Large Cap Capital Goods – Turning a Revisions Corner – Time for the Laggards to Win

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 12th, 2014

Large Cap Capital Goods – Turning a Revisions Corner – Time for the Laggards to Win

  • In aggregate large cap Capital Goods revisions have turned a corner, after a disappointing year in 2013. There is consensus that Europe has started to recover, though views on China are more mixed than they were 6 months ago. The US is recovering, but it is slow outside energy.
  • Performance in the group has been quite disparate – with some real winners and losers: SNA, ITW, PCAR and PH performing well over the last few years, while SWK, CAT, ETN and IR have done less well. The turn in revisions – if sustained, should add support to the expensive names but provide more momentum to the cheaper names.
  • Valuation dispersion within the group is close to an all-time high and we have highlighted the extreme relationship between SNA and SWK in recent research. SNA has a very negative skepticism index, suggesting that earnings will have to keep surprising to the upside to support the stock; SWK, by contrast discounts further negative surprises. We would expect the laggards to catch up with the leaders.
  • Focus should be on companies where valuation discounts further declines in earnings – i.e. stocks with high skepticism. These are mostly companies we have talked about before – CAT, SWK and ETN, but DOV also looks interesting, despite a longer tail to the negative revisions.
  • Capital Goods remains one of the least expensive sectors within Industrials and Materials in our view, but this is in the context of a broad Industrials group that is relatively expensive. We like companies with exposure to the US, and increasingly Europe (while we expect any recovery to be slow, operating leverage should be high).
  • We believe that CAT can trade above $130 per share and SWK above $115 per share. For ETN we see upside to $90 per share.

Exhibit 1

Source: Capital IQ, SSR Analysis

Discussion

For many in the capital goods space, 2013 was a year of rebasing earnings expectations and negative revisions. Hope of a global recovery, a repeated theme from the prior year, was misplaced, in large part due to Europe, and, for a second year in a row, expectations, both at the company and analyst level, were too optimistic. As often happens in these situations, forecasters over-reacted and in our view we entered 2014 with more appropriately conservative expectations.

We are not out of the woods yet with respect to a global recovery, but we do appear to have turned one corner – Europe. If we look at the Europe column in Exhibit 2, all of the larger cap Capital Goods companies saw improving trends in Europe. This was not isolated to Capital Goods; all of the large conglomerates showed a similar trend – Exhibit 3 – as did many of the chemical companies, DOW, DD and LYB for example.

Exhibit 2

Source: Capital IQ, Company Earnings Reports

Exhibit 3

Source: Capital IQ, Company Earnings Reports

Compare and contrast this table with Q3 2013 – Exhibit 4. While most pointed to a more stable Europe, 7 of the 11 in the table lowered guidance. Granted, it is more unusual for companies to lower guidance in the first quarter of any year, because there is always hope that shortfalls in Q1 can be made up in subsequent quarters, but at least we do have consensus on Europe.

Exhibit 4

Source: Capital IQ, Company Earnings Reports

Where we still have some debate is in the US, and, more worryingly, in China. Looking at Exhibits 2 and 4, there is no stronger conviction about the US today than there was 6 months ago – not more negative, but not more positive either.

China looks worse – more suggesting stagnant demand and even declines than growth, which contrasts with the view 6 months ago. We would make the following observations on China:

  • The debt to GDP ratio is a concern to many – as China’s most obvious tool to bring this under control is to actively manage towards slower growth.
  • The demographic changes in China as well as the development of more advanced manufacturing industries are beginning to change some of the demand patterns, both for locally manufactured goods and for imports.
    • Both Dow and DuPont have pointed to growth, in some cases strong growth, in the more value added products they produce – advanced materials, more sophisticated packaging products etc. They point to stronger middle class demand for better consumer durables and better food packaging (changing behavior in food purchase), paint, etc.
    • There is a concern that the demand for more run of the mill products is slowing and import demand is rapidly being replaced by domestic production.
    • The different demand views from different companies are likely a function of where their products lie in the value chain.
    • We have written recently about the risk of higher China exports in a slower domestic growth environment.

China should remain a concern and something we watch very closely – Asia exposure (including China) for each of the companies is summarized in Exhibit 5. Note that both CAT and DOV sit to the left in this chart, and China would be the largest risk for both.

Exhibit 5

Source: Capital IQ, Company Reports, SSR Estimates

As we think about exposure from an end market perspective, we do expect to see a slow but steady recovery in US non-residential construction as well as further improvements in housing starts. In Europe we would also expect more positive comparisons in these sectors but against a very low base. Both CAT and SWK will be beneficiaries of these trends. We like the engine market generally, but more specifically in the US and Europe as manufacturers adapt to meet fuel economy and emission standards and also adapt to meet changing relative fuel costs (i.e. natural gas in the US). This is a good dynamic for PCAR, which is already pricing in positive earnings surprises, and CMI, which looks more interesting. Though the stock is certainly not at a valuation low it has more upside than PCAR in our view.

Note: We have excluded Deere from this analysis. While certainly a large cap Capital Goods stock, we have some broader concerns about farm machinery demand as discussed in
the piece that we published on agriculture earlier in the year
. Please see that report for more detail.

Revisions – A Point of Inflection

Revisions have generally turned positive for this group. While the year to data numbers are very mixed – Exhibit 6 – with DOV the real outlier, down 19.5% for the year so far, an aggregate measure for this group has turned more positive over the last couple of months, as was shown in Exhibit 1. After several years of declines and relative to other industrials and materials sectors there has been a lag, and now the group is starting to play catch up – Exhibit 7. The current laggards in the broader group are Packaging and Paper, where revisions have recently turned more negative.

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ, SSR Analysis

Valuations – Some More Interesting than Others – Some Extreme Relationships

In Exhibit 8 we show current valuation and skepticism values for the 11 companies. The data shows quite a range and a lack of correlation. The companies that have had a good couple of years generally are pricing in continued forward momentum and for the most part expectations that earnings can continue to surprise positively: SNA, ITW, PCAR and PH. In all four cases the Skepticism index is negative suggesting that valuations are ahead of earnings – see Exhibit 9. By contrast, CAT, SWK, ETN and DOV are inexpensive on a stand-alone historical basis, but also on an instantaneous basis relative to returns and earnings – as signified by a positive skepticism index – again shown in Exhibit 9. At a time when it appears that revisions are turning, we are much more interested in the cheaper names discounting earnings declines as they have the most upside.

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

Some of the valuation extremes are also worthy on note and we have published the charts in Exhibits 10 through 12 before. Correlation within this group has stopped declining from close to a recent all-time low Exhibit 13, and we would expect some further correction, as we have seen in past.

Exhibit 10

Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

APPENDIX

©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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