3 Contrarian Industrial Stock Picks

May 05, 2008 6:01 AM ETSNA, SWK, TTC

On May 5, The Wall Street Transcript interviewed James C. Lucas, Managing Director/Infrastructure at Janney Montgomery Scott LLC. Key excerpts, including his sector picks, follow:

TWST: Where are you pointing investors at this point?

Mr. Lucas: I think you have to go back to that last comment. Just as we're seeing a bifurcation in the economy between consumer, financial, and then industrial, and more general infrastructure spaces, the same thing is true for stocks. You have well-managed companies that you're able to make investments in at reasonable prices. Then there is also a handful of what I would call deeper value at this point, stocks that for whatever reason, people decide that they have a little consumer exposure, and they've got a little housing-related exposure, so they want nothing to do with them. There are some well-managed companies that are generating a lot of cash flow but the valuations are just not reflecting that right now. On the quality side, I would start with a company like ITT (ITT) or IDEX (IEX); in terms of more value contrarian names, I would point to Snap-on (SNA), Stanley (SWK) and Toro (TTC).

TWST: Why these consumer names? They would seem to be the laggards in the world.

Mr. Lucas: As I said, these are in the value contrarian camp. When you look at a Stanley Works or a Snap-on or a Toro, what often comes to mind is tools or lawnmowers from a consumer standpoint. The consumer-related piece of the business for Snap-On is virtually non-existent, although they get painted with the consumer brush. Whereas Stanley and Toro each have about 25% to 30% of their business tied to consumer housing or retail, the other 70% to 75% of the portfolio is in a variety of industrial or professional end markets. While those two companies do have a little less than a third of the portfolio facing headwinds, they're managing their way through it by managing expenses closely, and the rest of the portfolio continues to grow. More important, these companies are generating a lot of cash and being very shareholder-friendly with it. As a result, we're seeing some nice improvements in ROIC for these companies. When we look at valuations today, there is clearly a consumer discount that being applied to all three of these names. To me what's going on is that to understand the true underlying value of these companies, you need to peel back two or three layers of the onion to get there. In this type of market, people don't want to peel back one layer of the onion — if they're even going to pick it up.

TWST: Are these good companies? Historically they've had their troubles. Are they over them?

Mr. Lucas: In the case of Toro, they've done a good job over the last six years of establishing a strong track record with investors. When you look at Stanley, it's been since 2004, so they're maybe three or four years into building that track record of credibility with investors. Snap-on is about 18 months into establishing that track record of credibility. While Snap-on is the farthest behind in that regard, their valuation is probably the highest of the three, whereas Toro and Stanley are lagging because people are thinking, "Oh, Stanley, they make hand tools and that's used to build a house and we buy them at Home Depot so therefore business has got to be crummy." Although the top line will be relatively flat this year, these guys are on track to generate a record amount of free cash. To me, that speaks to the quality of the management teams that is recognizing the slowdown in the business and managing their working capital efficiently.

In the case of Toro, it's the same thing — "Well, nobody is going to go out and buy a new lawnmower." There are a lot of misperceptions that come with that. Number one, when you buy a house, going out and buying a lawnmower is usually not high on your list. Two lines I always love to use are "Mother Nature trumps the economy every time" or "In a recession, the grass still grows." It's really dependent on whether there is a drought or not. That's what affects that business. Other factors that are driving Toro's business are things like golf courses, municipal grounds, sports fields — professional end-users.

The growth in the landscape contractor market also benefits Toro, as more and more homeowners pay somebody else to mow their yard for them. A guy who's got a trailer with a couple of mowers on the back comes into a neighborhood, he knocks out eight or 10 yards, and then he's on to the next neighborhood. Those landscape contractors are Toro's biggest customers. When you look at Toro's products, whether it's selling to the landscape contractors or to golf course superintendents or sports field managers, it's all about productivity. It's how you cut the grass cleaner and quicker and make life easier. Toro has by far the strongest brand, has one of the broadest distribution channels and is well known for its service capability.

This year will clearly be somewhat of a struggle on the top line. While it will likely grow, it will be at a muted rate. Margins will be under pressure because of all the inflation pressure that we talked about earlier, and while consumer is only about 30% of the business, that is where the company has less ability to pass along price increases. That being said, the company is still growing, is still expanding margins, but most important, they're generating a lot of cash. They, along with everyone else, are looking for acquisitions. In the absence of deals, Toro has a long track record of being shareholder-friendly; they've raised the dividend for three years and they've bought back over $600 million worth of stock.

This article was written by

The Wall Street Transcript (https://secure.twst.com/subscribe.html) is a paid subscription publication that features analyst, money manager and CEO interviews. Reports are published weekly, and tend to focus on one or two industries. They contain the views of money managers and analysts about the sector, as well as interviews with eight to fifteen CEOs of companies that operate in that industry. Here on Seeking Alpha we provide extracts of our reports. We think they're valuable for two reasons. First, The Wall Street Transcript often highlights microcap and smallcap stocks that investors may not be aware of. And second, the CEOs often make comments about their industries that are valuable to investors in larger cap stocks as well.

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