We initiated on 25 Diversified Industrial stocks across the Capital Goods, Construction & Building Systems, and Flow Control Sectors. Investors were not myopic around a particular space, although value and energy investors focused on Flow Control as a way to represent oil derivative views. On the Capital Goods side, investors generally agreed that while we see a lot of positive data points, most have been priced in, and that sound capital allocation, such as PH’s CLARCOR acquisition, will be what drives multiple expansion. In the Construction space, our conversations revolved around IoT as a meaningful differentiator going forward (specifically for AYI, which is already a beneficiary), the distributors that are not impacted by AMZN (such as WCC and AXE) and our top pick, SWK, again for sound capital allocation, with its purchase of the Craftsman brand.
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WSO is normally the questing beast on our list – you get to see it (pull back) once a year, but you’ll generally have to chase it. We like HVAC’s growth outlook for the next several years and WSO’s long-term potential with the mobile app and the
first step to acquiring Sigler through Carrier Enterprise, but not at this price.
WCC represents the epicenter of cyclical reflation as industrial capex rebounds
and carries along both pass-through material inflation and an abatement in
cyclical pricing pressure. While investors harbor concerns over distributor
operating leverage, WCC’s margin profile is much more cyclically depressed
and we view the business as the most under-earning in our coverage. We
believe WCC has lost a $1.00+ of price/mix, which could reassert itself
quickly in a pro-capex environment, representing 25%+ EPS growth.
Thermon is tricky. Management has set a low bar for FY18 and, in particular, F1Q18, but refinery turnaround activity should pick up in the fall and appears to be underrepresented in consensus. That said, the opposite could happen in FY19 (March YE), and this year’s likely catch up on maintenance drops off considerably in the refiners’ plans for next year. THR is underearning and near-term consensus appears too low, but the structural headwinds in profitable geographies like Canada give us pause.
We like the spate of M&A, particularly the Craftsman transaction as well as the new product development with FlexVolt and believe that housing/construction
related names are reasonably valued given still-solid momentum. Housing
data plateaus could spark some concerns, as well as tougher FlexVolt
comps in 2H17, but that is largely in the narrative. We believe Craftsman
optionality is just too large over time to not expand valuation at the onset.
The premium for ROK is tremendously hard to argue based on a short-cycle inflection in a vacuum, but the optionality US capex deductibility, cash repatriation, and an evolving industrial IoT environment set the stock apart vs. prior cycles. Risk/reward suggests that the stock is fairly valued given that there are secular shifts in the franchise value for IoT and US manufacturing incentives, but with two “early cycle” estimate revisions, the beats appear likely to decelerate.
RBC occupies an interesting middle ground on our list. We are attracted to the operating leverage and cyclically depressed C&I + energy businesses that should cycle up over the balance of 2017, but also cognizant that RBC’s valuation is serially inexpensive for a reason. Pricing power and share retention appear to be
more challenged than most for RBC and many of the cost savings initiatives
appear to leak before working down to operating income. Cash generation
allows for consistent M&A, but RBC is typically on the unfavorable end of the
multiple arbitrage for acquiring better quality assets.
We believe PNR’s valuation and new business mix ex-Valves & Controls come at a mismatch in that investors are expanding valuation based on businesses that are not underearning to fund an open M&A policy with a mixed track record. For the core water properties that have defined PNR beyond the quick shift in and out of
energy, we see a mix of businesses that either are performing well if not
overearning or not as fundamentally sound as a “water” multiple would
justify. We’re not outright bearish, but believe the base case is a flat stock for
the next 12 months.
Parker Hannifin may be the only company in our sector in recent memory that has done M&A that is justifiably accretive to its multiple, which is so rare in a sector constantly competing for multiple expansion that it bears recognition. While a high gross margin property, CLARCOR should have tremendous G&A consolidation potential under PH, expand its OEM offerings, and tap into PH’s extensive,global distribution network which largely falls outside its truck parts distributor core markets. PH’s margin initiatives and short cycle inflection come as a bonus.
LII has all the screening markings of “peak on peak on peak” – peak replacement following a release of pent up demand, peak margins with good pricing and hedged raws for 2017, and peak valuation. The valuation component is fair given a growth premium for the sector that doesn’t stand out given reflation elsewhere in industrials. That said, concerns that tough 2H17 weather comps mark the start of a downturn are more likely to create an opening for long-term bulls. In the meantime, we want to manage risk/reward amid choppy catalysts.
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