million unit level--to 16 million, for example--that's still a healthy level for profitability across the supply chain.
• New single-family home construction remains healthy, and we project new single-family starts will increase more than 6% this year. Homebuilder and building materials companies should continue to benefit from increased new-home demand.
• Rail traffic throughout North America remains lackluster. Total traffic year-to-date is down about 5%, with both intermodal units and carloads under pressure. That said, intermodal container demand should see improvement in the year ahead, and we continue to believe intermodal is the key secular volume growth driver for the rails, with help from truck-to-rail conversions.

As a whole, industrials stocks saw a solid uptick throughout the fourth quarter, outperforming the broader market, including a meaningful bump for many U.S.-based names following Republican Donald Trump's victory in the November presidential election.

We think higher valuations following the election relate in part to investor optimism surrounding potentially stronger U.S. economic growth in the years ahead, driven in part by the prospect of fiscal stimulus such as corporate tax cuts. While there are exceptions, for the most part we think it’s a bit early to bake such an outcome into our model assumptions and fair value estimates.

On average, industrials have been hovering in fairly valued territory, and the recent swing upward pushed many stocks one step closer to modestly overvalued territory. Currently, our industrials coverage is trading at roughly a 7% premium to our fair value estimates on average. Said another way, fewer than 20% of stocks we cover trade in 4-star or 5-star territory. Nonetheless, the space isn't without its opportunities, and we would point to Kion Group, Stericycle, and Fiat as stocks that look attractive.

In terms of fundamentals, underlying industrial sector conditions have seen improvement this year, though we wouldn't characterize trends as robust just yet. In the U.S., the Institute for Supply Management's manufacturing Purchasing Managers' Index, or PMI, improved throughout the year, turning positive by the second quarter and averaging 52.6 in October and November (with November coming in at 53.2). The recent numbers point to manufacturing expansion but are still running below levels seen in early 2015.

In terms of the retail sector, which impacts freight demand for the trucking, intermodal, and logistics providers, consumer spending is healthy (up more than 3% on average thus far this year), but shippers’ inventory levels remain elevated in the U.S. This factor will continue to temper shipment volumes into the first half of 2017 as inventories work down, but we expect gradual improvement.

Manufacturing data in Europe is also generally positive, with the Markit Eurozone Manufacturing PMI registering 53.7 in November. Preliminary reports suggest manufacturing growth accelerated slightly in December; thus, Europe is on track to finish out the year on a decent expansionary note, with help from a weaker euro. The Caixin China General Manufacturing PMI read 50.9 in November, representing a moderation from 51.2 in October, but it was still the second highest reading in two years and suggests continued strengthening in the region.

Looking at a few subsectors, we expect total U.S. housing starts to increase 3.4% in 2016 to 1.15 million starts and single-family starts to increase 6.4% to 760,000 starts. We remain bullish on the long-term prospects of single-family housing, as millennials eventually settle families in suburban areas.

To date, financial constraints have remained a limiting factor for millennials. However, slow income growth and student debt obligations have merely postponed millennial home ownership. With wage growth approaching 4%, those still living with parents will have more opportunity to cover rental payments or save for a down payment.

Although mortgage rates have recently ticked up, current rates are about in line with the average rate between 2014 and 2015 when starts increased by more than 10%. We expect that future meaningful rate increases will come in tandem with an improving economy and growing wages.

Automakers reported November U.S. light-vehicle sales on Dec. 1 that got help from incentive spending as well as two extra selling days compared with November 2015. Total sales rose by 3.6% year over year to about 1.38 million, while the seasonally adjusted annualized selling rate, SAAR, was 17.83 million per Automotive News compared with 18.17 million in November 2015. TrueCar estimated November incentives increased 13% from November 2015 to $3,475 a unit. We expect December will be a good month as automakers clear out remaining 2016 model year inventory and heavily advertise holiday sales programs.

We still think that the industry is done growing on a full-year basis for this cycle due to a rising supply of used vehicles coming from the off-lease market and already-high penetration of leasing. We do not think a recession is imminent, and we remain upbeat on U.S. auto demand because even if sales fall all the way to 16 million from the current mid-17 million range, that is still a very healthy level for profitability across the supply chain.

The North American railroads continue to grapple with anemic overall carload trends. Total carloads and intermodal units are down year to date approximately 8% and 2%, respectively. Weakness has been most pronounced for carloads carrying coal, petroleum products, and metals and metallic ores. Low natural gas and oil prices continue to constrain coal and crude shipments.

That said, although intermodal container volume is currently facing headwinds from depressed rates in the competing truckload-shipping sector, we believe conditions will improve by the second half of 2017 as truckload capacity tightens thanks in part to the limited driver pool and work-hour-logging device installations required by new regulations; this dynamic should help reignite truck-to-rail conversion activity.

Overall, our optimism concerning intermodal container volume offsetting coal declines has been stymied this year, but we still think intermodal will be the secular growth engine for the rails longer term. Additionally, volume malaise and decreased commodity prices have posed insufficient concern to threaten our moat ratings or dramatically transform long-term sector fundamentals--indeed, margins remain strong. Extensive track networks form staggering barriers to entry that we expect to remain high, fending off economic moat deterioration. We also note that improving intermodal activity will benefit the intermodal marketing providers, which originate most of the freight moving on domestic intermodal containers.

Top Picks

Fiat Chrysler

FCAU

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $16.00

Fair Value Uncertainty: Very High

Consider Buying: $8.00

Fiat Chrysler makes automobiles (Fiat, Chrysler, Dodge, Alfa Romeo, Lancia, Abarth, Fiat Commercial, and Maserati), automotive parts (Magneti Marelli), engines (Teksid), and industrial robots (Comau). We believe the market continues to aggressively punish Fiat Chrysler's valuation owing to incredulity over management's five-year plan and a debt-laden balance sheet. Even though our forecast already includes significant discounts relative to management's objectives, our fair value estimate is double the market's consensus price target. Additionally, this 5-star-rated stock currently trades at roughly half our fair value estimate. Even though Fiat Chrysler's profitability is at the low end of the industry range, we think the market has missed the margin expansion potential resulting from a richer product mix, potential operating leverage from Brazil and China as new products launch, and the impact of demand recovery in Europe.

Kion Group

(

)

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: EUR 70.00

Fair Value Uncertainty: Medium

Consider Buying: EUR 49.00

Kion Group is a global leading manufacturer of forklifts and warehouse automation systems. Kion's share price offers attractive upside to our EUR 70 fair value estimate with the market exercising caution in the near term for two reasons.

First, with its recent acquisition of Dematic, the company is carrying a significant amount of debt, which it has already started to reduce but could lead to a dilutive equity issuance in 2017. We forecast debt coming back to normalized levels by the end of 2018, excluding an equity issuance.

Second, Dematic’s plan to open an additional manufacturing plant in North America has met with delays resulting in cost overruns. This will cause some margin weakness in 2017 on a reported basis. However, the underlying profitability should remain strong and resurface on a reported basis in 2018.

We are less concerned than the market over these short-term issues as we believe that Kion is in an excellent position to capture growth from a structural change in warehouse management. The industry is moving toward greater automation with customers beginning to ask for end-to-end solutions that can integrate forklifts and sorting and picking systems. With its Dematic acquisition, Kion can offer this using a propriety software system refined using its own library of data collected from years of warehouse management experience.

E-commerce is still in its early stages and will drive increasing demand for automation systems that enable cost savings and improvements to next-day or same-day delivery. Despite rapid growth, e-commerce still accounts for only a small portion of global retail sales, just 8% in the United States and about 14% in China. The low penetration levels suggest a long runway for growth, as we believe forklift sales will naturally follow the expansion of warehouses needed to support an e-commerce supply chain. As one of the few companies globally that can offer a full suite of warehouse automation, we think Kion Group will offer attractive long-term revenue growth and increasing returns.

Stericycle

SRCL

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $105.00

Fair Value Uncertainty: Medium

Consider Buying: $73.50

Stericycle is the largest domestic provider of regulated medical waste management to large-quantity generators (such as hospitals and pharmaceutical companies) and small-quantity generators (such as medical and dental offices); international operations represent nearly 30% of total revenue.

The current market price of Stericycle shares reflects a discount of nearly 30% versus our fair value estimate, a significant margin of safety. Following the $2.3 billion purchase of Shred-It in 2015 and the $275 million PSC Environmental deal in 2014, we've seen Stericycle accelerate its evolution from a pure-play medical waste company toward a comprehensive provider of ancillary services. Adding these compliance-driven services expanded Stericycle's addressable market far beyond healthcare into the industrial, retail, legal, and financial landscapes; however, we believe the better potential resides in generating incremental revenue streams from Stericycle's healthcare customers through bundled service adoption.

We expect recently disclosed pricing headwinds to progress through a three-year contract cycle. In the meantime, we believe that Stericycle's efforts to re-energize organic growth will largely come from strategic sales deployment, which has the potential to offset price declines in the existing customer base by targeting new customer additions, as well as increasing penetration of ancillary services across the customer base. We expect these efforts to support our midcycle organic revenue growth target of 5% and 20% EBIT margins.

More Quarter-End Insights

Market Outlook: New Expectations Set the Tone for 2017

Economic Outlook: More of the Same Anemic Growth

Credit Insights: Global Rates on the Rise

Basic Materials: China-Led Rally of 2016 Rests on a Shaky Foundation

Consumer Cyclical: Poised (and Priced) for a Strong 2017

Consumer Defensive: Cooking Up a Bit More Value

Energy: OPEC Adds a Plot Twist, but Ending in Unchanged

Financials: What Will Really Drive Interest Rates?

Healthcare: What Does a Trump Administration Mean for Healthcare Stocks?

Real Estate: Through the Noise, Opportunities Exist

Technology: This Firm Is the Newest Software Empire

Utilities: Still High Even After Bonds' Withdrawal