With earnings starting this week, we found that our top picks this season are a lot more idiosyncratic based on sentiment, cost structures, and market inflections than focused on a common theme ( earnings preview here). We expect GDI (OP; $37 PT), HUBB (PP) and ROK (OP; $232 PT) to be top outperformers into the quarter, and that RBC (PP), JCI (PP), and FLS (PP) will be top underperformers. In terms of the battleground stocks - ETN (PP), IR (PP), and to a lesser extent SWK (OP; $195 PT) - we are more constructive on SWK and IR’s growth and business models longer term but view the set up into the quarter as risky, and that sentiment and quarterly catalysts favor ETN in the short term but would fade the strength as long-term growth remains a challenge.
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Most of our top ideas into earnings season are built less around a theme and more on company by company sentiment, cost structures and market inflections, which seems like the breakdown in correlation we’d all like. Our long ideas are GDI (OP; $37 PT), HUBB (PP) and ROK (OP; $232 PT) and our top shorts into earnings are RBC (PP), JCI (PP), and FLS (PP).
This week we introduced the “new mid-cycle” in our 2018 outlook, which we believe is no longer just one point on the curve but multiple curves – some with more runway than others. The steepest curve with the most runway contains the premium growth markets such as Automation and Connected Buildings, the below trend growth markets on the shorter curve are Power Generation, Capital Projects, and Distribution, and the typical GDP-type curve contains the O&G, Machinery, Short-Cycle/MRO, and Construction markets – yet all are on different points on the curve (Exhibit 3 below). ROK (OP, $232 PT) remains our top pick for 2018 with growthier end markets on top of being a multi-layered tax beneficiary. We are hosting an earnings preview lunch in NYC, this Friday (1/19), to go through company specific earnings and our 2018 outlook in more detail. Register here.
Our view on AYI entering today (1/9/18) was markets are still weak, but tax reform and a clean balance sheet gave management a tremendous opportunity to bridge the gap to market stability and greater tier 3/4 importance through share repurchase. Markets are weaker and the improving macro backdrop remains at deep odds with management’s characterization of the business – it’s not a macro problem, it’s a lighting competition problem that is mischaracterized. The capital deployment strategy has not changed with the tax and cash flow climate. While AYI is trading at a 10% discount to peers based on our 2019 numbers, well below its 33% historical average premium, it’s hard for us to step in front of price/cost, a surprise deceleration in tier 3/4, and new challenges in DIY. A ramp in buyback could unlock meaningful value in shares, but the standalone fundamental story has few positive near-term catalysts with the lingering threat that lighting is meant to be a ~35% GM industry, not 40%+.
Revenue was light and gross margin was a bit weaker sequentially, neither of which should be directionally surprising. Investors should be 1) concerned about the new weakness in home center and international channels, neither of which were large but did cost ~3pts of revenue in total; 2) encouraged by LT tax guidance of 23-25% vs. 35% historically and; 3) encouraged by meaningful growth in Atrius IoT platform adoption with installed sq. footage of 160M vs. 90M last quarter. While shares will clearly be weak in the short-term on the miss, sizable positive revisions to consensus from tax and the potential for accelerated capital deployment (further supported by sound FCF generation this quarter) amid 13% short interest suggests today could be an overreaction.
Wolfe Research's Senior Industrials analyst, Josh Pokrzywinski, hosted a Webcast discussing his 2018 outlook. Topics on the call include: Big Themes for 2018: Tax Reform and Extended Byproducts; The New Mid-Cycle: Not a Single Point on the Curve; and New Year's Resolutions: Emerging Topics and Names to Focus on for 2018.
Growth appears solid across most major end markets outside of Power Gen and Capital Projects, neither of which should improve in 2018 as capacity demands remain scarce. Against a solid growth backdrop, we’ve reached a cyclical point where the sector tends to derate and are biased to names with secular growth and a better case for retaining out-year multiples. While we believe we are mid-cycle, there appear to be multiple curves – some with more runway than others. Being early in a recovery matters less if the recovery is short and subtle. ROK (OP, $232 PT) is our top pick: mid-cycle on a steeper, longer curve, a multi-layered beneficiary of tax reform, and with secular growth that makes a premium multiple more defensible as the sector risks multiple compression.
ROK remains our top pick into 1H18 (note here) as a multi-layered tax beneficiary with secular growth that justifies a higher premium. With CGNX up ~9% this week, we think investors are beginning to appreciate how tax reform favors automation given the relative higher cost of labor due to capex deductibility. We expect further upside to automation players as management’s capex plans are tweaked in favor of investing in productivity. JCI was particularly weak on Friday, which might be attributable to the ADT IPO process, which features plenty of emphasis on expanding into commercial security.
Earlier this morning (1/2/18), Mike Kiernan, Wolfe’s Director of Research, sent around the Wolverine update for the firm’s top fundamental picks for the next 6-12 months (see his email below). Always a believer in marrying the fundamentals with the technicals, I thought it would be helpful to provide the charts for each. While a few have some work to do, there are plenty of constructive setups on both the long and short side.
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