Due to the departure of the analyst, the Firm is suspending its ratings and target prices for all Diversified Industrials coverage until coverage is reassigned.
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Oh good a trade war. While it makes for adventurous reading, we wouldn’t expect our group to be a fundamental negative outlier although this is an at-the-margin nuisance at a more delicate point in the economic cycle. As much as our companies play both sides of the market with China, we would expect a technology-centric set of proposed tariffs not to be matched against similar technology. For example, while the US may hit China robotics or automation, we would expect ROK (OP) to be fine as a supplier in China, although aggregate demand may fall with China exports.
Trade war concerns consumed the markets this week continuing to target China, with the White House considering tariffs on more than 100 Chinese products. In light of that, JCI (PP), ROK (OP; $232 PT), PH ($220 PT), and ETN (PP) all sold off >2%. Our group was up ~1% on average on Friday vs. a flat S&P on better February IP numbers (1.1% vs. consensus 0.3%). Sentiment is all over the map, but leans most positive on names that haven’t been working, particularly ETN, PH, and SWK.
Industrials are contending with rates, inflation/tariffs, and a sentiment shift that we are now later in the cycle. We’re less concerned about demand and a late cycle mentality. While we are cognizant of inflation and downside margin risks, a tariff is a great catalyst for a price discussion. Rates and loan growth do fuel some concern about construction post-2018 and suggest a one-and-done year for project capex. There is too much going on at once to isolate the factors, but this group seems fine if you can dodge the major issues thematically.
This was a bad week for Industrials with almost all of our 25 stocks under coverage underperforming the S&P’s ~2% decline. ATU (UP; $21 PT) was the worst performer down ~8.5% with WCC (PP) not far behind down ~8%. A lot of the reaction was driven by President Trump’s newly imposed tariff on imported steel (25% tariff) and aluminum (10%) which hurts distributors like WCC and large steel consumers like RBC (PP), LII (PP), and HUBB (OP; PT $160). A disappointing construction report added fuel to the fire, offset slightly by a better than expected ISM.
With earnings season finally over sentiment has twisted around again. It’s now more fashionable to call the end of the cycle coming although short cycle indicators held or accelerated as often as not over the past 3 months. What we’re confused about is how non-resi is a popular end market even with a maturing cycle and sentiment on macro and rates a bit more tepid. We’re glad we upgraded Flow Control to Market Weight as a sector to start the year but still would prefer to be selective vs. uniformly positive. Flow sector sentiment is a bit more positive than us but moving in the same direction. We’re still convinced there are multiple cycle curves at work and some end markets could well be a 2018-and-done expansion, such as project capex, but expect automation to be in a transformation that extends the growth potential. This is the new mid-cycle (Exhibit 1 below).
We understand that KKR will sell more stock, but if the stock is only reacting to the next secondary then it seems overdone. If the stock is reacting to the fundamentals, we heard a different call. Energy appears solid with some latent OE pump benefit to come (although partially in the base) while Industrial orders suggest a MSD revenue outlook for 2018 is simply too low. We expect beats and raises to define 2018 again with perhaps additional M&A as a bonus. The KKR overhang notwithstanding, the growth algorithm and operating leverage are moving GDI into premium industrial territory and we are buyers on this weakness.
Bulls are winning a rate of change argument that the first brick in the wall matters more than how tall it can be. FLS is not cheap, even on a strong turnaround scenario for margins and FCF conversion. That said, guidance appears quite achievable and commentary around order momentum suggests a beat-and-raise setup. Investors looked through the low bar pretty early, but with a mid-year portfolio and margin target update, better order momentum, and achievable guidance, we understand the longer leash on valuation. That’s not the same as finding enough upside to be constructive; it’s just a reason to be less negative.
The quarter was fine, Energy didn’t wow us, but others in the space called out a pause in 4Q/1Q recently, so it’s not entirely surprising. We had hoped lead times would mask the pause, but c’est la vie. Orders will be the bigger focus and were quite strong. Guidance will likely be viewed as conservative in light of orders but mid-teens growth in upstream energy appears to be a solid start without the benefit of a power end cycle as best we can tell. The call will be over before the stock opens, but we’d imagine this is good enough for a modest positive reaction.
The quarter had puts and takes – orders were solid, cash flow was solid, EPD margins were weak on mix and a project issue in LatAm. While we had previewed a weak guide and slow end to the year in EPD on aftermarket mix, the guide was far weaker and noted as 2H-weighted. Our negativity in front of the quarter was set to be a transition point to look past a weak start to the year for a longer cycle business, but we need more color that the operational improvement is being masked by incentive comp vs. not showing up. We expect shares to be under pressure and while our bias is to not overstay negativity, the cyclical leverage is still unclear.
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