Industrial's Sector Analysis - Q1 2018

Summary

• Analyzing macro economic conditions at the time of writing (Q1 2018) to gauge the industrial sectors competence prior to investing.
• Gauge each business line within the industrial's sector to make recommendations before diving into company analysis.

Drexel University- Dragon Fund

Industrials Sector Report- Q1 2018

Austin Wolfe

FIN T680

Table Of Contents

Executive Summary………………………………………………………………………………………………………………….3

Positive Catalysts…………………………………………………………………………………………………………6

Negative Catalysts……………………………………………………………………………………………………….6

Recommendation…………………………………………………………………………………………………………………….7

Economic Overview………………………………………………………………………………………………………………….9

M&A Activity……………………………………………………………………………………………………………………………10

Sector Overview……………………………………………………………………………………………………………………….11

Capital Goods……………………………………………………………………………………………………………….11

Commercial Services & Office Supplies…………………………………………………………………………12

Transportation……………………………………………………………………………………………………………..12

Portfolio Review……………………………………………………………………………………………………………………….14

Conclusion………………………………………………………………………………………………………………………………..16

Appendix…………………………………………………………………………………………………………………………………..18

References………………………………………………………………………………………………………………………………..24

Executive Summary

The industrials sector is divided into three industry groups and 20 industries.

Capital Goods	Aerospace & Defense | Agricultural Farm & Machinery | Building Products | Construction & Engineering | Construction Machinery & Heavy Trucks | Electrical Components & Equipment | Industrial Conglomerates | Industrial Machinery | Trading Companies & Distributors
Commercial Services & Supplies	Commercial Printing | Diversified Support Services | Environmental & Facilities Services | Human Resource and Employment Services | Office Services & Supplies | Research & Consulting Services | Security & Alarm Services
Transportation	Airlines | Marine | Railroads |Trucking | Air Freight & Logistics

Looking over the past 3 years, the S&P 1500/Industrials has outperformed the S&P 1500 benchmark by 326 basis points, has been roughly the same for the past year and had underperformed by 189 basis points year to date. Market took a dive in February and have been highly volatile mostly after a report that showed unexpectedly strong wage growth and after Mr. Trumps announcements of imposing tariffs on Steel and Aluminum in March.

In terms of P/E LTM, Industrials although being fairly expensive, are trading at a slightly lower multiple compared to the Benchmark.

In terms of EPS Growth, it has been trending up ever since president Trump took the office and announced the new corporate tax brackets. Industrials over the year has outperformed the S&P 1500 composite by 219 basis points.

Positive Catalysts:

• Decreasing jobless claims and unemployment rates portray good economic conditions for the future.
• New corporate tax rate will provide firms with more cash flows with some major companies like Walmart, Target etc. already increasing the wages.
• Increased government spending with more than half of $1.203 trillion going to Department of Veterans Affair and other defense related departments, and current military and political tensions with N Korea and Syrian crisis makes Aerospace and Defense more likely to benefit if any military actions are taken.

Negative Catalysts:

• Increasing oil prices may affect airlines and transportation industry.
• While tensions over trade war with China are currently at ease, it might negatively affect the Agricultural & Farm industry if there are some new announcements from either the US or Chinese government. Currently stocks in this sector are showing sign of growth.
• With increasing FED rates, target 3% by 2020, credit to businesses can tighten and limit the money supply for highly levered firms.
• Inflation rates are forecast to be 2.64% in 2019 and gradually decreasing to 2.27% by 2022.

Recommendation

Aerospace & Defense, Construction Machinery & Heavy Trucks, and Industrial Conglomerates look most promising based on current economic and political conditions, and the increased spending by the government for the fiscal year 2019 as well as slashing the corporate taxes by 14% to a flat rate of 21%.

Aerospace & Defense remains a strong sector given the current political tensions concerning N Korea and Syria. Plus, President Trump’s “whole of government” plan, which aims to ease export rules on military exports will help American manufactures to better compete against Chinese and Russian competitors. Also increased government spending along with less sensitivity to the market, upwards trending PE Valuations and neutral investor sentiment makes it an attractive industry.

On the other hand, Construction Machinery and Equipment, and Construction and engineering while being slightly sensitive to the market, has increasing valuations and growing earnings with positive investor sentiment. With increasing Housing STARTS over the months of February and March, this sector should also gain some momentum.

Industrials Conglomerates are not doing well, but given low-risk factor, higher valuations and earnings, this sector is worth looking into to find some discounted stocks.

Industrials, as a sector, having minimal risk, increasing valuations, growing EPS, and neutral investors sentiment should be a very attractive to investors.

Below is the Matrix providing a quick summary of key factors for each of the industries over the course of FY 2017 till end of Q1- 2018.

Industries	Risk Factor	Valuation	Earnings Trend	Investor Sentiment
Green Cells- Current Industries in Dragon Fund Portfolio	Ishares core S&P Mid Cap	P/E Trend-Over 2017-Q1 2018	EPS- Growth Over 2017-Q1 2018	Short Interest Vol
Industrial Average	1.06	+	+	o
Aerospace & Defense	0.88	+	-	o
Agricultural & Farm Machinery	0.93	o	-	+
Airlines	0.83	o	+	+
Building Products	1.14	+	-	o
Commercial Printing	0.94	o	o	o
Construction & Engineering	1.18	+	o	-
Construction Machinery & Heavy Trucks	1.11	+	+	-
Diversified Support Services	0.91	+	o	-
Electrical Components & Equipment	1.07	+	-	+
Environmental & Facilities Services	0.98	+	+	o
Human Resource & Employment Services	1.35	+	+	o
Industrial Conglomerates	0.75	+	+	-
Industrial Machinery	1.09	o	-	-
Marine	0.79	o	+	-
Office Services & Supplies	1.13	+	o	-
Railroads	1.18	+	+	o
Research & Consulting Services	0.85	o	-	-
Security & Alarm Services	0.93	+	-	+
Trading Companies & Distributors	1.18	o	+	+
Trucking	1.14	+	+	+

• Risk Factor- The beta of the industry compared to ishares core S&P Mid Cap ETF.
  • Green- Not as risky, more than 10% less risky compared to the market
  • Brown- Neutral, moves in accordance to the market in either direction within 10%
  • Red- Risky, more than 10% compared to the market

• Valuation- P/E Trend over the year of 2017 till the end of Q1-2018
  • Positive- Upwards trending, high multiples
  • Neutral- Consistent trend, occasional ups and downs
  • Negative- Low multiples, trending downwards
• Earnings Trend- EPS Growth over 2017 till end of Q1-2018
  • Positive- Trending upwards
  • Neutral- No apparent trend
  • Negative- Trending Downwards
• Investor Sentiment- Quarterly short interest volume over 2017 till end of Q1-2018
  • Positive- Decreasing Volume
  • Neutral- Consistent Volume
  • Negative- Increasing Volume

Economic Overview

The market is giving mixed signals whether it will continue its uptrend or will go into reversal after a staying bullish ever since February 2009. There are many factors affecting current market trend such as: the new tax reform, reducing jobless claims, decreasing unemployment rates , increasing wages, GDP almost 3%, Inflation at 2.4%, above desired 2%, PMI of 59.3 and increasing housing starts, the economy sure looks in a healthy state. But some economists argue that all this starts a vicious cycle of increased spending resulting in increasing prices of goods and services and ultimately leading towards recession.

Federal Fund Rate currently stands at 1.69% up from 1.25% following the March meeting and with some sources expecting it to be 2.5% by the year end. Housing starts is up 9.3% in Q1-2018 and is up month over month by an average of 1.19% over the last five years point towards a healthy economy.

Treasury Yields are increasing, and curves premiums are going flat with only a difference of 45 basis point between 2 year and 10 year yields. Historically it has been observed that if the curve starts to flatten between short term and long-term yields, investors start to be cautious and demand higher returns for the short term to offset the effects of inflation. For now, we cannot be sure if there is recession coming in near the future, for which an inverted curve is a good indicator. Plus 10-yr yields have hit 4 year highs with FED fearing inflation.

Oil price have increased more than 100% over the course of 2 years and is expected to rise in the short term. Plus, recent contractions in US Oil Stockpiles and with OPEC’s output cuts, might harm transportation sector as the costs might increase shrinking operating margins. But OPEC is planning to stabilize the markets beyond 2018.

Optimism around increasing spending and recent tax cuts is clouded by the ever-increasing Global Debt with US having 103% of GDP and IMF is warning to cut back on spending on fears that if there is a downturn in the market, the economy can slide into recession with high-levels of debt.

Aluminium price hikes (approx. 35% over a year and 16% ytd) amid tariff concerns can affect the aircraft parts, truck and truck parts, electrical equipment and some construction manufactures.

M&A Activities

United technologies is in talks to acquire Rockwell Collins for a 56% premium over the market value of COL at $30 billion. Rockwell will be a stronger company in the long term with an attractive aerospace product portfolio. The most advantageous aspect of United Technologies/Rockwell Collins deal is that their able to pay off its debt as funds are freed up under the new tax law. Under the new tax law, which slashed the corporate tax rate from 35% to 21%, United Technologies will be able to pay down its debt from the deal to acquire Rockwell Collins. Approximately 2/3 of United Technologies’ earnings come from abroad. Having this access to cash will alleviate debt burden and allow the company to buy back some of its shares. After the completion of the deal, United Technologies will have $50 billion aerospace business and $30 billion of commercial business.

Sector Overview

The table suggests that industrials as a whole are not as volatile as the market, S&P 1500. But it worth noting that there is a significant amount of debt by the difference between levered and unlevered beta. And with rising interest rates, this could negatively affect the industrials sector.

Industry	Beta vs S&P 1500	Unlevered Beta vs S&P 1500
Industrials Average	1.04	0.54
Aerospace & Defense	0.89	0.35
Agricultural & Farm Machinery	1.28	0.63
Air Freight & Logistics	1.12	0.32
Airlines	0.82	0.45
Building Products	1.03	0.43
Commercial Printing	1.1	0.46
Construction & Engineering	1.11	0.87
Construction Machinery & Heavy Trucks	1.11	0.74
Diversified Support Services	1.02	0.69
Electrical Components & Equipment	1.03	0.59
Environmental & Facilities Services	1.24	0.76
Heavy Electrical Equipment	1	0.71
Human Resource & Employment Services	1.06	0.88
Industrial Conglomerates	1.04	0.61
Industrial Machinery	1.14	0.76
Marine	0.78	0.58
Office Services & Supplies	1.15	0.30
Railroads	1.04	0.69
Research & Consulting Services	0.92	0.66
Security & Alarm Services	0.93	0.20
Trading Companies & Distributors	0.91	0.55
Trucking	1.05	0.42

Capital Goods

Capital Goods is overall an attractive choice with beating S&P 1500 on 3 year and 5 year basis, and underperforming the benchmark by only 16 basis points on ytd basis. GDP from manufacturing has been in an uptrend with average yearly gain of 0.43% 4% change from 2016-2017.

Aerospace & Defense is leading subindustry with historical and forecasted performance, outperforming market by 3115 basis point over the last three years. EPS has been in uptrend for prior 3 years. With current fiscal policy and detailed plan to ease exports of military and defense equipment this sector is poised to benefit in near term. Increasing P/E Valuations and EV/Sales show that investors are expecting higher sales growth and are willing to pay more for the expected rate of return.

Building Products although underperforming the market, showed 88% gain in EPS from 3Q 2017-1Q 2018. Housing starts is good main indicator, which has been trending upwards as economy is recovering from the financial crisis of 2008 and the March new home sales increased by 4% over the revised February figures. Housing starts increased by 11.3% over a year with average monthly increase of 1.5%. P/E is trending down with EV/Sales remaining relatively flat over the last three Quarters.

Industrial Conglomerates, however is not doing well in terms of earnings with GE dragging down the whole sector. P/E values shot up more 50% from 4Q 2017-1Q 2018 largely due to decreased earnings. Also, decreasing EV/Sales indicate that investors are not hoping for sales growth in the near future.

Construction, Farm machinery & Heavy Trucks EPS has been relatively flat over the last two quarters with high P/E valuations and decreasing EV/Sales, mainly due to current trade concerns with China affecting Agricultural Machinery and Equipment prices.

Construction & Engineering have been relatively flat in terms of earnings and EV/Sales. P/E has no specific trend with trending downwards. Moreover, this sector has been underperforming the market ever since the end of recession.

Electrical Components & Equipment has outperformed the market for the last 3 years. EPS increased 19% over the last three quarters, PE valuations are quite high with staying flat for the last year.

Industrial Machinery has been outperforming the market over the 1, 3 and 5 years basis with underperforming the market by 425 basis points ytd. P/E valuations are rising making it expensive to buy the stocks in the industry. EPS are trending upwards over the last year and EV/Sales is trending down with investors being pessimistic regarding the sales growth.

Commercial Services & Supplies

Commercial & professional services gave good returns over the last three years and is underperforming the market by only 54 basis point ytd. This is most likely due to the volatility in the market with current economic tensions. With decreasing unemployment rates, increasing wages and an average beta of 1.01, this industry group has historically followed the overall market very closely and has potential to give either good returns or provide bad returns if the economy slips.

Transportation

Transportation industry underperformed the benchmark by 1286 basis points over the three-year course and is still underperforming the benchmark on ytd basis. On one side, this industry group is seeing rapid growth in e-commerce boom and increased airlines sales, and on the other side the rising oil prices might have a negative impact on the operating margin, which have been trending down since the oil prices started rising in late 2015 to over 100%. P/E valuations are trending downwards across all industries in this group. EV/Sales are relatively flat, staying between 1 and 2 for all industries except, Air Freight & Logistics, which is at 5.26 and is trending upwards. However, the entire industry is faced with contracting crude oil supplies which can decrease the operating margin if the prices rise.

Air Freight & Logistics is growing rapidly with increasing e-commerce business, which is proved by its high EV/Sales. Historically, this industry has outperformed the benchmark during the times of holidays, from October to January. Currently it is underperforming the market by 334 basis points but based on its high EV/Sales, investors are expecting sales to grow. EPS for Q1 increased by 39% compared to the same period last year.

Airlines outperformed the market over the 5 years by providing a total return of 276.63% compared to market return of 186.99%. EPS have been trending down from 2Q 2016 with an average quarterly decrease of 9% over the course of 2016-2017. EPS increased by 23% in Q1 2018 and this trend is forecast to increase with increasing sales. Last year was a rough year for this industry with news of passengers being forced out of the plane in bad manner. On the other side, airlines offering low cost fares have increased EPS by more than 50% over the last year compared to full service airlines like American and Delta. P/E valuations are also low, 9.12.

Marine has underperformed the market over the course of 3 and 5 years and is outperforming the market with 20% return compared to only 0.52% return on the market. EPS was trending down with average quarterly decline of 8% but increased by 212% from 4Q 2107 to 1Q 2018. P/E multiples are down by 65% for the same period and EV/Sales being relatively flat.

Road & Rail has been outperforming the market for 1, 3 and 5 year periods largely due to e-commerce boom.Diesel prices have also rallied 34.95% from last year which can affect the operating margins. EPS jumped 149% from the last quarter of 2017 to first quarter of 2018. P/E valuations declined, and EV/Sales have been increasing proving investor expectations of growing revenues.

Trucking industry is a backbone for every economy with 70% of the domestic freight transported by means of trucking. This industry can be harmed by increasing diesel prices. Trucking industry beat the market over 1 and 5 year course with currently outperforming the market by 213 basis points. EPS increased by 129% over the previous quarter. P/E valuations are trending down due to current market volatility and EV/Sales have remained consistent between 1.4-1.8 over the last year.

Portfolio Review

The following table displays the performance of each industry and security in Dragon Funds’ Industrial Sector.

	Shares	Portfolio Weight	Beta vs ishares Core S&P MIDCAP	YTD %Chg	Q1-17 Return	Q2-17 Return	Q3-17 Return	Q4-17 Return	Q1-18 Return	Weighted Total Return YTD
Capital Goods		9.94	1.03	-4.12	3.27	3.63	13.48	10.38	-3.68	-0.19
Aerospace & Defense		0.66	0.37	-1.73	5.10	8.49	24.70	4.01	-0.32	-0.01
COL	112	0.66	0.37	-1.73	5.1	8.49	24.7	4.01	-0.32	-0.01
Building Products		4.25	1.41	-8.12	0.63	6.57	10.60	13.61	-3.44	-0.29
PATK	825	1.94	1.46	-22.82	-7.08	2.75	15.44	23.87	-10.94	-0.44
AOS	804	2.31	1.36	6.59	8.34	10.38	5.75	3.35	4.06	0.15
Construction & Engineering		1.13	1.30	-12.34	6.48	-11.29	13.52	4.66	-12.17	-0.14
PWR	750	1.13	1.3	-12.34	6.48	-11.29	13.52	4.66	-12.17	-0.14
Industrial Machinery		3.90	1.03	5.72	0.88	10.74	5.12	19.25	1.20	0.25
CR	425	1.78	1.09	7.11	4.22	6.52	1.18	11.95	4.34	0.13
SNA	151	1.01	0.89	-12.78	-1.1	-5.91	-5.24	17.52	-14.88	-0.13
PRLB	200	1.11	1.12	22.82	-0.49	31.6	19.41	28.27	14.13	0.25
Commercial Services & Supplies		2.22	1.39	-7.97	15.42	9.76	5.53	7.83	-8.73	-0.18
Human Resource & Employment Services		2.22	1.39	-7.97	15.42	9.76	5.53	7.83	-8.73	-0.18
MAN	425	2.22	1.39	-7.97	15.42	9.76	5.53	7.83	-8.73	-0.18
Transportation		2.83	0.86	5.51	-2.37	-0.05	19.17	4.15	4.51	0.16
Trucking		2.83	0.86	5.51	-2.37	-0.05	19.17	4.15	4.51	0.16
JBHT	300	1.6	0.69	5.58	-5.25	-0.14	21.81	3.72	2.1	0.09
LSTR	256	1.23	1.03	5.43	0.52	0.05	16.53	4.57	6.92	0.07
[Unassigned]		0.37	1.04	-0.02	4.20	4.21	5.01	6.50	-1.94	0.00
VIS	59	0.37	1.04	-0.02	4.2	4.21	5.01	6.5	-1.94	0.00
Industrials Average		15.36	1.08	-1.65	5.13	4.39	10.80	7.21	-2.46	-0.21
S&P Mid Cap 400/Industrials Average			1.13	-1.28	2.26	3.86	7.44	7.4	-3.26
Ishares Core S&P Mid cap Average			1	-0.45	2.13	0.74	3.55	4.6	-1.11

The Fund underperformed the ishares Core S&P Mid Cap by 120 basis points, and underperformed S&P Mid Cap 400/Industrials by 37 basis points on YTD measures. The sector is not as volatile compared to the benchmark. But looking at Q1 2018 the fund outperformed the S&P mid cap 400 by 80 basis points, but underperformed iShares Core S&P Mid Cap by 135 basis points.

LSTR was the best performer in the industrials sector. LSTR raised its target on revenue and earnings in the last quarter of 2017. This gave Landstar a major advantage to benefit from rising prices and better than expected volumes at the beginning of 2018. Earlier this month, the trucking company raised its first quarter profit; also their revenue exceeded expectations mainly due to their strength in truckload volume and price trends. EPS was expected at $1.35 to now $1.40. On the other hand, revenue is supposed to beat expectations from $1.03 billion to $1.05 billion. The loadings on its trucks has jumped a staggering 21%; this is an 11% increase from a year ago. Sales increased by 15.11%, net income by 28.93% and decreasing the debt by 4.12% with a significant reduction in net debt of 74.87%.

PRLB was added to the fund in March 2018, and is up 6.72%, making it a second-best stock in the portfolio.

A.O. Smith had a major announcement early in the month. They were selected as a primary supplier of residential water treatment products for all Lowe’s home improvement stores. This new business impact will affect multiple areas of A.O Smith Corporation. First off, this will not take place until August 2018. Earnings per share will change minimally due to various startup costs involved. This new start up, however, will benefit customers with solving certain water treatment problems. On April 9 of this year, A.O Smith declared a $0.18 dividend; this dividend is payable to shareholders on May 15. A.O Smith is positioned well within the Chinese market (i.e residential water heating). This is also a positive signal of its market being well positioned overseas.

The fund had majority of the stocks with negative returns with Quanta Services (-12.17%) and the two other stocks which were the star performers for the last quarter of previous year, Patrick Industries (-10.94%) and Snap-on Incorporated (-14.88%).

Quanta Services took beating during the trading day of Feb 5, 2018 and the reason for share price to drop was weak guidance which was due to project delays from the severe winter conditions and revised Q1 earnings expectations by several analysts.

Patrick Industries and Snap-on Incorporated stock prices fell in early February and the main reason for the drop was just the overall market volatility.

Conclusion

Given the current political and economic conditions, the US economy might slip into recession in the near term. Interest rates are increasing with forecasted 1.75% by the end of 2018, increased spending and tax cuts are seen as a threat to rising global debt by IMF, and concerns over tariff on aluminium imports & trade war with china can have a significant impact on prices of goods and services produced domestically.

CPI slipped by -0.1% MoM, and PPI grew by 0.2% MoM. CPI and PPI have been stable with inconsistent patterns over the years and currently show no signs of recession. GDP has been fluctuating with current levels near 3%. PMI has been trending up since the beginning of 2016.

All these indicators suggest the FED concerns that inflation is starting and will continue grow over the years of 2018 & 2019 after a long recovery are true. Moreover, decreasing unemployment, increasing wages along with increasing disposable income, and rising CCI (quarterly average of 3% over ten years) further support the claim. Rising government yields if start to flatten, can be a sign of inflation and might make the economy go into recession.

Furthermore, oil prices are rising as a result of OPEC reducing the total output of 200,000 barrels per day and contracting domestic supply.

Increased spending of $601.5 billion on Department of Veterans Affair and other defense related departments with possibility of easing export rules on military and other defense related products to help American manufactures better compete against Chinese and Russian competitors. This plan also aims to sell American manufactured defense products to allied countries while they are out shopping. This makes Aerospace & Defense an attractive industry plus it relatively underweight in the Dragon Fund.

US industrial production increased by 4.4% yoy over the month of February also the new orders for machinery manufactured in US grew by 11.4% in January 2018 yoy. This suggests expanding economic activities which can provide good but not exceptional returns in the Industrial Machinery industry.

Appendix

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References:

https://www.nytimes.com/2018/03/20/business/economy/economy-recovery.html?rref=collection%2Ftimestopic%2FFederal%20Budget%20(U.S.)

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