Finding Inspiration in Industrials

 | Dec 02, 2011 | 9:30 AM EST  | Comments
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bc

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atu

A stock picker is forever on the prowl for the freshest theme from which to select the next potential winning call. Once I even went as far as to doing the analysis on Brunswick (BC) because I noticed more beer-loving men on my Sunday night bowling league tossing the company's pretty expensive balls down the lane.

The trigger that got me to rationalize that the industrial complex is deserving of a medium-term move higher was catching an episode of "Gold Rush," a reality show that follows the trials and tribulations of three gold-mining teams in Alaska. I was amazed at how primitive the gold-mining process is for smaller businesses. From panning for gold to fixing constantly breaking parts on the dredge (separates gold from dirt), the tools have basically lacked any innovation throughout the years. Furthermore, I found the somewhat carefree nature of making a capital equipment purchase that could enhance the mine's operating performance as interesting, perhaps a result of the government's generous depreciation policy designed to spur growth and cash on the books earmarked for investment.

There isn't yet a publicly traded company on the scene that is manufacturing innovative mining equipment for smaller businesses. I also couldn't find a solid derivative name that profits from auction sales of heavy equipment.

What I came up with is Actuant (ATU), which does a little of this (sells essential building components to big-box home-improvement retailers, etc.) and a little of that (sells essential machine parts to the oil and gas industry). The company has made a total of seven acquisitions since Lehman Brothers went bust, $313 million this year alone, to boost its long-term market share in key growth industries. These acquisitions have been nicely integrated, as evidenced by strong double-digit percentage segment operating margins and consistent quarterly improvements in days of inventory outstanding as well as returns on equity and assets. Also, management is a veteran bunch, which is vital when investing in industrials.

The lackluster performance in the price-competitive electrical segment that sells into the major home centers and OEMs leave me less than thrilled, and 35% of the company's annual revenue is tied to Europe while 12% of annual revenue comes from Asia. Having said that, I do view Actuant as presently having more than enough factors fundamentally in its favor as to not warrant its below-market forward P/E multiple and to be an appropriate investment, not a trade, given the benefits of acquisitions at attractive valuations and operational enhancements dating back to early 2010.

Macro Thesis

Something positive is happening in the domestic economy. While the papers highlight justifiable global worries, there is positive macro data that deserves attention. I can't imagine that the domestic news flow of the past month is reflected in U.S. stock valuations; everything has been eurozone dominant. When the eurozone news firms up a bit, like it did earlier in the week, I think the market is returning to a forming bedrock of solid domestic economic data (see list below) and slowly pricing it in.

  • Chicago PMI saw new orders at an eight-month high and production at a seven month high.
  • Consumer confidence expectations on future income prospects continue to turn the corner.
  • Pending home sales were up 10.4% in October, and new-home sales in October saw the best percentage increase since May. (If we are finally rising off the bottom instead of bumping along the bottom in the housing market, then Actuant's electrical segment that gives me pause should perk up in 2012.)
  • Companies have underinvested in their businesses and need to put cash to work to prevent burning through the useful life of their revenue-producing assets. (Tricks of the trade: When you hear that companies have a ton of cash on their balance sheets, it means that they are reluctant to invest in their business.)
  • Consumers are generally responding well to initial promotions by retailers this holiday season (and for that matter, responding very well to retail price increases in 2011).

Talking Points on Actuant

  • The company has delivered six straight quarters of double-digit percentage gains in core revenue.
  • In the two most important segments of the company, industrial and energy, new product introductions and higher activity levels have led to flourishing operating margins. If my macro thesis holds, the industrial segment will keep firing away, ditto energy, and possibly even receive a boost with oil and gas prices likely to trend higher. (Have you noticed the quiet calls for $150-a-barrel oil in 2012? I have.)
  • Free cash flow is positive, meaning a continued balanced approach of compelling acquisitions and share repurchases.

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