Mid-Cycle Has Arrived;What You Can ExpectWritten By: ELI LUSTGARTEN
Article Date: 12-04-2006
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Demand has peaked at historic highs, and cooling is likely in most markets.
Construction and industrial end markets should remain solid through the end of 2006 and into next year, but we have seen the transition to slower growth as the fourth quarter of 2006 unfolds. Weakness has been reflected in flat North American Industrial fluid power orders at Parker Hannifin, slowing Kennametal cutting tool orders, as well as disappointing earnings reports from Caterpillar (due to lower machine volume and higher costs and inventories), Ingersoll Rand (reflecting severe weakness in Bobcat light equipment) and Timken (pre-announced earnings weakness due to slowing domestic automotive markets).
In addition to weaker auto, falling residential construction, declining light construction machinery sales, and weaker farm equipment demand, we expect to see other markets show declining activity as we enter CY2007 led by dramatically lower heavy truck demand.
Mid-cycle has arrived and virtually every piece of economic data supports the slowing of the domestic economy. The PMI index for October was 51.2, down from 52.9 in September, which was down from 54.5 in August and 54.7 in July.
Auto production softened materially in Q3 (down 13 percent) with similar cuts projected for Q4 as GM, Ford and Daimler Chrysler endeavor to reduce bloated inventories; Ford has already extended their production cuts into the first half of 2007.
Recent government data showed a continuing housing slump but surging non-residential and highway markets. Industry construction machinery sales declined 3 percent to 7 percent in Q2 and weakened further in Q3; CNH Global indicated a 15 percent to 20 percent decline in Q3 in several light construction machinery segments and even a 2 percent decline in heavy construction machinery.
The Farm sector also continues to report sharply weaker than expected retail sales during the past several months.
Our profile of the domestic economy has not changed, but one of the two key indicators we use for recession warnings has worsened. October data indicates that manufacturers' inventories expanded in October to 49.4 from 46.4 last month; the data suggests manufacturers have expanded stock levels modestly to at least more normal levels. However, the customer inventories index also rose to 52 percent from 49 percent suggesting adequate to higher inventories for the first time in 64 months.
We expect the ISM index to break through the 50 (growth) barrier over the next several months given ongoing softening of various end markets, the need for a modest inventory liquidation cycle outside of auto, and the long awaited fall-off of the truck sector.
The overall trajectory for the industrial sector remains positive, with solid growth across most domestic key end markets, excluding consumer (housing, auto, light construction) ag and truck in 1Q 2007 and strengthening industrial demand outside of North America, particularly in Europe.
For the construction machinery sector, it means demand has peaked at historic highs, and cooling is likely to occur in most markets, but will be much more pronounced in areas that have benefited from the extra-ordinary housing bubble.
Three initiatives are likely to unfold.
Caterpillar's actions are indicative as they are fostering a dealer inventory reduction plan. The goal is to improve inventory turns for Caterpillar and its dealers from about 3.5 to more than 5 by the end of the decade.
- Dealer orders will soften as dealers recalibrate market demand to the new level of activity.
- Compact equipment will be most impacted, though it appears for now compact excavators and compact loaders are holding up better than other products.
- Dealers will voluntarily undergo or be pushed by manufacturers to reduce field inventories more likely due to increased machine availability than lower demand.
Though utilization remains good, rental fleet purchases will slow.
Recent M&A activity in rental , such as the acquisition of Nations Rent by Sunbelt Rentals, the sale of RSC rental division of Atlas Copco to private equity investors, and the expected IPO of Hertz and other rental companies will impact equipment purchasing patterns going forward.
Anecdotal evidence from surveys supports this: United Rentals has indicated moderately lower purchases of equipment in 2007, and both Deere and Volvo have commented on weakness in the rental channel. We are being told that rental companies are likely to buy less equipment in 2007 compared to 2006 as the focus becomes improved profitability.
The bottom line hasn't changed. 2006 will clearly be a good year for the construction equipment industry, although 2007 will probably be much more challenging. If the Fed will cooperate and begin to cut rates next year, this expansion may have legs to last to the end of the decade.
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