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Quarter-End Insights

Our Outlook for the Industrials Sector

Industrial production is hindered by housing and input costs.

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Sluggishness in housing continues to plague the general economy, as well as the domestic industrial sector. Residential fixed investment nicked overall gross domestic product by more than a whole percentage point for the third consecutive quarter in the first quarter of this year, and five of the past seven overall. It doesn't appear to have gotten much better in the second quarter, as construction statistics such as housing starts and permits both continued to plummet more than 30% year over year in each of the first two months of the second quarter at seasonally adjusted annual rates. It's difficult to see any bottom in the near term, as bloated inventories of for-sale homes combined with rising foreclosures make for a tough supply-demand equation for at least the next several quarters. The offshoot is that any company even tangentially exposed to housing continues to suffer top-line pressure.

Also troublesome, rising input costs continue to exert pressure on margins for many companies within the industrials sector. Firms that incorporate material amounts of steel, copper, aluminum, or petroleum-based products are currently struggling to pass on these increased costs to a domestic end user that's feeling a lot less wealthy due to rapidly declining home equity and materially increased transportation and food outlays. Case in point: high-quality shippers such as  FedEx (FDX) and  United Parcel Service (UPS) will see material margin pressure this year due to fuel surcharges that lag cost increases, while some of our lower-quality sub-industries such as airlines hang on the precipice of disaster due to rapidly escalating costs and high financial leverage.

On the other hand, industrial companies that sell into industries such as agriculture, mining, energy extraction and exploration, overseas infrastructure, and, to a lesser extent, aerospace continue to post record results. Beneficiaries range from giants like  Caterpillar (CAT) and  John Deere (DE), which are enjoying huge demand from booming agriculture and mining industries, to lesser known lithium producers such as  Sociedad Quimica y Minera de Chile (SQM) and  Rockwood Holdings (ROC). Caution is warranted, however, as the current prices of many beneficiaries of these trends reflect a very rosy outlook.

The end result of all three trends (continued weak demand in residential construction, rising input costs, and booming demand for commodity-based products and services) is a domestic industrial output environment that's currently in moderate decline. The manufacturing component of industrial production declined slightly in both April and May, the first consecutive decline since 2002. We look for the industrial sector to continue to muddle along for the remainder of the year, based primarily on a continuation of these trends.

Valuations by Industry
Our average price/fair value ratio for the industrials sector declined slightly to 0.91 from 0.92 in the first quarter, implying the sector remains slightly undervalued based upon Morningstar's estimates of intrinsic values.

 Industrials Valuations by Industry

Segment

Current Median Price/Fair Value

Three Months Prior Change
(%)
Aerospace and Defense 0.88 0.87  

0

Agricultural Machinery 0.87 1.01 -14
Agriculture 1.03 1.23 -16
Agrochemical 0.93 0.97 -4
Aluminum 0.83 1.00 -17
Automakers 0.63 0.87 -28
Auto Parts 0.99 0.86 15
Auto Retail 0.79 0.73 9
Building Materials 0.67 0.71 -5
Chemicals 0.99 0.96 3
Construction Machinery 1.58 1.37 16
Diversified 0.87 0.81 8
Electric Equipment 0.98 0.92 6
Machinery 0.94 0.96 -2
Manufacturing--Misc. 1.35 0.94 44
Metal Products 0.84 0.89 -5
Packaging 0.95 0.93 3
Paints/Coatings 0.82 0.91 -10
Plastics 1.0 0.76 32
Recreation 0.82 0.85 -3
Rubber Products 0.67 0.79 -16
Steel Iron 0.88 0.95 -7
Transport Equipment 1.68 1.32 27
Truck Manufacturers 0.84 0.67 25
Data as of 06-13-08.

Industrial Stocks for Your Radar
We see a number of attractively valued stocks in the space. In particular, we think the following names are worth putting on your radar screen.

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

Mkt Cap
($ Bil)

Mohawk Industries $110 Narrow Medium 7.5
Pacific Airport Group $48 Wide Medium 1.9
Cen North Airport Gr $31 Wide High 0.8
Republic Services  $39 Narrow Low 5.7
Vulcan Materials $111 Wide Medium 7.0
Data as of 6-20-08.

 Mohawk Industries (MHK)
It's no secret that Mohawk is currently suffering from weak demand for its flooring products in the residential construction segment. Yet the company is not as susceptible to new home builds as is often perceived. In fact, 60% of the company's sales are derived from the replacement market, which has historically shown its greatest strength when the new-construction market softened. Even though the replacement market has yet to reprise its counter-cyclical role amid the current housing malaise, Mohawk's strong product portfolio should generate adequate sales and profitability until the replacement and/or housing market starts to recover.

 Grupo Aeroportuario del Pacifico (GAP) (PAC)
Recent struggles in the airline industry--including high oil prices and maintenance issues--have driven down GAP's passenger traffic in recent months. Despite these factors, we think that the long-term picture remains intact for the firm. Low-cost carriers will likely continue to grow their share of the Mexican air-travel market by keeping fares low and stimulating demand. The low fares should enable greater access to air travel, which is still relatively low in Mexico's developing market. Furthermore, GAP's sites are geographically isolated with little competition, resulting in our estimated wide economic moat. We think the firm may face continued near-term head winds, but we still expect long-term free cash flow margin improvement, which already stands at an impressive 30%.

 Grupo Aeroportuario del Centro Notre (OMA) (OMAB)
OMA has faced many of the same challenges as its counterpart, Grupo Aeroportuario del Pacifico, but the firm's higher degree of domestic passengers has steered the firm toward traffic growth versus GAP's year-over-year declines. That said, OMA is still feeling the pinch of an economic slowdown, with markedly weaker passenger-traffic growth than earlier in the year. Still, like GAP, we think OMA enjoys a wide economic moat due to the minuscule competition facing its airports. Though OMA's free cash flow margin trails GAP's, and the firm faces considerably greater hurricane risk, we expect long-term success for the company.

 Republic Services (RSG)
Republic Services boasts an attractive business model that throws off strong and predictable cash flow, even during tough economic times. The waste hauler's landfill network and exclusive, long-term monopolistic contracts, which cover about 40% of revenue, offer key competitive advantages. Further separating this trash taker from the pack is its geographic exposure to the faster-growing Sunbelt states, which, due to their higher-than-average population growth, help Republic outpace competitors in terms of waste volume expansion. Plus, the rubbish handler's stock-for-stock merger with rival  Allied Waste (AW) should provide greater support for continued real pricing growth, the source of much of the trash taker's operating margin and return on invested capital gains during the past few years.

 Vulcan Materials (VMC)
Although aggregates producer Vulcan Materials is facing near-term head winds due to slowing domestic construction activity, we think this wide-moat company's strong competitive position will generate solid returns to shareholders in the long run. Vulcan owns a network of quarries along the southern portion of the United States, from California to Florida, and stands to benefit from growing demand for its increasingly valuable construction aggregates as population expands in those regions. Important competitive advantages include Vulcan's scale and lower-cost distribution capabilities, benefits that become even more important during periods of increased cost of transportation due to high fuel prices.

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