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Quarter-End Insights

Industrials: Attractive Opportunities in Industrial Distributors

Logistics also looks promising.

The Morningstar Global Industrials Index rose 11% over a trailing three-month period, in line with the broader global equity market. However, the index lagged the market’s 1% increase after sliding 2% over the past 12 months on transpacific trade tensions and concerns about a looming economic slowdown.

Global industrial stocks have outperformed the market recently - source: Morningstar Analysts

Valuations in the industrials sector rose to a price/fair value of 0.97 during the first quarter, ahead of 0.85 at the end of 2018. However, we see upside in industrial distribution and logistics.

Industrials mostly fairly valued, but we see attractive entry points - source: Morningstar Analysts

Many of the U.S. industrial distributors we cover reported strong growth in 2018 amid recovering industrial end markets. While revenue growth might not be as robust in 2019, we nonetheless expect solid growth from the group. We expect gross margin pressure to persist because of faster growth from lower-margin national accounts and a generally more competitive environment. Still, given our solid top-line growth expectations, we expect distributors will leverage their selling, general, and administrative expenses to drive year-over-year operating margin improvements. Industrial distributors generally exhibit countercyclical free cash flow due to their ability to quickly pull back working capital when demand slows. So even if economic activity does slow, this group should continue to generate strong free cash flows.

Truckload operating conditions proved exceptionally robust in 2018 in the United States. Unprecedented tightening on the back of limited capacity, widespread adoption of electronic logging devices, and constrained driver availability translated into a massive uptick in carriers’ pricing power. The less-than-truckload, or LTL, landscape benefited from healthy spillover shipments from the supply constrained truckload, or TL, sector. We think the trucking industry supply/demand balance will still favor carriers slightly in 2019, but pricing will normalize as they calibrate to ELDs and drivers gradually enter the TL market. We’ve long baked that dynamic into the midcycle assumptions supporting our TL and LTL fair value estimates. Importantly, investors are resetting their expectations as it’s become more obvious that most truckers have little chance of matching the unparalleled rate gains in 2018. Thus, after a long stretch of our rating these stocks as highly overvalued, market valuations have been correcting. 

TL pricing will ease in 2019, but should remain positive on 2018 gains - source: Morningstar Analysts

Top Picks
 XPO Logistics (XPO)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $61
Fair Value Uncertainty: High

XPO Logistics has sold off more than other logistics and trucking-related stocks because of near-term idiosyncratic headwinds. In our view, investor sentiment has turned overly negative and shares are modestly undervalued. XPO’s myriad asset-based and asset-light operations carry extra uncertainty, but it has executed well on integrating acquisitions, particularly in terms of optimizing the former Con-way LTL trucking division. The fragmented highway brokerage industry offers opportunities for share gains, the last-mile heavy goods delivery niche is growing nicely, and XPO’s contract logistics pipeline appears healthy.

 Wesco International (WCC)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $88
Fair Value Uncertainty: Medium

We think Wesco is significantly undervalued, trading at an approximately 40% discount to our fair value estimate. We expect it will register robust revenue growth and margin expansion in 2019 on a host of secular trends. Wesco is now our preferred industrial distributor because of its improving fundamentals, its stock repurchases, and a notable activist investor (Blue Harbour Group) that has taken a stake in the company. Furthermore, if Anixter stumbles with its enterprise resource planning implementation, Wesco may be positioned to capitalize in the longer term.

 Anixter International
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $98
Fair Value Uncertainty: Medium

We previously preferred Anixter because of its historically more balanced capital-allocation strategy and our belief that its resumption of special dividends and/or share repurchases was on the horizon. We expected Anixter to register robust revenue growth and margin expansion on secular trends including: data center expansion, retrofit spending aimed at making buildings smarter, safer, and more energy efficient; power-grid modernization; and growing demand for outsourced supply chain management services. However, its multiyear enterprise resource planning system implementation set for 2020 could delay our investment thesis.

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