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A Dispatch From the Trade-War Front

Brooke Sutherland

(Bloomberg Opinion) -- If the trade war is a tornado, we are all living in Dorothy’s house. As expected, China retaliated against the U.S.’s increased tariffs by vowing this week to raise levies on $60 billion of goods, while also exploring other measures. These include a sharp shift in the tone of state media coverage of the trade negotiations, with multiple pieces fanning nationalist sentiment, and talk of curbing Boeing Co. jet purchases, dumping U.S. Treasuries and halting agricultural and energy orders. Take these last two with a grain of salt, as it’s unclear how China would execute this kind of drastic action without painful consequences for itself. But as for Boeing, China already hasn’t been ordering many of the jetmakers’ planes for the better part of a year and a half. “It’s been crickets,” Bank of America Merrill Lynch analyst Ron Epstein said in an interview. It’s unlikely China never buys a Boeing plane again, but the two fatal crashes of its 737 Max and the subsequent grounding of the jet make Boeing an easier target. It’s not inconceivable that China could tilt the balance of its orders in Airbus SE’s favor, or at the very least drag its feet on recertifying the Max. On that note, Boeing said this week that it had completed work on a fix for the software implicated in both accidents, but the Federal Aviation Administration said it still needed more information before it considers returning the plane to service, and pilots griped about the associated training courses.  

Meanwhile, Deere & Co. reported earnings on Friday and managed to fall short of expectations that had already been significantly reduced owing to the collapsed negotiations between the U.S. and China. A combination of the tariffs, a delayed U.S. planting season because of bad weather across the Midwest and a swine-flu epidemic that’s massacring much of China’s hog herd has made farmers more cautious about splurging on new equipment, Deere said as it slashed its sales outlook. Unsold agricultural equipment has piled up at dealers and Deere cited a need to work through that logjam before distributing new products, echoing the cautious inventory comments we heard from Emerson Electric Co., 3M Co. and Fortive Corp. earlier in the earnings season. While Commerce Department data released this week showed overall business inventories held flat in March, manufacturers notched their fourth month of gains. Federal Reserve data indicated U.S. factory production fell in April for the third time in four months. Also on Friday, Deere lowered its economic forecast for total fiscal 2019 construction investment to flat, while increasing its outlook for oil prices, shifts that should have implications for wider swaths of the industrial sector. Generally, I remain wary that manufacturing demand is strong enough to weather another tariff storm. 

Elsewhere on the trade front, President Donald Trump seems to be realizing that his trade war with China will be more successful with support from U.S. allies. The administration is reportedly set to roll back steel and aluminium tariffs on Canada and Mexico, is pressing more urgently for an agricultural deal with Japan and also agreed to a six-month delay in tariffs on European and Japanese automotive imports. While Trump said Friday he agreed with the Commerce Department’s conclusion that automotive imports pose a national security threat, the pause is meant to give negotiators more time for talks on ways in which to reduce imports from the European Union and Japan to mitigate the supposed risks to U.S. innovation. The Trump administration stopped short of calling for a specific quota of auto imports, something which the EU and Japan have resisted, so that at least gives these negotiations a chance. I am somewhat skeptical that either the EU or Japan feels a need to be particularly helpful to the U.S. right now on trade, but the EU’s chief negotiator said the bloc of nations was willing to work toward a limited trade agreement that includes cars. Either way, the pause in tariffs is a welcome relief for an automotive market that’s been battered lately. On a related note, Bloomberg News wrote an interesting story about how the trade war could disrupt the battery boom that’s fueled the rise of electric cars and is poised to upend power markets by enabling larger-scale energy storage. That’s because lithium-ion batteries are among the roughly $300 billion in Chinese goods that the Trump administration wants to slap 25% tariffs on next and China makes up about 40% of U.S. imports currently.  

OLD GE HABITS DIE HARDI’ve written often about questions of accountability and transparency at General Electric Co. and that’s because I think the company has an opportunity not just to stabilize its cash flow and balance sheet but also to attack the cultural shortcomings that allowed those problem areas to fester. I’ve tried to give credit where it’s due, and GE has made some advancements on this front including rejiggering its board. But at the same time, the company’s financials remain opaque, with a bounty of adjustments and below-the-line puts and takes that can be hard to decipher. It also seems like GE has a hard time letting go of its past tendency to micromanage perceptions and expectations. CFO Jamie Miller this week acknowledged that GE’s decision to tout order gains as defined by industry data firm McCoy Power Reports on its first-quarter earnings call may have created some confusion as that metric is “apples and oranges” to the way it actually books orders in its results. GE’s power-equipment orders for the period were already better than expected, but it’s almost like the company wanted the extra good vibes implied by McCoy numbers that were arguably misleading in that context. Or maybe management just made a mistake, which is fine but also shows how the transparency overhaul remains a work in progress. Elsewhere, Reuters reported that the FBI is investigating GE’s health-care business, as well as those of Siemens AG, Royal Philips NV and Johnson & Johnson, for allegedly giving illegal kickbacks to Brazilian government officials.   

BAYER CAN’T WIN AT ALLA California jury this week ordered Bayer AG to pay $2.055 billion to a couple that claimed they got cancer from using Roundup weedkiller. That brings Bayer’s Roundup court track record to 0-3, just as we approach the first anniversary of the $66 billion Monsanto Co. takeover that bought the company this nightmare. The $1 billion in damages for each spouse is likely to get reduced on appeal as the dollar amount is multiples higher than the $55 million the couple received as compensation for their medical bills and suffering. Even so, Bloomberg Intelligence analysts raised their estimate of what it would cost to settle the outstanding cases to as much as $10 billion. Bayer continues to resist a settlement, saying each trial has its “own factual and legal circumstances.” I mean, sure, but you lose enough of these and I think it’s pretty clear what the common thread is. Right now investors are pricing in a much more dire scenario, so a $10 billion settlement may actually be something of a relief. Bayer’s approach to the Roundup controversy reminds me a lot of Boeing and the 737 Max. Boeing relied on an engineering mentality to respond to a crisis that called for empathy. Bayer’s ongoing insistence that science proves the safety of Roundup left it blind to the risks of negative public sentiment and has opened it up to allegations that Monsanto manipulated data to its benefit. Never underestimate the value of a good PR person and an even better lawyer.PRICING POWER INDEEDRegular readers of this newsletter may recall that a few months ago I flagged TransDigm Group Inc. as an industrial company worth watching, in part because its focus on proprietary aerospace parts gave it significant pricing power that translated into adjusted Ebitda margins in the high 40% range. Well, I may have underestimated just how much pricing power TransDigm had. The Pentagon is understandably a bit miffed that TransDigm seemingly charged significant mark-ups for many of its goods. Among the examples cited in a report by the Defense Department’s Inspector General that was obtained by Bloomberg News, TransDigm charged $8,819 for a valve assembly check-oil pump that should have cost $369, while a new contract signed in July 2018 would see the Pentagon paying $4,361 for a half-inch metal pin that should cost $46. TransDigm didn’t do anything illegal and the company claims prices were comparable to similar parts in the commercial market, but it’s a bad look, and the report is rallying support for a reform of the U.S. defense contracting process to allow acquisition officers to seek backup data on underlying production costs. If that happens, it could have margin implications throughout the supply chain of defense spare parts.   

DEALS, ACTIVISTS AND CORPORATE GOVERNANCEColfax Corp. agreed this week to sell its Howden air-and-gas handling unit to KPS Capital Partners for $1.8 billion. The deal both rids Colfax of a business whose results could be lumpy and eases the balance-sheet pinch from the $3.15 billion acquisition of orthopedic device company DJO Global Inc. that Colfax completed in February. On the trade front, Cowen analyst Joseph Giordano points out that this divestiture also eliminates most of Colfax’s exposure to China, most notably in the structurally challenged coal power market. DJO’s sales of braces and joint implants come at high margins and are more stable, so this is really more about rethinking what kind of company Colfax really wants to be. That said, the shakeup will now make Colfax effectively a welding company with a medical-device business, which is a bit weird. These halfway transformations rarely seem to work. It’s worth noting that Danaher Corp. – which like Colfax was founded by the Rales brothers – is one of the primary examples of this, with the company at last spinning off a dental business that had dragged down efforts to remake itself as an environmental quality and life-sciences business.Kone Oyj is reportedly exploring a bid for the elevator division that Thyssenkrupp AG announced last week it will try to take public. Thyssenkrupp made the decision after abandoning a plan to split its sprawling business into two and merge its steel operations into a joint venture with Tata Steel Ltd. A combination of Kone and Thyssenkrupp’s elevator divisions has been speculated for years. On the one hand, an outright takeover would likely give Thyssenkrupp more cash up front than an IPO would to fix its weak balance sheet. But the steel joint-venture proposal is collapsing because of antitrust scrutiny from European regulators, who at the very least seem likely to give any combination of Kone and Thyssenkrupp’s elevator businesses a rigorous (read long) review. And there’s also an appeal for Thyssenkrupp in retaining a stake in a stand-alone public elevator company that it can use to raise more cash down the road as needed. But it’s an interesting backdrop for the expected spinoff of United Technologies Corp.’s Otis elevator unit.A.O. Smith Corp. plunged this week after J Capital Research said the maker of hot-water heaters used an undisclosed partnership with Jiangsu UTP Supply Chain to mask a steeper-than-reported revenue slowdown in China and questioned whether the company’s cash holdings in that country were tied up in distributor loans. A.O. Smith said the short-seller’s report, which also argued the company’s gross margins were inflated, was inaccurate. All revenue associated with third-party supply chain partners including Jiangsu UTP was properly recognized in accordance with GAAP accounting rules and the $457 million of cash held by its China subsidiaries is in “unencumbered bank accounts,” the company said. Spruce Point Capital Management, which has also issued critical reports on companies whose shares it’s shorting, said it agrees with J Capital that A.O. Smith’s margins seem too high. Analysts from William Blair and Robert W. Baird said the short-sellers may be overplaying things, but agreed there was a risk to A.O. Smith hitting its 2019 targets amid weakness in China. 

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Brooke Sutherland is a Bloomberg Opinion columnist covering deals and industrial companies. She previously wrote an M&A column for Bloomberg News.

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