2008 Industrial Outlook: A Long Hot SummerBy Eli Lustgarten
Article Date: 08-01-2008
Copyright(C) 2008 Associated Equipment Distributors. All Rights Reserved.
Rising costs plague both North American and European industrial sectors.
The 2008 industrial climate continues to be shrouded in uncertainty. In our view, the industrial sector has already passed through two different phases and may be poised to enter a third phase of ongoing sluggishness that may last at least into the fall.The first phase reflected a doom and gloom outlook with respect to the economy.
Through early 2008, valuation multiples for public industrial stocks contracted sharply based on the fear of weakness developing across the industrial economy as reflected in reported economic data such as the ISM index below 50. The focus was on recession even if the data didn’t support that economic outlook.The second phase appears to have been a transition from pessimism to a more constructive look at the domestic and global economy. The turn-around began with optimistic statements at the Caterpillar investor meeting at CONEXPO 2008 in March about longer term demand and earnings trends, and was supported by better-than-expected earnings performance by industrial companies in the April quarter. Most industrial stocks rallied off their early 2008 lows as economic data suggested that the domestic/industrial economy was muddling through, and there may be some hope as the rest of the year unfolds. This phase may have ended with Deere’s second quarter report in April, which raised the specter of surging input cost inflation.The pending third phase may be related to the fundamental issues as to why most industrial companies gave only tepid future guidance despite reporting relatively robust April 2008 earnings results. It had to be more than economic uncertainty and the spike of oil prices, which was and continues to be unpredictable.Our view is that most companies have yet to recognize the dramatic surge in input costs in their income statement due to the use of FIFO accounting for most transactions outside the U.S. and less conservative use of LIFO in domestic accounting than in prior cycles. The stage is set for earnings disappointment either from calendar Q2 earnings, Q3 guidance or Q3 earnings from rapidly rising cost pressures. In addition, the recent translation benefits to earnings from the decline of the dollar will begin to anniversary as we go into Q4, with currency possibly becoming a modest headwind.Deere’s (DE) Q2:08 earnings report underscores the current environment. DE reported a strong April quarter but issued cautious guidance due to the impact of escalating costs. DE indicated that they have recognized $110 million of increased costs in their first half of 2008 of an originally projected $250 million increase. The company noted that cost projections have risen dramatically and are now projected between $400 million and $500 million. We note that DE’s strength is in the Ag sector, which is essentially sold out for 2008 and capacity constrained. Any pricing action will have limited effect on the current backlog. Construction and lawn and garden equipment faced much more intense competitive pressures due to soft demand. We note that CNH Global recently instituted a 5 percent surcharge on farm equipment sales, but not on construction equipment in an attempt to offset the input cost pressures cited by Deere.As the economy enters the third calendar quarter, industrial markets remain mired in this period of surging input costs and uncertain demand. The ISM Purchasing Managers Index (PMI) was 50.2 in June, suggesting a continuing flat domestic industrial environment. The ISM (Input) Price Index, however, surged to 91.5, the highest reading since 1979, and up from 87 in May, 84.5 in April and 83.5 in March, suggesting intense cost pressures on virtually all phases of industrial manufacturing.Compounding our concern is evidence of slowing economic activity in Europe with recent weak European PMI indexes in several countries including Germany, France, UK, Spain and Italy. We also had two earnings preannouncements from Rockwell Automation and Oshkosh Corp., both citing slowing European demand and rising costs. Even our industrial market surveys reflect the cautious tone as our contacts characterize the near term as a challenging environment for industrial companies, with weak end-markets in North America awaiting signs of improved demand. Distributors are reporting anecdotal evidence of broader and longer summer shutdowns in response to a soft domestic economy. A number of public industrial distributors have also reflected a cautious tone in their outlook, giving guidance that anticipates weak U.S. industrial demand to continue for at least the next three months.In our view, we ought not to confuse the ongoing near-term period of economic sluggishness and earnings surprises with the multiyear, longer term positive outlook for the industrial sector. The industrial
sector still shows all the signs of muddling through 2008 with relatively flat domestic performance and continuing growth outside the U.S. The wild card continues to be energy prices.
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