This blog is devoted to helping investors make informed decisions. It will be regularly updated and provide opinions on earnings results. It is not intended to give investment advice and should not be taken as such. Consult your investment advisor.
It's no secret that 3M Company
is a very well run company, but is it a great investment right now?
Aside from some weaker conditions in Latin America, 3M Company delivered
on almost every front in the quarter. Moreover, the commentary around
the results made for good news for the industrial sector, and
specifically, for Pall Corporation . Were the earnings good enough to suggest that 3M Company can go higher in 2014?
3M Company's quality of earnings doesn't come cheap On
an absolute and relative basis, 3M Company doesn't look like a
particularly cheap stock. A quick look at its valuation versus a
collection of its industrial peers indicates that the stock has a lot of
good news already priced in.
Pall Corp
presents one of the most compelling investment propositions in the
industrial sector. The filtration and separation company's operations
span a wide range of industries, where it competes with companies such
as 3M and Donaldson. However, with the stock trading on 29 times current earnings, it's
hard not to conclude that much of the good news is already in the price.
With that said, what can Pall do to take the stock higher?
A nice mix of stability and growth The
interesting thing about Pall is its combination of earnings drivers
that ensure it can generate operating income through the economic cycle.
The company operates out of two operating segments. The life science
segment generates underlying demand from throughput activity in
relatively stable industries such as pharmaceutical production.
Meanwhile, the industrial segment is more focused in cyclical industries
such as aerospace, microelectronics, and process.
A quick look at its segmental revenue (broken down
into industry groupings) shows its life science segment has done
relatively better than the industrial segment in recent years -- which
is to be expected given the sluggish global economic recovery. The life
sciences end market is in blue with dotted lines. I'm focusing on
consumable sales, rather than systems, because they made up nearly 89%
of sales in the last quarter and tend to be higher margin.
Investors always like to look at Alcoa’s (NYSE: AA)
earnings and use them as a guide to the rest of earnings season. In the
latest second-quarter results, there were some surprising elements
which deserve to be looked at in more detail. In this article, I want to
examine Alcoa’s end market commentary and discuss the implications for
some companies which you might be looking at.
Alcoa changes guidance, but not for China
I’ve tabulated the updated full-year guidance below. The green
segments are where numbers were upgraded, and red is for the downgrades.
Probably the most surprising aspect of these results was that Alcoa
didn’t reduce guidance in any of its end markets within China. A number of companies have reported recently and cited specific weakness in the country. For example, FedEx recently spoke of global trade growing slower than global growth, Oracle cited weakness in China, and filtration company Pall (NYSE: PLL) delivered some disappointing numbers in its industrial filtration results.
Pall’s Chinese industrial sales were down 11% in the quarter. The
company spoke of the ongoing changes in the Chinese economy and how they
are forcing Pall to adjust its sales focus. In general, China is trying
to shift towards more domestic consumption and reduce its dependency on
export-led manufacturing. This is presenting challenges
to Pall, and given that nearly 60% of its industrial sales are in
process technologies and 20% in microelectronics, it is likely to face
some difficulties.
Aside from what companies are saying, China’s own economic data has
been weaker recently, with the official Purchasing Managers’ Index
registering 50.1 in June. A reading above 50 indicates growth, so
clearly China’s manufacturing industry is not growing by much. However,
this is not the way that Alcoa sees it! Indeed, it actually cited
Chinese demand for aluminum as remaining strong and kept its 11% demand
growth forecast.
The reason why Alcoa may be seeing relatively better conditions is
because aerospace and automotives have been the standout performers
within the industrial sector this year. Furthermore, beverage can
packaging is relatively non-cyclical, and China’s heavy truck &
trailer industry is benefiting this year from some regulatory changes.
It looks like a case of good news for Alcoa, but not necessarily for the
wider economy.
Winners and losers from Alcoa’s report
Aerospace and automotive have been strong this year for similar
reasons. The U.S. consumer is starting to benefit from employment
increases, and lenders are more willing to expand credit in the form of
car loans. North American auto sales have been improving, while China’s
remain strong.
Aerospace has been very solid, and the industry has the
potential to outperform in a cyclical recovery because its dynamics
have changed. The need for austerity has forced
governments to stop subsidizing national loss-making champions, and
airlines are getting much better at dealing with high oil prices and
outsourcing unnecessary work. The result is increased airline
profitability driven by Asian passenger traffic.
This commentary will interest shareholders in a diversified industrial company like General Electric(NYSE: GE) or Ametek (NYSE: AME). Aviation is GE’s largest industrial profit generator,
and it needs strength in aviation, transportation, and health care in
order to offset some weaker performance in Europe (particularly within
its power & water segment). Alcoa spoke of a 40% rebound in growth
in its regional jet business and 12% for its business jet segment. This
is great news for GE, but, on a more worrying front, Alcoa also said
that it anticipated a weaker demand from Europe for industrial gas
turbines. It looks like GE’s weakness in power & water is set to
continue, so this is a mixed report for GE.
However, it was a good report for Ametek shareholders. The company has heavy exposure to aerospace, particularly the business jet sector (Textron is
a major customer). Ametek also has customers in the North American
heavy truck & trailer market. Indeed, in its most recent results,
Ametek had cited some softness in its power & industrial business,
thanks to softness in the heavy truck market. My point here is that if
Alcoa is talking about order rates being up, then this will surely feed
through into Ametek in future quarters.
Other stocks worth considering for the aerospace theme are B/E Aerospace, Heico, and Precision Castparts. Finally, the heavy truck & trailer market seems stronger, so stocks like Cummins could see better prospects.
The bottom line
In conclusion, this was a pretty good report from an
end-market-demand perspective. There were no downgrades to expectations
over China, and if anything, the news on the aerospace and automotive
sectors was a little better. There was even some positive news for the
heavy truck & trailer market. Overall, it was a favorable report,
but investors still need to remain selective about where they invest in
the industrial sector, because the sub-sectors within it are reporting
some varied performance.
When looking at a stock it is always tempting to take an initial peek at its share price graph to make a quick and easy assessment. In the case of Pall Corp(NYSE: PLL) and its impressive looking chart, it would be easy to conclude that things are going great, but the reality is that it has been a challenging environment for the industrial sector.
In summary, there are some changes afoot, and investors would be best advised to be selective with investments within the sector.
Structural changes
I have two main observations here.
The first is that it has been a mediocre Q1 reporting season for the industrial sector outside of the automotive and aerospace sectors. This has been a recurring theme in this reporting season whether from a large industrial bellwether like General Electric(NYSE: GE) or a smaller niche player like Ametek(NYSE: AME). I’ve discussed these companies' results in articles linked here and here.
The second is that the nature and quantum of growth in China is shifting. We all know that China is taking up an increased percentage of global manufacturing but we also know that its reliance on export led growth cannot continue indefinitely. Europe’s growth is anemic, and the long term prospects for US growth look hampered given its public deficits. Moreover, the Chinese government knows this and is gradually trying to shift the economy towards domestic consumption. And China matters for the global players. Even a cursory look at Alcoa’s(NYSE: AA) results will demonstrate the emphasis it is placing on growth from China. Many of us that think that China has the reserves in order to ‘buy’ its way to 7-8% growth but we must recognize that its stimulus plans are likely to be different this time around.
What did all this mean for Pall Corp?
It was a tricky Q3 for Pall Corp, and the repercussions of these two changes are being seen in its numbers. Total sales fell $18 million to $640 million and investors can take little solace in the fact that excluding currency effects its sales would have been flat. On the positive side pro forma EPS for the nine months was up 11% to $2.15 with some notable cost savings being implemented while higher margin consumables increased as a part of the mix. Naturally this meant that margins went up. This is good but recall that future consumables sales rely on the system sales being made now.
In order not to cover old ground I have a primer article on Pall Corp linked here. In fact its growth prospects have progressively weakened since that article. The latest numbers imply that sales are still weakening (particularly within industrial), but at least system orders are looking relatively better at the moment.
Digging deeper into the numbers shows that Life Science sales (67% bio-pharmaceuticals,16.3% food and beverage and 16.7% medical) are doing okay with good growth from bio-pharmaceuticals (pharma is still investing) of 9% offsetting a 21% decline in food and beverage sales.
Turning to Industrial sales (59.4% process technologies, 20% aerospace and 20.6% microelectronics) it’s clear that there are some issues here. Ametek recently spoke to strong performance in its aerospace markets and it’s been a strong reporting season for aerospace companies. On the other hand it mentioned some softer than expected numbers in its process industries as well as softness caused by the heavy truck and trailer market. Indeed, this is exactly the sort of thing that Alcoa’s results had presaged when it forecast deteriorating conditions in its heavy truck markets.
Pall Corp’s process technologies sales declined 13%, and it was no surprise to see its microelectronics sales down 14% as well. The one bright spot was--you guessed it--in aerospace as sales rose 25%; but as it only makes up 9.8% of total sales, it is not enough to make a significant difference.
The conclusions are clear, outside of automotive, aerospace and parts of healthcare, the industrial sector is doing great and investors should be minded to consider factoring this into their decision making.
China?
Similarly with regards to the regional breakdown, Pall stated that its Asian sales were down 11% due to weakening in its industrial markets in China and ‘mature Asia.’ Obviously part of this will relate to tougher conditions within microelectronics and you only have to look at what Intel said to confirm this. However, Pall’s management stated that conditions were changing in China, and I think this is self evidently true from most commentary on the country. Aerospace and automotive should do fine because they are strongly related to the Asian consumer (car buying and air passenger traffic), but some of the major infrastructural markets may see a slowdown.
For companies like Alcoa or General Electric this may cause some problems, but it may cause opportunity as well. Alcoa does have significant exposure to automotive and aerospace but any weakness in China will hit its growth prospects quite hard.
As for General Electric its healthcare, transportation and aviation (which together contributed 61% of industrial profits in the quarter) should do fine this year, but its power & water division disappointed last time around (Europe was blamed), and it’s hard to read what its oil & gas numbers will be for the rest of the year. Both companies' future results are well worth looking at in this context.
Where next for Pall Corp?
Pall Corp is attractive, and it has some good long term prospects from filtration demand promulgated by environmental regulation. My concerns would be more over the short to mid term outlook. This is a stock that trades on nearly 23x full year EPS estimates to July 2013. It is hardly cheap and its outlook has been getting worse even as the share price has risen.
Clearly the market is pricing in a second half industrial recovery here with no knock–on effects from China’s shifting growth path. Even if you are comfortable with these scenarios then Pall Corp does not look cheap.
