|Summary: The climate across Australia’s broad industrial sector is a mix of dark and bright spots. In manufacturing, the demise of the local car industry continues to take centre stage. But in the area of transport and logistics, strong growth is ahead. There are winners and losers, but on a fundamental level the industrials sector is set to rebound as economic activity picks up.|
|Key take-out: Certain industrial stocks are underperforming, not because the economy is languishing, but because they have had poor leadership and have made bad decisions.|
|Key beneficiaries: General investors. Category: Economy.|
Last week Sam Fimis wrote a great article in Eureka Report on the earnings season to date (see Behold the profits bonanza), noting that four out of five firms had reported better-than-expected earnings.
Now, it was always my view throughout last year that earnings estimates were too low and that earnings would continue to surprise on the upside. So far so good, and these latest positive earnings surprises would certainly support that view. However, questions linger as to how sustainable these earnings results are.
I outlined last week why I think our major banks can maintain the pace – and, in fact, I think earnings will accelerate in that space. Broadening that outlook, things don’t appear to be as positive, especially in the industrials space.
Investors appear to hold little affection for industrials
Charts 1 and 2 suggest that investors aren’t optimistic on the industrials sector. Price action for industrials, shown in chart 1, has been sedate throughout this market rally, and the sector has been a key underperformer, having done little since 2009. You’d think that if investors held any optimism for the sector, price action would be a little more in line with the market.
That the sector hasn’t seen much affection means it looks cheap. The lack of bidders has seen industrials trade at an earnings multiple of 14 times, which is a decent discount to the market – around 12-14% – when they normally trade at a slight premium (3-4%). Moreover, they are trading cheap relative to their own history – that multiple of 14x is normally around 15x – and in a cyclical upswing it’s closer to 16x.
None of this is inconsistent with what many consider to be the broader macro picture though. The common perception is of an economy besieged by structural change, weak demand, and the unwinding of the mining boom. We are seeing evidence of this everywhere: massive jobs losses, corporate closures (Toyota, Ford, Holden), Alcoa’s decision to close its Port Henry smelter, and now Qantas needs government assistance. That industrial stocks are unloved and untouched would seem natural in that environment – it reflects economic reality. On that basis, earnings would certainly disappoint, and charts 1 and 2 simply show the market pricing in this publicly available information. Simple right?
Is the earnings outlook really that bad?
It sounds simple, and it certainly does all look consistent – except when you drill down further into the industrials sector. Sure, this week we found out that one of our largest industrial stocks, Toll, reported a 10% decline in net profit. Similarly, Asciano reported a 4% fall in half-year net profits. Transurban, too, reported lacklustre profit growth.
Yet, these uninspiring results mask, in some cases, quite strong revenue growth. That’s certainly the case for Asciano and Transurban, which reported revenue growth of 7% and 13% respectively. Seek too saw a very strong 38% rise in revenue, and a 29% spike in net profit – a record half-year. Brambles half-year revenues surged 7%, excluding gains from the Recall demerger transaction, with underlying profit 10% higher.
It’s clear to me then that there is no general malaise afflicting the industrial sector or the economy more broadly. It’s a simple story of winners and losers. There are stocks – Brambles Transurban, Seek etc – with the leadership team in place to take advantage of Australia’s great economic fundamentals. That other stocks can’t has less to do with a poor earnings environment, and more to do with a failure of leadership at a micro level – poor decision-making and an inability to compete effectively.
That the industrials sector is cheap as a whole actually hides an interesting fact. That it’s a highly polarised market. The fact is some industrial stocks have done very well over the last year or two. In that space I would put Brambles, Aurizon, Transurban, Sydney Airport and Asciano – which together make up just over 50% of the industrial market. The index itself (S&P/ASX 200 Industrials – XNJ), is largely comprised of 11 stocks, which make up 76% of the index (transport stocks – AZJ, TCL, SYD, AIO, TOL and QAN – too represent a huge chunk of the index, nearly half).
The top five (Brambles, Aurizon, Transurban and Sydney Airport) already have higher earnings multiples than what the index alone would suggest – considerable in the case of Transurban and Sydney Airport. They are market darlings in a sector that looks unloved – and not without good reason.
- Brambles has seen consistently robust revenue growth and has benefited from the turnaround in US and domestic activity.
- Transurban offers yield and growth – tied both to the domestic economic rebound and traffic growth.
- Sydney Airport will see rising passenger traffic associated with improved and accelerating economic activity here and abroad – it’s that simple. The stock offers a decent yield as well.
- Aurizon has the benefit of rising haulage from the production phase of the mining boom. This stock is a volume story. Growth in our major trading partners, especially China, remains strong. Prospects are very favourable here. Moreover, revenues have been on a consistent upward trajectory – the company advised only this week of an 18% lift in underlying net profit.
That these stocks trade on premium relative to the market and their own sector shows that investors aren’t actually as bearish on industrial earnings as a casual glance at the ASX 200 industrials index would suggest. Investors are just picky – there are winners in there, but there is also a high proportion of problem stocks. The key point though is that these stocks are underperforming not because the economy is languishing, but because they have had poor leadership and have made bad decisions.
Otherwise, I’ve outlined why I’m bullish Australia elsewhere, and recent partial indicators give me greater confidence in that view. We know the checklist – global growth is accelerating, property prices are surging, credit growth is rising and building approvals are strong.
Retail, too, has seen a sharp uplift and the broad spread of confidence indicators have picked up (see Brendon Lau’s article, Retailers delivering the goods). This is great news for the earnings outlook – it makes sense right? If economic activity picks up, and it looks to be – so does transport activity: rail freight, warehousing, crates, pallets etc. Each and every business will benefit from the domestic upswing, the global upswing and, in many cases, the mining production boom.
It would actually be highly unusual to have the macro backdrop Australia does (to see our bank stocks surge, and some of our retailers), and not see a turn in sentiment for the industrials sector overall. Indeed, chart 3 below shows that’s exactly what we saw after the downturn in the early 2000s.
After an initial surge with financials, industrials lost favour, only to come back nearly two years later to outperform. I don’t think we’re too far from that outperformance this time around either. It makes sense when you think about it. Growth slows, the Reserve Bank cuts rates, banks do well in anticipation of a credit lift, the rest of economy follows. Overly simplistic I realise, but that’s the general gist.
By the way, don’t be scared off either by some of those industrial stocks that look expensive on a trailing basis.
Note the phenomenal earnings per share growth some of these stock are recording – see table 1. On a forward basis they don’t look anywhere near as rich and, in any case, most of them aren’t too far off their own historical norms (however short).
There is still a lot of value in there, and industrials have yet to truly take off. Certainly, the earnings environment is very supportive and the market has taken note, despite appearances. History suggests that a period of outperformance will ensue.
* This article is part of the 'It's Time' series in Eureka Report focussing on new opportunities for investors in 2014. Click here to see the entire series.