Industrials could signal slower growth ahead
By Nick Zieminski
NEW YORK (Reuters) - U.S. manufacturers are entering an period where growth is more muted, profit margins are harder to raise and earnings beats are less common.
The easy money has been made, many analysts and shareholders of U.S. industrial stocks say.
General Electric Co's <GE.N> Jeff Immelt, whose company reports second-quarter earnings next week, acknowledges that the industrial conglomerate is operating in volatile times.
Demand is tremendous, the company's chief executive says. "You see it getting better, yet at the same time, there's more discontent," Immelt said this week at a sprawling GE factory in South Carolina. "This recovery has been so different from previous recoveries."
Analysts say industrials are in transition from a
"V-shaped" recovery after recession, when nearly everyone increased sales and profits, to an unpredictable period when some businesses thrive, others lag and picking winners is harder.
"Industrials as a group may be among the first to see their profit margins challenged," said Keith Goddard, manager of the Capital Advisors Growth Fund, which owns GE, Johnson Controls <JCI.N> and FedEx <FDX.N>, among other companies whose fortunes are tied to the business cycle.
"Margins are bumping up against all-time highs," said Goddard, who favors healthcare stocks. "Don't go to the industrial space looking for positive earnings surprises."
Increasing commodity and labor costs will trim profits across corporate America, he said, hitting labor-intensive manufacturers. GE has more than 100,000 workers just in the United States.
Many investors play down the negative effects of the U.S. government debt-ceiling impasse and a cautious, debt-burdened U.S. consumer. Slow growth is not a double-dip recession, they say.
Although the U.S. recovery has stalled by some measures, other large economies are still hungry for heavy machinery, cooling equipment, tools and other industrial goods.
Companies keyed to Brazil, India and China, including 3M <MMM.N>, Eaton Corp <ETN.N> and Emerson Electric Co <EMR.N>, will again benefit from robust capital spending, much of it funded by governments.
One question earnings season may answer is whether Europe's debt crisis will affect growth and alter profit expectations. Europe's problems are overemphasized, said Oliver Pursche, co-manager of the GMG Defensive Beta Fund, which holds shares of Caterpillar <CAT.N>, Deere <DE.N> and United Technologies <UTX.N>.
Industrial shares have rallied into earnings season. For a graphic, click: http://r.reuters.com/wes62s
"I'm not too worried about earnings this quarter," Pursche said -- but a potential global economic slowdown could damp prospects for corporate profits. "I'm much more concerned about cautionary statements from CFOs and CEOs about the rest of the year. It's going to be a much more challenging environment."
Caterpillar could sound a cautious note because of China's efforts to rein in its economy, he said. China's leaders have suggested they will again raise interest rates and bank reserve requirements to bring down inflation.
STALLED RECOVERY
U.S. industrials are among the most globally diverse multinationals, but the U.S. market still accounts for as much as half of their revenue. Recent data offers fodder for both bulls and bears.
U.S. June industrial production data disappointed on Friday, and May was revised lower.
A monthly gauge of factory activity by the Institute of Supply Management rebounded last month from a May slump, easing fears of a broad slowdown.
But construction spending -- a key market for companies ranging from Eaton to Ingersoll Rand <IR.N>, United Technologies and Tyco <TYC.N> -- has fallen for six straight months to its lowest in a decade.
And a quarterly Manufacturers Alliance/MAPI survey pointed to further growth, but at a slower rate. The poll of financial executives, a leading indicator of manufacturing activity, found a fourth straight decline in sentiment.
Companies whose fiscal years ended in June, including Parker Hannifin <PH.N> and Kennametal <KMT.N>, will give initial glimpses into 2012 when they introduce 12-month earnings forecasts. Both are known for starting with conservative profit targets.
Other variables to watch this quarter are how much Japan's March earthquake hurts companies such as 3M; electrical manufacturers' ability to offset higher steel and copper costs with pricing; and the impact of a weak U.S. dollar.
Depressed housing and a delayed recovery in non-residential construction could hurt machinery makers and rental companies, as well as makers of air conditioners and components.
Other late-cycle markets, such as power generation equipment and aerospace, are also expected to grow over the next two years after declines in 2009 and 2010, so any sign of whether their rebound has begun will be an area of focus.
Electrical equipment and multi-industry companies are near the end of a beat-and-raise phase of their cycle, said Nomura analyst Shannon O'Callahan.
"You had the big V-shaped snapback against easy comparisons," he said. "Growth has been abnormally high. We're entering a maturing part of the cycle."
Managers will point to moderating growth rates this quarter, with few sounding especially bullish. Corporate crystal balls are as cloudy as anyone else's, O'Callahan said.
'WHITE-KNUCKLE' BULLS
Enough investors see the glass as half-full that earnings expectations and price-to-earnings ratios have risen this year. Industrial shares <.GSPIC> are up 7 percent year to date, outperforming the broader market. A few, such as Tyco and SPX <SPW.N>, have jumped 25 percent or more.
At 16 times this year's estimated earnings, industrials are more richly valued than the overall S&P 500, but are only slightly above their historical average, according to Goldman Sachs.
Goldman analysts, in a July 10 note, predicted industrial companies would sound a more "constructive" tone about the second half of the year than recent economic numbers suggest. They cited expanding late-cycle markets, the weak dollar, and share buybacks and acquisitions.
Most U.S. industrials will beat Wall Street forecasts by 1 percent or 2 percent, said analyst Brian Langenberg of Langenberg & Co, who calls himself a "white-knuckle" bull.
"I expect bigger beats out of companies levered to energy," he said, citing Dover <DOV.N>, Ametek <AME.N> and Emerson. "Ninety-some-dollar oil makes it worth punching holes in the ground."
Langenberg said current expectations of double-digit profit growth over the next two years are reasonable.
"We're not back at peak earnings yet," he said.
(Additional reporting by Scott Malone in Boston; Editing by Steve Orlofsky)