Industrials: Despite Bullish CEO Talk, Few Values

• At a gathering of diversified industrial CEOs at the end of May, bullishness was a predominant theme. Nearly every CEO reiterated that the macroeconomic outlook was extremely healthy, as was the case last year. Even so, we find few values in the general industrials sector, as the market-cap-weighted price/fair value estimate stands at 1.03, suggesting that industrials stocks are trading within a realm of reasonableness.
• The CEOs also touted tax reform. We see wide-moat-rated industrial firms with operations based primarily in the U.S. disproportionately benefiting from this reform. Specifically, the latest changes to the Internal Revenue Code of 1986 encourage capital expenditures by allowing companies to expense these investments on a temporary basis.
• After General Electric CEO John Flannery appeared to waffle on his company's commitment to its 2019 dividend at a recent industrials conference, GE's board reaffirmed that commitment by declaring a quarterly dividend of $0.12 per share on June 8, 2018. Even so, we believe the company will continue to struggle with three primary issues, including weakness at its power segment, liabilities in the capital segment, and the need for capital, both for reinvestment and the dividend.

At a recent industrials conference in Florida, CEOs consistently preached macroeconomic bullishness, and nearly all expressed a near-uniform commitment to share buybacks. Implicit in these endorsements is that the underlying stocks of their companies are cheap. Even so, in aggregate, we find few bargains in industrials. Currently, the market-cap-weighted price/fair value estimate for the sector stands at 1. Fundamentals, however, remain attractive.

Tax reform was also at the forefront of the conference. We expect certain firms to disproportionately benefit from the Tax Cuts and Jobs Act of 2017, including those that have operations based in the United States; pay high effective tax rates; avoid a high amount of leverage in the capital structure; earn high returns on capital; and have high capital expenditures as a percentage of sales. Clearly, U.S.-based wide-moat industrial firms fit the bill, so it’s understandable that tax reform was a prevailing theme in CEOs' discussions.

Finally, on June 8

Top Picks GEA Group

G1A

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: EUR 47

Fair Value Uncertainty: Medium

5-Star Price: EUR 32.90

We believe management's clumsy handling of its restructuring program has clouded the market's view of wide-moat GEA's long-term value. At issue is a disappointing margin performance and guidance combined with a top line has that suffered in the past two years from overcapacity in dairy processing equipment, as well as an extraordinarily weak milk price, hurting dairy farming orders. We continue to expect margin expansion over the next several years but believe the market has overlooked the nearer-term opportunity for earnings growth to return in 2018 from orders outside of dairy. Our analysis of the company's order intake shows that while dairy processing orders have been declining by 8% per year for the past three years, the rest of the order intake has grown by 3%. Food (bakery, ingredients, and pasta, for example) is now the largest category and grew at 5% organically over the same period.

GEA supplies food and dairy processing equipment, specializing in decanters and separators that determine a product’s texture and consistency, essential to brand creation for food companies, and together with food safety standards create high switching costs for its 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 number-one or -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.

Anixter International AXE

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $107

Fair Value Uncertainty: Medium

5-Star Price: $74.90

As a result of the market's overreaction to narrow-moat Anixter International's unremarkable first-quarter results, the company's shares are deeply undervalued. As Anixter's end markets strengthen, we think shareholders will be rewarded with consistent earnings growth and occasional outsize special dividends over at least the next few years.

Over the past three years, Anixter has completed three transactions that have bolstered its market presence, growth potential, and operating flexibility. After acquiring Tri-Ed, selling its capital-intensive OEM supply fastener business, and purchasing HD Supply’s utility distribution business, Anixter is now the global leader in network and security distribution, a major 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 firm from many of its competitors. In many cases, Anixter is not the low-cost leader, but its value-added services can provide its customers with the lowest cost of ownership.

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 solutions to comply with regulatory standards. Growth in wireless and cloud-related products should augment network and security growth. Anixter's electrical and electronic solutions business has suffered from industrial end-market weakness and has been generating depressed EBITDA margins. As industrial end markets recover, we expect this segment to return to growth and normalized profitability. After acquiring HD Supply’s power solutions business, the utility power solutions segment was created, which has industry-leading scale and should benefit from market share gains and improving utility capital spending.

Anixter's capital-allocation strategy has favored returning cash to shareholders through special dividends and share repurchases. Once Anixter achieves its targeted leverage ratio of 2.5-3 times EBITDA, which we think could happen by 2019, we expect it to resume returning cash to shareholders.

Johnson Controls International JCI

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $53

Fair Value Uncertainty: High

5-Star Price: $31.80

Narrow-moat Johnson Controls was long viewed as an auto-parts company, given that it historically generated about two thirds of its annual revenue from the automakers. However, over the past few years, Johnson Controls has been on a mission to transform itself by selling noncore assets and acquiring businesses that complement the building efficiency segment. The most transformative transactions came in 2016, when the company merged with Tyco International in September and spun off its automotive seating business (now called Adient) to shareholders in October. As a result of these transactions, Johnson Controls is a more profitable and less cyclical business with much lower exposure to the automakers (was 59% of sales, is now 6%) and more exposure to higher-margin recurring service and aftermarket revenue, which now represents over 40% of sales.

Tyco, the global leader in security and fire-protection products and services, nicely complements Johnson Controls' legacy building efficiency business, which is a global leader in HVAC systems and building automation and controls. 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 in earnings per share) of cost and revenue synergies.

Johnson Controls should also 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 technologies and solutions business. Johnson Controls' power solutions segment is the largest producer of lead-acid automotive batteries in the world, manufacturing approximately 154 million annually. The company has 36% global market share; it is the leading supplier in the Americas and Europe and the third largest in China, with aspirations to become the second largest by 2020. Power solutions' significant exposure to the inelastic aftermarket business (76% of segment sales) yields stability, while the segment's participation in emerging markets and start-stop vehicle technology provide substantial growth opportunities.

Former Tyco CEO and Johnson Controls COO George Oliver recently succeeded Alex Molinaroli as chairman and CEO. With Oliver at the helm, we commented that we saw an increased probability of the company divesting its power solutions segment. On March 12, Johnson Controls announced that it is exploring strategic alternatives for the power solutions business, which should be completed “over the next several months.” While it’s true that the power solutions business has limited synergies with Johnson Controls’ building technologies and solutions segment, power solutions is growing faster and is more profitable than the firm’s buildings business. That said, we certainly see how a well-structured spin-off or a favorable selling price could create shareholder value.

Quarter-End Insights

Stock Market Outlook: Some Values to Be Found in Defensive Sectors Healthcare, breakfast, and gassing up the car are always necessary, even during downturns.

Energy: Despite Geopolitical Wildcards, the Reckoning Is Still Coming for U.S. Shale Producers The longer the delay, the worse the supply onslaught becomes.

Real Estate: Strong Fundamentals Persist--As Do Opportunities REITs should have several more years of solid growth in property fundamentals as the economic cycle continues and many sectors have the peak in supply growth behind them.

Utilities: Back to Fair Value With Some Emerging Opportunities Utilities investors have buying opportunities but should pick carefully.

Healthcare: Drug Pricing Concerns Weigh on Valuations, Creating Opportunities Innovation, consolidation, and a mixed regulatory picture for healthcare stocks in the first quarter.

Consumer Cyclical: The Themes Driving Retail's Rebound Amazon continues to linger as a disruptive threat, but the market is coming around to those retailers offering specialization, convenience, and experience.

Consumer Defensive: Attractive Opportunities in Competitively Advantaged Stocks Lackluster fundamentals and competitive pressures persist, but fail to warrant the recent retreat in shares.