Industrials: China Shows Signs of Softening, but the Sector Remains Healthy Overall

• Industrial stocks were about 10% overvalued in our first-quarter report, and this ratio has declined slightly, with our sector coverage's market price/fair value estimate ratio at 1.07. Our fair value estimates have increased on some names, partly due to a new department-wide tax policy, where we model the U.S. statutory corporate rate falling to 25% from 35% in 2018.
• Industrial activity still looks healthy with expansion levels of the Institute for Supply Management's Purchasing Index for U.S. manufacturing and solid freight volumes.
• U.S. auto sales almost certainly peaked in 2016, but current U.S. levels are nowhere near recessionary, and sales in China and European registrations are still up year over year.
• Millennials' homebuying is causing surging demand for housing at the lower end of the pricing spectrum.

Despite the initial market euphoria of a Republican presidential victory turning into uncertainty over what, if any, changes such as tax reform will come out of Washington, manufacturers seem quite willing to move ahead with investments.

The April U.S. PMI fell to 54.8 from 57.2 in March but remains well above the threshold indicating expansion of 50, with May's reading of 54.9. Survey respondents reported that the economy grew for the 96th straight month in the ISM's May Report on Business. May's PMI saw 15 of the 18 manufacturing sectors surveyed growing, led by nonmetallic mineral products, furniture, and plastics and rubber products.

Apparel and textile mills reported contraction in May relative to April, but sentiment across the PMI survey cited very healthy business conditions, and respondents from fabricated metal products and food, beverage, and tobacco products cited difficulty in finding workers. The index last fell below 50 in August 2016.

May's employment report saw unemployment reach 4.3%, a 16-year low, but our economics team would like to see more actual jobs being created, and there remains debate as to whether there are too few jobs or too few workers. The May report showed 138,000 jobs created, coming in well below the consensus expectation of 185,000.

Our director of economic analysis, Bob Johnson, continues to look for second-quarter U.S. GDP annualized growth of 2.5%-3.0%, up from the government's first-quarter number of 1.2% (revised up from 0.7% originally reported). April durable goods orders did decline from March by 0.4%, but Johnson sees this as nothing to be too alarmed about after three good months of growth to start 2017. Five of the six major sectors tracked posted a decline, with only computers and electrical components increasing orders. The Federal Reserve's Industrial Production Manufacturing index through April is averaging 103.986, up about 1.1% year over year, and through April, the index has increased from the prior month in each month of 2017, except in March.

International markets are not showing major signs of distress either, but Chinese growth is slowing and something to keep an eye on. China's National Bureau of Statistics Purchasing Managers Index dipped in April to 51.2 from 51.8 in March and remained at 51.2 in May. The government's index has remained above 50 since a 49.9 reading last July.

The Caixin PMI, which focuses on small and midsize Chinese firms and is administered by the private sector, fell to a seven-month low in April of 50.3 and grew at its slowest pace since September 2016. The May Caixin PMI brought more weakness, with the index falling below 50 for the first time in 11 months to 49.6. The report also cited the slowest growth in new order books since the most recent upturn began in July 2016. Employment is also concerning, with the survey saying job losses slightly increased for the third straight month, and May had the largest decline in workforce numbers since September. The survey mentioned some downsizing but also the nonreplacement of workers who voluntarily quit, none of which indicates confident companies. Continued weakness in China would potentially have ramifications across a wide swath of our industrials coverage, including large diversified manufacturers and autos.

The IHS Markit Eurozone Manufacturing PMI for May contrasted well with China's reading, posting a 73-month high of 57.0. The index has come a long way from below 35 in 2009. Seven of the eight nations surveyed reported improved business conditions, led by Germany, with its fastest growth rate in over six years. German PMI was a 73-month high of 59.5. Only Greece posted a contraction level below 50, with its 49.6 level still a nine-month high for the country. Eurozone manufacturing production grew at its fastest rate since April 2011, and for the first time since November 2016, employment rose in all nations surveyed. Moreover, manufacturing backlog grew for the 25th consecutive month at a rate not seen since April 2011, which is also encouraging. Firms that sell industrial equipment in Europe may be seeing more growth coming, as per the survey, supplier capacity is strained, with vendor lead times increasing at the largest rate in over six years.

Demand for industrial bellwether

Another conglomerate,

Autos Trends throughout our industrials coverage suggest plenty of healthy data, but areas such as Chinese autos or rail volume could be better. European passenger car registrations are healthy, with year-to-date growth through April up 4.7% year over year. Even the U.K. is still up 1.1%, despite the uncertainty of Brexit's effects on the economy. The five largest markets of Germany, the U.K, Italy, France, and Spain, which together comprise about 75% of registrations, have grown 3.5% year over year through April.

Chinese passenger demand in the first quarter increased year over year by 4.6%, led by SUVs growing by 20.9%, per data from the China Association of Automobile Manufacturers. With the government increasing the sales tax on vehicles with engine displacements up to 1.6L back to 10% (from 7.5%) in 2018, we expect a prebuy rush in the fourth quarter. Vehicles with this displacement make up over 70% of the Chinese passenger car market.

For U.S. autos, we made a call earlier this year that sales peaked for this cycle in 2016 at 17.54 million, and that prediction is playing out through May. After April's sales fell by 1%, adjusting for one less sales day in April 2017, May's sales to end customers fell 0.5% (down 4.5% adjusting for one extra selling day this May), and sales for the first five months of the year are down 2%, not far from our full-year expectation of a roughly 2.5% decline to a range of 17.0 million-17.2 million.

Sales have fallen year over year for five straight months. Incentive pressures have elevated this year, but we do not see an across-the-board price war under way. Cheap gas and some crossovers cheaper than large sedans are resulting in a continued mix shift to light-truck models (crossovers, SUVs, vans, and pick-ups) from cars, which is helping incentive pressures. In 2016, light trucks' share of the U.S. market increased by 400 basis points versus 2015 to 60.7%. This shift continues in 2017, with the year-to-date light-truck mix through May up 410 basis points year over year to 62.8%.

Crossovers are the big winner in this shift, while midsize sedans are the biggest loser. Vehicle segment share data shows crossovers through May constituting 33.5% of the U.S. market, up 290 basis points year over year, while midsize sedans have lost 260 basis points of share and now comprise 13.6% of the market. This news is not as favorable for

For the first five months of 2017, U.S. car model sales have declined year over year by 11.6%, while light truck models are up 4.8%. Light trucks did surprisingly post roughly flat growth in April but rebounded in May to grow by 6.2%. Despite slowing U.S. auto demand, we do not see current levels as anywhere close to a recession, or as indicative that a recession is imminent. Automaker executives would be quite happy to see sales sit in the 16 million-17 million unit range forever. Sales won't stay here forever, as it's still a cyclical business, but the industry is still at reasonably healthy volume.

Housing U.S. housing demand is improving, and we believe U.S. residential construction growth will be robust over the coming decade, but the road to a fuller recovery has proved longer than expected. Household formation is building momentum, but slowly, especially among younger adults.

Younger adults were hit harder by the global financial crisis than any other age group, and their circumstances have been slowest to improve. Household formation among younger adults has been correspondingly weak post-crisis, which explains much of the slow pace of the housing recovery. We estimate as many as 2 million households were "postponed" among the 25-39 age group since 2006.

Recently, conditions have begun to improve for younger adults, setting the stage for stronger housing activity in the years to come. Labor markets have tightened since early 2015, catalyzing a significant and long-awaited rebound in inflation-adjusted wages for younger adults. With unemployment remarkably low, underemployed young workers are finding better job opportunities. Household formation among younger adults should accelerate, with a lag, as balance sheets are rebuilt. Rising mortgage rates are unlikely to prove an insurmountable barrier to homeownership, nor do we see any evidence that millennials are meaningfully less inclined to own than prior generations. Meanwhile, new housing supply is changing to meet nascent millennial demand, as homebuilders' mix shifts to affordable starter homes.

Year-to-date housing starts have been running at a seasonally adjusted annual rate of just over 1.2 million, about in line with our forecast for total housing starts in 2017. However, we expect housing starts will accelerate through 2021 as 2.25 million new households are formed by those aged 25-39. We expect starts to peak at 1.9 million by 2021 before falling back to a demographically sustainable 1.5 million.

Railroads North American railroads are benefiting from solid recovery after nearly two years of freight recession. Total North American carloads are up 7.6% for the year to date through late May, and intermodal units are up 3%. We find the intermodal recovery encouraging, but attribute much of the other growth to three idiosyncratic situations related to commodity prices and weather, rather than a sign of broad economic expansion.

First, after sliding for years, coal volume tipped into free fall during most of the past two years. This year, because natural gas is more expensive than coal in some regions, coal volume has improved 18% in the year to date over last year's weak comparisons. Some export coal is also helping, particularly in the East, backfilling demand for Australian mines taken off line due to harsh weather.

Second, U.S. and Canadian grain harvests were robust last year, and grain and farm products carloads are up 10% and 17% so far this year.

Third, due to more attractive natural gas prices and somewhat stable oil prices, well activity has increased, and frac sand shipments have expanded tremendously from 2016 lows.

In keeping with our auto team's sales expectations for this year, rail shipments of motor vehicles and parts are down 3.8% in 2017--autos had been a rare bright spot in rail volume in 2015-16.

Although intermodal container volume is still grappling with headwinds from depressed rates in the competing truckload-shipping sector, we still believe conditions will improve by the first half of 2018 as truckload capacity finds a healthier balance, driven by work-hour-logging device installations required by new regulations. Essentially, the intermodal industry needs full-truckload pricing to firm--excluding fuel, TL industry rates fell 1.5% on average last year and were still down slightly less than 1% (year over year) in the first quarter. As those trends improve, we expect truck-to-rail conversion activity to recover, benefiting both the Class-I railroads and intermodal marketing companies, which originate most of the freight moving on domestic intermodal containers.

Overall, our optimism concerning intermodal container volume offsetting coal declines has been stymied over the past year and early in 2017, but we still think intermodal will be the secular growth engine for the rails in the longer term. Additionally, volume malaise and decreased commodity prices have posed insufficient concern to threaten our railroad 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.

Top Picks

Currently, our industrials coverage is trading at roughly a 7% premium to our fair value estimates on average. As in our first-quarter update, 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 GM, Johnson Controls,

(

) as some of the stocks that look attractive.

General Motors

GM

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $51.00

Fair Value Uncertainty: High

5-Star Price: $30.60

General Motors is starting to see the upside to high operating leverage, thanks to lower fleet sales and smarter manufacturing than in the past, including a reduction in its vehicle platforms. 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 per quarter, followed by a 20% increase in 2015 and another 6% increase in 2016, equivalent to a yield often in the 4%-5% range.

In January 2017, GM announced an additional $5 billion buyback authorization with no expiration date, in addition to the $9 billion by the end of 2017 it had already announced. Buybacks totaled $6 billion at year-end 2016, and after the Opel sale announcement, GM changed its guidance for 2017 buybacks to total $5 billion (about 10% of GM's market capitalization) from $3 billion. In March GM announced a lowering of its cash target to $18 billion upon completion of the Opel sale in late 2017. We like that GM is focusing only on markets where it can be profitable in the long term, even if that means exiting a huge market such as Europe, where it has not made money since 1999, or large markets such as India where GM's share was minuscule.

Our investment thesis is based on great product and manufacturing efficiencies rather than top-line growth, and the company isn't done reducing its cost base--it is $4.5 billion into removing $6.5 billion of costs through 2018 from year-end 2014 levels, up from previous cost-reduction guidance of $5.5 billion. Further reductions in platforms and partnering with suppliers to gain purchasing scale and save on shipping costs are starting to have an impact, but the transformation is not complete.

Key holes in the U.S. product lineup (full-size sedans, full-size trucks, and SUVs) are now filled or will be this year as the new generation of crossovers launches. 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-11 million U.S. industry units. 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 $34.4 billion of automotive liquidity as of March 31, including $20.4 billion of cash.

We see GM remaining viable even in an autonomous world, as it is making the right investments now. Examples are its Maven car-sharing brand, taking about a 9% stake in Lyft, bringing the all-electric Chevrolet Bolt to market well before

Johnson Controls International

JCI

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $54.00

Fair Value Uncertainty: High

5-Star Price: $32.40

Before its recent transformation, Johnson Controls was long viewed as an automotive-parts company, and rightfully so, given that the company had historically generated two thirds of its revenue from the automotive industry. Company veteran Alex Molinaroli stepped into the CEO role in 2013, and under his leadership, Johnson Controls embarked on a mission to transform itself into a true multi-industrial company by divesting noncore assets and acquiring businesses that complemented the building efficiency segment.

The most transformative transactions came in 2016, when the company merged with Tyco International (Sept. 2, 2016) and spun off its automotive seating business, now called

We are taking a more conservative stance than JCI management on the company's merger-related revenue and cost synergy opportunities, and we assume that the company realizes 70% of its goal. If we assume 100% of the company's synergy goal is realized, our fair value estimate increases to $58 per share.

Tyco, the global leader in security and fire-protection products and services, should nicely complement Johnson Controls' legacy building efficiency business, which is a global leader in HVAC systems and building automation and controls, and the combination should result in meaningful synergies and enhanced market penetration as the company eliminates redundant costs, streamlines operations, leverages research and development capabilities, and goes to market with a more comprehensive portfolio of products and services. Over the next three years, Johnson Controls is targeting $1.2 billion (about $1.10 EPS) of cost and revenue synergies. In addition, as an Irish-domiciled company, Johnson Controls should also benefit from a lower tax bill.

In addition to synergy realization, Johnson Controls should benefit from secular growth trends. We expect global urbanization, increased demand for smart building technology, and growing aftermarket and retrofitting activity to act as tailwinds for Johnson Controls' enhanced building technology business. Johnson Controls' power solutions segment is the largest producer of lead-acid automotive batteries in the world, manufacturing approximately 152 million annually. The company has 36% global market share and is the leading supplier in the Americas and Europe, and the firm is the third-largest supplier in China, with aspirations to become the second-largest by 2020. Power solutions' significant exposure to the inelastic aftermarket business (74% of segment sales) yields stability, while the segment's participation in emerging markets and start-stop vehicle technology provides substantial growth opportunities.

Fluor

FLR

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $61.00

Fair Value Uncertainty: High

5-Star Price: $36.60

Narrow-moat Fluor currently offers an attractive risk-reward trade-off for those willing to invest in a global market leader near its cyclical earnings trough. Our $61 fair value estimate represents our opinion that the market undervalues Fluor's broad-based competitive strengths, experienced management, clean balance sheet, and industry-leading order backlog. We expect this to translate into healthy growth as customers' appetite for discretionary capital spending steadily returns.

Engineering and construction providers have faced weakening demand since the crude oil and industrial commodities peak. However, it is now more than three years from the energy price peak, and we believe the downside risk to E&P spending declines are modest. Share prices for Fluor and other E&C stocks have eased in 2017, as the catalyst of optimism following the U.S. election fades. While we doubt a federal infrastructure spending boom is imminent, potential benefits from lower U.S. corporate tax rates, reduced regulatory burdens on business, and repatriation incentives all seem achievable and of tangible benefit to those considering capital projects.

Fluor is one of the premier "big-project" E&Cs, with a broad range of in-house capabilities tailored for billion-dollar project work in infrastructure, energy, petrochemicals, power, and industrial sectors. Industry-leading capabilities in offshore engineering, modular design, remote construction, and equipment leasing enhance its reliability and flexibility to keep large, complex projects on track.

Fluor's strengths extend across the entire energy chain. Rising domestic production will boost development in midstream distribution and logistics, as well as downstream refining. Demand growth from cheap energy beneficiaries in petrochemicals, power generation, and (within a few years) LNG appears set to grow. Rising government defense and security spending, along with demand from healthy niches in pharma, aerospace, and technology, offer further opportunities.

GEA Group

(

)

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: EUR 45.00

Fair Value Uncertainty: Medium

5-Star Price: EUR 31.50

GEA supplies food and dairy processing equipment, specializing in decanters and separators that determine a product's texture and consistency. These qualities are essential to brand creation for food companies, and together with food safety standards, create high switching costs for GEA's customers. Nearly another third of its equipment is used in food processing to make products such as edible oils, instant coffee, and baked goods. As GEA is a leading global supplier and the number-one or number-two player in nearly all its markets, it will benefit over the long term from increasing food production demand to feed the world's growing population, as well as urbanization increasing demand for convenience food.

We believe management's clumsy handling of its restructuring program has clouded the market's view of wide-moat GEA's long-term value, reflected in our EUR 45 fair value estimate. At issue, from the market's standpoint, is a disappointing margin relative to the company's previous medium-term guidance of 13%-16% adjusted EBIT margins, starting with a profit warning at the end of last year. Our forecasts are roughly 2% above consensus on revenue in the medium term. We think 2017 will mark a rebound in demand for dairy-related equipment, which drives about one third of revenue, and we also expect to see margin improvement by the end of the year.

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