Industrials: Labor Shortages Driving Innovation

• Prices in our industrials sector remain slightly overvalued on average, with a mean market-cap-weighted price/fair value estimate of 1.04, with a few notable values outlined below.
• Interest in industrial automation and autonomous vehicles continued to accelerate during the quarter, as CEOs are faced with tight labor markets and stressed supply chains. Extending solutions beyond repetitive tasks on the factory floor, research and investment has ventured into increasingly complex territory such as autonomous agricultural and mining equipment.
• The Internet of Things, or IoT, is gaining penetration in the industrials sector for its own productivity goals, increasing the prospects of margin expansion. As early adopters of this technology, industrials stand to disproportionately benefit.
• Compelling automation and autonomous vehicle technologies are likely to foster new company formation and M&A. A raft of startups is gaining visibility with large corporations and venture investors alike.

With an unemployment rate of 3.9%, U.S.-based companies are forced to seek new pathways to enhance labor productivity. In the trucking sector, the problem is particularly acute, given a shortage of over 50,000 truckers, while the average age of existing truckers is 55. Likewise, 39% of  Boeing (BA) technicians are aged 50 and up. During a recent meeting with management, Boeing touted the benefits of automation, which include higher quality (improvements of 50%), improved throughput (2 times faster on 737 wings), and decreased manual labor (80% manual on wings to 80% automation). Similarly,  FedEx (FDX) recently discussed the limited deployment of fully autonomous forklifts in its highly automated sortation hubs.

The pain of present-day labor shortages has led various parties to accelerate efforts to explore fully autonomous applications. Wide-moat industrial firms like  Caterpillar (CAT) are further extending their leads by investing in technologies that address high labor costs in the mining sector. After many years of successful operation of autonomous Caterpillar above-ground mining trucks, the firm has made recent advancements in autonomous excavators and underground mining equipment. Despite significant investments in such technology, Caterpillar’s board has authorized 10 billion dollars in share repurchases.

During the third quarter, we launched coverage of Swedish vehicle technology vendor  Veoneer . The firm designs, develops, and makes safety electronics for the global automotive industry. These include passive products such as sensors, as well as active devices such as advanced driver assistance devices. While we currently consider Veoneer shares to be overvalued, we believe firms like this will pioneer advancements that usher in autonomous vehicles.

Top Picks

 Kion Group (KGX)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: EUR 90
Fair Value Uncertainty: Medium
5-Star Price: EUR 63.00

As a market leader in forklift manufacturing, Kion is already well positioned to benefit from growing e-commerce. With the addition of its Dematic acquisition, we think the company will offer attractive long-term revenue growth and increasing returns. Despite rapid growth, e-commerce still accounts for only a small portion of global retail sales, just 12% in the United States and nearly 14% in China. The low penetration levels suggest a long runway for growth, as we believe forklift sales will naturally follow the expansion of warehouses needed to support an e-commerce supply chain.

Kion's and Dematic’s respective leading market share positions in forklifts and warehouse automation secure dominance in a complementary product set that could increase the combined company’s importance to customers over time. Eventually, we think Kion and Dematic will offer a one-stop software-driven solution that combines the management of forklifts with automation systems. Given that warehouse automation is still in its early stages, we think Kion has an opportunity to gain critical early-mover ground with the addition of Dematic’s solutions. This could offer upside to our current revenue growth outlook.

 G4S
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: GBX 337
Fair Value Uncertainty: Medium
5-Star Price: GBX 235.90

G4S is the largest security provider in the world, with estimated market share of around 12% in a highly fragmented market. Its primary business activities center around providing manned and mobile guarding, security systems, and cash-management services. The company also provides outsourcing services for governments, such as back-office systems for police services, employment support services, and the management of entire prisons.

Having spent several years at the beginning of the decade overextending itself into areas removed from its core competencies, G4S now focuses on its primary businesses and driving revenue and margin growth by upselling clients and providing more value-added services. Examples of this can be seen in “Cash 360”, a program in which G4S effectively assumes back-office functions for retailers, recycling cash within their business, and reducing the need for external collection and counting services, as well as working-capital requirements. Other value-added services include risk consulting, where G4S analyzes companies’ current setups and advises on and provides solutions to companies’ operational risks. These activities not only allow G4S to enhance margins above those from basic services, but also enable it to differentiate itself from smaller peers with inferior capabilities.

 Anixter International
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $107
Fair Value Uncertainty: Medium
5-Star Price: $74.90

In 2014 and 2015, Anixter completed three transactions that have bolstered the company’s market presence, growth potential, and operating flexibility. After acquiring Tri-Ed in 2014, selling its capital-intensive OEM Supply - Fasteners business in 2015, and purchasing HD Supply’s utility distribution business in 2015, Anixter is now the global leader in network and security distribution, a top player in global electrical and electronic solutions, 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 company from competitors that rely on product pricing and availability to drive business. In many cases, Anixter is not the low-cost leader, but the firm’s 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, or NSS, 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 utility customers as they invest in security solutions to comply with regulatory standards. Growth in wireless and cloud-related products should also augment NSS growth. Anixter’s electrical and electronic solutions, or EES, 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 the acquisition of HD Supply’s power solutions business, the utility power solutions segment boasts industry-leading scale and should benefit from market share gains and improving utility capital spending.