SMID Cap Capital Equipment – More Long Ideas Than in Large Cap

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

February 27th, 2017

SMID Cap Capital Equipment – More Long Ideas Than in Large Cap

  • Continuing our analysis of relevant possible fundamental factors for 2017 – we focus on the electrical and capital equipment/machinery sectors – sectors we think are unattractive in the large-cap arena
    • We also look more closely at some of the valuation controversies and taking all inputs into account we come up with the following stock preferences:
    • Positive: GNRC appears towards the top of many lists – it is a stock that we have a detailed valuation model for and it does not look particularly cheap, despite what Exhibit 2 suggests – otherwise we would look at TRN, TRS
    • Negative: We would stay away from Ag, despite the screens – AGCO in particular because of limited US exposure
  • This analysis covers a group of 50 companies, and we rank on the following metrics as we did for the Industrials & Materials SMID group as a whole and for Chemicals (click to jump to a particular list):
  1. US sales focus – potential benefits from America First stimulus
  2. High current effective tax rates – upside to lower corporate rates
  3. High sales/employees (relative to the group) – less impact from potential wage inflation – more operating leverage
  4. Offshore cash – favorable repatriation terms could result in large buyback/dividend programs
  5. Performance since Election Day – those that have been missed, are down on earnings, or have the most potential upside remaining
  6. Optimism – tendency of corporate optimism to manifest itself in poor capital allocation decisions and underperformance
  • Overall, we would have a preference for construction equipment over Ag equipment as we are not convinced that any of the Trump policies will help Ag
    • While highly unlikely, any move against reformulated fuel would be nothing short of a disaster for all the US Ag names – equipment and otherwise
    • Lighter machinery and Electrical Equipment look vulnerable to trade – but on the flip side could benefit if trade barriers are raised – especially those with high US exposure
  • Companies appearing in the top ten on three or more lists are summarized in Exhibit 1 – this is a simple screen and throws up a couple of Ag names, which we would avoid

Exhibit 1

Source: Capital IQ, Company Reports, and SSR Analysis

Overview

30 days in and it remains very unclear which if any of the possible Trump initiatives will see the light of day, in what order and in what form. Among the larger cap names we have seen strong rallies in capital goods in particular because of anticipation of a better demand and pricing environment, and we have written cautiously on this topic – concerned that any demand stimulus will likely not impact anyone before the end of this year and additionally concerned that in the meantime many face a raw material (commodity) headwind.

For the most part these are companies for which we do not have complex – historically anchored – valuation models and we use the analysis in Exhibit 2 as a simple valuation screen – on the basis that anything above the line is perhaps pricing in too much and anything below, too little – all else being equal.

We do have models on both GNRC and TRN and have written about both periodically. We believe that both have upside from any increased focus on US infrastructure spending, and given that both are very US centric, they do not suffer from much of a currency headwind and both would gain from a tax cut. TRN is probably more vulnerable to US metal price increases than GNRC, but GNRC might be hurt by a border tax as we are assuming that the company buys components from overseas.

Exhibit 2

Source: Capital IQ and SSR Analysis

As we have done with other SMID pieces, we sift through the screens, valuation and our own views of likely fundamental drivers and add a larger list of positives and negatives – Exhibit 3. Despite our broad concerns about the valuations in larger cap Capital Goods today, we find many more names that we like than dislike in this group. Well over half of the companies in the group derive more than 60% of their sales in the US which we see as a positive from a growth, currency and potential tax rate perspective. The flip side is that not many have much they can do in terms of cash repatriation.

Exhibit 3

US Sales Focus

Exhibit 4 lists the companies in order of US sales focus and includes a number of valuation and growth metrics.

Exhibit 4

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

 

Tax Rates

The assumption here is that Trump will try to cut US corporate taxes and that those with the highest effective rates – often those with the highest concentration of US sales – will see the greatest benefit.

Tax rate concessions as well as repatriation of offshore cash will likely come with strings attached in terms of the proportion of new free cash that companies have to reinvest, but as we have seen in past attempts to stimulate growth in this way, companies find ways to funnel the cash to buybacks, dividends and M&A, where the M&A generally results in fewer jobs and lower new investment than the opposite.

 

Exhibit 5

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

 

Sales/Employee

We are using this measure as a sign of leverage – Exhibit 6 – companies with high sales per employee often have the highest incremental operating leverage, benefitting the most from incremental sales. In addition, should Trump policies lead to inflation and wage rises, these companies are less exposed.

Exhibit 6

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

 

Offshore Cash

The potential repatriation of offshore cash holdings has received attention and there are a few companies here with significant cash in foreign jurisdictions. In Exhibit 7 we have expressed the amount of offshore cash as a percentage of the company’s current market cap – equivalent to a special dividend or the potential reduction in share count if the repatriated funds were used to buy back stock. We assume a 15% repatriation tax.

In this group there are a handful of companies that could make a meaningful dent in shares outstanding if they were able to repatriate cash. However, if this initiative coincided with some sort of border tax adjustment, some companies might be persuaded to invest in the US to replace purchases of either finished equipment or components from overseas.

Exhibit 7

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

Performance since Election Day

This is in part a momentum indicator, showing what stocks have run post-election in anticipation of gains derived from Trump policies – those are the companies at the bottom of the table. As habitual seekers of value we are more interested in those that have not run, hence the upside down table. It is important to note that there are likely no companies on any lists here likely to see direct earnings gains from anything the new Administration does before, at the very best, Q4 2017. Consequently, for the outperformers there is a risk that expectations get ahead of what is practical and we see some earnings misses before we see the gains.

This is a sector that has performed well since the election for the most part, with a few stragglers – some are lagging because they are already expensive, others because they are in the wrong business (not likely to be helped by Trump) and others may just be more interesting as a result – GNRC would be in this camp as would WTS and IEX. WAB is significantly lagging the rest of its direct peer group.

Exhibit 8

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

Optimism

We often reference our work on corporate optimism as a complement in our process of identifying investment opportunities – simply put, those companies that habitually guide to realistic earnings expectations and subsequently over deliver not only predictably outperform, but have been shown to exhibit expanding returns on capital relative to their more overly-optimistic peers – they make better capital allocation decisions. In Exhibit 9 we show the most conservative companies in the group – those that have consistently over-delivered and the measure is by how much annual earnings have beaten expectations.

The measure is called “Optimism” but we are actually looking for the least optimistic companies and the indicator can be confusing in its labeling if you have not followed our work here – in Exhibit 9, TRN and GNRC has most consistently over-delivered and by the most significant level.

Exhibit 9

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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