Industrial Sector Outlook: Making Sense of the Economically Sensitive
Editor’s note: Our industrial sector outlook is part of a regular series sharing our views on various sectors with advisors and consultants. It’s part of our efforts to increase communication with investors at a time of economic and market uncertainty. While the sector outlooks provide a short overview of our thinking, we invite you to contact us if you are interested in a deeper discussion.
The economic fallout from the coronavirus has created an undeniable rough patch for the industrial sector. But there are bright spots beneath the darker clouds. We see investment opportunity in a few companies with innovative businesses using technology to improve manufacturing in other industries. We also see potential in “self-help” stories – management teams who are using efficiencies to improve the bottom line even as top-line growth slows.
We share these bright spots, some of the sector headwinds, and how we are navigating this economic environment in our industrial sector outlook.
First, the headwinds:
Industrial businesses tied to the oil patch are in a tough spot. Low and volatile oil prices are significantly reducing capital spending by energy companies. But it could take years before the full extent – and impact – of these reductions becomes transparent. For example, if an energy company is in year four of a six-year project, it will likely complete the project, but delay starting new ones. We believe capital budgets could be down ~20% in 2020 and will likely fall in excess of 20% in 2021. As a frame of reference for what that means for industrial companies serving the energy complex, consider that energy exploration and production Capex was roughly $550 billion in 2019.
The move away from fossil fuels also threatens the long-term demand profile, further hurting the growth outlook for the sector. Many industrial companies supply a variety of goods into the energy sector — generators, motors, pumps, trucks, pipes etc. — and this portion of their business will likely be weak for an extended period.
The aerospace industry is also hurting. Airline passenger traffic will drop 60% - 70% in 2020, with only a gradual recovery over the next five years. Order books from Airbus and Boeing will likely see a significant number of cancellations/deferments, but most of these orders will not be lost until the airline needs to make a significant financial commitment, at which time their financial health will be the driver of the decision. With airline profitability years off, airlines will only take possession of planes that already have received financing and ones that have already begun the production.
It is likely that aircraft production rates will be cut, especially in the wide-body segment, where the economics are particularly challenged during this time of demand weakness. A large number of industrial companies sell into the aerospace market, so this exposure is not just limited to large aerospace names like Boeing.
There could be disappointment for infrastructure-related companies. Divided government, while typically good for businesses overall, is a negative for investors in infrastructure. While everyone seems to favor infrastructure investment generally, the details on what kind of infrastructure to add and its funding remain key issues. There may be some disappointment for companies with exposure here, as positive government rhetoric around infrastructure spending has not led to action for many years.
Industrial Sector Positives
Demand is strong for construction-related companies. As consumer spending shifts to goods from experiences during the pandemic, the residential construction market has been strong. Money that was spent on leisure activities is now spent on home improvement. Going forward, low rates will help maintain a strong residential market.
We believe non-residential markets are also poised to improve, after a ~25% fall in construction starts year to date. Non-residential spend is highly correlated with GDP growth, and GDP should grow in 2021 after falling in 2020.
Efficiencies in the railroad industry are promising. Railroads are in the midst of re-designing their networks, going from a “hub and spoke” network to one that is point to point. As this occurs, the rails become more efficient and need less infrastructure to ship the same amount of goods. Train speed increases and train length increases, with less handling of equipment and faster turnaround times. This leads to a step function increase in profitability. Improving profitability has been partially masked by falling volumes coinciding with the COVID-induced recession. As volumes improve over the next year, however, we believe this profitability will shine through, resulting in improving revenue growth and rapidly improving earnings.
Connected devices are not just a technology trend; industrial businesses benefit too. Innovative companies are delivering connected devices to the factory floor. Equipment with diagnostic capabilities for monitoring performance or predicting problems improves asset efficiency and worker productivity. Given that 90% of unplanned factory shutdowns are due to equipment failures and 80% of business workflows are still paper based, technology improvements are something companies are willing to spend on … in any economic environment.
How are we navigating the sector?
In a word: selectively. We want exposure to areas where we think the market is underappreciating growth and avoiding areas where there could be disappointments, such as the tailwinds listed earlier.
In this volatile environment we like stories with a self-help element, such as a structural cost improvement that should lead to higher-than-expected profitability/durability coming out of a recession.
We’re also looking for companies with solid balance sheets. That’s a common mantra at Dana, but an important one, especially now. In times of distress you don’t want to own companies that may be forced sellers of assets or equity. It is much better to own the buyers of those assets—which implies a good balance sheet and financial flexibility.
Finally, we are investing with management teams that we are comfortable with—because they have shown consistently that they are good stewards of capital and have positioned their businesses in a favorable competitive position.
These industrial businesses should be well-poised to ride out the economic storm, and well-positioned when the economy bounces back.