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.
We believe the bull case is that the series of margin headwinds from warranty, inflation, and mix subside as Industrial Tools growth remains solid and Energy bounces cyclically. Industrial looks quite strong and investments seem promising, but Energy appears underexposed to improving areas of the US market. On the discrete cost headwinds, guidance appears to contemplate fairly dramatic improvement in F2H18 as it is. With valuation still at a premium to peers, bulls need to assume that ATU is materially under-earning, early in its cyclical recovery, or primed for meaningful beats and raises. We don’t see this and reiterate our Underperform rating and $21 PT.
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).
CGNX’s rapid growth profile has called for a catch up on sales/engineering, which is showing up in 4Q17/1Q18 weak operating leverage. This is still a mid-teens+ revenue growth algorithm with a strong growth outlook in traditional automation (auto, electronics) and burgeoning verticals in logistics (picking, scanning) and next generation robotics. We expect incremental margins to accelerate back to 50%+ in 2H18 and view the pullback as an unavoidable S/T response. That said, we don’t view the problem as structural, particularly as growth remains above-trend on difficult comps and the infrastructure must catch up to the opportunity.
ALLE’s narrative cleans up meaningfully with a solid 4Q report, guidance with a good amount of margin conservatism, and selective capital deployment. The concern from 3 months ago that organic growth was stalling at the end of the cycle for an expensive name has been lifted and valuation looks as inexpensive as it has in some time. We have management in Boston next week and will focus on how electronic is evolving outside of residential and this pivot in strategy to include a complete hardware + door solution. Outside of that, the core business is clean – base incrementals in guidance are quite conservative in the low 20s before M&A/FX/price/cost. We view the path for shares as fairly clear until the construction season when labor shortages could flare up again.
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