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Our Outlook for the Industrials Sector

Industrial stocks as a whole are overvalued, but opportunities still exist.

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The market has been on a wild ride since our previous industrials-sector outlook in June, as fears over the housing meltdown and credit market woes have taken a collective toll. The Dow Jones Industrial Average has recovered nicely from its August lows, thanks to a half-percentage-point cut in the fed-funds rate, and the index is now just shy of its all-time high. Although we're generally opposed at Morningstar to prognosticating on the direction of the economy, the Fed's outlook for increased U.S. economic uncertainty is something we're not taking lightly. It may also be worth noting that in The Wall Street Journal's September Economic Forecasting Survey, economists estimated the risk of a recession within the next 12 months at 36%, 8 percentage points higher than just one month earlier.

Although there are signs the corporate debt market has improved following the rate cut, we admit economic conditions could still deteriorate beyond what we've already witnessed. Specifically, the housing slump and credit crisis have punished some of our big-ticket consumer discretionary names.  Harley-Davidson (HOG) announced intentions to reduce motorcycle shipments because of weak sales at dealerships, especially in August when the credit market turmoil hit an apex. Weakness in the boat-retailing industry has also come to the fore--perhaps most prominently at  MarineMax (HZO)--as falling home prices in coastal markets appear to be adversely impacting consumer appetite and wherewithal to finance new boat purchases. And just recently, used-car retailer  CarMax (KMX) cut its fiscal 2008 expectations for comparable-store used unit sales growth to 1%-3% from 3%-9%, driven by a widespread slowdown in the used-auto market.

As we monitor the impact of the housing meltdown and credit crunch on companies in our industrials universe, we are also watching major developments unfold in the auto and aerospace industries.  General Motors (GM) landed a tentative labor contract with the United Auto Workers, and we expect new worker agreements, if ratified, to help narrow the well-documented labor-cost gap between the Big Three and Asian auto manufacturers. On the aerospace side, we're monitoring the later development stages of  Boeing's (BA) ultra-efficient 787 Dreamliner, which has fallen under media scrutiny recently due to potential concerns about the crash-worthiness of its mostly composite structure. Boeing has pushed the revolutionary aircraft's test-flight back twice now, and while modest delays beyond its first delivery date are immaterial, more extensive setbacks could have larger implications across the sector.

Valuations by Industry
The median price/fair-value ratio equals about 1.14 across the industrials universe. The reading is the highest of any market sector, suggesting that industrials stocks as a whole are overvalued, in Morningstar's opinion. The table below presents our star-rating and median price/fair-value estimate by industry.

 Industrials Industry Valuations
Segment

Average
Star Rating

Median
Price/Fair Value
Stocks Covered
Aerospace and Defense 2.95 1.04 20
Agricultural Machinery 2.00 1.18 3
Agriculture 2.33 1.11 3
Agrochemical 2.33 0.97 3
Aluminum 3.50 0.98 4
Automakers 3.00 0.96 7
Auto Parts 2.92 0.98 15
Auto Retail 3.33 0.94 14
Building Materials 4.00 0.73 9
Chemicals 2.61 1.04 35
Construction Machinery 2.20 1.18 5
Diversified 3.50 0.97 7
Electric Equipment 2.65 1.05 24
Machinery 3.17 1.00 12
Manufacturing--Misc. 3.00 0.95 2
Metal Products 2.80 1.00 11
Packaging 3.60 1.01 10
Paints/Coatings 3.00 1.04 1
Plastics 3.00 1.08 1
Recreation 3.75 0.84 8
Rubber Products 3.00 0.91 3
Steel/Iron 2.85 0.95 20
Transport Equipment 3.00 1.00 2
Truck Manufacturers 1.80 1.29 5
Data as of 09-19-07.

As the above table reveals, we think the building-materials industry is undervalued with an average star rating of 4 and a median price/fair-value ratio of 0.73. In fact, this industry is home to five out of the 10 industrial companies that currently garner a 5-star rating. Although shipments of building materials in the U.S. will likely be weak over the next several quarters, particularly for those levered to residential construction, some firms should be able to mitigate volume weakness with robust pricing growth. For companies like  Vulcan Materials (VMC) and  Martin Marietta (MLM), we think future price markups will continue to trump inflation, driving margin expansion at these firms.

Aerospace continues to experience record demand, with Boeing on pace to post its third consecutive year of at least 1,000 orders. The aluminum and metal-products industries, which serve aerospace, are booming largely by extension. Suppliers like  Precision Castparts (PCP) have seen their profit-margins swell beyond expectations over the past few quarters, and the heightened pace of aircraft production should continue to drive operating leverage for many firms in the aerospace supply chain.

Industrials Stocks for Your Radar
We've picked five stocks from our industrials universe that we recommend keeping on your radar screen. Four of the names are new, with  SAIC (SAI) the only repeat from our previous industrials-sector outlook.

 Stocks to Watch--Industrials
Company Star Rating Fair Value Estimate Economic
Moat
Risk

Mkt Cap (bil)

Alcoa  $52 Narrow Average

$33.0

Boeing $122 Narrow Average $80.8
Cemex $41 Narrow Average $23.4
SAIC $25 Narrow Average $7.5
Vulcan Materials $144 Wide Average $8.2
Data as of 09-25-07.

 Alcoa  (AA)  
Alcoa continues to benefit from strong global demand, and its exposure to the prolonged aerospace cycle is icing on the cake. From the  Analyst Report: "Alcoa is one of the kings of the aluminum industry, and its sheer size affords it economies of scale and a low-cost position. Alcoa controls an estimated 24% of the world's bauxite reserves and produces aluminum on every continent. The company has significant relationships with large aluminum consumers such as  Boeing (BA) and General Motors and generally ranks as one of their largest suppliers."

 Boeing  (BA)
Boeing is the only 4-star name on our list, and a company we're closely watching. We would consider buying should a three-month delay in the delivery of the first game-changing 787 or further increases in research-and-development expense--both events likely, but not tragic to the long-term investor--put this jet maker's shares on sale. From the  Analyst Report: "Boeing's dominant position in the small widebody jetliner segment should help it capture a majority of commercial aircraft demand over the next five years. The jet maker's strategic vision into future market developments and its revolutionary use of composite materials have given it a lead over Airbus that could eventually extend beyond the 787 program."

 Cemex  (CX)
At recent prices, Cemex shares have a free cash flow yield over 10%. While its U.S. operations face tough sledding for a stretch, we think the firm's global portfolio, competitive cost structure, and ongoing acquisition program will help mitigate the current downturn in one of its largest markets. With the Rinker deal now complete, we expect substantial cost savings to show up in the firm's earnings before long. Also, management continues to build modern new plants in order to meet growing demand in existing markets. From the  Analyst Report: "Cemex's assets would be nearly impossible to replicate. This narrow-moat firm enjoys enviable positions in some of the world's most attractive markets, and its seasoned management team boasts one of the lowest-cost structures in the industry."

 SAIC  (SAI)
One of the top 10 defense contractors, SAIC distinguishes itself through its broad scientific and technological expertise that runs the gamut from future combat systems to integrated port inspection systems and even more exotic applications such as biopharmaceuticals. Capital requirements for the business are low, averaging just 1% of sales, and the firm's most valuable assets are its employees, whose innovation and ambition drive new systems advances. As a result, SAIC generates strong returns on invested capital and copious amounts of free cash flow that can be used to reinvest in next-generation solutions and return excess cash to shareholders. From the  Analyst Report: "By identifying emerging technology priorities and offering cutting-edge solutions, SAIC has become a major defense player with a grasp on the government's wallet."

 Vulcan Materials  (VMC)
Due to concerns about slumping residential construction, especially in (soon to be acquired) Florida Rock's markets, Vulcan shares are now trading with a price/earnings ratio similar to that of the overall market. While some market participants might be skeptical about future price hikes, we are optimistic that Vulcan will be able to price ahead of inflation for some time due to the strong fundamentals of the quarry business, declining supply in some locales, and increasing concentration of ownership among rational public entities. From the  Analyst Report: "Competitive advantage in the stone quarry business is based on three factors: location, location, and location. Because Vulcan owns quarries in numerous attractive markets, we think the company is surrounded by an economic moat."

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Brian Nelson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.