Industrial Cyclicals are Facing Headwinds
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The Industrial sector has been sold off aggressively in recent months as investors begin to price in a cyclical slowdown and Cummins Inc (NYSE: CMI) recent update is only likely to make sentiment even more negative. The truck engine and power generation company lowered its full year revenue guidance to flat from being up 10%. If that wasn’t bad enough, it also mentioned a softening in order trends in North America as well as the failure of the BRIC economies to rebound.
Continuation of a Trend
The BRIC news can hardly be unexpected. Growth forecasts have been reduced in Brazil, India and China and electricity consumption figures in China have seen a significant moderation. With regards to China, in the last quarter Cummins reduced its overall domestic revenue forecast to -5% from previously being flat. India was previously forecast to be up 7%. I think it’s safe to assume that both countries estimates will be lower now.
The Heavy Truck market started to turn down in November last year and as the housing market has weakened, so the demand for commodities has caused a slowdown in the transportation market. Running in parallel is the overall demand for power. Fixed asset investment makes up a huge portion of China’s GDP so any signs of a slowdown will leave the industrials like Cummins, Eaton Corp (NYSE: ETN) or Caterpillar (NYSE: CAT) heavily exposed. If you rely on China for your marginal growth then you have to be prepared for disappointment when it slows down.
The key point is that Cummins was previously expecting a rebound in the second half in China. When companies usually see customers inventories run down within a market place that was previously growing consistently, it is tempting to assume that future quarters will see a snap back in growth. Throw in the argument that China can always stimulate infrastructural spending by throwing its vast reserves towards it and you have a strong bullish case. It hasn't worked out like that.
It appears that China’s fixed asset investment slowdown is for real this time around and there are significant questions to be raised over the ability of the central Government in China to effectively stimulate the economy. The latter is discussed in more length in an article linked here so.
It's time to look at another bellwether.
What Say You Alcoa
Having confirmed a slowdown is in place and touched upon the reasons why, perhaps it is time to try and find a decent forward indicator?
I think that Alcoa (NYSE: AA) is very useful. I’ve broken down the series of outlooks that it gave by geography for the demand outlook for the Heavy Truck & Trailer segment.
Alcoa lowered its full year 2011 China outlook in Q3 of 2011 and since then the outlook for 2012 has been lowered in each quarter. The US outlook has undulated, but interestingly the European outlook is getting relatively stable. As for Alcoa there is a more detailed discussion in an article linked here.
Long Term Prospects?
The bullish investment thesis for Cummins and for that matter its chief rival Navistar (NYSE: NAV) is that a combination of tighter emissions standards, a historical aging US truck fleet, plus a long term bull market in commodities will drive end demand higher. It is a powerful case but both companies are going to have to deal with the uncertainties inherent in relying on communist countries ability to stimulate its economy. The resolution of this question is likely to dictate mid-term growth rates for Cummins.
In conclusion, I think investors can take two complementary approaches to the investment question. On the one hand, it makes sense to apply a significant margin of safety to Cummins’s valuation in terms of current metrics in order to try and factor the risk. On the other hand, monitoring forward indicators (for example as illustrated with Alcoa’s segmental outlook above) will give a good approximation of when things are going to start trending better.
A balanced approach will be to quantitatively reduce/increase your margin of safety factor by an ongoing assessment of a range of forward indicators are saying. Right now, there is a lot of uncertainty about China and I would urge some caution here. There is plenty of time to buy into the industrial cyclicals.
SaintGermain has no positions in the stocks mentioned above. The Motley Fool owns shares of Cummins. Motley Fool newsletter services recommend 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.If you have questions about this post or the Fool’s blog network, click here for information.