Industrials: Solid Fundamentals, but Few Screaming Buys
GM, Johnson Controls, and Stericycle are our favorites.
- We view the industrials sector as slightly overvalued on average, with a market capitalization-weighted price/fair value estimate of 1.10, representing our belief that industrials stocks are about 10% overvalued as whole. That said, we do see value in select stocks, with some value concentrated in aerospace and automotive shares.
- Industrial activity is plowing forward. North American transports are hauling more freight than in the year-ago period, and industrial indicators remain firm.
- U.S. housing demand continues to improve, in line with our midterm projections for expansion. Auto sales remain robust, though we view U.S. light-vehicle sales as having leveled off and likely to decline modestly in each of the next few years. In our view, global auto demand is adequate to fuel healthy performance as automakers refine their operations.
Industrial activity is steadily plowing forward, and we are optimistic about demand and operating execution at most firms we cover. Industrial indicators remain firm, and transports are hauling more freight than in the year-ago period. That said, we think stock market prices fairly reflect our expectations of good performance in most instances, leaving few shares on sale at material discounts to our fair value estimates.
The Institute for Supply Management Purchasing Managers' Index for manufacturing in the United States was 56.0 in January and 57.7 in February, and 17 of 18 manufacturing industries reported growth in February. The February National Bureau of Statistics of China Manufacturing PMI rose 30 basis points from January to 51.6 in February, and the private Caixin Manufacturing PMI was 51.7 in February; it has exceeded the 50 demarcation in 7 of the past 12 months. The Markit Eurozone Manufacturing PMI was 55.4 in February, slightly above January's 55.2; this index has scored above 50 since mid-2013.
U.S. industrial production was unchanged in February after declining 10 basis points in January, but manufacturing advanced for the sixth consecutive month (up 50 basis points). U.S. manufacturing improved 1.2% from February 2016. In January 2017, EU28 industrial production rose 50 basis points sequentially and 130 basis points year over year. Eurozone industrial production has been on the climb since mid-2013. Underpinning February's industrial production index expansion was capital goods production growth, up 2.4% sequentially and 80 basis points year over year. China's industrial production increased 60 basis points from January to February 2017 and on a year-over-year basis grew 6.1% and 6.2% in January and February.
North American trucking and rail demand is still improving over prior-year levels, albeit with rails lapping easy comparisons. The latest (February) seasonally adjusted ATA Truck Tonnage Index declined 0.1% from January after improving 2.9% sequentially from December to January; January improved 2.6% year over year, and February declined 2.8% year over year (February 2016 was strong). Year-to-date (January and February) tonnage is down 10 basis points from the same period in 2016. The most recently reported Cass Shipments increased a strong 7.0% from January to February and 1.9% from February 2016; Cass Expenditures rose 5.1% month to month and 3.2% year over year.
Through March 11, North American railcar traffic improved a robust 5.7% year to date, and intermodal gained 70 basis points. Leading the growth are coal (up 14%), metallic ores and metals (up 17%), agricultural products (up 3%), and nonmetallic minerals (up 9%). While consolidated volume is strong, volumes of three significant commodities are lower than in the prior-year period: Chemicals, forest products, and motor vehicles and parts are down 3%-6%. After nearly two years of railroad freight recession, this growth offers significant relief and reflects much more positively on the health of these economies.
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.
Year-to-date housing starts have been running near a 1.3 million seasonally adjusted annual rate, in line with our forecast for total housing starts in 2017. Within this total starts projection, we expect 2017 single-family starts to grow 19% to 935,000 units and multifamily starts to slip to 375,000 from 2016's 380,000. Single-family permits, which typically lead starts by about one month, have risen in early 2017, whereas multifamily permits have begun to flatline amid tighter credit and ample new supply.
Homebuilders note the immense demand potential from millennials and are building smaller, more affordable homes to attract these first-time buyers. Labor markets have tightened, catalyzing the first real wage growth since early 2015 for those aged 18-34. With job opening levels at prerecession highs across numerous industries, we expect further wage gains to support rising household formation in the coming quarters. Our updated forecast assumes that momentum in single-family starts continues, thanks to firmer labor markets and early signs of a more affordable mix shift in single-family construction. We expect starts to peak at 1.9 million by 2021 before falling back to a demographically sustainable 1.5 million.
Auto sales remain robust, though we view U.S. light-vehicle sales as having leveled off and likely to decline modestly in each of the next few years. We do not see the U.S. market peaking and then immediately crashing, in part because the U.S. fleet remains quite old at 11.6 years. Instead, we anticipate a gradual decline for a few more years, giving General Motors (and others) a chance to complete restructuring while also generating healthy profits.
In our view, global demand is adequate to fuel healthy performance as automakers refine their operations. February U.S. auto sales carried on the trend of a slight decline year over year that the industry posted in January. Total units sold came in at 1.33 million, down 1.1% from February 2016, while Automotive News put the seasonally adjusted annualized selling rate at 17.57 million vehicles compared with 17.69 million vehicles in February 2016.
Ford said the retail channel part of the industry mix was flat to slightly down, and we think incentives are being used to prop demand up to a degree. ALG estimated that February incentive spending per unit rose 13.5%, to $3,443, with spending up for every major automaker except
). This trend is not shocking as automakers have to play a delicate balancing act between remaining competitive and profitability, but demand kept up by incentives is one reason we predict a decline in full-year sales to 17.0 million-17.2 million from 17.54 million in 2016.
GM bucked the industry trend of a sluggish month, with total sales up 4.2% and retail channel up 4.9%. All four brands increased average transaction prices, with the company's overall ATP rising $570 a unit, or 1.7%, to a February record of $34,900. We discuss GM shares a bit more below.
Let's turn to one other sector that has attracted some investors at least in part because of Warren Buffett's indicated interest. Airline stocks have sold off on the back of deteriorating unit revenue guidance and are now trading at an average price/fair value estimate of 0.97 compared with 1.09 in December.
Among the U.S. airlines we cover,
We think air travel demand should remain firm over 2017, resulting in an improving outlook for the airlines. While the recent downward pressure on oil prices could exacerbate near-term fare weakness as airlines give away cost savings in the form of lower ticket prices, we think decreases in fuel prices should still be a positive over the mid- to long term. Corporate tax reform could also be another positive for the U.S. airlines--particularly after their net operating loss carryforwards burn off in 2018-19--due to limited overseas earnings and high effective tax rates.
With these potential catalysts on the horizon and the sell-off well underway, we think investors should give airline stocks another look. Despite all the negative momentum, we think investors are overlooking the solid air traffic growth forecast for 2017 and still-prudent capacity management by most U.S. airlines. In January, air traffic increased a relatively solid 3.4% year over year, and although United has raised its capacity guidance, other airlines are staying with their original capacity expansion plans. Barring any shocks, we think the current economic environment will support enough air traffic growth for a unit revenue recovery toward the back half of 2017, and over the midterm, lower fuel prices will keep a key expense down for the airlines, which have now largely eschewed fuel hedging.
M&A activity has been quite high among industrials this year. Major sector transactions announced this year include Johnson Controls' sale of a safety business to 3M and Wood Group's takeout of Amec Foster Wheeler, plus several automotive deals.
Johnson Controls agreed to sell its Scott Safety business to 3M for $2 billion. We expect the deal to close in the second half of 2017. Scott Safety, a legacy Tyco business that was acquired with the recent Johnson Controls-Tyco merger, is a leader in respiratory protection products. Tyco acquired the Scott business in 2001 for $391 million; since then, the business has increased its top line at about a 5% compound annual rate to $570 million. Although the deal valuation metrics seem to favor Johnson Controls at 3.5 times trailing 12-month sales and 13 times trailing 12-month EBITDA, after adding the deal proceeds and removing the Scott business from our model, we see a net neutral impact on Johnson Controls' valuation. We therefore maintain our $54 fair value estimate and think the shares are undervalued. On a pro forma basis, sale proceeds reduce Johnson Controls' net debt from about $12.9 billion (improving the net debt/capital ratio from 39% to 35%). The company intends to use the sale proceeds to repurchase shares and pay down a portion of its merger-related debt.
Wood Group announced that it will acquire Amec Foster Wheeler, with shareholders receiving 0.75 share of Wood Group stock in exchange for each AMFW share--roughly a 29% premium of the 30-trading-day average price per AMFW share and a 15% premium to the March 10 closing price. AMFW shareholders will own roughly 44% of the combined company. We believe there is only a modest probability of a higher bid emerging, given the premium Wood Group offered, lagging prospects in Amec Foster Wheeler’s core energy activities, and the uncertain status of ongoing restructuring. In our opinion, the timing of the deal reflects in part the mediocre prospects for Amec Foster Wheeler’s and Wood Group's core engineering and project management activities for higher-cost offshore and oil sands-based energy exploration and production.
Automotive M&A this year includes Intel's acquisition of auto supplier Mobileye and GM's sale of much of its European business, on which the firm has lost money every year of this century. In other automotive deals,
Mobileye, a designer and developer of system-on-chip advanced driver assist and autonomous driving technology, agreed to be acquired by Intel at a 16% premium to our stand-alone $55 fair value estimate. The acquisition price places a 34% premium on Mobileye's stock price before the announcement, valuing the equity at $15.3 billion. Our technology team sees little challenge from regulators, given the limited amount of product overlap between Intel and Mobileye. Even though it's plausible that another bid may arise, Morningstar believes the potential for a competing semiconductor company bid is limited as others lack the financial resources of Intel or have other major deals in process. Furthermore, tech companies like
We increased our GM fair value estimate to $51 per share from $50 after incorporating the deal announced on March 6 to sell Opel/Vauxhall to PSA Group. GM Europe has not been profitable on an annual basis in this century and has lost over $22 billion. We think it would have taken GM well into the next decade to possibly bring GM Europe to meaningful profitability, so we do not mind that it becomes less of a global automaker by selling a business that made up about 12% of its 2016 unit volume. The fair value estimate increase comes from the net impact of our capital expenditure forecast for 2018-21 declining 4.5% compared with our prior model, removing an unprofitable business, cash sale proceeds of about $1.9 billion, selling part of GM Financial, and GM contributing $400 million (beyond issuing $2.8 billion in new debt) to fund the active employees' pensions that will be transferred to PSA. GM will retain the retirees' pensions. GM still has interesting EU options. Once Cadillac has a more complete lineup and more cachet, GM could still re-enter Europe. To give GM some benefit should PSA succeed in turning around Opel/Vauxhall, GM receives nine-year warrants in PSA exercisable starting five years after the deal closes (end of 2017) with a strike price of EUR 1. These warrants equate to 4.2% of PSA shares and are valued for deal purposes at about $700 million.
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $51
Fair Value Uncertainty: High
5-Star Price: $30.60
We believe General Motors remains misunderstood and is not done transforming itself into the formidable global automaker it will be. GM pays a dividend yielding over 4%, and we love that the firm is devouring its stock while it's undervalued, a central reason for our recent fair value estimate increase.
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 billion into removing $6.5 billion of costs through 2018 from year-end 2014 levels, up from previous 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.
Another upside catalyst comes from Cadillac, a premium brand that we think has plenty of untapped potential given its low number of crossover offerings that will increase considerably this decade. Further cost reductions, along with a complete new lineup of crossovers when that segment is white hot with Americans, should enable the company to stay relevant with consumers in 2017. The company continues to beat
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 Tesla's Model 3 and with a better range, and testing autonomous cars, all while also dominating the full-size SUV segment, which should remain popular with consumers outside dense cities in an autonomous world. We see many reasons to remain optimistic about GM, and we do not think the U.S. market peaking means only bad news for the company.
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $54
Fair Value Uncertainty: High
5-Star Price: $32.40
Johnson Controls' shares are currently trading at about a 20% discount to our fair value estimate. The company operates two distinct businesses. Its building technologies and solutions segment manufactures, installs, and services HVAC systems, building management systems and controls, industrial refrigeration systems, and fire and security products. The power solutions segment manufactures vehicle batteries that are sold to automakers and aftermarket retailers.
Before its recent transformation, Johnson Controls was long viewed as an automotive-parts company, given that it had historically generated two thirds of its revenue from the automotive industry. Company veteran Alex Molinaroli stepped into the CEO role in 2013, and 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 and spun off its automotive seating business (Adient).
Johnson Controls is now a more profitable and less cyclical business with much lower exposure to the automakers (was 59% of sales, 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, should nicely complement 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.
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, with a 36% global market share. It is the leading supplier in the Americas and Europe and the third-largest supplier in China. The inelastic aftermarket battery business (74% of segment sales) yields stability, while emerging markets and start-stop vehicle technology provide substantial growth opportunities.
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $105
Fair Value Uncertainty: Medium
5-Star Price: $73.50
Stericycle is the largest domestic provider of regulated medical waste management to large-quantity generators (such as hospitals and pharmaceutical companies) and small-quantity generators (such as medical and dental offices). The company also provides risk-management platforms, such as returns and recalls management, as well as compliance training and secure document destruction.
Recent pricing pressure in the small-quantity customer category (pressuring discounts of 30%-35% in hospital-owned small-quantity customers and 10%-15% in independent doctor offices) has weighed on Stericycle's shares. We expect this headwind to remain in place through at least 2017 as the company progresses through a three-year contract cycle.
In the meantime, we believe Stericycle's efforts to re-energize organic growth will largely come from strategic sales deployment, which has the potential to offset price declines via new customer additions, as well as increasing penetration of ancillary services. While this will come with higher-than-average selling, general, and administrative spending, we believe investments in sales are long overdue and will support our forecast for midcycle organic revenue growth of 5% and EBIT margin of 20%.
We believe 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 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.
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