Are Smaller Industrials Pointing to a Broader Recovery?

by: Stephen Simpson, CFA

It is no great surprise that today's earnings report from machine tool manufacturer Hurco (NASDAQ:HURC) is largely going unnoticed. Even though sales jumped 92% from last year, orders more than doubled (and the book-to-bill is over 1), and the company handily beat its estimate, only one analyst follows this stock and the company booked only $224M in revenue in its best year. In other words, it is a very small company that just falls through the cracks, more often than not.

My objective here is not to sing the praises of Hurco (though I do believe it is a fine company and currently undervalued), but rather to try and connect a few dots that the earnings from companies like Hurco might be telling us.

The Return of the Small/Mid-Sized Business?

Much of the recovery story so far has been dominated by the improved performance at major companies. Corporate earnings have clearly recovered, and the major North American stock indexes have rebounded as well.

At the same time, though, there has been a great deal of hand-wringing about the state of the job market. Small and mid-sized businesses (SMB) normally employee a large percentage of people in this country, and those businesses have not been hiring all that many people. Likewise, those who follow bank stocks have no doubt noticed that the pace of commercial lending has been poor as well, and it is largely SMBs that do that sort of borrowing.

These industrial earnings, though, may be a sign that things are getting better in this important segment of the economy.

Metalworking Seems to Be Working

Turning back to Hurco, the company reported that sales within North America were up the strongest (up 121%), and so too were North American orders. That seems relevant to me because Hurco sells largely to smaller metalshops and manufacturers – a large industrial like Caterpillar (NYSE:CAT) or General Electric (NYSE:GE) may well have machine tools on hand, but a lot of their machine tool needs are going to be outsourced to suppliers (who may in turn outsource to even smaller metalworking concerns).

But it is not just a Hurco phenomenon. Kennametal (NYSE:KMT), a company with a sizable metal-cutting tools business, likewise reported strong organic sales growth for its December quarter (up 31%) and boosted its growth guidance for the full year. Though it's true that Kennametal serves markets like transportation and aerospace -- not necessarily thought of as bastions of SMBs -- the reality is that small businesses that focus on a handful of components or products are more crucial to the supply chain than many people realize.

So too with Lincoln Electric (NASDAQ:LECO). Lincoln Electric is not a household name for most investors, but it is one of the three largest welding-product companies in the world (alongside Illinois Tool Works (NYSE:ITW) and Charter). Like machine tools, welding equipment is a critical component of the equipment list of many small manufacturers and fabricators. Lincoln Electric's seeing better than 20% volume growth and particular strength in export-oriented manufacturers is another positive sign.

Bits And Pieces

Other examples?

WW Grainger (NYSE:GWW) offers a huge selection of tools and supplies through more than 400 branches in the U.S. alone. With a customer base of over 1.7 million for 2010, it is clear that a large number of Grainger's customers have to be SMBs. Not only did Grainger announce that daily sales increased 14% for the fourth quarter, momentum built sequentially through the quarter.

If the Grainger example is not convincing, perhaps adding MSC Industrial (NYSE:MSM) to the picture helps. Like Grainger, MSC is an MRO supplier, but MSC Industrial is even more focused on small/mid-sized manufacturers (metalworking equipment and supplies is a large product category for it). In fact, for MSC's last quarter sales were up 23% with only one-third of that growth coming from large accounts and 71% of sales going to manufacturers. Again, here is a company that is very leveraged to the health of SMB that is doing well today.

Maybe this will strike readers as a strange name to include, but Middleby's (NASDAQ:MIDD) success may also be an encouraging sign of recovery. While it is true that Middleby is working hard to penetrate major fast food and casual dining chains, there is still a large segment of the restaurant industry that is made up of small businesses. It is improbable, then, that Middleby's 22% organic sales growth in the last quarter was just a byproduct of selling more fryers or ovens to McDonalds (NYSE:MCD). As restaurants are one of the larger employers of less-skilled (but young) workers, a recovery in this sector would be good news not only for employment but also for consumer spending.

Correlation, Not Causation

Investors always have to be careful about drawing conclusions from a few positive data points. That said, if companies that largely rely on small businesses are seeing strong revenue and order growth, it is an encouraging sign. If the small business sector is in fact on firmer footing and spending more liberally on capital equipment and supplies, that could be a prelude to better employment numbers and an overall extension of this economic recovery.

Of course, no good deed goes unpunished. If employment picks up and the SMB sector is in fact rebounding and expanding, that probably means that interest rate hikes are not too far away -- and institutions will want to rotate away from industrials and into the next cyclical play. All that being said, companies like Hurco, Lincoln Electric, Middleby, and Kennametal are at least worth a spot on a watch list, if not further due diligence.

Disclosure: I am long HURC, MSM.