Industrials: Trade Tensions Lead to Attractive Valuations

The Morningstar Global Industrials Index has dropped 17% quarter to date through Dec. 20 amid concern about trade sanctions (Exhibit 1), underperforming the broader global equity market, which lost 14% over the same interval.

Exhibit 1: Global industrials index fell, underperforming the global equity market

As a whole, the industrials sector now ranks among the more undervalued sectors globally. The median stock we cover trades at a 15% discount to fair value versus a 3% premium at the end of the third quarter. In particular, we see quite a few 4- and 5-star names in the heavy equipment and industrial distributors industries (Exhibit 2).

Exhibit 2: Industrials slightly undervalued, but we see attractive entry points

We anticipate revenue growth and margin expansion in the heavy equipment industry that will be fueled by operating improvements and a quest to improve end-user productivity. In recent quarters, heavy equipment manufacturers have demonstrated they can reduce costs by consolidating product lines and rationalizing assets. At the same time, end users are increasingly focused on obtaining equipment that offers the lowest total cost of ownership. This translates into sales of higher-margin products with better fuel economy, improved ergonomics, and enhanced data connectivity. Going forward, we believe such trends will favor heavy equipment manufacturers with strong brands and unique research and development capabilities.

Exhibit 3: CAT EBIT margin improving radically in 2018—we believe this will persist

While the term industrial usually implies cyclicality, industrial distributors generate strong free cash flow throughout the business cycle because they can quickly pull back on working capital investments when the economy softens. Despite this, we think investors are concerned about industrial distributors' ability to maintain profitability amid growing fears of a looming economic recession and a trade war between the United States and China. Additionally, many investors continue to believe that Amazon Business poses a major threat to traditional industrial distributors, pointing to declining gross profit margins as proof that Amazon is gaining a competitive edge. We think concerns about tariffs and Amazon Business are mostly misguided. In terms of tariffs, the industrial distributors we cover have noted that these incremental costs affect a relatively small portion of cost of goods sold and can be mitigated by changing suppliers. Regarding Amazon, we believe many distributors offer services from knowledgeable industry specialists that Amazon won't replicate (though office and cleaning commodities are indeed threatened).

Exhibit 4: Distributors preserve EBIT margin amid gross margin compression

Top Picks
 Caterpillar (CAT)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $186
Fair Value Uncertainty: High
5-Star Price: $111.60

Structural changes at Caterpillar have enabled the company to provide significantly higher margins in the past three quarters. We feel that many of these cost-cutting changes are permanent. Management reduced 20 million square feet of manufacturing space (25% of total), trimmed headcount by approximately 14%, and reduced assets by $3.3 billion. At the same time, there has been a 40% improvement in quality. This shows up in a dramatic increase in operating margins that we estimate will be 16.4% in 2018 versus 13.8% in Caterpillar's highest revenue year, 2012. 

 Anixter International
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $107
Fair Value Uncertainty: Medium
5-Star Price: $74.90

We think Anixter's shares are currently deeply undervalued. As the company's end markets strengthen, we expect consistent earnings growth and the resumption of special dividends and/or share repurchases over at least the next few years. We see key growth drivers for each of Anixter's segments over the next five years. With the addition of Tri-Ed, Anixter's network and security solutions segment is set to gain share with midsize system integrators and in residential end markets. This segment should also benefit from cross-selling security products to utilities customers as they invest in security products to comply with regulatory standards. 

 Johnson Controls International (JCI)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $46
Fair Value Uncertainty: High
5-Star Price: $27.60

Johnson Controls is significantly undervalued, trading at a 34% discount to our fair value. The buildings segment's organic growth has accelerated, and its margins have expanded despite adding 950 people to the sales team. We expect further margin expansion over the next several years as additional Tyco synergies are realized and the recently added sales capacity improves productivity. We think a prudent capital allocation in tandem with a simplified business model that is clearly showing improving fundamentals will help Johnson Controls close the gap between its current stock price and our estimate of its intrinsic value.

Exhibit Sources: Morningstar, Caterpillar. Margin data includes Anixter, Fastenal, Grainger, MSC Industrial, and Wesco. Data as of Dec. 20, 2018.