Retooling for Recovery

Morningstar’s Daniel Holland explains why business is starting to boom among industrial equipment makers

We’ve all heard plenty about how consumers drive the U.S. economy. They generate two-thirds of economic activity, after all. It turns out that manufacturers of big industrial equipment are aware of this fact. So, when consumer spending nosedived in 2008 and 2009, heavy-duty equipment makers ran for safety by warehousing inventory, laying off workers, and postponing repairs, upgrades, and purchases.

Recovery is now well under way among industrial companies, maintains Morningstar stock analyst Daniel Holland. He reports that although consumer demand remains tepid, there’s been an increase in corporate demand for generators, pumps, and other heavy gear. The machines that companies use to make everything from fast food to factory parts need servicing or replacement. As a result, industrial equipment revenues have begun to rebound. Equipment makers are also running leaner operations, so revenue gains are having a greater effect on profits.

Holland, who holds an M.B.A. from the University of Chicago, analyzes diversified industrial and electrical equipment companies for Morningstar; he formerly worked in the finance departments of global health service organization Cigna and leading consulting firm Hewitt Associates.

So you’re still bullish on industrial companies. Why?

Even while things have cooled off on the consumer side, manufacturers took the slowdown a step further in 2008 and 2009 by cutting off all types of capital spending. That meant they were not repairing equipment, not building new structures, not fixing what they had. When consumer spending came back at the beginning of this year, demand for new goods triggered demand for new equipment. Manufacturers fired up their old machines and found that a lot had broken down or needed maintenance. Capital spending picked up since a lot of companies have tightened their belts and amassed cash balances to maintain a set level of spending. Even in the face of some concern about the economy’s direction, there’s enough money out there to keep equipment expenditures steady.

How about industrial equipment makers? Did they get leaner too?
Yes. They’ve strengthened their balance sheets, particularly in comparison to the months preceding the recession. Several companies are operating at peak margins, in some cases the best in history. I didn’t expect this sector to come back so soon—but from second quarter results, it’s clear that the group has more flexibility and is in solid shape for the long term.

Tell us more about the rebound.

The group has taken restructuring charges and in turn gone a long way to cut cost structures, trim payroll, and cut back on excess. Now that demand is coming back, higher revenues are coming in on higher margins and boosting the bottom line. A lot of major companies have seen operating margins climb 2.5 to 3 percentage points higher than they did last year, which is phenomenal. Emerson, for instance, reported that it had 18% profit margins on its businesses compared with 14.7% last year—in general terms, the leap and the new level are unheard of. That may be an extreme example but not too incredible. Siemens, Honeywell, Phillips Group have all pulled out costs and reaped higher profits on their product lines.

How much do emerging markets play into the story?
China and India are certainly factors. Industrial manufacturers first ventured overseas to take advantage of lower [production] costs and then ship output to the U.S. or Western Europe. Now that China, India, and other economies have more income, emerging markets are becoming major customers in their own right. For folks like Emerson, GE, or Honeywell, sizeable operations in China or India can now be leveraged to fuel growth.

What sets companies in your sector apart from the run-of-the-mill?
Well, the linchpin of Morningstar’s methodology is return on invested capital, or just how much money a company makes on funds collected from shareholders or bondholders. Call it return on capital or return on assets, it presents a clear picture of whether or not a company is bringing in a reasonable return for the money it spends. As a rule of thumb, we set the bar for the cost of raising capital at 10%, so a return above 10% definitely makes a company more attractive. It’s a bit difficult to pinpoint just how high returns should be. They vary from company to company since the cost of borrowing is different in each case. Another important yardstick is cash flow, or more specifically, free cash flow relative to sales. Think of it as a measure of the dollars brought in after costs. That number tells us volumes about the health of a company’s operations and just how well management has a grasp on balancing capital inflows and expenditures.

What are your favorites in the sector?

Start with General Electric (GE). For a couple of years, there’s been something of a stigma around GE Capital, the company’s finance arm. There have been questions about its overall financial health and whether it might be a drag on GE’s earnings. It’s now boosting earnings. On the industrial side, GE’s healthcare business has developed one of the strongest product portfolios it’s seen in a long time. There’s a cash flow story at work, too: We expect the company to have $25 billion in cash on its books once GE completes the sale of NBC Universal [to Comcast]. However, I think the market hasn’t yet come to appreciate GE’s story.

We hear a lot about green markets and processes. Are there any green opportunities in industrial shares?
Honeywell (HON) fits that description. In a nutshell, it’s positioned to profit from our society’s increased energy efficiency awareness. Honeywell is a big player in the market for products that promote lower energy consumption, including thermostats. It also makes controls that monitor lighting, and it’s behind a turbo diesel product that controls fuel consumption for diesel-powered cars that’s a big seller in Europe.

And a third idea to round out your list?
That’s Parker Hannifin (PH), a company whose products are inside almost every manufacturing facility around. Parker Hannifin makes valves and fittings in hydraulic hoses. You might think of the company as a manufacturer of motion facilitating machines. If you can think of a process that requires the movement of fluids, there’s probably a Parker Hannifin product involved. There’s Parker Hannifin equipment in McDonald’s smoothie dispensers. The company is a textbook case in profit margin expansion. It’s gone from 3% margins in 2002 to 12% in 2008. Now, as manufacturing facilities come back on line, companies are going to notice the basic wear and tear on items they had delayed replacing. That’s a golden opportunity for Parker Hannifin.

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