Industrials: Worldwide Growth Is Resilient, But Valuations Look Full

• Industrial stocks were about 7% overvalued at the end of June, and this ratio has slightly declined, with a market price/fair value estimate ratio at 1.04 for our sector coverage. Despite this premium to our fair value estimates, we still believe that there are several opportunities for investors, including General Motors, Fluor, and Anixter.
• Worldwide growth shows signs of resilience despite nearly a decade of expansion since the Great Recession. We believe this resilience, especially excluding North America, is likely to continue, as several of our companies announced higher growth rates in their international segments relative to their North American segments.   
• Despite geopolitical turmoil and hurricanes, we see interesting trends across our industrial universe in the agricultural equipment, automobiles, and diversified industrial segments.

Ten years after the financial crisis, the global economy is experiencing a period of steady growth with limited inflation. Even though the Federal Reserve's industrial production report showed a 0.9% decline in August compared with a 0.4% increase in July, the report suggested that the drop was primarily related to the impact of Hurricane Harvey. Indeed, Capital Economics expects U.S. gross domestic product to rise 2.5% in 2018 and forecasts inflation to be a modest 2.1% next year.

Meanwhile, global industrial production growth appears to be on the rise. According to the National Bureau of Statistics of China, Manufacturing PMI rose 6.0% year over year in real terms. Additionally, the Markit Eurozone Manufacturing PMI was over 57.4 in August, 1.8 points above July's reading of 55.6, showcasing a continued strong growth trend in an area mired by financial banking turmoil in recent years.

Overall, global industrial activity is on the rise, and we remain optimistic about growth opportunities from increased demand and operating execution for most of our coverage universe. While the stock market can get ahead of itself at times with heightened optimism, we highlight a few themes in our sector, as well as actionable investment opportunities below.

Agricultural Equipment
The past few years have witnessed weakened crop prices, which have made the environment increasingly difficult for agricultural equipment manufacturers. However, the past nine months have shown a striking improvement from recent trough levels.

In fact, we view the agricultural equipment sector as a beneficiary of several green shoots that have sprouted as worldwide economic growth continues. Globally, we believe export data from Latin America and the Black Sea region show that those areas are witnessing record crop production despite recent political turmoil. Our view of an agricultural equipment recovery is further supported by the U.S. Department of Agriculture's recently published report, which shows a 2.3% increase in 2017 U.S. farm real estate prices, and by the recent  Deere (DE) earnings call, where management raised fourth-quarter revenue guidance for equipment sales.

Along with robust global demand growth, we continue to expect agricultural equipment companies that we cover to benefit from the farming sector's increased demand for productivity needs, particularly in the core large-farm market. Since there are many volatile variables, such as weather and commodity prices, farmers across the world are particularly attuned to factors they can control, like productivity. This has led larger farming enterprises to yield greater economies of scale and demand more resources. Deere and  CNH Industrial's (CNHI) extensive dealer networks will help them to gain from the adoption of new technological developments and increased farming equipment demand.

In conjunction with these positive dynamics, we see calorie consumption per capita growing with continued global expansion, and increasing farming operations in emerging-markets countries that have shown increasing willingness to utilize agricultural mechanization to meet this demand growth.

Notwithstanding these positive fundamental themes, we see the agricultural equipment industry buttressed by producers of seeds and pesticides that are continuously working to increase crop productivity, and whose products are implemented in conjunction with agricultural equipment. Thus, although a recovery from the recent trough levels may take time due to sluggish commodity prices, several pockets of optimism lead us to conclude that undervalued opportunities are present for stakeholders.

Autos
Trends throughout our industrial sector coverage suggest healthy global growth in the automotive industry, particularly internationally, with near-term U.S. growth likely to come from hurricane-affected areas. In fact, European passenger-car registration growth through August is up 4.5% year over year and displays healthier signs of growth compared with a 2.7% year-over-year decline in the U.S. The five largest markets of Germany, the U.K, Italy, France, and Spain, which together comprise about 75% of registrations, have grown 3.4% year over year through August.

While the exact losses from Harvey and Irma are not yet known, we have seen estimates between 200,000 and 1 million vehicles for Houston alone. After a couple of months for residents to assess damage, and in some cases receive an insurance check, we think the industry will see a surge in sales. However, we think supply shocks have temporary impacts on U.S. demand, and we anticipate greater automotive growth internationally.

Domestically, we see the Detroit Three as especially well positioned for a Harvey bounce because Texas is by far the largest state for full-size pickup truck sales, often at around 15% of the overall segment. Last year, the Detroit Three had about 94% of the full-size pickup market and 84% of the full-size SUV market. According to the National Automobile Dealers Association, Texas constituted 8.9% of new-vehicle registrations. We believe Houston's mix is 20%-40% of the state's sales, so it is possible that damaged vehicles in Houston equate to about a full year of sales for the area, if not more.

Internationally, we have seen two interesting trends within the auto sector: strong global consumption growth for both sports utility vehicles, or SUVs, and cross-over vehicles, or CUVs, as well as rising demand for non-internal-combustion powertrains (hybrids and electric vehicles). The popularity of SUVs and CUVs has spread from the United States to all parts of the globe, including China, Europe, and South America.

We believe that  Fiat Chrysler Automobiles (FCAU) is a big benefactor of the SUV/CUV craze, not only in the U.S., but all around the world. The company has realigned North American capacity for more pickup, SUV, and crossover volume, but Fiat Chrysler's U.S. sales mix was already about 85% light trucks in 2016. Globally, the company is expanding Jeep production with new capacity in Brazil, Italy, India, and China. Other new, upscale crossovers that reach global markets in 2017 and 2018 include the Maserati Levante and the Alfa Romeo Stelvio.

Second, the international auto market has also witnessed strong demand for hybrids and all-electric powertrains, with growth coming from rising consumer adoption.  BorgWarner (BWA) benefits from the growth in hybrid and all-electric powertrains. Demand for these powertrains is driven by worldwide clean air regulations. BorgWarner's powertrain technologies enable automaker customers to meet their legislated requirements for fuel economy and tailpipe emissions.

Diversified Industrials
A few common threads have emerged in recent months among suppliers of industrial gases, pumps and valves, components, and staffing services. Top-line growth was modestly but consistently higher, mainly due to stronger results offshore. Margins remain healthy due to volume improvement and efficiency gains. Higher cash flows stem from improvements in overhead efficiency and tight control over discretionary capital spending.

Industrial gas giants  Praxair (PX) and Linde (LIN) reached a definitive agreement for a merger of equals in June. A combination would create the leading global supplier with $60 billion of gross assets and an enterprise value exceeding $80 billion. We consider this a bold step that could cement the industry status quo for the next decade or beyond. 

Electronic materials demand growth has been robust for companies such as  Versum Materials , as volumes respond to rising chip production, technology transitions, plus development of China-based chipmaking capacity. We expect double-digit revenue growth to continue over the medium term as chipmakers utilize greater amounts of specialized gases, chemicals, and materials to optimize their existing production capacity, in part as an alternative to building expensive new fab capacity.

Demand for engineering and construction services remains subdued, as major customers continue to defer or delay major capital commitments, particularly across the energy and industrial chains. Demand seems much stronger for the companies themselves, with major acquisitions announced this year by  Jacobs Engineering Group (JEC) (to acquire CH2M),  SNC-Lavalin Group (SNC) (to acquire WS Atkins), and  Amec Foster Wheeler  (to be acquired by Wood Group). We consider heightened M&A activity indicative of troughing market conditions. Top pick  Fluor (FLR)  remains well positioned to benefit from an upturn in downstream energy, petrochemicals, and complex logistics.

Top Picks

 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 Company emerged from the bankruptcy of General Motors Corporation (old GM) in July 2009. GM has 10 brands and operates under five segments: GM North America, GM Europe, GM South America, GM international operations, and GM Financial. The United States now has four brands instead of eight. The company remains the market leader in the U.S. with 17.3% share in 2016. GM Financial became the company's captive finance arm in October 2010 via the purchase of AmeriCredit.

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 $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. Also, we think the market underappreciates that key holes in the U.S. product lineup are now filled or will be this year as the new generation of crossovers launches.

 Fluor (FLR)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $58.00
Fair Value Uncertainty: High
5-Star Price: $34.80

Fluor is a global provider of engineering, procurement, fabrication, construction, and maintenance services to a wide range of customers, including oil and gas, manufacturing, and mining companies, along with the U.S. government. Much of its revenue comes from energy, chemical, and mining work. Fluor aims to leverage its wide capabilities and global reach to win larger and more complex projects. The company generated 2016 revenue and adjusted operating income of $19.0 billion and $599 million, respectively, and employs 59,000 people.

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 $58 fair value estimate represents more than 40% appreciation from the current share price, which undervalues the firm's broad-based competitive strengths, experienced management, clean balance sheet, and industry-leading order backlog. We expect these attributes to translate into healthy growth as customers' appetite for discretionary capital spending steadily returns.

Engineering and construction providers have contended with weakening demand since the crude oil and industrial commodities peak, and Morningstar forecasts global crude markets still face a multiyear period of selling prices averaging $60 per barrel or below. However, it is now more than three years from the energy price peak, and we believe the downside risk to further exploration and production spending declines are modest.

 Anixter International
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $103.00
Fair Value Uncertainty: Medium
5-Star Price: $72.10

Anixter International is a leading distributor of network, security, electrical, and utility power products and services. The company has a global footprint with 320 warehouse or branch locations across 50 countries and offers more than 150,000 customers access to nearly 600,000 products, as well as valued-added supply-chain and technical services. Anixter operates three distinct businesses: Network and Security Solutions, Electrical and Electronics Solutions, and Utility Power Solutions.

Anixter has recently transformed itself, leading us to believe that the market fails to fully appreciate the new company. We think shareholders will be rewarded with consistent earnings growth and occasional outsize special dividends in the coming years. Over the past three years, Anixter has completed three transactions that have bolstered the company's market presence, growth potential, and operating flexibility. After acquiring Tri-Ed in 2014, selling its capital-intensive OEM Supply--Fasteners business in 2015, and purchasing HD Supply's utility distribution business in 2015, Anixter is now the global leader in network and security distribution, a top-three player in electrical distribution, and the leading utility power solutions distributor in North America. Anixter's focus on value-added technical and supply chain services across a global platform differentiates the company from competitors that rely solely on product pricing and availability to drive business. Our fair value estimate of $103 per share represents a 20% discount to the current share price.

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