Industrials: Stronger U.S. dollar, weaker energy activity weigh on sector

Naturally, idiosyncratic influences vary by company, but broadly speaking, we suspect that rich industrials-sector valuations reflect healthy cash flow, potential for internal improvement, plus optimism regarding future macroeconomic conditions. Economic tailwinds have supported decent demand and pricing in most industries in the past few years. Firms also have become leaner and more efficient since the 2008-09 downturn, providing fertile ground for incremental operating leverage and margin gains. In many cases, we suspect investors are extrapolating these positive operating trends out over the long run.

Overall, U.S. real GDP declined 0.2% in the first quarter of 2015, following annual 2.3% GDP growth in 2014 and 2.2% in 2013. The U.S. Census Bureau reported industrial production has eased in 2015, declining 1.1% through May after increasing 4.1% in 2014 and 2.9% in 2013, and rising of 4.7% in the fourth quarter. Within industrial production, declining mining activity (including energy drilling and production) is by far the largest negative factor for 2015. Manufacturing output has declined 0.7% year-to-date through May, after rising 3.4% for 2014 and 2.2% in 2013.

Exports have supported the U.S. economic recovery, increasing 2.7% to a record US$1.63 trillion in 2014. Even so, goods exports through the first four months of 2015 declined 4.7%. The decline comes as the Federal Reserve Board trade-weighted U.S. dollar index hit 115.5 in early June, increasing 12.7% versus the same period a year ago. The current index level is the highest since May 2004. Beyond the United States, the Markit Eurozone Composite PMI continues to signal expansion (above 50) since mid-2013. That said, the reading peaked at 54.0 in April 2014 and has remained below peak ever since, but at 53.6 for May, the index signaled expansion for the 23th month in a row. Thus, there are hints of a sustained moderate eurozone manufacturing recovery.

In terms of other key indicators, the Architecture Billings Index (ABI) reflects an approximate nine- to 12-month lead time between architecture billings and construction spending. The ABI has been positive 12 times out of the past 14 months, with declines in January and April of this year. The index score for April, the most recent reading, was 48.8, down from 51.7 in March. A showing above 50 indicates increased billing activity. Residential activity has been the weakest index component. Residential new housing starts dropped 11.1% overall in May and remained 5.4% above the rate of one year earlier. The May decline seems to indicate weakness beyond what might have been expected from the frigid winter temperatures experienced throughout much of the United States, though weather effects are difficult to parse out from economic factors.

In the auto sector, we think 2015 global demand for new light vehicles will increase by approximately 3%, favourable for global original equipment manufacturers and for suppliers with a worldwide operational footprint. Light-vehicle sales volume in the United States increased 1.6% in May compared with the same month last year, with the seasonally adjusted annualized selling rate at 17.7 million, according to Ward's Automotive, the best reading since July 2005. For the first five months of the year, U.S. light vehicle sales have increased 4.5%. Desirable new products, an aging fleet of vehicles on the road, readily available credit and higher usage as measured by average miles driven should continue to have a favourable effect on demand.

European unemployment and austerity measures, among other industry fundamentals, will make for a protracted period of auto demand recovery. We look for European light vehicle registrations to increase between 3% and 5% in 2015. However, a "Grexit" (VID-705045) might create an unfavourable detour on the road to recovery. The rate of demand recovery in the region should perk up more in 2016 as the unemployment picture improves, provided Greek fiscal issues subside.

In other world markets, we expect demand growth for passenger vehicles to slow to a 7% increase this year in China and for economic recovery in India to support a 3% rise in demand. High inflation and weak economic conditions could smack down demand in South America by 15%. The Ukraine conflict along with economic sanctions, plummeting oil prices and the substantially devalued ruble stifles Russian new vehicle demand, perhaps by as much as 50%.

World trade has eased by 1.5% in the first quarter of 2015, including a 0.1% decline in March, as measured by the CPB World Trade Monitor. Fourth-quarter 2014 world trade increased 1.2% after a 2.0% rise in the third quarter last year. World industrial production had a slight 0.3% quarterly sequential increase in the first quarter of 2015 after a 1.0% sequential rise in the fourth quarter of 2014.

However, the volume index of U.S. imports rose sequentially to 110.2 in the first quarter of 2015 from 109.0 in the fourth quarter of 2014 (2005=100), while export volume decreased to 142.5 in the March quarter versus 149.3 in the December quarter. According to the CPB World Trade Monitor, world exports were at 137.0 in March, down from the October peak of 140.7, while the import index of 136.5 compared with 140.0 at year-end 2014.

Freight demand has softened for the U.S. trucking industry this year, as the ATA truck tonnage index has declined 5.3% through April, following an increase of 3.5% for full-year 2014. For the month of April, the index fell by 3.0%. Highway brokers and carriers had both been seeing robust pricing power thanks to secular truckload-capacity constraints.

The Association of American Railroads reported U.S. rail carload volume in 2015 has eased 0.7% year-to-date through June 6, after increasing for full-year 2014 by roughly 4.5% over 2013.

Lower fuels cost should be a tailwind for transportation in coming months. West Texas Intermediate crude fell from US$109 in July 2014 to its current trading range just below US$57. During the third quarter of 2014, the International Air Transport Association forecast that global airlines' profit would be US$19.9 billion in 2014 but increase to US$25 billion in 2015 due mainly to lower fuel cost net of ticket pricing. We expect reductions in rail fuel costs, which account for roughly 15% to 20% of annual expenses, to have a mostly neutral midterm impact due to effective fuel surcharges, but the loss of oil shipments is likely to reduce volumes slightly. According to the U.S. Department of Transportation, if truckers' average fuel economy is between 5 and 7 miles per gallon with the price of a barrel of oil between US$60 and US$80, the cost per mile would be around US$1.82. At current levels, the price of a barrel of oil might imply 10% to 30% savings in fuel cost. Because of the aforementioned truck capacity constraint, however, we don't expect to see a major shift from railroad intermodal to trucking.

Top Industrials Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
General Motors		$50	None	High	$30.00
NVR		$1,600	None	Medium	$1,120
Joy Global		$56	Narrow	High	$33.60
Data as of 06-22-2015. All figures are in U.S. dollars.

 General Motors (GM)
GM is poised to see the upside to high operating leverage thanks to rising volume and smarter manufacturing than in the past, including a reduction in its vehicle platforms. Old GM broke even with 25% U.S. share and a U.S. industry sales level of 15.5 million units, while new GM breaks even, depending on mix, at just 18%-19% share of 10.5 million to 11 million U.S. industry units.

We believe many investors are focused on the large underfunding of pension and other post-employment benefits, the recall, and the overhang of government and VEBA ownership. However, the pension will not be due all at once and is closed to new participants. The U.S. Treasury exited GM in late 2013, and we expect the Canadian federal government to exit soon now that the Ontario government sold in early 2015.

GM also has a cash hoard that it could use for share buybacks or discretionary pension funding, and we like the announcement of a significant initial dividend in January 2014 of US$0.30 a quarter, which is going to increase this year to an annualized rate of US$1.44, equivalent to about a 3.8% yield. In March, GM announced a clear capital-allocation policy that will see the company buy back US$5 billion of its stock before the end of 2016. The company also reduced its cash target to US$20 billion from US$20 billion-US$25 billion previously.

The ignition switch recall increases headline risk and litigation risk, but we think GM can pay any fines or judgments that come its way thanks to US$37.2 billion of automotive liquidity at year-end 2014, including US$25.2 billion of cash. Last June, we reduced our fair value estimate by US$4 per share for a US$7 billion reserve estimate for fines, lawsuits and the compensation program related to the ignition switch recall. We think this accrual will prove too high, but we factor a conservative penalty into our valuation. It would take a lot more bad recall news for us to materially decrease our valuation further.

 NVR (NVR)
We expect homebuilder NVR to benefit from our above-consensus view of U.S. new home sales over the next 10 years. We forecast new homes sales to significantly overshoot mid-cycle levels in the years ahead as fading financial constraints unleash significant demographic potential and pent-up demand.

No-moat NVR stands out from its homebuilding peers due to its commitment to a land-light business model. The model entails obtaining ownership of land on a just-in-time basis from land developers via options on finished lots. Not only do options protect the company from industry downturns, but it also frees up cash for shareholder-accretive share repurchases, to which NVR has dedicated the entirety of its healthy free cash flows over the years. In fact, NVR has reduced its diluted share count by a cumulative 54% since 2002, or 6% annually.

 Joy Global (JOY)
We believe that mining equipment manufacturer Joy Global is undervalued by the market. Although we do not think the mining equipment industry is on the cusp of a dramatic recovery, we do believe that Joy stock, which is trading between 11 to 12 times our 2015 free cash flow estimate, is inexpensive for a business where conditions are stabilizing. Joy Global is unique relative to its peer group, in that roughly 70% of sales come from aftermarket parts and service. Most competitors have given this business to their dealers.

While mining capital expenditures are clearly inclined to fall in 2015 and potentially in 2016, mining customers have finally reached a point where they have to begin rehabbing their fleet of equipment, which should benefit Joy Global. Joy is also unique because roughly 60% of the company's business is exposed to coal (predominantly in the U.S.). While most major commodity prices have continued to plummet, U.S. coal consumption ticked up in 2014, while thermal coal prices actually stabilized. Even though our long-term outlook for U.S. coal consumption is not for growth, our basic materials team sees upside in Powder River Basin coal prices and stability in Illinois Basin coal prices beyond 2015.

We think these conditions mean that Joy Global is inexpensive relative to near-term earnings with share price upside to a future recovery in new equipment sales. Lastly, Joy is not solely captive to its environment. Over 2014, management pulled US$80 million of cost out of the business and in 2015 plans to remove another US$25 million of expenses. The company's attractive free cash flow has been used to buy US$553 million of stock over the past 21 months, and it is authorized to buy back another US$447 million through August 2016. We believe this cash deployment is particularly attractive relative to Joy's US$3.8 billion market capitalization.

More quarter-end insights:

• Outlook for U.S. stock market: Pick your spots carefully
• Economic outlook: Stuck in neutral as we cling to cash
• Financial services: A favourable outlook for insurance
• Consumer cyclical: Assessing disruptions in restaurant, retail and travel
• Consumer defensive: Top-shelf picks for a cautious spending environment
• Basic materials: China slowdown weighs on commodities (with one exception)
• Energy: No rapid rebound for oil prices
• Real estate: Rising interest rates wreak havoc on REITs
• Utilities: Starting to look attractive after a woeful 2015 start
• Health care: A few stocks still offer upside
• Tech and telecom: M&A heats up, and the cloud changes the landscape