Industrials: Pockets of Uncertainty Present a Few Opportunities
Industrials are the second-most-expensive sector we cover, but these picks can reward investors.
Healthy indicators correlated with global manufacturing activity raised optimism and returns for investors in the industrial realm over the back half of the year. The IHS Markit Global Sector PMI reported consistently above 53 for industrials, with readings above 50 typically signaling expansion.
Developed markets led the charge, with the eurozone PMI reporting near a record high in the fourth quarter. In addition, low unemployment rates in the U.S. coupled with the probability of a federal corporate tax rate cut had bulls forecasting a pickup in industrial production.
Hurricanes Harvey and Irma increased uneasiness centered on economic development within the U.S., but these concerns proved to be short-lived, and healthy construction and manufacturing numbers highlight the solid fundamentals we are witnessing in the sector. With that said, we see a couple pockets of uncertainty that investors should give attention to, including the auto and industrial distribution sectors.
Political tension between the U.S. and Mexico ramped up over the past 18-24 months as administrative officials frequently discussed NAFTA. We do not envision any winners should the U.S. exit NAFTA.
We see higher prices thanks to a 2.5% tariff on cars and a 25% tax on pickup trucks not made in the U.S. or Canada, and believe both tariffs will result in lower demand. Pickup trucks are typically the most profitable vehicles for American automakers, and a bulky 25% tax would produce numerous headwinds. In our opinion, General Motors (GM) and Fiat Chrysler Automobiles (FCAU) have the most exposure to the additional pickup truck tax because they make a material quantity of their trucks in Mexico, but Ford (F), which only makes its trucks in the U.S., would not necessarily benefit, because it would not be able to single-handedly meet the pickup demand.
To further complicate the uncertainty surrounding NAFTA, in the summer of 2018, Mexico elects a new president, and populist candidate Andres Manuel Lopez Obrador has been gaining momentum. Given that the country may be looking for someone to stand up to U.S. President Donald Trump after comments made during his own presidential campaign, and because Mexico has the highest income inequality in the Organisation for Economic Co-operation and Development, we would not be surprised if the populist movement wins another victory in 2018. If NAFTA does not get settled before the election and Obrador takes the presidency, we see heightened uncertainty as to whether the U.S. and Mexico can maintain free trade or reach any type of trade deal.
The countries have agreed to keep negotiating through March 2018, and some believe NAFTA will just be amended or that Trump will give notice to withdraw, but then not follow through after six months, as the agreement's exit provisions stipulate. We find Trump to be somewhat unpredictable, but we hope the administration will ultimately realize that protectionism is not a good idea for U.S. companies.
The growing popularity of e-commerce has amplified price transparency in the industrial distribution market and opened the door for capable Internet-based competition. In 2015, Amazon (AMZN) retooled its business-to-business platform, renaming it Amazon Business. Amazon Business offers business-only prices on millions of industrials and office products to customers of all sizes. It reached $1 billion of sales within its first year and 1 million customers in July 2017, up from 300,000 customers about a year earlier. In our opinion, we believe Amazon will expand its business-to-business operations and keep the venture as one of its top priorities.
The industrial distribution sector sold off in October, in part because of the announced launch of Amazon Business Prime Shipping, which allows multiple users within businesses to receive unlimited free two-day shipping on eligible items. The good news for the industrial distributors we cover is that they have all embraced e-commerce and continue to build on their digital platforms amid growing usage of these applications.
In addition, many distributors offer strong service capabilities, ranging from knowledgeable and accessible sales representatives who can help with product selection, to inventory management services, to more consultative offerings such as operational and energy consumption reviews. We believe industrial distributors that serve market niches, such as Anixter International (AXE), are generally well-insulated from online competition. Conversely, we think W.W. Grainger (GWW) is more exposed to online competition because it doesn’t serve a market niche and sells less-specialized products.
Logistics: Truck Brokerage
Digital freight-matching companies, or DFMs, such as Uber Freight, have entered asset-light truck brokerage over the past few years. It's early in their evolution, but most DFMs hope to reinvent the truckload shipping process via highly automated marketplaces that can match shippers and truckers on demand.
At times, this has caused investor trepidation over the potential threat to traditional brokerage providers, and that is likely to recur, creating buying opportunities for the informed. DFMs' most addressable part of the brokerage market might approach $15 billion-$20 billion in gross revenue. We think this includes certain kinds of low-touch spot freight. Small brokers, which often lack the resources to boost process automation, are at greatest risk for losing market share to DFMs.
However, traditional brokers add value to shippers by providing access to the massive fragmented supply base of small truckers and attract carriers by aggregating freight demand and providing abundant cargo opportunities to build substantial lane density. This is also where the network effect comes into play--as a broker's network of shippers and carriers expands, it becomes more valuable to all parties.
Although there's certainly room for productivity gains from digitizing more of the transaction, and the large providers are increasingly on that path, evidence of traditional brokers' strong value proposition shows up in the fact that brokers as a whole have materially increased their processing share of the $370 billion for-hire trucking market over the past decade.
We identify three chief reasons why we don't believe the proliferation of DFMs will derail the growth prospects of moatworthy brokers we cover: 1) The network effect mounts a powerful defense in asset-light truck brokerage (customer and carrier density are paramount), 2) digital freight apps' limited sales and service capabilities will probably curb their addressable market, and 3) the large brokers aren't standing still. DFMs are driving the top-tier traditional firms to automate more processes (especially carrier connectivity) and to adopt a less people-intensive model, though headcount will remain a key input for success. Additionally, the brokerage industry is fragmented enough to handle new entrants; we believe the masses of small unsophisticated brokerage firms face the greatest threat from losing market share to successful DFMs and traditional moatworthy brokers.
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $105.00
Fair Value Uncertainty: Medium
5-Star Price: $73.50
We believe that the market is discounting Stericycle’s ability to return to more predictable growth after a tough 24 months marked by acquisition integration headaches, pricing headwinds, legal challenges, and operational issues. With a long-term strategic plan in place, we expect the company will be able to achieve a normalized midcycle organic revenue growth rate of 4.5% and operating margin of 20%. In our opinion, these assumptions address the cyclical pressures inherent in the industrial hazardous waste business while acknowledging the strengths of the core medical waste business, as well as growth in scalable ancillary solutions such as patient communications. In our view, secular growth of patient admissions due to an aging population, a recurring revenue base subject to price escalators, and the ability to seamlessly offer healthcare customers cost-saving bundled service solutions can support this admittedly lower but more mature state of organic growth relative to Stericycle's historical high-single-digit average.
Babcock International (LSE: BAB)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: GBX 1,060
Fair Value Uncertainty: Medium
5-Star Price: GBX 742
Narrow-moat Babcock is one of the main beneficiaries of rising U.K defense budgets and a pickup in outsourcing in the international defense market. Due to lower volumes from the Queen Elizabeth Class aircraft carrier program, Babcock's revenue in the marine sector will be modestly down in fiscal 2018; however, we expect that solid profitable growth in land, aviation, and nuclear will plug the hole, resulting in 3.6% revenue growth for the group in 2018.
As such, we consider the recent pullback in Babcock's shares as symptomatic of near-term uncertainty, rather than deterioration in the firm's longer-term prospects. With shares trading at 5 stars with a discount of 33% to our fair value estimate, we see a buying opportunity in Babcock's shares.
The backlog of approximately GBP 19 billion, as announced on Sept. 20, represents four years of sales and provides increased visibility (89% of revenue in place for fiscal 2018 and around 57% for 2019) and supports our view of rising revenue (we assume a 3.9% five-year CAGR), with operating margins expanding to 9.1% in 2022 from 7.9% in 2017. We expect margin expansion because of strong project execution, cost control, and operational leverage stemming from volume growth. Using our assumptions, we expect Babcock to generate returns on invested capital including goodwill of 9.8% on average during our five-year discrete forecast horizon--above the firm's 8.2% cost of capital.
General Electric (GE)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $26.00
Fair Value Uncertainty: Medium
5-Star Price: $18.20
The investment thesis for General Electric has swiftly changed from transformative growth to turnaround as the industrial giant embarks upon a multiyear restructuring to drive out excess corporate costs, aggressively manage working capital, and fix its struggling power generation business. GE shares are trading as if there is no clear path for improvement of admittedly dismal free cash flow generation in recent quarters. Recently, the company cut its dividend in half to $0.48 per share and plans to eliminate 12,000 jobs in its power segment.
However, under new CEO John Flannery, we believe that GE has a way forward, especially because 70% of GE's sales and 85% of its earnings come from businesses that dominate their markets. Flannery pledged to retain focus on aviation (which we consider GE's crown jewel), healthcare, and power. These businesses all boast market leadership positions, strong customer relationships, massive installed bases, and attractive high proportions of sales from aftermarket services. We believe GE's role in power generation markets remains important, as customers increasingly contemplate hybrid power generating footprints that switch between natural gas-fired and renewable power generation.
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Eric Anfinson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.