Industrials Rise From the Ashes -- Part I

 | Feb 03, 2013 | 2:00 PM EST
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During the fourth quarter, much of the market's focus was on the U.S. election and the looming "fiscal cliff," but a very pronounced -- though less discussed -- development was taking place amid industrial stocks. After a modest pause early in the fourth quarter, most industrial businesses saw a pickup as the quarter progressed, and they are entering 2013 with accelerating business momentum. Across a wide swath of industrial enterprises, orders from emerging markets have seen a marked re-acceleration. Moreover, Europe is beginning to stabilize after two years of decline, and North America has seen continued firming.  

This unexpected and positive change in direction has analysts raising 2013 earnings estimates for the industrials group, based primarily on a noticeable climb in activity from China. After 12 to 24 months of deceleration, growth is finally beginning to pick up in this globally vital region, with recent easing by the People's Bank of China beginning to stimulate domestic housing and infrastructure markets. Among other emerging markets, India, Indonesia and Brazil are also seeing higher activity levels. 

While China's turnaround has been long anticipated, the bigger surprise might be in the recession-stricken Europe, where good news has been scant of late. European industrial production had rapidly declined in the past two years because of its own financial crisis and a slowing China. But -- thanks to the abatement of the European fiscal crisis and China's economic re-acceleration -- production is currently stabilizing, and it should now cease being a drag on major multinational industrials.

North American activity, led by the U.S., is also beginning to improve after 12 months of deceleration. With the presidential elections and fiscal cliff behind us, customers are beginning to increase their order and inventory levels -- a definite improvement from the no-growth reality during the preceding year. Notable improvements within the sector are coming from commercial aerospace, fuel-efficiency-driven airline orders, industrial and automotive production -- both in North America and in emerging markets -- and healthcare capital-equipment orders. 

While fourth-quarter business was decent and 2013 outlooks have been positive, we believe more improvement will emerge as the year progresses. In fact, the better-positioned and more global franchises should now be entering a multiyear up cycle. While industrials are not as cheap as they had been over the prior few years, they are finally benefiting from business momentum and warming investor sentiment. We should also begin to see more stock buybacks and rising dividends. 

Here are just two representative updates, with four more to follow Tuesday.

General Electric (GE) reported better-than-expected revenue and earnings growth during the quarter. Order rates reaccelerated to grow 7%, while the backlog grew to $210 billion. In particular, the oil-and-gas segment, aviation, healthcare and home/business solutions all came in ahead of expectations. The company continued its cost-reduction actions, both in its industrial unit and its efforts to right-size GE Capital. That business should begin to add to earnings in the coming years after five years of pulling down the bottom line.

Management also affirmed the long-term outlook of 10% earnings growth in 2013 and beyond. General Electric shares have an attractive valuation level of 13x earnings, as well as a favorable 3.5% dividend yield.  

United Technologies (UTX) reported a solid $0.12 earnings beat for the quarter, led by strong cost-reduction strategies. Overall, 2012 was a disappointing year for the company due to a lack of organic revenue growth and higher cost levels. However, the coming year is shaping up more favorably as order levels begin to pick up in key emerging markets such as China.

United Tech should also see strong benefits from a broad restructuring that it implemented in 2012, as well as positive earnings synergies from the recent Goodrich acquisition. For the first time in a year, management is beginning to be more positive on the company's overall activity levels. The stock is attractively valued at 14x 2013 earnings with a 2.5% dividend yield. 

While industrials are still in the early innings of a full recovery, many of these stocks have already enjoyed impressive rebounds after they'd bottomed out last summer. Although these recent upward moves should slow near-term appreciation, sector names should still reward investors with rising earnings and dividends, both of which bode well for solid returns to come.

To see Part II of this column, please click here.

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