Pulse Check On Industrials: Q1 Valuations Rich

Summary

• While not a large cap investor, keeping an eye on growth, trends, and management commentary from the biggest firms in the industry help guide small cap decision making.
• Making those efforts easier, automated heat maps can help provide cross-sector comparisons on which areas have stronger sentiment and value.
• Top 10 bellwether firms listed. Sell-side analysts have their opinion, but which ones are buys and which ones are sells?

While not predominantly large cap focused in my research (smaller firms are the niche in Industrial Insights) the big names in industry are incredibly important. Highly cyclical, tracking trends in the larger companies within the industrials sector can often point to bellwether indicators within the space. While buying opportunities are often few and far between in larger companies due to greater market coverage and excellent liquidity – more eyes means less disconnects – efforts here are still worthwhile. With only so many hours in the day, constant deep dive due diligence across most of these companies on a continuous basis is a tough undertaking. Automation helps greatly. I personally use heat maps, updatable on the fly by tweaking assumptions, which can often bring some quick insight on sectors of the market rotating out of favor. This finger on the pulse of major firms, can indicate areas of the market that have opportunity.

Giving an example of putting this to work, Titan International (TWI) remains a favored small cap pick. The tire and wheel manufacturer relies heavily on new equipment sales in heavy equipment. An unjustified sell-off in the summer not driven by market fundamentals (overall outlook for key customers Deere and Caterpillar suggested otherwise) led to a great occasion to add shares on the cheap:

Titan International still trades at a deep discount to intrinsic value today. While not everyone wants to invest in smaller firms, heat maps can still provide context across the sector on where to direct capital (or at least dedicate greater research) to where it will generate the greatest risk-adjusted returns over the long term. Personally I stay deeply in tune with ten large cap industrials to track trends in areas of growth and overall market sentiment: Boeing (BA), 3M Corporation (MMM), General Electric (GE), Honeywell (HON), United Technologies (UTX), Lockheed Martin (LMT), Caterpillar (CAT), Illinois Tool Works (ITW), Waste Management (WM), and Cummins (CMI):

I’m sure I’ll get squabbles on my picks above, but it gives a great diversified bundle look over several end markets. Like anything else, there are a couple of caveats to the above data. Just as screening can often include or exclude potential investments unfairly or make unwieldy cross company comparisons, there are some issues to keep in mind.

A high multiple does not necessarily signal overvaluation versus another sector peer – these firms can all be in different stages of their business cycle. Investor outlook on future growth is required. EV/EBITDA above is based on 2018 EBITDA expectations only. Capital spending used to compute free cash flow yield above is structured off of three-year trailing averages; maintenance spending might (and is likely) to be significantly lower than recent overall capital expenditure output. One-time costs are excluded from walking EBITDA to free cash flow (e.g., restructuring and acquisition charges) and the metric also assumes no changes in working capital year over year. Leverage is calculated as consolidated debt versus consolidated consensus EBITDA, with debt including pension liabilities. Pension assumptions are different across firms and there is no normalization here. Majority-owned (but not 100%) subsidiaries and/or financing businesses can all drive this metric higher. Further, not all of this debt is necessarily guaranteed by the parent company.

Analysts have clear favorites here: Long General Electric (perhaps surprising to many readers given headline reactions) and Caterpillar remain the top two long side choices. On the other side, Wall Street is less enthusiastic about the prospects of Cummins and 3M Corporation, with those two remaining out of favor. Taking a contrarian stance and throwing my own view out there, below are two large caps to buy and two to sell.

Two Buys, Two Sells

Buy Cummins. Deeply cyclical and the quintessential contrarian play, strong demand continues to exist within on-high and off-highway markets for Cummins products. North American markets in particular have continued to beat expectations as engine and associated equipment sales recover as the mining, oil and gas, and power generation end markets firm back up. The company continues to have massive market share in the medium duty trucking market (83% at year end) and heavy duty share has been improving as well (over 40% in large fleets). Management guided China down heavily (14%), but early signs point to a significant drubbing of that initial outlook. The recently announced Cummins/Eaton (ETN) joint venture that will create integrated engine and transmission development by the largest players in the space is likely to boost market share in the medium term. Growth is still on the horizon and risks related to electrification are far away. Cummins is trading at a steep discount and is throwing off significant cash flow while the rock-solid balance sheet provides safety.

Buy United Technologies. It is no wonder that sum of the parts analysis continues to be a core tenet of the long thesis at United Technologies; the company is dirt cheap compared to many of its peers. Solid commercial HVAC orders (as well as transport refrigeration), as well as a firming elevator business, continue to boost outlook. Within aerospace, geared turbofan (“GTF”) engines continue to ramp. After problems late in 2017/early 2018 (much to the delight of General Electric) problems appear to have been worked out. While still early (and not yet on balance sheet... remember those caveats to the heat map), the Rockwell Collins merger should lend stability to aerospace revenues and cash flow in the future. 2018 expectations from the sell-side look more than achievable and United Technologies is likely to beat on the bottom line – just as it has for every single quarter since Q2 2014. Much of that overperformance is likely to come from the aerospace segments where overall market sentiment is weakest. CEO Gregory Hayes and his management team have not seen their recent execution rewarded by the market as it should have been.

Sell General Electric. As a long-term bear, there simply still isn’t enough to like here. Anyone that can read financial statements was, and has been, perplexed by General Electric accounting. I do think CEO John Flannery is the right man for the job and I do think the market will, eventually, appreciate his rummaging around the darkness bringing old skeletons to light. However, cash flow generation remains poor, leverage high, and potential future grenades on the balance sheet remain scattered. An equity raise, even at these depressed levels, is not out of the question. GE Capital, despite the value of GECAS, begins to look further like it only has marginal value. Within the Industrials business, a turnaround in GE Power is unlikely in the immediate term and management continues to try to utilize creative financing deals (hybrid deals, spin-offs) to unlock value. Entering the market as a seemingly forced seller is not the best position; divestitures since the wind-down of GE Capital have not been priced as well as they could have. It will take an incredibly long time for sentiment to turn. This is the number one issue that investors make: buying too soon. Watching Seeking Alpha readers buy each leg down has been an unfortunate sight to watch.

Sell Lockheed Martin. Defense stocks have been en vogue of late due to the Republican stranglehold on the federal government and potential military action, but low growth Lockheed Martin is not likely to experience much in the way of expansion in 2018. Revenue growth will be low single digits (2% by management guidance) even in this environment and unlike other firms with lower free cash yields, Lockheed Martin is unlikely to grow out of this problem due to the nature of its contracts . Bulls have pointed to the backlog and strong book to bill, however many of these contracts will ramp slowly and will not contribute meaningfully to earnings before the turn of the new decade. ASC 606, the new accounting standard on contracts, will impact revenue recognition meaningfully on long-term contracts such as the F-16, C-5, and Black Hawk programs. The $16,422mm underfunded pension lability is a heavy noose around the company’s neck, sopping up cash that could be used for shareholder returns. Leverage will keep the firm from supporting the share price to the levels other companies can on this list. Capital is better put elsewhere.

Takeaway

On the whole, valuations aren’t particularly cheap across most of the large cap industrials space, even considering the impacts of tax reform and a supportive environment. Overall outlook is for a slowdown in GDP growth in late 2018, with most corporations in the stock market beginning to lap incredibly difficult prior period comps in 2019. Interest rate hikes – as many as four – risk putting a further pause on already dull economic activity. Investors often forget this is the second longest running economic expansion in one hundred years. In my view, buy and hold is going to have a tough time in the near term, with active management (particularly those that hedge and/or run short strategies) set to make significant strides in outperformance. Investors need to stay dynamic.

Analyst’s Disclosure: I am/we are long TWI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[User 41156665]

Michael Boyd,

Since you are an investor in TWI, maybe you know why they are losing money? My interest is simply this; prior to 1978 we Mfg. tires like these for companies like Caterpillar and they were the most lucrative things we sold with Goodyear unwilling in most cases to meet the requirements of the heavy equipment makers.

So they pay a 1/2 cent per quarter dividend on a ~$12 share? I looked through their 160 page catalog online so I can see exactly what kind of tires they are selling, insofar as to whom and for what applications. Start-up and tooling costs aside, these are very high value-added tires and markets. Only a lack of volume, poor distribution/marketing and/or undercapitalized start-up or poor management could cause losses aside from cyclical nature of Commercial, Farm/Forestry, Mining, and Excavation markets. Something is missing in this story.

[Michael Boyd]

I think you pegged it pretty well, cyclicality. Farmers simply don't have the cash for new equipment. A lot of them bought new in 2011-2014 when they were making double the money per bushel of corn (similar trends across most agriculture). With crop prices in the tank, they've been deferring maintenance spending on tires as long as they can. Tires ain't cheap; combine tires going for $3,000+ a piece isn't unusual as you know. That's quite a bit of money for even larger farms. Unfortunately heavy equipment spending in mining sectors (where tires cost even more) is also in the tank at around the same time. There is likely a little tailwind from replacement market as I think individuals have differed spending as much as they can at this point.

In 2017, excluding some changes in working capital TWI was pretty neutral in terms of free cash flow. If you think commodity pricing will improve it's a pretty good company at current levels in my view.

[User 47998195]

Michael Boyd,

I was very young when my dad retired from the Tire Industry after being drafted in the form of being an Emancipated Minor after my Grandfather had a massive Heart Attack following a giant Urban Tire 🔥 in a new building with insurance issues. Yet I can recall him filling the requirements of Caterpillar's Mining Tire specifications which were inflated with Anti-Freeze rather than Air for center of gravity issues. Individual tires were F.O.B. New Jersey at as much as $5,000 per unit and minimum orders were set in carloads (rail).

Those tires went to either Caterpillar or the Mines and Caterpillar always stated their requirements and when Goodyear didn't feel like the order was worth it was pretty easy to "work under Goodyear's Umbrella". Meaning the prices set by Goodyear for similar types and capacities, including ply and CVC (specific synthetic rubber compound) were easily estimated and costing was an easy task for our family's manufacturering business. The number of units required is usually well understood and estimated so it was simply a question of if their was a contractual number of machines being made for a reasonable contract to be offered. The 🔧 ing for Special Orders usually required a sizable upfront payment from the equipment maker and a few times even by mines with large inventories of Capital Intensive, replacement cost prohibitive Off-Road equipment. Farming/Forestry Tires were more easily and cheaply made, but there were a lot of auxiliary types for implements, low speed, low-platform trailers and unusual Front Tires for Farm/Forest tires that were designed for Mud, Flotation or Utility use. The last category was the one that we tried to use or use with CVC or Tread Design modifications for a wide range of aftermarket uses.

The point is, without getting into wheels and other multi-application products. Cycles the effect 🚜 implements and special application tires, especially with a direct link to Goodyear's Distribution for O.E. and Aftermarket Sales should NOT pose insurmountable cyclical issues because those cycles are both not acting in concert with each and other and not without the benefit of the O.E. Mfg. and Goodyear for financial, distribution and planning support. The overlapping of inelastic and elastic demanded products Types, in itself removes a great deal of the downside risk.

I spoke with my dad about this at length over the years. So I didn't have all this industrial experience but I saw it going on in the 70s as a child and my dad has spoken about it often over the years.

[User 41156665]

I liked the 🔧 and 🚜 symbols you put in. Reminds me of the "Colorforms" you liked so much when you were a child.

[User 41156665]

Are We Headed For Bear Country?

Found your write-up very insightful. It does look as though actively managing towards secure sectors and individual companies will become increasingly important as the upward creeping interest rates create an increasing headwind. Of the companies mentioned in the article, we've been adding Eaton and we sold off MMM at $255 to yet again buy it back at ~$215 last week. Bearish sentiment for MMM is curiously quite different from GE's Bearish sentiment. A year or 2 ago it took 5-6 shares of GE to Buy 1 MMM and now, after MMM's largest share price reversal in a decade it takes ~15 shares of GE to Buy 1 MMM and MMM has a higher Market Capitalization than GE for the 1st time that I've been aware of and I do recall 2007-2009.

When Did A Recovery Occur?

In any event, recession is a dirty word, but with both interest rate hikes and recently higher Energy prices that can both be lowered quickly by market shocks, the landing doesn't have to be a terribly hard one. But it could be with the kind of political Brinksmanship that's been played lately with "other" people's consequences.

In my opinion, however, consumer spending, especially discretionary spending has never recovered from "The Great Recession" which still seems to be lingering and has left a large well of untapped "Pent-Up Demand" across many sectors. Just look at the average age of American cars! Historic Plates are almost fitted to cars in daily use! So: Either this lower standard of living is becoming the norm or there is an ultimate recovery that we have yet to experience. I am hoping for the later because the country can really use an overall lift.

[User 44750306]

Thanks Michael, for another interesting lesson in investing. I do agree that CMI and UTX are the best picks in the bunch at this point, by far.

ITW is going to run out of gas suddenly in my opinion, when is hard to guess but I wouldn't touch it until it does. ITW's share price is padded heavily by employees buying the stock in there retirement plan. Also, the 80/20 business model is too often abused by business managers that stretch their divisions to paper thin, squeezing big prophets for a while, but creating huge disappointments at some point.

[easindc]

Read your post of April 15 on ITW. Fantastic call anticipating the stock falling off a cliff only days later. I hold a small position and I’m curious if the stock ‘reset’ means, after a base building, will the stock recover? Your thoughts? Thanks, EAS

[User 44750306]

Hi easindc: This is a long answer and I only have a few minutes. I'm not a fan of the 80/20 business model, I think it's a Fascist business model that breeds dishonest and creates a hostile business environment. In my opinion it should be taxed and regulated much more. It too often, and I wish to underline the too, circumvents free market capitalism and creates an environment where individual management set a horrible example for hourly employees, it creates a bully dishonest society. This kind of business is destroying American civil society.

[valuinvstr99]

Michael Boyd
Regarding CMI, you say, "Deeply cyclical and the quintessential contrarian play....". Please elaborate on where in the cycle CMI is at and provide supporting data. You also say, "Growth is still on the horizon....". How far away is the horizon, the contraction of growth? Stocks are frequently, correctly labeled as cyclical without discussion of the cycle. The fact that a stock is cyclical is not nearly as meaningful to the investment decision as knowing where it is in the cycle. Frankly, I struggle with identifying cycles.

[Michael Boyd]

Cyclicality is, of course, reliant on what your view of future earnings will be. The market has been a bit bearish on CMI's future business prospects since the weak initial guide in 2015; the company has beat earnings expectations (despite analyst target hikes) consistently since then, with the sell-side about 10% too low going into the most recent quarter on their expectations for 2018 (management guide vs. their forecast).

The trucking market in the United States has been extremely solid lately, both off highway and on highway. Even though I think the market is being too bullish on 2018/2019 GDP forecasts, Cummins likely does better than the market in my opinion.

For what it's worth, I'll probably be as high as 30% short by the end of the year; I don't see 2H 2018 and 2019 as likely to be solid years for S&P 500 returns. My buy recommendations here are relative performance to the rest of the market.

[pro8]

Of the ones you article refers to my preference would be ETN . UTX looks interesting and MMM a close 3rd