We spoke to a good portion of our companies this week and unsurprisingly little has changed . Capital projects are still not improving, construction is fine but nothing to write home about, resi HVAC sounds uninspiring (not to mention the recent hurricane debate coincides with weak 3Q17 results, tough comps through mid-2018, and price/cost challenges in the near-term). Our “Have” and “Have Nots” note (here) continues to receive good feedback as investors become increasingly aware of the lack of growth in industrials right now and the important role capital deployment will play in companies’ ability to differentiate themselves (webinar here). In the Flow Control space, we think there is somewhat of a sentiment shift since 2Q17 (specifically on CFX and FLS) as increasing data points indicate a trend towards productivity and automation in the process industry as well as reduction in the scope of maintenance.
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Last week we went through a high level, structural assessment of the haves vs. have nots on long-term growth - now we’re bringing that down to near-term ideas and updating the Heat Map. We’re also collaborating with WR Technical Analyst Rob Ginsberg on a few trades (see Exhibits 3-12 below). Our updated heat map leans more negative on HVAC (IR/LII/JCI/RBC/WSO), more positive on ALLE, and continues to favor PH, SWK, and CGNX as longs. Technicals line up particularly well on JCI (on the short side), and ALLE, PH, and SWK (on the long side).
Wolfe Research's Senior Diversified Industrial analyst, Josh Pokrzywinski, hosted a Webcast exploring how the structural shift towards optimization and productivity is displacing the need for new capacity.
Construction outperformed the S&P by 1.7% this week on the back of HVAC and GNRC in response to the hurricane. Conferences are picking up again and as one smart client put it – “good companies sound good, bad companies sound bad”. As we noted on Friday, we believe we have reached The End of the Metal Bending Age – capex facing companies may underwhelm for a long time. The line between bad and good is getting thicker.
We believe the slow recovery in capital project activity relative to other short cycle areas of the industrial economy will be a persistent trend even as overall activity remains healthy. Productivity, including automation, is displacing the need for capacity spending. We expect this to drive a divergence in the “haves” vs. “have nots” in the industrial world.
CFX (PP) bulls are starting to capitulate a little in what was a very crowded name during our July launch. CGNX (OP) is attracting interest on the long side. FLS (PP) has attracted more interest both positive (deep value turnaround) and negative (fundamental on structural deferred maintenance and weaker power gen markets) but without a narrative from the new CEO. HVAC (IR, LII, JCI, WSO) appears to be untouchable to most investors, but we’re starting to detect a sentiment bottom. We suspect IR would be downgraded by most of the buy-rated sell side back at $90, even the relative value in the sector (based on the asset quality) favors IR.
We believe risk/reward is less attractive relative to the rest of our Capital Goods coverage given persistent negative trends in the Hydratight business in Energy as customers structurally stretch maintenance cycles – which helps to explain why process automation suppliers have outpaced physical maintenance: it’s not a complete lack of spending, it’s optimized maintenance vs. a history of over-maintaining. Management wants to get deeper in this space, which we view as suffering from overcapacity. The Viking sale is a clear positive, largely reflected in prior valuation, but there’s still too much time spent on Energy. A catch-up in Enerpac investment and mature growth in Euro/China truck limit upside.
The premium on revenue growth and sound capital allocation continues to grow and the nuance of who can perform well in a difficult environment is lost at the moment. This will undoubtedly act as a throttle on OP-rated AYI, AXE, and WCC, although we believe risk/reward is sound from here. Investors aren’t cyclically constructive from what we can tell and we spent more time on secular automation nuances in CGNX (OP) and ROK (PP) than debating a cycle. Value focal points continue to be PP-rated JCI and FLS, but with very little sense of urgency.
THR is a proxy for Process MRO, and while we originally viewed this as advantage given the potential incremental margins associated with aftermarket activity, we now think that THR is one of the worst positioned for a downturn in process MRO spending as it benefits from a lot of incidental non-priority maintenance. With consensus at 7% revenue growth and 51% incremental margins in FY19, we think expectations assume we are at the onset of a recovery with next year as the inflection point. We don’t think investors are considering the fact that the recent pushouts are not a source of upside for next year, but rather, a permanent reduction in spending as the scope of maintenance is reduced.
We believe the decline in shares following the quarter was the result of expectations management on Payment, weaker Aerospace results, and, following the initial downdraft, technical selling pressure with substantial passive ownership in the top 10 shareholders. Following the decline and with a more muted view on cyclical growth, CR’s defensible niches appeal to us and we expect 2018 visibility in Payment, a reasonably derisked outlook in Aerospace, and positive momentum in Fluid Handling to outweigh the 25% discount in asbestos-adjusted EV/EBITDA vs. peers compared to CR’s typical 15% discount. Given the challenging growth environment, CR’s businesses and return profiles look more attractive on a relative basis.
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