The U.S. has released mixed macroeconomic data since our last outlook. The reduction of fourth-quarter GDP was expected, and we still look for GDP growth similar to 2013. On the positive side, January housing sales increased more than consensus and February PMI also beat expectations. Autos remain the source of most undervalued names in industrials. We are concerned about a slow start to U.S. light-vehicle sales this year, but we expect improvement once the cold abates. In addition to the auto sector, we highlight value in diversified manufacturers and agricultural equipment.
4Q GDP Downward Revision Not a Disaster
At the end of February, the Bureau of Economic Analysis sharply revised downward sequential fourth-quarter GDP growth to an annualized rate of 2.4% from its previous estimate of 3.2%. On the positive side, business spending categories of equipment and software were revised upward to 10.6% and 8%, respectively. Consumption makes up about 70% of GDP, so higher business spending could not offset the consumer spending that was lower than previously estimated. Personal consumption still contributed 1.7% of the 2.4% total growth, but this is down from a 2.3% contribution in the original estimate. Exports and inventory also each contributed about 30 basis points less than originally reported. Fourth-quarter consumer spending did increase year over year mostly because of more spending on services and an easy comparable with the fourth quarter of 2012 due to Hurricane Sandy. Our director of economic analysis, Robert Johnson, is leaving in place his 2014 GDP growth estimate of 2.0%-2.5% and expects continued steady, but not dramatic, growth.
February PMI Beats Expectations
On March 3, the Institute for Supply Management in the United States reported the February Purchasing Managers' Index at 53.2%. This beat the consensus expectation of 52.5% and showed improvement from January's 51.3%. The indexed finished near 57% in 2013, so we suspect weather is holding back some industrial output. Production in February fell 660 basis points from January to 48.2% (a level below 50% normally indicates contraction). However, new orders rose 330 basis points and raw inventories grew 850 basis points, which suggests an uptick in production this spring. The PMI report showed no commodity shortages, which is good news for avoiding supply chain bottlenecks. The report did indicate price increases for aluminum, steel, natural gas, and resins, however.
U.S. Unemployment Rises, but Not Severely
In March, the U.S. released better-than-expected February jobs data, but the unemployment rate did increase 10 basis points to 6.7%. The economy added 175,000 jobs, above the consensus of 140,000 but below the 189,000 average of the past 12 months. Still, the new job figure is higher than 86,000 in December and 129,000 in January. The severe U.S. winter did not affect numbers as much as our economic team expected; the retail sector was an exception, losing 4,000 positions. The private sector is leading the way over the government in job creation, which we think is a good sign for future growth. Private-sector jobs grew 2.0% in February compared with 2.1% in January. We would like to see private-sector wage growth higher than the 3.6% it was in February. Weather probably held this number below 4% for the month. It was 4.1% in January and ranged between 4.0% and 4.5% in each month of 2013. Our economic team estimates that the U.S. may recover all the jobs lost in the recession within three to four months. This news is certainly good, but it will have taken more than four years since jobs began growing in early 2010. More good news came out March 13, when the Labor Department said initial unemployment claims for the week ending March 8 fell to 315,000 from 334,000 in the prior year and 324,000 in the week ending March 1. The 315,000 figure beat market expectations and was the lowest level since late November.
U.S. Auto Sales Off to Slow Start in 2014; European Growth Continues
February U.S. light-vehicle sales were essentially flat year over year and are down 1.4% year to date through February. The seasonally adjusted annualized selling rate, according to Automotive News, was 15.36 million units compared with 15.32 million in February 2013 and 15.20 million in January. General Motors (GM) and Ford (F) both cited acceleration in sales as February unfolded. We think consumers are tired of staying home because of bad weather, and we expect the SAAR to pick up as the year progresses. We still expect 2014 sales of 15.9 million-16.2 million units, up from nearly 15.6 million last year. North American light-vehicle production through March 15 is up 2.5% year over year, resulting in some concerning inventory build after automakers reported January sales. February sales helped somewhat, with GM reporting its U.S. inventory down to 87 days' supply from 114 at the end of January, while Ford reported 91 days from 111. Ideally, we want those levels to be closer to 60 days, but we are confident that there is pent-up demand and that the industry is not done recovering from its 2009 bottom of 10.4 million vehicles sold. We just expect growth to slow from the low-double-digit percentage increases of recent years. Should we be incorrect on our 2014 sales prediction, it is likely that industrial production will see bad news later this year, especially if GM makes meaningful production cuts. Automotive News has year-over-year production for GM up 2.8%, while Ford is down 6.5%.
European Union passenger car registrations grew in January for the fifth straight month, posting a 5.5% increase over January 2013. Key markets such as France, Germany, Italy, and the United Kingdom all posted increases, with the critical German market up 7.2%. It is also encouraging to see the U.K. up 7.6% after robust 10.8% full-year growth in 2013. If continental Europe can join the U.K. in growing throughout this year, that will be nothing but good news for our European auto coverage and large diversified industrial firms like ABB (ABB), Honeywell (HON), and Siemens (SI).
Housing Data Mixed, but January Is Positive Surprise
With conflicting weather-affected housing data and homebuilder outlooks, the near-term outlook for homebuilders has become cloudier. We should get a better read in the coming months as temperatures rise, ideally before the end of the important spring selling season that runs from February to April. The most probable outcome is that buyers return to the market when the weather improves, especially considering that the builders are beginning to better supply the market with double-digit community count increases. Further, the negative sticker shock effect from the 100-basis-point escalation in interest rates in the summer and fall has ebbed, with the 30-year fixed mortgage rate now hovering near 4.4%.
In the midterm, we continue to believe in the multiyear recovery to midcycle new-home sales, given the underproduction since 2008, improved household formation, supportive demographics, and slowly relaxing lending requirements. To be sure, record new-home prices and higher interest rates have challenged the affordability equation for buyers with stagnant income growth. We expect these factors to cause the housing construction recovery to unfold at a pace below market expectations, ramping to midcycle attainment in 2018 at 1.55 million housing starts and 790,000 new-home sales (including multifamily sales), a 67% and 74% improvement from 2013 levels and approximately in line with 50-year averages.
The homebuilding sector has seen a mixed set of demand signals in recent weeks amid highly unsupportive winter weather. The list of negative data points includes homebuilder sentiment falling 10 points to 46 in January, lackluster starts and permits data for new construction, and recently declining existing-home sales. More encouraging data included January new-home sales data that was approximately 15% better than consensus expectations, with a positive 3% revision to December data. The three-month moving average of new-home sales is up 9% year over year against an increasingly difficult comparison. We do caution that the January data is subject to substantial revision. Meanwhile, pricing growth, albeit slowing, continues to advance following the sprint in the first half of 2013 amid very low levels of existing and new homes for sale. The positive pricing dynamic should keep gross margins at or near historical highs for the large builders.
Recent quarterly results and commentary from the large builders also have given mixed signals. On one hand, the likes of Lennar (LEN), D.R. Horton (DHI), and PulteGroup (PHM) pointed to better-than-seasonal demand through January when reporting their most recent quarterly results, and each expressed a high degree of optimism that the spring selling season would be a strong one. However, luxury builder Toll Brothers (TOL) struck a much different tone in its conference call, saying that it was "baffled" by the flat markets in most areas and that homebuyer confidence is still a bit fragile. Sequential order trends improved for most builders with December-ending quarters, but Toll Brothers saw deteriorating order trends in its January-ending quarter. We surmise that Toll's disproportionate exposure to the frigid and snowy Northeast, Mid-Atlantic, and Midwest markets was the primary driver to its weaker performance, but the company also noted mixed demand trends in areas less affected by weather.
Despite our overall upbeat assessment on intermediate-term demand, we continue to believe that most builders are overvalued. We expect gross margins to peak for most builders in 2014 amid slowing pricing growth and rising land (especially), labor, and material costs. We expect housing bulls to be disappointed by the limited operating leverage that the no-moat builders possess to the multiyear recovery we expect in housing construction. Rapid increases in land prices since the end of 2011 will make recycling sold lots an expensive proposition for an industry that is still thirsty for suitable land. For instance, PulteGroup has indicated it will spend $2.0 billion on land and land development in 2014 versus $1.3 billion in 2013 and $925 million in 2012, while Taylor Morrison (TMHC) looks to spend more than $1 billion in 2014 versus $993 million in 2013. Among the big builders, Lennar and Toll Brothers have the most attractive land positions at 11.6 years (controlled lots divided by trailing 12-month closings) and 8.4 years, respectively.
Truck and Train Volume Still Respectable, but Rails Hit by Vicious Cold Winter
Truck volume slid early in the quarter, but we attribute this to bad weather. The American Trucking Associations truck tonnage index dropped 4.5% from December to January, reaching the lowest level since April 2013 (this index reports with a significant lag). This follows an 80-basis-point sequential monthly decline in December. January's was the greatest monthly drop in two years, but we think the decline cannot be considered in isolation from harsh weather and resulting lower consumer demand. Compared with the prior-year period, January tonnage improved 1.0%. The index reached an all-time high in November 2013, and full-year 2013 tonnage increased 6.2%, the greatest annual growth since 1998's 10.1% increase. While we don't project 2013-level gains again this year, we also don't believe January's decline is the shape of things to come in 2014. Turning to another measure, February Cass Freight Index shipments declined 40 basis points and expenditures increased 6.4% from prior-year levels, but shipments and expenditures sequentially increased 7.3% and 6.8%, respectively. Generally speaking, we expect low-single-digit truck freight demand expansion this year.
Overall North American railroad volume year to date has declined slightly from prior-year levels, with carloads down 1.9% and intermodal units up 90 basis points. Among the most significant commodities, coal carloads declined 2.3% during the first 10 weeks of 2014, chemicals declined 90 basis points, and grain cars increased 5.6% over last year's drought-hindered level. The greatest decliner was metallic ores (down 21.6%), and the greatest gainers were petroleum and petroleum products (up 6.5%). Among individual Class I rails, total carloads improved year over year only at Union Pacific (UNP) and Kansas City Southern de Mexico (up 5.1% and 3.6% year to date, respectively). Brutal winter weather slowed rail traffic and decreased capacity as a result of fewer asset turns and the need to build shorter trains. This hindered January and February volume, particularly at the Canadian rails. For example, by mid-March, year-to-date Canadian Pacific carloads declined 7.9% versus the aforementioned 1.9% decline for all North American rails. We expect demand in most railroad commodities, excluding coal, to grow slightly this year (led by crude and intermodal), but we think first-quarter weather slowed some networks such that rail movements may have shifted modes to trucking, as well as from the first couple of months into later months. We also expect coal to drag on first-quarter earnings, particularly at the Eastern railroads, CSX (CSX) and Norfolk Southern (NSC), due to their high exposure to expensive Appalachian coal.
Two shocks hit the shares of Kansas City Southern (KSU) during the first quarter, and while we currently have a 3-star rating on the stock, we believe the brunt of these developments is likely to soften during the year; thus, we would not be surprised to see the shares recover from a pair of declines in January and February. During January's fourth-quarter earnings call, management discussed frankly its expectations for onboarding new automotive shipments originating at new plants in Mexico, and these expectations were lower than the Street's. We had not assumed full production gains early in 2014, so we maintained our existing volume estimates and fair value estimate. Kansas City Southern's shares declined again in February when Mexico's lower house passed a bill that could threaten confidential pricing and require the railroads that currently own operating concessions in Mexico to grant access to other carriers. Nearly half of the firm's consolidated 2013 revenue came from Kansas City Southern de Mexico, so Mexican operations represent a material portion of the firm's business, as well as the growth engine to which we attribute this railroad's typically premium price/earnings multiple. To become law, the bill still must pass the Mexican senate and gain presidential approval, plus survive Mexican and Nafta legal challenges. We believe that if a law emerges from this action, it could differ significantly from the current bill, and we consider the impact on price, volume, or operations too poorly defined at this time to discretely adjust our valuation assumptions. However, we did increase our fair value uncertainty rating from medium to high so that a greater margin of safety is required to trigger our 4- and 5-star ratings.
Value Hard to Find Outside of Autos
The auto sector continues to offer the best value in industrial stocks. However, overall industrial prices look fairly valued with a median price/fair value estimate ratio of 1.08. Automakers are the cheapest industrial subset with a median P/FVE of 0.88, and the area is the ninth most undervalued in all of Morningstar's equity coverage.
At the other end of the valuation spectrum, we see trucking and auto parts suppliers as our most expensive sectors with median P/FVE ratios of 1.33 and 1.23, respectively. Certain automakers still have work to do to streamline their cost bases, so we see an eventual improvement in economies of scale presenting bargains today for long-term investors. GM now has significant headline risk due to its recall woes, but we think any fines or payments to victims will be manageable for the company.
GM, Fiat (FIATY), and Ford are the most undervalued automakers we cover, all trading at 4 or 5 stars during the quarter. Fiat is a turnaround story that keeps getting better. The Jan. 20 deal to buy the rest of the company from the United Auto Workers' retiree health-care fund was at almost exactly the EUR 3.2 billion price we predicted. This transaction probably explains the stock's price movement from just under EUR 6 to more than EUR 8 during the quarter. As one can infer from our $19 and EUR 14 fair value estimates, we think there remains plenty of upside potential for investors who are willing to accept the risk of a leveraged turnaround in a cyclical, capital-intensive, highly competitive industry. Also, we increased our valuations in the first quarter for Toyota (TM) and Honda (HMC) as the yen further weakened against the dollar, to more than JPY 100 from about JPY 97 since our last valuation update. We model stocks using spot rates at the time of our valuation update, but investors who think Abenomics will result in further weakening of the yen have these two large Japanese exporters and 4-star Nissan (NSANY) to consider.
Top Industrials Sector Picks
Data as of 03-17-2014.
General Motors (GM)
Star Rating: 4 Stars
Fair Value Estimate: $57
Economic Moat: None
Fair Value Uncertainty: High
Consider Buying: $34.20
We recently slightly increased our fair value for GM after factoring in a $9.4 billion decline in global pension and other postemployment benefits underfunding at year-end 2013 versus 2012, offset by a slightly lower adjusted EBIT margin than previously modeled. We still think GM is not done turning itself into the formidable automaker it has the potential to be. With global unit sales of 9.7 million last year, GM has the size but it does not yet have the scale. Major cost-saving initiatives will take more than one year to unfold, but we see great potential. Significant actions still coming are the closure of the Bochum, Germany, plant at the end of this year, the launch of the new-generation heavy-duty pickups and SUVs now underway, and 96% of volume coming from 17 platforms by 2018 compared with 77% from 25 platforms this year.
The capital structure is also becoming clearer. The Series B mandatory convertible preferred shares converted to common stock Dec. 1, 2013, and management has said it will redeem the last $3.9 billion of the 9% Series A preferred on Dec. 31 this year. The U.S. Treasury is completely out of GM, and we expect the Canadian government entity to sell its approximately 110.1 million common shares this year, though no announcements have been made. The balance sheet remains very strong with automotive net cash excluding legacy obligations of $20.8 billion, or more than $11 per diluted share, per our calculation. We would like GM to increase its pension funding and repurchase its cheap stock, but we also like the company returning cash to shareholders with the initiation of a common stock dividend announced in January paying $1.20 per share annually. This payment equates to a respectable yield of more than 3%. The recent recall is likely to weigh on the stock in the short term because of headline risk and a likely media circus as GM executives testify before Congress. Also, buybacks or other ways of returning cash to shareholders are less likely than before the recall news.
Star Rating: 4 Stars
Fair Value Estimate: $25
Economic Moat: None
Fair Value Uncertainty: High
Consider Buying: $15.00
Like GM, Ford is also moving to improve its economies of scale via reducing its vehicle platforms. The difference is that Ford got an earlier start on its restructuring thanks to Alan Mulally's joining Ford as CEO in September 2006. The company will have 99% of its volume on 9 core platforms by 2016 compared with 15 platforms this year and 27 in 2007. The market did not like management's December announcement of higher North American launch costs this year, along with unfavorable pricing from selling off outgoing models, leading to guidance of Ford North America's 2014 pretax profit being lower than 2013 with an operating margin between 8% and 9%. North American margin in 2013 came in at 9.9%, which is very high for a volume automaker. Ford's guidance for this segment remains 8%-10%, so we do not see our investment thesis in jeopardy. Management also warned in December that its ongoing global automotive operating margin of 8%-9% is "at risk" because of the size of the European downturn and recent unrest in Venezuela.
We prefer to look at Ford beyond 2014, and we like what we see. We expect continued rising volume in the key U.S. market, Ford China now growing ferociously following a 49% sales increase last year to about 936,000 units, and eventual rising volume in Europe combined with plant closings likely bringing the segment back to profitability in 2015 or 2016. Automakers have to spend money to make money, so we see Ford North America's 16 launches this year, up from 5 last year, as setting the table for a positive earnings surprise next year as the company gains economies of scale, recouping its launch costs in 2015. Shareholders get paid to wait with a dividend yielding more than 3%, and the balance sheet is in good shape, with Ford boasting $36.2 billion in automotive liquidity and automotive net cash of $9.1 billion. Rising interest rates also significantly helped Ford's pension problem. Global pension and OPEB underfunding at the end of 2013 declined $10.7 billion, or 42%, compared with year-end 2012. Like all automakers, Ford will always have exposure to macroeconomic headwinds, but we think the bottom-up story has more positives than negatives, even if Mulally retires this year.
CNH Industrial (CNHI)
Star Rating: 4 Stars
Fair Value Estimate: $14
Economic Moat: None
Fair Value Uncertainty: High
Consider Buying: $8.40
We think there's currently more upside to CNH Industrial's valuation than downside. CNHI is a late 2013 merger of farm and construction equipment manufacturer CNH Global and its parent company, Fiat Industrial (which owned Iveco and Fiat Powertrain engines). The firm has enjoyed strong farm equipment markets recently (roughly 50% of total sales), but challenged construction (13% of sales) and trucking (33%) businesses. Over the next several quarters, we expect these prospects to reverse; lower global farm income and difficult comparisons are likely to threaten CNH's ag machinery sales, but an improved construction picture and trucking market should help the company still increase earnings. Although CNH Industrial looks to face challenges in its core farm equipment segment, we think the firm will still enjoy growing earnings, given a more positive outlook for truck sales.
Meanwhile, Iveco's margins have climbed sequentially in recent quarters, suggesting the company has worked through higher-than-expected costs associated with the launch of its new heavy truck in the first quarter of 2013. In addition, we think the firm is poised to benefit from restructuring its heavy-truck production facilities in Europe in 2012 (combining two factories into one operation in Spain, for instance) as volume recovers, and management has commented recently that it believes its manufacturing base is set to capture any upturn from this point, limiting the need for immediate capital spending. Including the company's financial services arm, we forecast net income growing at a 7% compound annual rate from 2013 through 2017, far higher than the flat earnings we project for farm and construction equipment peers AGCO (AGCO) and Deere (DE).
General Electric (GE)
Star Rating: 4 Stars
Fair Value Estimate: $29
Economic Moat: Wide
Fair Value Uncertainty: Medium
Consider Buying: $20.30
The market continues to discount General Electric more than we think is warranted. Management has been diligent over the past five years in pruning noncore, less moat-worthy assets and investing in its core, strengthening its ability to generate economic profits over the long run. While the market has begun to recognize the potential of the firm, we think concerns about near-term earnings stagnation are keeping investors on the sidelines until growth is more visible. We expect earnings growth will resume in 2015. Meanwhile, the company's dividend yield is among the highest in the diversified industrial universe, reflecting management's intent to return excess cash to shareholders.
Star Rating: 4 Stars
Fair Value Estimate: EUR 29
Economic Moat: None
Fair Value Uncertainty: High
Consider Buying: EUR 17.40
Alstom's shares remain undervalued as the company's end markets remain under heavy cyclical pressure. Most recently, weak order patterns have sparked fears that the company will fall into a cash crunch that forces equity dilution. While we think there are legitimate concerns about the long-term growth rate of Alstom's thermal energy business and we question the effectiveness of selling part of the rail transportation business, current prices have factored this in beyond what we think is warranted, presenting the opportunity for a long-term investor wanting exposure to capital spending growth in Europe and Asia.
David Whiston, CFA, CPA, CFE does not own shares in any of the securities mentioned above.
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