The Pick of the Engineering Sector?

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

The market has been in bullish mood recently, and much to the chagrin of those of us with a contrarian persuasion it’s becoming ever harder to find anything that doesn’t have optimism already priced in. With that said, there are always stocks with some evaluation upside, and I think Regal Beloit (NYSE: RBC) is worth a look. In summary it is a highly cash generative company with a history of accretive acquisitions operating in markets that are set to do well in 2013 provided the global economy holds up.

Introducing Regal Beloit

With further ado (it is not a well known company) RBC is a manufacturer of electrical and mechanical equipment with a heavy focus on Heating, Ventilation and Air Conditioning (HVAC) solutions. As such, it describes its end markets as being 39% residential, 34% industrial and 27% commercial with around 66% of sales occurring in the US in the last quarter.

I’m going to list a few key takeaways and markers to help understand the company better:

  • Free cash flow conversion for the full year 2012 was around 130% of net income. RBC has averaged nearly 140% in this metric since 2007.
  • Highly acquisitive and uses cash flow to grow via acquisition
  • Expanding production in China with two new factories
  • Creation of synergies via acquisitions such as consolidating North American warehousing
  • Increasing energy efficiency standards will raise demand for new HVAC products.

As ever, a lot of investor interest will focus on China, but the country still only represents around 8% of sales. I think RBC should be viewed as more of a US focused stock with exposure to construction markets in line with the percentages outlined above. The good news is that it looks like RBC is being primed for growth in 2013. I'll explain.

Setting up for a Good Year?

Across its geographies there is a good case for a some upside surprise with RBC in 2013. In the US it was doing well in 2012 until some weakness hit in the third quarter, which fed into the fourth, but there was some strengthening towards the end of the quarter. Even then it was a mixed story with residential, commercial HVAC, refrigeration and its food and beverage operations but weakness in industrial equipment and energy.

In my book this looks like the more cyclically based industries in the US reacted to fears over the fiscal cliff and the election (in line with what so many others have said) in the winter, but the underlying economy is still growing okay. If I’m right about this then there is upside as its US based customers should return to making orders this year. Companies can't stay 'worried' forever and do tend to get used to these things.

In addition, Europe (not a major market for RBC) was described as stabilizing and RBC outlined some signs of a return to growth in China. The latter would be welcome as it has experienced weaker conditions in China since the winter of 2011.

What the Industry Is Saying

RBC competes with some smaller divisions of some huge companies. Cummins (NYSE: CMI) has an electrical motors division and its commentary on oil and gas construction (a key vertical for RBC) was pretty much in line with what RBC said. It described construction activity as being ‘flat’ with little sign of a pick-up in North America. As for China, it was described as disappointing overall, and oil and gas was not spared.

Emerson Electric (NYSE: EMR) also gave results recently. The key comparator here is its climate technologies business. EMR had some positive things to say and cited strong growth in residential AC markets in China and more favorable conditions in the US residential.  It expects a continued recovery in residential end markets in Asia and China. Emerson also stated that its climate technology orders were ‘above the line’ in Q4, and January is expected to be the same. This bodes well for RBC.

Where Next for Regal Beloit?

Putting these things together builds as picture of a well run company that has some upside potential this year. My biggest concern would be with China, but it is not a major part of RBC’s sales. On the other hand the US makes up 2/3 of sales, and with an improving residential construction market I think RBC is set to outperform the wider engineering sector.

RBC tradeson a forward PE ratio of 15.3 and if you assume it will generate 140% of its net income ($5.18 of EPS) in free cash flow for 2013 you are looking at a stock set to produce 8% of its Enterprise Value in 2013 and with some possible upside. It's attractive.


SaintGermain has no position in any stocks mentioned. The Motley Fool recommends Cummins and Emerson Electric Co.. 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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