This Industry Is Poised to Surge Amid Depressed Expectations

Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Machinery companies have been pushed to the side in the last twelve months following a legendary boom/bust/boom during the 2006-2010 timeframe.  Global growth has been weak of late and the impact has been felt on related equities.  The S&P 500 Machinery Index has lagged the broader S&P 500 by more than 11% during the past year.  Recent quarterly results were generally bad and forward guidance offered nothing to get excited about.  But with global growth poised to improve in 2013 and massive reflationary efforts still underway by central banks across the globe, these pessimistic views may prove to be just that.  The combination of higher earnings expectations, multiple expansions, and a bullish equity backdrop could see several stocks in this industry surge to new all-time highs. 

The Smoking Gun?

The just released Durable Goods order for January was exceptional, especially for the machinery industry.  January new orders for the machinery industry exploded 13.5% in the month on a seasonally adjusted basis!  Below is a graphical depiction of the absolute value of new orders.  Too much emphasis should never be put on one data point, but this at least has to be viewed in a positive lens.

 

Earnings Reset

Caterpillar (NYSE: CAT) finished off 2012 with EPS of $8.48, a gain of 15%.  But markets are forward looking and consensus analyst expectations for 2013 sit right in the middle of management’s guidance range of $7.00-$9.00.  A year ago, analysts were looking for EPS of $11.33 for 2013 and have since chopped more than 25% off that initial estimate.  This is a big reset and it is clearly reflected in the stock’s valuation.

Prior to the financial crisis, Caterpillar EPS topped out at $5.66 and the stock at $86.  Now earnings-per-share is north of $8.00 and the stock hovers around $91.  This equates to a massive drop in the P/E ratio to roughly 11x.  This ratio now sits at a 28% discount to the S&P 500 versus a normal 5-10% discount.  The graph below shows the relative P/E ratio of CAT versus the S&P 500.  Just getting back to a 10% discount would equate to a stock price of $113- or a 22% advance from current quotations.

 

An almost identical situation has unfolded for Cummins (NYSE: CMI) which is a leading manufacturer of engines, turbo chargers, and power generation products.  The company has seen its 2013 estimated earnings-per-share drop 24%.  The company saw its earnings-per-share decline in 2012 amid weakness in all global regions.  Management extrapolated this with 2013 sales forecasted to decline modestly again.  The price/tangible book value is close to its lowest non-recessionary level in the last ten decades and reflects this pessimistic tone.  But with strong exposure to emerging markets along with secular trends favoring increasing fuel emission standards, now looks to be a favorable entry point.

CMI Price / Tangible Book Value data by YCharts

Agriculture Equities are Well Positioned

Deere & Company (NYSE: DE) dominates the North American farm equipment market.  The company generates roughly 75% of its $36 billion in sales from agriculture equipment.  While quarterly results are certainly difficult to forecast given volatility in grain prices and the lumpiness of sales, demand should be well supported in the medium term thanks to depressed stocks of global grain (below).  And demand continues to move higher via increasing wealth in emerging markets.

 

Combine a favorable demand backdrop against depressed valuation and you have a winning recipe.  The graph below shows the EV/EBITDA of Deere and it has historically been a good investment to buy the stock when this ratio dips below 10x.  During the last ten years this scenario persisted for 12-18 months before the stock embarked on a new bull run.  If history is a guide, we are in the late innings and a new bull run is plausible at any moment.

DE EV / EBITDA TTM data by YCharts

Foolish Bottom Line

Machinery companies have paused after surging during the initial post-recession recovery.  Global growth concerns have been embedded in expectations and valuations are cheap.  Now is the time to buy- when expectations are depressed.  Machinery stocks such as CAT, CMI, and DE offer strong secular earnings growth combined with multiple expansion opportunities.  This is a recipe that can lead to explosive stock price surges. 


market8 has no position in any stocks mentioned. The Motley Fool recommends Cummins. The Motley Fool owns shares of Cummins. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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