Industrial Firms Using Recession to Reload

by: Morningstar
By Daniel Holland

Earnings continued to impress during the second quarter. A number of industrial companies delivered strong revenue growth and operating margins at or above our midcycle assumptions. The strength in earnings, while welcome, is unlikely to be broadly sustainable over the long term, as manufacturers add capacity to meet burgeoning demand. However, we think some companies have made fundamental changes which will buoy ongoing profitability, and we highlight a few of these below.

A Healthy Dose of Restructuring Goes a Long Way

In 2008, signs of a looming recession forced many manufacturers to slash workforces and shut down plants abruptly to mute the impact of rapidly declining volumes. In doing this, many manufacturers were able to retain solid profitability in a shrinking economy. Because the recovery has stretched over several quarters, manufacturers have had the luxury of satisfying demand with a dramatically lower cost base. New revenue is coming on with little associated fixed cost, resulting in robust operating margins. For most companies, we think these margins are unsustainable, because companies eventually will have to add capacity--more people and more machines--to satisfy demand, thereby dampening operating performance. We view this as less of a setback than a return to a normal environment with fewer strains in the supply chain.

Cause for Optimism

Companies like Emerson (NYSE:EMR), Siemens (SI), and Philips (NYSE:PHG) may have actually pushed profit profiles higher through fundamental changes to their cost structures. In the case of Emerson, the company shut down legacy manufacturing facilities in high-cost regions, and shifted capacity to lower-cost regions. New demand will be satisfied with a materially lower cost structure, thereby improving margins over the longer term.

Similarly, Philips and Siemens exchanged manufacturing bases in high-cost regions for lower ones, lifting margins to all-time highs. The European conglomerates suffered from cumbersome labor agreements in countries that punish companies that lay off workers, which kept the companies behind U.S.-based peers. Instead of accepting the status quo, both firms took a material hit to earnings in restructuring charges to reduce the number of workers in Western Europe. Resulting double-digit operating margins at both companies are twice their historical levels. We think neither company will be eager to build capacity in higher-cost regions in the near term.

Investing for Growth as Opposed to Cutting to the Bone

Through the recession, many manufacturers kept research and development spending intact relative to prior years, giving companies strong products pipelines. General Electric (NYSE:GE) launched its Healthymagination initiative, where the firm committed to ramping up spending in its health care segment, resulting in a broad suite of products that GE can introduce to emerging markets, as well as many developed regions. Similarly, the key strength in Honeywell's (NYSE:HON) portfolio is products aimed at reducing energy consumption, and the company used the breathing room afforded by the downturn to reinvest in its fleet of controls products as well as the turbo-diesel business. While these firms may have sacrificed some potential earnings boost from holding back on reinvestment, both now have an impressive catalog of products to meet new demand with innovative products, as opposed to a refresh of yesterday's fleet.

Closing Thoughts

The abrupt drop in end-market demand caught many companies off guard, but manufacturers have delivered impressive operating performance by quickly tightening spending. We think companies that made fundamental changes to the way they do business, as well as firms that managed to invest during the cycle, have a better chance of maintaining this success over the long run than do firms that trimmed their cost structures to the bare necessities.

Companies Positioned Well to Deliver Strong Margins

Emerson Electric
Emerson's intense focus on emerging markets has positioned the firm well for near-term growth, more so than other multinational firms. Although most companies did not accurately anticipate the severity of the recession, we don't think it caught Emerson off guard. The company had a plan to reduce costs coming into the downturn, and we think the improved operating structure will lead to better margins when volumes return. Emerson's management team has proved to be adept capital allocators, generating incremental returns on capital exceeding 30% through this decade. As the company continues to grow in emerging markets, we expect these higher incremental returns to persist.

Siemens has a longstanding tradition as a technological leader in all of its markets, a notion that we think remains relevant today. With several quarters of weak orders and revenue, the recession forced Siemens to retool, lower its cost structure, and introduce new products. Since many of its peers have had the same internal focus in the recent past, we think the next wave of innovation should be of particular interest to investors. If Siemens can avoid the temptation to rehire in high-cost regions, we think it can generate returns rivaling industry peers General Electric, Emerson, or Rockwell Automation (NYSE:ROK). Each of these companies has been quicker to shift manufacturing bases, but Siemens has closed the gap with this latest round of restructuring.

Philips Electronics
The global push for energy efficiency and cheaper health care is Philips's main growth driver over the next several years. With a strong foothold in LED lighting, the company should have no trouble capitalizing on the initiative to retrofit old buildings with newer and more efficient lighting systems. The push toward lower-cost health-care equipment should also move in Philips' favor. Competitors such as General Electric and Siemens have decided to rededicate engineering resources toward finding ways to strip costs out of existing technology platforms as opposed to advancing the high end of the imaging landscape. We think Philips' strong and growing position in home health care and its consumer electronics focus may help it commercialize technologies sooner than its peers, helping the firm catch the beginning of a large wave.

General Electric
Exiting the recession, we think CEO Jeff Immelt finally has the portfolio he wants. Immelt essentially put the company on a diet, trimming down the business to an impressive core portfolio. NBC Universal should move out of the picture by year's end, leaving the energy, health care, and aviation pieces intact. All of these are wide-moat franchises, in our opinion. In a move repeated by many of the diversified manufacturers in Morningstar's coverage universe, GE shifted its growth focus from acquisitions to heavy research and development, giving the company one of the strongest new product portfolios in recent memory. We expect GE Capital to contribute to parent earnings and cash flows, as delinquencies slow and the firm liquidates noncore assets. We are encouraged by the company's recent dividend increase, and believe that this step is the first of many capital allocation decisions for GE.

Honeywell International
Honeywell spent the past decade retuning and focusing its portfolio for its next phase of growth. Energy efficiency and energy conservation are key drivers that will push Honeywell forward during the next few years, with the automation and control segment--as well as specialty materials--being primary beneficiaries. While we believe aerospace markets will be weak over the next couple of years, we expect Honeywell's other segments to fill the gap. Leading indicators are trending higher for the company's end markets, and after several years of investing in the business, we think Honeywell's portfolio is ready to execute and take share.

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