Third-Quarter Earnings Report: Industrial Worries by Tom West, Columbia Threadneedle Investments
- Lower energy prices are not a noticeable tailwind for industrial companies close to contraction in the North American energy sector.
- It is hard to picture enough good news this quarter to cause a significant change in sentiment for stocks in the industrial sector.
- The rest of this year may be tough in industrials, and 2016 may not be that great either, but I think we can avoid more dire scenarios.
Corporate reporting season started in earnest this week, and with it all the analysis of results, parsing of management commentary, and triangulation across industries in order to refine our expectations for future results of companies and industries. Some of the most acute questions are in the industrial sector: Are we having a recession within industrials, or is the downturn in energy just casting a longer and darker shadow than we first thought?
This is not to say there is nothing going on in the other sectors. Many tech companies need to show progress in growth initiatives, migrating their products to “the cloud” and other key milestones. But that is more normal course for reporting season. The biotech indices sold off 20% in the last couple months, but that’s more about reimbursement jitters than quarterly results or even hitting milestones. Market volatility in August and September combined with expected credit losses in energy provided a minor stress test for the financial sector, but early reports aren’t showing too much damage concentrated in any one firm. Also, keep in mind that many are interested in getting more color from global consumer companies on sales in China and other EM regions. And of course, the energy sector is still working through its woes, but that has been and will remain an ongoing story.
So industrials are by no means the only interesting sector. But a recent comment by the CEO of Fastenal, an industrial distributor, certainly gets one’s attention: “The industrial environment is in a recession. I don’t care what anybody says because nobody knows that market better than we do… [since] we touch 250,000 active customers a month… Right now, in the third quarter, 44 of our top 100 customers are down.” -Dan Florness, CEO of Fastenal (Fastenal Investor Conference Call, October 13, 2015)
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The three putative causes for this weakness are the decline in the energy and commodity sectors, a strengthening dollar and economic deceleration in China. Basic materials excluding energy encompass a broad variety of things from copper to corn, each with their own cycles and fundamentals. Broadly speaking though, basic materials started showing weakness in 2011. Orders for mining equipment followed soon after. But the energy decline is more recent, starting with the steep drop in prices last November, which was followed directly by decreases in spending by companies in that sector.
Source: U.S. Bureau of Economic Analysis
Many U.S.-domiciled industrial companies produce and sell all over the world, but a strong dollar does tend to hurt competitive position. China is a manufacturing powerhouse, but still imports various machinery and equipment. Also, many U.S. companies have joint ventures there that produce for domestic and other markets. So deceleration in China is transmitted readily to the results of many industrial companies. But none of these issues are new or new this quarter, so why the attention and worry? It’s a variety of things, but energy is probably foremost.
The shale oil boom drove spending and activity well beyond the confines of the energy sector. Industrial distributors saw increased sale of general tools and supplies, and pump and valve makers saw a rising tide, just to give a couple examples. Any time a major sector like energy (or housing) experiences a pronounced contraction, there is collateral damage in related sectors and even the broader economy. Unfortunately, that process may not be over in terms of the spillover effects of lower energy prices and the ensuing cuts to production. And while lower energy prices are a positive for businesses and consumers, that benefit is muted, diverse and not a noticeable tailwind for those industrial companies so close to contraction in the North American energy sector.
With business conditions tough in major swaths of the industrial sector, does that mean 2014 was a peak for industrials? 2014 certainly didn’t feel that frothy. Perhaps a de-leveraging economic recovery is bound to yield “don’t-blink-you’ll-miss-it” peaks. Despite references to “the” cycle, industrials run on a variety of cycles that are inherently different, even if they do exhibit some degree of correlation. Energy and other commodity industries, aerospace and consumer-driven industries like autos rarely move in lock-step. The good news is that the recession-like feel in industrials is probably the result of a few significant negatives- energy, China slowing, and a strong dollar- all lining up at once, but with a relative scarcity of really strong positives.
So what are analysts and investors watching for this reporting period? Management teams will tell us how sales and orders trended through the quarter. Also, some companies are on a September fiscal year end so they will give guidance for the year to come. While there may be some bright spots, it is hard to picture enough good news to cause a significant change in sentiment for the stocks in the industrial sector. It will also be interesting to see how stocks react to bad news. The stock market is, after all, a forward-looking mechanism so the stocks should bottom before the results do. But to feel good about investing before the results reach a bottom, I think one of two things needs to happen. Either you need to have some sense that the bottom isn’t too far away or you need enough confidence in “normal” results that you don’t really care about the path to get there.
A silver lining to the tepid recovery following the great recession was that the slow pace of growth and cautious investment in people, machines and structures seemed to leave the economy free of any excesses. When economic jitters would creep in, it was hard to find any “overhang.” And while the pace and extent of investment in the NA energy sector leading up to 2014 looks more like overhang in today’s environment, it is harder to say there has been general over-investment in capital goods. So the rest of this year may be tough in industrials, and 2016 may not be that great either. But I think we can avoid more dire scenarios.