A Capital Goods View – Europe & China

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

November 21st, 2014

  • A Capital Goods View – Europe & China
  • There has been a notable change in the European outlook among large cap Capital Goods companies over 2014. Comments had been almost universally positive earlier in the year, but Q3 reports were less optimistic and decidedly mixed. ECB President Draghi’s comments indicate the Eurozone’s continuing struggle to stimulate demand and stem deflation.
  • China has been a focus of more skepticism for some time as growth has slowed, but the flat to mixed positive outlooks seen in early 2014 have turned largely mixed to negative. The themes here, noted by several companies, are volatility and lack of directionality throughout this year. These views were confirmed and addressed by the People’s Bank of China cutting interest rates in a fresh wave of stimulus (see our recent blog on the subject with respect to industrial commodities).
  • If you believe the stimulus story in Europe, SWK sets up with the best combination of sales exposure (29% Europe), outlook and valuation support. If you share ETN’s view that “Europe is teetering on the edge of something a little worse than over the last couple years,” PH and PNR are two of the more Euro-levered names that screen more expensive and have seen or anticipate weakness there. To limit European risk, IR, CMI and DOV have relatively low Euro sales exposures, are still seeing positive signs for their end markets, and offer some valuation support.
  • China is more difficult to play given the volatility and uncertainty in the country. For China bears, PLL has one of the largest Asian exposures among the large caps and screens on the expensive side – the company is also heavily tied to Europe (40% of sales) and has been consistently negative on the region year to date (Q3 results are due out November 25th). More than 50% of company sales come from the Life Sciences segment, which should be marginally less benefited by interest rate cuts than some of the heavier equipment manufacturers (CAT for example, was up 4% on the Chinese stimulus news, but PLL was behind the market). ITW is an expensive stock that is less levered to China than large cap industrial peers and would receive less of a tailwind if interest rate cuts provide a legitimate catalyst for machinery companies.

Exhibit 1

Source: Earnings Transcripts, SSR Analysis

Overview

The Capital Goods sector as a whole has been a marked underperformer in 2014. Outlooks for global economies in 2015 generally are not anticipating a material pickup in demand, as evidenced by the specter of stimulus in Europe and the outright rate cuts in China. Beyond the European concerns, emerging markets are in the midst of growing pains, seen most notably perhaps in Brazil but even growth in China has mitigated and while not a hard landing, it has been a volatile path in a generally lower direction (cue the stimulus). Construction markets have slowed and are expected to be little better than flat, raising concerns of a Chinese overbuild. Certain segments of the Chinese economy are still performing well, the auto sector being a notable example, exemplified by ITW. Overall China has been very uncertain and several companies, notably CMI and IR, have noted the lack of directionality.

There has been a much clearer shift in European sentiment over 2014 among the large cap Capital Goods companies in our coverage. Q1 reports were almost universally positive in their affirmation that Europe was improving, had turned a corner, was a surprising pocket of strength – Q3 reports have demonstrated a moderated view on Europe in several instances.

Exhibit 2

Source: Capital IQ, Company Reports, SSR Analysis

  • PH and PNR stand out here, with about 30% of sales in Europe, newly cautious outlooks for the continent, and valuations that are on the expensive side.
  • IR, CMI and DOV have less European sales exposure, still see positive signs for their end markets there, and offer some valuation support. CMI gets 7% of its sales in China and its view on the country has deteriorated over the year, but the stock responded very well to the stimulus news.
  • Europe was a strength for CAT in Q2 but third quarter commentary indicated a flatter outlook for 2015. This outlook extended to China. We were constructive on CAT in the low $80s and noted in July that a turn in the mining cycle is likely necessary to see further upside from here in the stock (our normal value is in the $150 range).
  • DE reports the Wednesday before Thanksgiving – Europe and China are not major exposures for the company (Europe about 17%, Asia, Africa & Middle East 6%). Last quarter’s comments indicated the company expected Europe and Russia to improve from 2013, and China to slow in the second half. The stock has been weak since Berkshire exited its position, but held in well during the October selloff, offering support for our belief that continued weakness in farm economics is priced in and downside is likely limited. We see DE as a longer term value play, with upside to over $130 per share on our model.
  • Improvements in Stanley’s European security unit would be accelerated by the likely shedding of targeted underperforming markets (Spain & Italy, together accounting for 10% of the current European security segment). The core tools business continues to gain share in Europe and benefit from global scale and operating leverage – we continue to see value in SWK (our model shows normal value of over $120).
  • Valuation looks much fuller for SNA, and is pricing in a significant increase in returns – forward estimates would need to rise 20% to equate return on capital with the stock’s current premium. Relative PE is at a twenty year peak. Its European operations are improving, but the runway for growth is mostly a function of the very low base (the business was down 25% following the GFC).
  • ITW has “not seen a slowdown in Europe” and has a relatively low sales exposure compared to other large cap industrials but while upside could remain in the stock, valuation is not currently compelling in our view. Complexity is clearly not hindering the company, which is extremely balanced and well-diversified. ITW is also relatively less levered to China compared to its peers.
  • PLL has one of the largest Asian exposures among the large caps and screens on the expensive side – the company is also heavily tied to Europe (40% of sales) and has been consistently negative on the region year to date (Q3 results are due out November 25th). More than 50% of company sales come from the Life Sciences segment, which should be marginally less benefited by interest rate cuts than some of the heavier equipment manufacturers (CAT for example, was up 4% on the Chinese stimulus news, but PLL was behind the market).

Exhibit 3

Source: Capital IQ, SSR Analysis

2015 Estimates

2015 EPS estimates have on average been revised lower for this group, with two of the most Euro-cautious names (ETN and PNR) among the largest negatives. We may still see downward revisions for DE, but again, we think the stock likely floors around $80. Machinery focused stocks with Asian exposure may see positive changes to 2015 estimates in the wake of Chinese interest rate cuts – CAT and DOV, and to a somewhat lesser extent, CMI and FLS. 2015 EPS revisions have been a main driver of performance during 2014.

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

©2014, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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