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.
Power Solutions’ sale or spin can be EPS neutral and not look aggressive, in our view, but that’s not what we believe is the greater question. Price discovery ultimately settles the question of batteries as either industrial or auto for valuation. Investors have struggled with how to value the melting ice cube threat from EV and now will find the answer. We believe the outcome of the exercise needs to be that core JCI trades at a discount to Ingersoll Rand (IR, PP) based on better organic growth, margins, and cash generation. That appears to be the case today. This is a sound move, but doesn’t make us want to buy the stock today.
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).
As a result, we upgraded HUBB to OP from PP and think investors are underappreciating the potential upside to earnings and valuation from Aclara. Amid the pullback we believe we’re reaching washout points for JCI and HUBB. We also continue to like GDI and CGNX into the prints this week. Both PH and SWK appear quite cheap now but without specific catalysts or positioning that could help reverse near-term performance.
So far companies like PH (OP; $220 PT), WCC (PP), GGG (PP), JCI (PP), and SWK (OP; $190 PT) have all been punished for it, and while the reactions to most were expected, some were more deserved than others. We would argue that PH’s miss was more temporary than structural, GGG’s weakness was mostly from higher investment spending, while JCI/WCC/SWK were price/cost issue with varying lifespans (WCC most uncertain, SWK least). IR (PP) was the outlier, missing on margins and guiding 1Q well below the street – exactly as we predicted, due to aggressive incrementals in consensus ex. price/cost– but was applauded by both the sell-side (us included) and investors for the way they handled 1H18 guidance as the headwinds are more a lag than inability to get price.
JCI bears speak to cash, orders and margins. Cash slid by unquestioned but wasn’t great. There’s still $200M of working capital to be worked down from 3Q17. Orders were pretty solid and while the question was never asked, if selectivity means actively turning down some business, 5% order growth could have been higher and eye-opening. Margins still need work and JCI appears to have less price/cost confidence than IR, UTX or LII, but backlog margin commentary appears to be an unquantified positive that can offset unplanned inflation. This was not a bad quarter but there are enough questions on price/cost, value creation within the portfolio (i.e. Power Solutions), and cash to suggest investors won’t look past a 2H-weighted year just yet.
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