By Kris Rosemann
How far we have come from the financial abyss! The US economy is now more than seven years removed from the credit crisis that sent shockwaves through the global financial system in the latter years of the past decade. In the fourth quarter of 2008, for example, real GDP in the US tumbled more than 8%, a figure not witnessed since the double-dip recession of the 1980s, and perhaps not surpassed since the time of the Great Depression.
During the Financial Crisis of 2008-2009, many industrial entities, particularly those with finance subsidiaries faced dwindling credit health, and several including General Electric (GE) and Harley-Davidson (HOG) cut their dividends to shareholders. Others such as General Motors (GM) even faced the prospect of extinction were it not for government intervention. As a result of the large purchase prices of durable equipment from airplanes to farm implements, the financial and industrial markets will forever be inextricably linked.
Economic activity growth in the US peaked at an impressive 5% in the third quarter of 2014, the highest pace of expansion since the recovery started. However, economic expansion in the nation has come back down to earth since then, as GDP rose just 0.8% and 1.2% in the first and second quarter of 2016. Though China’s economy seems to get most of the attention, the much larger and more diversified $17 trillion US economy remains the epicenter of global economic and financial health.
According to the Bureau of Economic Analysis, the slight acceleration of real GDP growth in the second quarter of 2016 was driven by personal consumption expenditures, as well as smaller declines in nonresidential fixed investment and federal government spending compared to earlier periods. Consumers are still spending money at a reasonable rate, but spending on plants and equipment continues to fall as global economic uncertainty impacts the willingness of firms to make big bets. Many of the industrial entities covered in this piece are experiencing significant pressure on their respective top lines, for example.
Strong employment rates, muted inflation (lower oil prices), and consumer wealth brought about by robust equity markets continue to be the main drivers behind US economic expansion, however. Actions by Federal Reserve officials to raise interest rates may impact the trajectory of growth in coming periods and perhaps remains the biggest concern of market participants. The timing of the continuation of the current credit tightening cycle in the US remains in question, particularly with most of the world experiencing negative interest rates.
As we saw in the second quarter reports of industrial bellwethers General Electric and Honeywell (HON), “Industrial Bellwethers Hit by Global Economic Growth Concerns,” the global industrial space continues to be pressured by concerns about economic growth and supply-demand imbalances in commodity-based markets, including oil and gas and a variety of metals. Let’s take a look at a few more reports from companies within our industrial coverage (XLI) to get a broader picture of the backdrop. Many have seen better days than the current operating environment.
Dover: Found Bottom in Energy?
In the second quarter of 2016, Dover (DOV) reported revenue falling 7% on an organic basis while acquisitions provided 3% growth from the year-ago period. The firm reported relative strength in its ‘Engineered Systems’ and ‘Refrigeration & Food Equipment,’ both of which reported positive organic growth in the quarter. Its ‘Fluids’ segment is directly impacted by the oil and gas markets and continued to suffer from lower capital spending from energy market companies. Total consolidated backlog fell to ~$1.1 billion from ~$1.2 billion at the end of the second quarter of 2015.
However, Dover believes the second quarter of 2016 represents the low point of performance in its energy-serving businesses. This commentary came at the same time as management’s lowering of its full-year 2016 revenue guidance to a decline between 3%-5% compared to a previous range of down 2%-5%. The revision was due in part to the expectation of continued softness in energy markets, as well as order and shipment timing issues in its other segments. The firm believes the ongoing stabilization of the rig count in North America and constructive oil prices will enable it to deliver improved results in the second half of 2016 and growth in 2017.
If Dover is unable to turn the tide in the back half of 2016, its tremendous dividend growth streak of 60 consecutive years of increasing its payout will come under increasing pressure. At any rate, we’re not running to scoop up shares hand over first, as they offer little valuation opportunity based on our fair value range for shares of $51-$77. Though Dover’s Dividend Cushion ratio is slightly above parity (1.1), we think there are better income-oriented options available, particularly in light of its cyclical end markets served.
Emerson Electric Not Expecting Near-Term Relief
Emerson Electric (EMR) continued its battle against uncertain economic conditions, particularly in the oil and gas markets, in the third quarter of its fiscal 2016 (calendar second quarter). Net sales fell 7% from the year-ago period largely due to the ongoing weakness in demand from energy customers that continue to scale back spending in light of the currently volatile energy resource pricing environment. The firm’s ‘Network Power’ segment was its only division to report top-line growth in the period thanks to strong order trends in data center and telecommunications infrastructure markets. Despite the poor top-line performance, the company reported expanding margins, in part a result of restructuring actions. This helped the firm keep the decline in adjusted earnings per share to a 5% drop on a year-over-year basis.
Emerson recently agreed to divest a number of businesses as part of its portfolio repositioning strategy announced last summer. It has agreed to sell its ‘Network Power’ segment for $4 billion to Platinum Equity and will divest its Leroy-Somer and Control Techniques business units to Nidec Corp for $1.2 billion. Management will use the proceeds from the sales to bolster its core ‘Automation Solutions’ and ‘Commercial & Residential Solutions’ businesses.
Emerson Electric continues to warn against the struggles its business will face in the near term; the firm is not expecting a recovery in spending levels in the energy markets until the second half of 2017. As a result, fiscal 2016 sales are expected to be down 9%-10% on an as-reported basis, which takes currency headwinds and divestitures into consideration, and adjusted earnings per share guidance has been revised to a range of $2.90-$3.00 from previous guidance of $3.05-$3.25.
Despite Emerson’s lofty dividend yield of ~3.5%, solid Dividend Cushion ratio of 1.8, and incredible track record of nearly 60 consecutive annual dividend increases, the company’s fundamentals could be better at the moment, even as we say we like Emerson’s competitive profile. Underlying drivers of the company’s performance are not expected to improve in the near term, and we view shares as largely fairly valued at current price levels based on our fair value estimate of $51. Dividend growth should continue, however.
Parker Hannifin
Parker Hannifin’s (PH) fourth quarter of fiscal 2016 report was indicative of the weakness in North American industrial end markets. Sales were down 6% in the quarter compared to the year-ago period, largely due to an 11% drop in the firm’s ‘Diversified Industrial’ segment in North America in the quarter. Adjusted segment operating margin expansion, a lower effective tax, and other items helped the company drive adjusted earnings per share 33% higher than the comparable period in fiscal 2015 despite the continuation of weak demand levels across the globe, reflecting in part the benefits of its Simplification and business restructuring actions. Adjusted earnings per share, however, fell 11% during all of fiscal 2016 (ends June 30).
Looking ahead to fiscal 2017, Parker Hannifin is expecting sales to be flat compared to fiscal 2016 but is also anticipating material margin expansion as a result of its Simplification and business restructuring actions. This is expected to drive adjusted earnings from continuing operations per share to a range of $6.40-$7.10 compared to $6.46 in fiscal 2016. While the firm has cited decelerated rates of declines in its end markets and progress being made towards stabilization as potential sources of optimism, it is not projecting any significant improvement in the markets it serves and will continue to hold a cautious view. Efficiency initiatives will continue to be key to its operations, at least in the near term until top-line growth resumes.
Even as Parker Hannifin continues to struggle in a difficult operating environment, its shares have climbed to near the upper bound of our fair value range of $125 per share. This keeps us from jumping to add it to the newsletter portfolios, though its dividend growth profile is as compelling as any, in our view. The firm’s dividend yield could be better at little more than 2%, but its tremendous track record of nearly 60 consecutive increases in its annual payout and strong Dividend Cushion ratio of 2.4 lead us to believe ongoing growth in the payout can be expected.
Roper Technologies Reduces EPS Expectation
Roper Technologies (ROP) reported solid revenue growth of 5% on a year-over-year basis in the second quarter of 2016 despite continued weakness in oil and gas related end markets. Organic growth in its medical, application software, and water businesses as well as contributions from acquisitions helped drive the top-line expansion. Orders advanced 9% in the quarter, and the firm ended the period with a record backlog of $1.14 billion, which should position the company nicely for revenue growth in the second half of 2016 and into 2017. Though free cash flow fell to $358 million in the first half of the year from $412 million in the first half of 2015, this was still good for more than 115% conversion from net income.
Despite the solid quarterly results, Roper lowered its adjusted diluted earnings per share guidance for 2016 to a range of $6.57-$6.71 from previous guidance of $6.85-$7.15 as a result of a “somewhat lower global growth environment.” Energy end market headwinds and delays in toll and traffic projects were cited as the core reasons for the reduced outlook. Meanwhile, the firm expects revenue in the second half of the year to be up 7%-9% on a year-over-year basis, though only 2%-4% of such growth is expected to be of the organic variety.
Though Roper Technologies is a fantastic company that generates tremendous amounts of free cash flow, shares appear overvalued at current levels, based on our fair value range of $106-$160 per share, even after being punished following the firm’s guidance reduction. We would love to see management grow its payout in a meaningful way–its Dividend Cushion ratio of 3.2 suggests it has plenty of room to do so healthily–but the company’s current yield of ~0.7% does little to attract our, or any income-minded investor’s, attention.
Stanley Black & Decker Raises 2016 Guidance
Stanley Black & Decker (SWK) reported a strong second quarter of 2016 despite its operating environment being fraught with slowing global growth, unprecedented geopolitical volatility, and an ever-growing pace of technological advances. Its ‘Tools & Storage’ segment delivered enough strength to buoy results as its ‘Security’ segment did little to help or hurt the top-line and the ‘Industrial’ segment was punished by a slowdown in oil and gas related infrastructure projects. Overall, the firm reported organic revenue growth of 4% from the year-ago period. Operating margin expansion helped the company deliver 19% growth in diluted earnings per share on a year-over-year basis.
Thanks to stronger than expected organic growth, as well as ongoing cost and productivity initiatives, Stanley Black & Decker raised its full-year 2016 diluted earnings per share guidance to a range of $6.30-$6.50, up from previous guidance of $6.20-$6.40. The adjusted range represents 6%-10% growth from 2015 diluted earnings per share. The firm also reiterated its anticipated free cash flow conversion of approximately 100% of net income.
Shares of Stanley Black & Decker have run far past the upper bound of our fair value range of $114. Though we are big fans of its dividend track record and solid Dividend Cushion ratio of 1.4, such a lofty price tag keeps us a bit skeptical about the robustness of returns from here on out; its dividend yield could be better than the current ~1.9%. We’re going to watch this one very closely, however.
Aviation, Industrial, and Systems Segments Power Textron
Textron’s (TXT) second quarter of 2016 results were boosted by strong volume performance in its ‘Aviation,’ ‘Industrial,’ and ‘Systems’ segment, all three of which reported solid top-line growth and pulled the firm’s overall revenue up by more than 8% from the year-ago period. The company’s bottom line fared even better in the period, as income from continuing operations advanced 10% on a year-over-year basis to $0.66. Cash flow from operations was negatively impacted by a material change in changes to working capital.
Management reiterated its guidance for the full-year 2016 for earnings per share from continuing operations of $2.60-$2.80 and manufacturing cash flow before pension contributions (a metric similar to free cash flow) of $600-$700 million. New products and recent acquisitions are expected to continue to contribute in a meaningful way to Textron’s overall financial results, and we like what its diverse, balanced product portfolio does for it in the face of a difficult operating environment.
Shares of Textron are changing hands near the middle of our fair value range of $32-$53, or ~14.5x the midpoint of management’s 2016 guidance. While this may sound appealing in the context of today’s ‘overheated’ market where many firms are trading at historically-high earnings multiples, we think the price is right, which is not what we are looking for. We demand stocks that are on sale.
Jun 10, 2016
We’ve Updated Our Reports on the Machinery & Tools Industry
Our reports on firms in the Machinery & Tools industry can be found in this article. Reports include ATU, BGG, CFX, CR, DOV, FLS, GGG, IEX, IR, ITW, KMT, LECO, NDSN, PRLB, ROLL, SSD, SNA, SWK, TKR, TTC.
May 18, 2016
Updating Our Reports on Firms in the Electrical Equipment Space
We’ve updated our reports on firms in the Electrical Equipment industry. Reports include A, B, BMI, CIR, EMR, FEIC, GRMN, NPO, ITRI, LII, MWA, OFLX, PH, PNR, RBC, ROP, SXI, SNHY, TRMB, TRS, WTS.