Industrials face rough ride

12/1/2008


The latest round of earnings reports shows shrinking backlogs for many industrial companies, and investors should use caution when dipping into a sector facing weakening demand and declining pricing power.

Several industrial companies stand by their backlogs, saying they don’t expect significant defaults during the downturn. But even companies with robust order books expect less new business and more deferrals as customers struggle to secure financing. In some markets, orders have already begun to slow.

October orders for medium- and heavy-duty trucks appear to have fallen to about half of year-earlier levels. The global market for business jets also shows signs of rapid deterioration as companies scale back costs and find it difficult to finance purchases. Expect the trends seen in trucks and planes to play out across dozens of end markets over the next few quarters.

While the economic slowdown has reached overseas, most foreign economies are still likely to grow faster than the U.S. economy in the year ahead. The industrial sector depends heavily on foreign economies — foreign sales accounted for about 34% of total revenue for S&P 1500 Index industrial companies in the last fiscal year and generated much of the sector’s growth in recent years. In the last five years, foreign sales for the 15 largest U.S. industrial multinationals rose at an annual rate of 15%, versus a 5% gain for U.S. sales.

Looking ahead, signals are mixed. The U.S. dollar’s recent rebound — up 24% versus the euro since the end of June — has crimped overseas profits. Continued strength in the dollar would further slow sales and profit growth for many industrial companies in the year ahead.

Despite the economic slowdown, the S&P 1500 industrial sector managed capitalization-weighted sales growth of 12% and profit growth of 8% over the last 12 months. Sharp rises in energy and metals prices have helped companies push through price increases. But with prices of most commodities substantially lower than just a few months ago, many companies may have to cut costs and accept lower profit margins to hold onto customers.

The linked table shows that the industrial sector as a whole boasts solid financials, with the average S&P 1500 industrial company earning an Overall Quadrix® score of 68. But there are plenty of worms in this apple, and we advise sticking with stocks we rate Buy or Long-Term Buy. The 30 industrials we cover are presented in the table below. Five are recommended for purchase, two of which are discussed in the following paragraphs.

INDUSTRY BREAKDOWN
—— P/E Ratio ——
12-Month
–— Change —–
3-Yr. Annual.
—–Change —–
Est. EPS
—– Change —–
Quadrix
——– Scores ——–
Group (No. of Companies)
Stock-
Market
Value
($Bil.)
Trailing
Trailing
Over 5-
Year
Avg.
Sales
(%)
EPS
(%)
Sales
(%)
EPS
(%)
Next
Fiscal
Year
(%)
Next
5 Yrs.
(Ann.)
(%)
LT Debt
As % of
Capital
Value
Overall
Industrials (205)
939.1
10
0.50
13
16
12
21
3
13
29
65
68
Capital Goods (127)
676.2
9
0.47
14
20
13
25
5
13
27
70
72
Aerospace & Defense (24)
211.1
10
0.49
13
26
16
27
12
14
30
67
79
Building Products (9)
7.1
10
0.64
(2)
(19)
4
(9)
4
13
28
65
47
Construction &
Engineering (10)
22.5
11
0.47
29
33
17
38
12
15
16
75
79
Electrical
Equipment (18)
50.1
8
0.40
15
21
14
26
10
12
28
66
73
Industrial
Conglomerates (7)
210.7
9
0.48
8
22
4
6
(4)
13
38
71
61
Machinery (50)
158.7
8
0.43
16
24
14
29
0
13
27
75
73
Industrial
Distributors (9)
15.9
13
0.63
5
7
8
23
2
12
27
55
64
Commercial Svcs. & Supplies (49)
81.2
11
0.49
10
9
11
16
(2)
13
32
64
63
Office Services &
Supplies (8)
11.7
8
0.42
9
12
8
20
(2)
10
46
73
65
Printing (5)
3.2
5
0.25
0
4
5
9
(10)
9
50
82
44
Environmental & Support Svcs. (15)
43.4
17
0.71
14
17
11
14
11
14
29
41
62
Professional
Services (19)
19.9
9
0.40
10
0
13
15
(11)
14
25
73
68
Transportation (29)
181.8
13
0.68
12
4
12
14
6
13
33
45
58
Air Freight &
Logistics (6)
74.3
17
0.65
15
5
12
16
8
14
12
34
66
Airlines (5)
9.2
12
0.57
13
(23)
21
2
21
16
58
44
36
Road & Rail (16)
96.0
13
0.75
9
5
9
15
4
13
34
47
61
Notes: Quadrix scores are percentile ranks, with 100 the best. Industry groups with two or fewer components are not broken out separately.    Averages exclude P/E ratios above 75 or below 0 and growth rates of more than 200%.

 

Airgas ($32; NYSE: ARG) appears to be weathering the industrial downturn better than most companies in its sector. About 40% of sales come from what the company calls strategic products — bulk, specialty, and medical gases; carbon dioxide; and safety products. These specialty products generate stronger growth than the average industrial gas and tend to be less sensitive to economic trends.

In the first half of fiscal 2009 ending March, Airgas acquired six companies with combined annual sales of $142 million, adding roughly 3% to total annual revenue. However, the company does not depend entirely on acquisitions for growth. Organic sales, fueled by price increases, rose 8% in the September quarter. Airgas controls 23% to 25% of the highly fragmented market for packaged gas but believes it can capture up to 45% of the market without running into antitrust problems.

A prolonged slowdown in industrial production could slow Airgas’ volume growth and limit its ability to raise prices. But in the six months ended September, results held up well. Operating cash flow rose 21%, while per-share profits increased 28%.

Consensus estimates project per-share-profit growth of 24% in fiscal 2009 and a conservative 5% in fiscal 2010. While Airgas has had success cutting costs in recent years, much of the profit growth expected in coming quarters should come from higher sales. The consensus calls for 15% revenue growth in fiscal 2009, and Airgas should be able to exceed the 2010 target of 4% growth. Airgas, trading at just nine times projected year-ahead earnings, is a Focus List Buy.


So far, United Technologies’ ($49; NYSE: UTX) business mix has been able to withstand an increasingly harsh environment. While many companies have slashed profit guidance, United Technologies reconfirmed 2008 targets in November. The consensus projects per-share-profit growth of 16% in 2008 and just 4% in 2009.

At the end of September, backlog was 18% higher than levels at the end of 2007. Yet United Technologies faces declining demand in several key markets. The Pratt & Whitney jet-engine segment is likely to struggle along with the commercial-aerospace market. Sales of spare parts for large commercial engines declined about 15% in the September quarter and should continue to decline. U.S. airlines plan to ground at least 600 planes this fall and winter, and the first planes deactivated will be the ones most in need of service.

Other United Technologies segments should fare better. The Sikorsky unit is on track to deliver more than 200 large helicopters in 2008, and a hefty backlog of military orders should support revenue in coming quarters. Sikorsky is also expected to compete for the U.S. Army’s new Armed Reconnaissance Helicopter program with an estimated value of more than $1 billion.

The Otis elevator division saw new-equipment orders climb 15% in the nine months ended September. United Technologies hasn’t yet seen any of the backlog defections it experienced during the last commercial downturn. Half of Otis’ revenues come from the aftermarket. Demand for elevator parts and services, unlike trends in the aerospace industry, should remain steady in a downturn. Most governments enforce elevator maintenance, so low building occupancies shouldn’t reduce revenue. United Technologies is a Buy and a Long-Term Buy.

FORECASTS INDUSTRIAL STOCKS
– P/E Ratio –
Quadrix
— Scores —
Company (Price; Ticker)
Trail.
Trail
Over
5-Yr.
Avg.
Value
Overall
Industry
Advice
3M ($63; MMM)
12
0.62
49
74
Indust. Conglomerates
Neutral
Airgas ($32; ARG)
10
0.50
65
87
Industrial Gases
Focus Buy
AMETEK
($32; AME)
13
0.62
52
86
Electrical Components 
Neutral
Boeing ($41; BA)
8
0.34
73
71
Aerospace/
Defense
Neutral
Burlington Northern
($73; BNI)
12
0.74
42
87
Railroads
Neutral
Canadian Nat’l Rail.
($35; CNI)
9
0.55
51
84
Railroads
Neutral
Caterpillar
($36; CAT)
6
0.40
85
83
Construct./Farm Equip.
Neutral
Cooper Industries
($22; CBE)
6
0.36
82
87
Electrical Components 
Neutral
Deere ($33; DE)
7
0.44
76
84
Construct./Farm Equip.
Neutral
Dover ($28; DOV)
8
0.40
82
87
Industrial
Machinery
Neutral
Emerson Electric
($33; EMR)
11
0.53
64
79
Electrical Components 
Neutral
Equifax
($23; EFX)
11
0.61
64
66
Research &
Consult.
Neutral
FedEx ($66; FDX)
12
0.66
55
55
Air Freight
Neutral
General Dynamics
($50; GD)
8
0.48
69
92
Aerospace/
Defense
Buy †
General Electric
($15; GE)
7
0.38
80
54
Indust. Conglomerates
Neutral
Honeywell Int’l
($26; HON)
6
0.33
83
79
Aerospace/
Defense
Neutral
J.B. Hunt Transport
($25; JBHT)
16
0.80
33
72
Trucking
Neutral
Ingersoll-Rand
($14; IR)
4
0.25
92
88
Industrial
Machinery
Neutral
L-3 Communications
($64; LLL)
9
0.53
69
86
Aerospace/
Defense
Neutral
Lockheed Martin
($73; LMT)
10
0.55
62
77
Aerospace/
Defense
LT Buy
Manitowoc
($6; MTW)
3
0.12
99
81
Construct./Farm Equip.
Focus Buy †
Norfolk Southern
($48; NSC)
11
0.72
40
89
Railroads
Neutral
Oshkosh
($5; OSK)
1
0.08
100
52
Construct./Farm Equip.
Neutral
Parker-Hannifin
($38; PH)
7
0.40
89
84
Industrial
Machinery
Neutral
Southwest Airlines
($8; LUV)
17
0.63
42
43
Airlines
Neutral
Tyco International
($20; TYC)
6
0.28
85
60
Indust. Conglomerates
Neutral
Union Pacific
($48; UNP)
11
0.59
37
79
Railroads
Neutral
United Parcel Svc.
($55; UPS)
15
0.67
29
28
Air Freight
Neutral
United Technologies
($49; UTX)
10
0.58
63
87
Aerospace/
Defense
Buy †
WESCO Int’l
($12; WCC)
2
0.15
99
81
Industrial Distributors
Neutral
* Quadrix Scores are percentile ranks, with 100 the best and 0 the worst.  
† Also qualifies as a Long-Term Buy.

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