U.S. macro industrial indicators are turning more positive, from industrial production to PMI to construction data, which should support improved demand levels across many companies in the months ahead. Meanwhile, Europe and China data continue to lag. Domestic auto demand remains robust, supporting our bullish thesis on the auto manufacturers. February seasonally adjusted annual rate of auto sales rose 6.2% year over year, and was the best February since 2008. Sector valuations look reasonable to us with average industrial stock price to fair values of 0.91. We find the auto manufacturer and aerospace & defense stocks to offer the greatest value, while the 3-D printing stocks appear expensive even after their significant recent selloff.
The industrial environment in the U.S. improved throughout the first quarter as executives moved beyond the fiscal cliff threat and automatic federal spending cuts known as the sequester and instead responded to continued strength in consumer spending. It is consumer spending, after all, that drives approximately 70% of the U.S. economy and what spurs industrial production. February retail sales advanced 1.1% from year-ago levels, significantly above economists' expectations, a nice improvement from 0.2% growth the prior month. The February U.S. industrial production index (seasonally adjusted, month over month) improved 0.7%, following 0.4% and 0.0% growth in December and January, and up 2.5% from year-ago levels.
Data from The Institute for Supply Management (ISM) appears similarly encouraging. The agency reported that the U.S. manufacturing Purchasing Managers Index (PMI) improved in each of the past three months from its recent nadir of 49.9 in November to 54.2 in February, its best reading since June 2011. As a reminder, 50 is the threshold that separates growth from contraction. Even better, the more forward-looking new orders portion of the ISM index increased to 57.8, indicating there are at least a few more good manufacturing months ahead. We surmise that the rebound in housing and strong auto sales drove the strength; new housing starts rose 24% in January and auto sales increased 4% in February.
In addition to broad indicators and survey results, we look to transportation volumes for near real-time insight into the health of the economy. North American trucking and rail volumes remain positive overall, but plenty of commodities are also weaker than the year-ago cumulative volumes. The ATA Seasonally Adjusted Trucking Tonnage Index in January improved 4.6% from the prior-year period and gained 1.0% on December. Prior to October, the truck tonnage index had increased year over year in every month since December 2009. The January index reading was the second-highest ever--slightly below the December 2011 maxima. Also, the Association of American Railroads reported that through early March, North American intermodal volume was up a sharp 7.0% from the prior-year period even as carloads declined 3.1%. Among major commodity classes, year-to-date coal is down 8.8% year over year and grain is off 9.4%. Sharpest gainers are petroleum products (up 46.1%), nonmetallic minerals and products (up 5.9%), and chemicals (up 2.2%).
Turning to overseas markets, Europe's manufacturing woes continue while China's growth moderates. In Germany, January PMI crossed the 50 mark for the first time in 12 months, but France's PMI accelerated to a four-year low in January and data out of Italy and Spain has not been too encouraging either. Meanwhile, China's industrial production rose 9.9% in January and February from a year earlier, a slight slowdown from December's 10.3% year-on-year increase, and the slowest year-to-date growth in four years. Still, industrial production is on pace to match China's industry ministry's target of 10% growth in 2013, unchanged from 2012. China's manufacturing PMI fell to 50.1 in February from 50.4 in January, and new orders also came in at 50.1, suggesting a more tepid manufacturing economy.
Diversified Industrials' Revenue Outlooks Reflective of Tepid Economic Growth, but EPS Guided to Double-Digit Growth in 2013
The performance of the world economy perhaps cannot be better reflected than in diversified industrials companies, whose products reach nearly every end market and geography. Here, we have seen organic revenue decelerate steadily throughout calendar 2012 to low-single-digit levels, reflecting slow-but-steady growth in the U.S., comparisons turning negative in Europe, and growth falling from the double digits to single digits in emerging markets. We did see more stabilization in the fourth quarter, though, a positive sign that demand is not following a slippery slope.
Initial forward-year company guidance accompanying fourth-quarter earnings results illustrates that the slow growth environment is not expected to impede a continued advance in revenue and earnings. We heard from 19 diversified industrial companies regarding their fiscal 2013 financial outlooks, ranging from Honeywell (HON) to Rockwell Automation (ROK) to ITT (ITT). Across these 19 companies, the average midpoint for organic revenue growth expectations was 2.5%, slightly above inflation. Still, companies expect to produce outsized earnings growth from these paltry growth rates, as companies guided to average EPS growth of 11.2% in fiscal 2013. Although we could see these guidance ranges revised down, as occurred in 2012, restructuring-driven cost savings, growth from acquisitions, and aggressive share repurchases are likely to drive the majority of the EPS improvement.
We expect those companies more levered to a clear improvement in U.S. residential construction and budding improvement in U.S. commercial construction, such as Ingersoll-Rand (IR) and Hubbell (HUB.B), to be better positioned this year relative to those companies with significant European and municipal exposure, such as Siemens (SI) and Xylem (XYL). The greatest guided-to EPS growth in 2013 is the industrial pump and welding & cutting manufacturer Colfax (CFX), which consummated the outsized acquisition of Charter International in January 2012 and plans to significantly improve the acquired company's subpar margins through its disciplined strategic planning and execution methodology. Colfax's shares have risen smartly alongside prospects for superior EPS growth, but now trade at a healthy premium to our $36 per share fair value estimate.
Construction Data Improving Nicely
The housing market continues to gain momentum and any arguments that this is another false start have become nearly impossible to defend. Over the past three months, permits to build new homes rose an average 31% from year-ago levels and housing starts rose 29%. Improvement is certainly showing up in the homebuilders, as the largest five U.S. homebuilders ( Lennar (LEN), Pulte (PHM), DR Horton (DHI), Toll Brothers (TOL), NVR (NVR)) by revenue reported average 34% growth in net orders in their most recent quarters. The National Association of Realtors reported that existing home price gains are now in the double digits, rising 12.6% in January from year-ago levels. Data from CoreLogic (CLGX) shows similar levels of pricing gains, up 9.7% in January. We expect a strong cyclical recovery in housing to sustain for many quarters ahead given the growing and self-reinforcing momentum and favorable medium- to long-term indicators such as the currently depressed level of new home sales, low housing inventory, favorable own-versus-rent valuations, and exceptionally low interest rates, to name a few. We continue to believe that the positive effects of U.S. housing will spill into the broader economy, supporting much of our coverage universe to varying extents.
Commercial construction indicators are beginning to follow suit, too. The Architecture Billings Index (ABI), which does a good job of leading non-residential construction activity by 9-12 months, is expanding nicely above the neutral 50 line. The three-month rolling average reached 53.1 in January, the highest level since December 2007. Actual nonresidential construction growth slowed to 1% from mid- to high-single digits in recent months but should resume better growth in the second half of 2013. Recent demand trends at construction equipment companies such as Caterpillar (CAT), Terex (TEX), and CNH Global (CNH) have been uneven, as the firms lap difficult comparison from last year's warm winter and energy infrastructure projects and distributors reduce their channel inventory. The companies are forecasting flat to slightly up construction revenue in 2013, but based on the recent advance in the ABI index, we think risk is to the upside.
U.S. Auto Sales Remain Robust
Automakers reported continued strong February U.S. light-vehicle sales. Total vehicles delivered to consumers increased 3.7% from year-ago levels. This February was also the fourth consecutive month the seasonally adjusted annualized selling rate (SAAR) exceeded 15 million units, according to Automotive News. The trade journal reported a February SAAR of 15.36 million, up 6% from year-ago levels and the best February since 2008. We remain very upbeat about the future of the U.S. auto industry as we believe there is still strong pent-up demand, many great new products available, and plenty of cheap financing available to consumers. We also are seeing zero evidence of the payroll tax increase hurting auto sales. We were encouraged to hear Ford (F) say on its fourth quarter conference call that full-size pick-ups made up 12.3% of the industry in February, up from 10.7% in Feb. 2012. This segment's mix pre-recession peaked in 2004 at 15.1% per our calculations but we do not expect the segment to reach this level of penetration as gas prices are much higher today even after adjusting for inflation. We are keeping our 2013 sales prediction of 15.2 million-15.5 million in place but remain open to the chance our forecast will prove slightly conservative by year's end.
General Motors (GM) reported its best February since 2008, with total sales up 7.2% from the prior year, and its best retail channel February numbers since 2007. All four brands posted sales increases and retail channel sales rose 7.1%. Also encouraging is that the company expects its February retail share to be more than 17% compared with 15.8% for full-year 2012. GM's overall share in February increased 60 basis points from February 2012 to 18.8%. GM's dollar level incentive spend per TrueCar.com was up less than 1% from Feb. 2012 and management cited J.D. Power PIN data saying its incentives declined from January as a percentage of average transaction price. GM's retail channel pick-up sales increased 33% from Feb. 2012 while fleet pick-up sales rose 7%, which is another great sign for consumer spending. The most significant concern we see in GM's numbers is the continued poor showing with the Malibu in the key midsize sedan segment.
Ford had its best February in six years and also is increasing second-quarter production by 9% from second-quarter 2012. The company's small-car share is up 200 basis points this year while the new Escape crossover and Explorer continue to generate record to near record volumes. The new Fusion mid-size sedan had a Feb. record and saw its sales more than double in key coastal markets such as Los Angeles, San Francisco, and Miami. Although the vehicle's newness helps its sales, it is encouraging to see the Fusion's February sales of 27,875 easily outsell the Chevrolet Malibu's 14,817 and also nearly equal to the Toyota Camry's total of 31,270. F-Series trucks gained 15.3% but did not outsell GM's Silverado and Sierra models.
Adjacent to the consumer vehicle space is another of our recent five-star calls, RV manufacturer Winnebago (WGO). After soaring 132% in 2012, the stock is up another 28% to-date this year to $22, eclipsing our $20 fair value estimate.
3-D Printing Stocks' Valuations Descend to Troposphere
3D Systems (DDD) and Stratasys (SSYS) have generated significant investor fanfare over the long-term possibilities of 3-D printing. We think the excitement is deserved given new and existing applications for hobbyists, medical professionals, and industrial users to create highly customized products with little material waste, but also believe the market has gotten well ahead of itself. Shares of 3-D Systems and Stratasys skyrocketed 270% and 164% in 2012, respectively, and seemed to go parabolic in January. At these levels, the stocks traded at 40 times and 39 times our adjusted 2014 EPS estimates. Perhaps this could be justified if organic revenue was sustainably growing around 40%, but we estimate organic revenue is growing only in the low 20s for both of these firms. On Jan. 18, we published a report highlighting our negative valuation call on the companies, and shares have fallen 28%-38% from their January highs. Still, at $29 and $71 per share, DDD and SSYS appear overvalued relative to our $25 and $52 fair value estimates.
A third pure-play 3-D printer firm entered the fray during the first quarter with an IPO, ExOne (XONE), and shares look even more overvalued. ExOne, much smaller than its peers with just $28 million of annual revenue (versus $230 million and $215 million for DDD and SSYS, respectively), solely targets industrial-use metal applications. Uncertainty is paramount with ExOne, which has yet to turn a profit and has only shipped four printing units in 2011 and 13 in 2012. Still, the spectacular performance of DDD and SSYS shares over the past 18 months unsurprisingly led to a huge surge in XONE: shares reached as high as $33.60 per share in its second trading day after pricing its IPO at $18, up from an original $14-$16 proposed pricing range. Shares have since zigzagged to near $30, and look quite risky relative to the $12-$14 per share value we produced under varying long-term revenue and gross margin assumptions.
Our Top Industrials Picks
On average, we consider our industrials coverage universe to be slightly undervalued. Since last quarter, the ratio of industrials sector prices to Morningstar's fair value estimates fell slightly from 0.93 to 0.91, still not a significant amount of margin of safety on the aggregate. Auto manufacturers and aerospace & defense present the greatest pockets of value, in our opinion (0.75 and 0.77 respective current price/fair value), and auto-parts suppliers and diversified industrials offer the next most attractive valuations by our metric. We have picked several individual stocks that we consider to be on sale at this time and suggest investors keep these names on their radar.
Top Industrials Sector Picks Data as of 03-26-13.
Expeditors International of Washington(EXPD)
Star Rating: 4 Stars Fair Value Estimate: $51.00 Economic Moat: Wide Fair Value Uncertainty: Medium Consider Buying: $35.70 We maintain our opinion of Expeditors as one of the highest-quality transport stocks we cover, and we believe shares are attractively priced at this time. This non-asset-based, third-party logistics firm produces impressive 20%-plus ROICs by arranging international air and sea shipping and handling customs brokerage so clients can focus on core operations. Although the firm has faced demand headwinds for more than a year, we think expectations of sluggish airfreight volume growth and related productivity pressures are already incorporated into the share price. We believe shares of well-managed well-capitalized Expeditors are trading at an attractive discount to our fair value estimate. Expeditors owns no debt, holds more than $6 per share in cash, and yields about a 1.5% dividend.
Star Rating: 5 Stars Fair Value Estimate: $52.00 Economic Moat: None Fair Value Uncertainty: High Consider Buying: $31.20 We continue to believe GM is well positioned to benefit from recovering U.S. automotive sales. U.S. light-vehicle sales rose 3.7% year over year in February, reaching nearly a 15.4 million February SAAR, but still short of our estimated normalized demand of 16.1 million-17.4 million vehicles. Over the past several years, GM has lowered its North America operating profit break-even point to 10.5 million U.S. industry sales, depending on mix, by lowering labor costs and offering fewer brands. Improving industry sales, combined with the manufacturer's high degree of operating leverage, should allow for healthy levels of profitability. The U.S. Treasury's 22% (16.2% diluted) remaining stake in the firm remains an overhang on stock sentiment, but we believe the government's ongoing divestiture will occur at a controlled pace through early 2014, limiting selling pressure.
Joy Global (JOY)
Star Rating: 4 Stars Fair Value Estimate: $75.00 Economic Moat: Narrow Fair Value Uncertainty: High Consider Buying: $45.00 We think the market is over-discounting the near-term demand headwinds mining equipment firm Joy Global is likely to face, and believe the narrow moat manufacturer trades at an attractive valuation. Fiscal first quarter orders and backlog were down significantly amid customers' reluctance to invest in mining equipment when coal, iron ore, and copper prices remain under pressure. Still, we expect results to improve beginning in fiscal 2014 given several encouraging leading indicators for Joy's business, including China's electricity usage, U.S. natural gas prices, and global commodity prices (which have ticked up in recent months). Furthermore, we expect the company's solid reputation, improving working capital management, and enhanced capture rate on service sales to serve Joy well in the interim.
Star Rating: 4 Stars Fair Value Estimate: $82.00 Economic Moat: Wide Fair Value Uncertainty: Medium Consider Buying: $57.40 We believe defense and aerospace firm General Dynamics is being unfairly punished by concerns surrounding the automatic federal spending cuts known as the sequester, and potentially long-term pressures on military spending. We think the firm's diversified offering with key platforms that ensure the superiority of the armed forces puts the company in an enviable position at a time of budget strains around the world. Though we think defense spending will ease in the coming years, GD's well-entrenched products, a robust aerospace business, and an operational focus will power the company's return on invested capital well above its cost of capital for years to come. We believe 2013 will mark the low point for EPS, and our $82 per share fair value estimate embeds conservative estimates that leave room for upside. James Krapfel, CFA, does not own shares in any of the securities mentioned above.