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Quarter-End Insights

Industrials: Despite Bullish CEO Talk, Few Values

Among a mostly fairly valued industrials sector, some good values remain.

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  • 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.  Honeywell International (HON) CEO Darius Adamczyk said he’s "quite bullish on 2018, 2019 and to the extent he can see 2020," and added that "overall, the markets look very, very good, almost without exception." Honeywell has the advantage of several long-cycle businesses in its portfolio. Adamczyk said that he observes Honeywell’s aerospace backlog increasing, as well as healthy order activity from some of its technology and automation offerings. Representatives for  3M (MMM) were also enthusiastic about certain newer, innovative offerings, particularly in the data center space, which we also see also as a faster-growing line of business. 3M's immersion cooling, which allows data center companies to dip their electrical components into a nonconducting liquid to prevent overheating, is the latest response to this rapid growth. 

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  GE (GE) reaffirmed its commitment to its dividend by declaring a quarterly dividend of $0.12 per share. Only a few weeks earlier, the market was spooked when Flannery appeared to visibly waffle when sell-side analysts pressed him on the firm’s dividend commitment. Even so, we think the issues that have plagued GE recently persist. As we see it, the three most critical issues facing the firm are GE's power segment, which continues to face overcapacity issues, as well as competition from renewables from a levelized cost of electricity standpoint; GE capital and its potential liabilities, including its shuttered subprime mortgage unit WMC, as well as long-term care in the firm’s run-off insurance business; and adequate levels of capital, both from a standpoint of maintaining dividend coverage and meeting the firm’s reinvestment needs. Even so, we think Flannery is the right person for the job as he has patiently shed exposure to some of the firm’s less attractive assets in order to focus on its core three segments: power, aviation, and healthcare.

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.

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