Cautious Long-Term on Machinery Companies

If the near-term attractiveness of machinery stocks is currently getting your attention, you should read what Zacks senior machinery industry analyst Mario Ricchio has to say about the sector going forward. He was on hand recently to offer his outlook.

Ahead of second quarter earnings, what are your expectations for machinery companies in your coverage?

Our expectations are very high for the second quarter. We anticipate the median second quarter EPS growth rate to come in at a healthy 20% clip. Strong international sales volumes, increased pricing power, and a weak U.S. dollar should fuel the profit gains.

The difference this time around, as opposed to other machinery cycles, is weak U.S. machine orders have failed to lead to a series of downward earnings revisions. And it’s really been a story of the booming global economy carrying the day. Since the companies we cover, in some cases, have more than 50% of earnings from international operations, they have been able to weather the storm called U.S. housing.

Unfortunately, we see the global decoupling ending within the next 6-9 months. International sales growth may fail to provide the same offset to weaker domestic market than it did in the last couple of years. So even if machinery companies report solid earnings growth this quarter and next, we believe it is already priced into the sector.

We believe the stock market is looking beyond the second quarter and paying much more attention to the outlook for 2009. Investors should focus all eyes and ears on management guidance. We believe the days of double-digit earnings growth are numbered. Our 2009 median EPS forecast calls for growth in the range of 2-4%.

What effect, if any, do you expect the global economy to have on the machinery group as a whole?

We are becoming extremely concerned about the global economy, which is a marked change from the past. Let’s start with the United States, where we were pessimistic and remain so. There is nothing bullish about the domestic economy. The residential real estate market is in a severe downturn and the commercial construction market is right behind it. It looks like Sam Zell nailed the top of the cycle by selling Equity Office Properties to private equity.

We expect U.S. commercial construction activity to slow dramatically amid a weaker labor market, reduced discretionary spending, increased retail vacancy rates, and tighter credit conditions. The decline in U.S. construction spending is expected to negatively impact the companies in our coverage, such as Caterpillar (CAT).

While we previously thought global decoupling would remain intact, our view has changed going into 2009. We believe the U.S. economic slowdown will spread to other parts of the world just as global central bankers raise interest rates to fight inflation. This is a potential recipe for a drop in industrial activity, production, job creation, and commodity demand. Investors must remember the top in prior economic cycles have been marked by repeated interest rate hikes to reign in soaring inflation. Just in the last few months, there have been interest rate hikes in Vietnam, Taiwan, Thailand, Australia, India, Mexico, the Philippines, the Euro Countries, Chile, Peru, and Brazil.

Monetary policy works with a lag, so we expect a global industrial slowdown to start sometime in the second quarter of 2009. As a result, we are turning extremely cautious on the machinery group.

Are there deals for bargain-hunting investors in machinery right now?

Due to our belief that a global economic slowdown reduces earnings growth rates in 2009 and beyond, we have no buy recommendations in our coverage. Even in the machinery sub-sectors that investors tend to prefer – mining-machinery and agriculture – orders could be at risk to changes in the commodity markets. If commodity prices buckle under weaker global growth, producers may invest fewer dollars in the machinery equipment necessary to boost output. In addition, producers could decide to delay or postpone projects, which would affect the timing of revenue realization.

Essentially, a global growth slowdown leaves very few hiding places for investors in the machinery sector. We expect the industry median P/E multiple to contract as the market discounts tougher times ahead.

Mario Ricchio is a senior analyst covering the machinery sector for Zacks Equity Research.