Industrial Sector Primer 2016

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Industrials Introduction– Industrials Sector is a diverse sector including the stocks related to produce, distribute goods in construction, manufacture and transportation industries as well as to provide wide range of business services such as commercial printing, office supplies and human resources services. The sector is highly affected by the health of economies and highly correlated to business cycles.

Composition – Industrial sector can be broken down into 3 subsectors by GICS. They are Capital Goods, Commercial & Professional Services, and Transportation. It is heavily weighted by capital goods, which accounts for 67.1% of the total market capitalization of $3.39 Trillion. Transportation is weighted at 23.14% and Commercial & Professional Services is weighted at 9.75%.

Correlation with Business Cycle – The fluctuation of the economy has impact on the performance of the industry sectors, therefore it is critical to determine the relationship between sector and the business cycle. Industrials sector tend to outperform during the early recovery stage in recovery and underperform during recession stage.

[Source: https://eresearch.fidelity.com]

Macro Analysis

The U.S. economy appears to be the best positioned from a global standpoint, and companies with exposure to the U.S. market may benefit from stronger U.S. growth. Elsewhere in the world, confidence in various markets is mixed, with China in question, Brazil under pressure, and India strengthening. China economy continues to slow down, causing a decrease in demand of industrials goods from around the world, including Canada. Decreasing potential export to China, however, is partially offset by the continuing recovery of the US economy. It is obvious that China’s economic development and the ability

67.11%9.75%

23.14%

Industrials Market Capitalization Weightage

Capital Goods

Commercial and Professional Services

Transportation

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for the Central Bank of China to stabilize their own economy outweigh the gradual economic recovery in the US.

While lower fuel prices benefit certain industries in the sector, such as airlines, they are less positive for others, such as industries that make machinery and equipment for oil companies, or railroad companies that transport oil from shale production areas. If lower prices result in curtailed production, it could have a negative impact on those industries. Oil price plays a major factor to the outlook of the entire sector. In the short to medium term coming ahead, the price of crude oil most likely will not recover to the previous high because of the discontinuing role of the swing producing states to maintain the equilibrium price of crude oil. Canada, a country that heavily relies on crude oil export, suffers greatly. In particular, their currency devalued approximately 20% from the intermediate high since the middle of 2014. If the crude oil price recovers in the short to medium term, companies in the industrials sector will benefit greatly by this impact. In particular, companies that have production cost based in Canadian Dollars and generate revenue from the US will be the ones with higher probability to outperform their peers.

The Conference Board’s Business Cycle Indicators (BCI)

Given that the Industrials Sector is correlated with the business cycle and the overall health of the economy, the Conference Board’s Business Cycle Indicators efficiently summarizes various growth metrics, including average weekly hours, manufacturer’s new orders, building permits, stock prices, interest rate spread, and consumer expectations. The BCI release for August 20, 2015 in the two largest markets is as follows:

United States

- The Conference Board Leading Economic Index: “(LEI) for the U.S. declined 0.2 percent in July to 123.3 (2010 = 100), following a 0.6 percent increase in June, and a 0.6 percent increase in May.”

- The Conference Board Coincident Economic Index: “(CEI) for the U.S. increased 0.2 percent in July to 112.5 (2010 = 100), following a 0.2 percent increase in June, and a 0.1 percent increase in May.”

- The Conference Board Lagging Economic Index: “(LAG) for the U.S. increased 0.3 percent in July to 118.1 (2010 = 100), following a 0.7 percent increase in June, and a 0.3 percent increase in May.”

China

- The Conference Board Leading Economic Index: “(LEI) for China increased 0.9 percent in July to 331.2 (2004 = 100), following a 0.6 percent increase in June and a 1.1 percent increase in May. Total loans issued by financial institutions made the largest positive contribution to the index, followed by the 5000 industry enterprises diffusion index: raw materials supply index, and total floor space started. The consumer expectations index, the PMI new export orders index, and the (inverted) PMI supplier delivery index declined in July.”

- The Conference Board Coincident Economic Index: “(CEI) for China, which measures current economic activity, increased 1.1 percent in July to 278.4 (2004 = 100), following a 0.2 percent

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increase in June and a 0.6 percent increase in May. Four of the five components contributed positively to the index in July.”

[Copied Verbatim from conference-board.org]

The U.S. Leading Economic Indicators are currently trending to moderate economic growth owing to rising employment levels and improved industrial production. China’s economic index rose slightly in July, but this was mainly driven by bank loans, as the consumer sentiment, manufacturing, and export elements of the index all fell. The recent economic turmoil in China suggests that this downward trend in manufacturing and exports is expected to continue.

Valuation

Industrial vs. S&P 500 – P/E Ratio

Industrials P/E ratio was at parity with S&P 500 and now the ratio is below S&P 500, which indicates the sector is undervalued.

Industrial vs. S&P 500 – DIV. yield

Industrials dividend yield spread with S&P 500 index is widening since 2013. It indicates the sector is becoming more valuable for investors.

Industrial vs. S&P 500 – EV/Sales

EV/Sales ratio is below S&P 500 and the spread is widening making the sector undervalued.

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Industrial vs. S&P 500 – EV/EBITDA

EV/EBITDA is ratio is below S&P 500 making it undervalued.

Industrial vs. S&P 500 – Price/CF

Price to cash flow ratio was higher than S&P 500 before 2015 and now it’s traded below S&P 500, making it more valuable

Industrial vs. S&P 500 – Price/BV

Price to book value ratio was historically higher than S&P 500, which indicates the sector is overvalued.

Sector Outlook - Industrials look slightly under valued versus other market sectors based on the valuation metrics. Considering, our macro analysis and global cues from different markets except U.S., we hold neutral views for the Industrials sector as a whole.

Capital Goods: Introduction - Capital goods consists of category of stocks related to the manufacture or distribution of goods. The sector is diverse, containing companies that manufacture machinery used to create capital goods, electrical equipment, aerospace and defense, engineering and construction projects. It accounts for 11.63% of the total market capitalization with $2.25 Trillion market capitalization.

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Composition - Capital goods industry is heavily dominated by three industries; Aerospace & Defense, Industrial Conglomerates and Machinery in aggregate accounts for 77.3% of the Industry group with 27.5%, 26.8% and 23.1% of total capital goods market capitalization respectively.

Aerospace & Defense - The Aerospace and Defense Industry in the Industrials Sector includes manufacturers of civil or military aerospace and defense equipment, parts, or products (including defense electronics and space equipment)

Machinery - The Machinery Industry in the Industrials Sector includes manufacturers of Construction, Farm and Industrial Machinery, and Heavy Trucks

Industrial conglomerates - The Industrial Conglomerates Industry in the Industrials Sector includes diversified industrial companies with business activities in three or more sectors, none of which contributes a majority of revenues. Stakes held are predominantly of a controlling nature and stake holders maintain an operational interest in the running of the subsidiaries.

Sub Industry Fundamentals Aero & Def. Machinery Ind Conglo.

P/E (Last Year GAAP Actual) 18.8 17.0 28.5 P/E (This Year's Estimate) 18.7 15.4 19.6 EPS Growth (TTM vs. Prior TTM) 8.8% 8.0% -35.0% Revenue Growth (TTM vs. Prior TTM) 2.5% -1.4% -1.3% Return on Equity (TTM) 32.9% 18.3% 11.7% Return on Investment (TTM) 16.0% 9.4% 7.1% Total Debt/Equity (TTM) 74.1 122.6 163.8 Dividend Yield 2.2% 2.1% 2.9%

Correlation with Business Cycle - The business cycle, which reflects the fluctuations of activity in an economy, can be a critical determinant of equity sector performance over the intermediate term. Performance in the capital goods sector is sensitive to fluctuations in the business cycle. Because it relies heavily on manufacturing, the sector does well when the economy is booming or expanding. As economic conditions worsen, the demand for capital goods drops off, usually lowering the prices of stocks in the sector. The early-cycle phase typically is characterized by lower interest rates and a sharp economic recovery, which tends to lead to outperformance by the capital goods industries. So it is imperative to do a business cycle analysis to predict the performance of capital goods industry.

Macroeconomic Indicators Analysis

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Leading Economic Indicators - The Conference Board Leading Economic Index ® (LEI) for the U.S. declined 0.2 percent in July to 123.3 (2010 = 100), following a 0.6 percent increase in June, and a 0.6 percent increase in May. “The U.S. LEI fell slightly in July, after four months of strong gains. Despite a sharp drop in housing permits, the U.S. LEI is still pointing to moderate economic growth through the remainder of the year,” said Ataman Ozyildirim, Director of Business Cycles and Growth Research at The Conference Board. “Current conditions, measured by the coincident economic index, have been rising moderately but steadily, driven by rising employment and income, and even industrial production has improved in recent months.”

Order Data - Nondefense new orders for capital goods in June increased $6.9 billion or 9.4 percent to $80.8 billion. Shipments decreased $0.1 billion or 0.2 percent to $ 78.6 billion. Unfilled orders increased $ 2.2 billion or 0.3 percent to $ 759.2 billion. Inventories increased $1.0 billion or 0.6 percent to $ 177.5 billion.

Defense new orders for capital goods in June decreased $ 0.2 billion or 2.5 percent to $8.8 billion. Shipments increased $0.4 billion or 3.8 percent to $9.9 billion. Unfilled orders decreased $1.1 billion or 0.7 percent to $149.6 billion. Inventories increased $0.1 billion or 0.3 percent to $21.9 billion.

Sector drivers

CAPEX cycle Capital goods companies’ earnings are directly related to their end customers’ capital expenditure activities, in both the private and public sector (the latter currently exposed to austerity budgets). Customer activity, in turn, is linked to the broader economic cycle, and the likelihood that these CAPEX investments will generate positive-NPV projects.

New equipment versus aftermarket

In addition, many capital goods companies make substantial profits on the aftermarket component: commercial truck makers provide vehicle servicing, while elevator companies maintain the lifts after they come off warranty. In such circumstances, the continued development of the installed service base (and competition in the third-party aftermarket sector) is key to maintaining these defensive revenue characteristics. In some circumstances, the sale of the new equipment is done at paper-thin margins (or even as a loss-leader), the primary target being the fatter service margins.

Input costs

Capital goods companies are big buyers of raw materials, including (but not limited to) industrial metals such as iron, steel, nickel and copper, plus plastics and other miscellaneous items. Policies vary, but as a general rule, the sector does not engage in overly long-term hedging, and is therefore exposed to rising input costs. That said, rising raw material prices usually correlate with rising end-user demand, especially in EM. In addition, the leading companies enjoy strong pricing power, and can often pass on price increases to end-customers.

Leading indicators

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The activities of capital goods companies are summarized at the macro level by the measurement of gross fixed capital formation, i.e., the value quantity of the fixed assets ordered and then manufactured.

Considering leading economic indicators as well as order data that are industry drivers, industry outlook looks moderate.

Valuation

Capital goods companies trade on traditional metrics, namely forward-looking PE ratios, EV/EBITDA, EV/EBIT and, to a lesser extent, P/BV or EV/IC. At the peak of the cycle in 2013, the PE reached 17.75x, from 9.10x immediately after the Lehman collapse. A normalized range for the sector is around 15.75x. Companies can also be valued using traditional discounted cash flow analysis, applying a weighted average cost of capital (WACC) to forecasts in order to arrive at a theoretical fair value.

CAP GOODS VS S&P 500 – P/E RATIO

Capital goods P/E ratio which was at parity in past with S&P 500 Index is currently trading lower making it undervalued against other sectors.

CAP GOODS VS S&P 500 – DIV. YIELD

Capital goods dividend yield spread with S&P 500 Index is increasing making it more valuable.

CAP GOODS VS S&P 500 – PRICE/ BV

Price/ BV ratio is widening between capital goods and S&P 500 Index making it overvalued against other sectors.

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CAP GOODS VS S&P 500 – EV/ SALES

EV/Sales ratio is widening between S&P 500 Index and capital goods making it undervalued against other sectors.

CAP GOODS VS S&P 500 – EV/ EBITDA

Capital goods EV/EBITDA ratio which was at parity in past with S&P 500 Index is currently trading lower making it undervalued against other sectors.

Industry Outlook - Capital goods look slightly under valued versus other market sectors based on the valuation metrics. Considering, our macro analysis and global cues from different markets except U.S., we hold neutral views for the capital goods industry as a whole. Commercial and Professional Services

Introduction – Commercial and Professional Services sector composed by two subsectors, Commercial Services Supplies and Professional Services. The industry provides wide range of services from commercial printing, environmental services to human resources services to business end-users

Composition - Commercial and Professional Services is a very diversified while highly fragmented sector. The total revenue generated is average contributed among every industry. However there are dominant player within each industry. For example, Waste Management has market capitalization of $23.9 Billion, accounted for 30% of environment services industry. Since the entry to industries is comparably easy because of the low cost and less differentiated services, small-scale players are widely running at local level.

Sub-industries

Commercial Services and Supplies: the industry includes stocks in commercial printing, diversified support services, environment services, office services & supplies, and security services industries.

4% 13%

28%

7%8%

13%

27%

Comm & Prof Services -Market Weightage

Commercial Printing

Diversified SupportServices

Environmental &Facilities Services

Office Services andSupplies

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Professional Services: the industry includes stock in human resources services and consulting services industries.

Macroeconomic Indicators

Commercial and Professional Services industry is highly correlated with the business cycle. When the economy is in expanding stage the industry is doing well; while when the economy is recession stage, businesses tend to cut their expenses in services sector and the stocks in the industries usually drops.

Sector Driver

Job Market - The Conference Board Employment Trends Index™ (ETI) increased in July for a second consecutive month. The index increases from 127.57 in June to now, 127.89. “The growth in the Employment Trends Index slowed down in the past 3-6 months, suggesting that we may see somewhat slower job growth in the months ahead,”

Source: https://www.conference-board.org/data/eti.cfm

Valuation

Commercial & Professional Services vs. S&P 500 - P/E

Source: Bloomberg

Comments: Between 2011 to 2015, P/E ratio for commercial and professional services stocks was constantly higher than the market (compare to S&P 500) with widest difference in 2013 at 24.4x comparing S&P 500 at 17.48x. The gap is narrowing down since 2013, but still it is higher than S&P 500 making it overvalued as against other sectors.

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Commercial & Professional Services vs. S&P 500 - EV/Sales

Source: Bloomberg

Comments: EV/Sales ratio is widening from 2011 to 2015. The commercial and professional services index is much higher than S&P 500. Again, it indicates the sector is not attractive but overvalued.

Commercial & Professional Services vs. S&P 500 - EV/EBITDA

Source: Bloomberg

Comments: Commercial and professional services EV/EBITDA ratio was below S&P 500 before 2012. It is in parity with S&P 500 index currently. It again indicates that the sector might be overvalued.

Outlook – By looking at the traditional valuation metrics, the industry appears to be overvalued and we recommend underweight rating for the industry.

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Transportation

Industry Overview

The Transportation Industry includes companies involved in air, rail, truck, and waterborne transportation of supplies, products, and people. It can be segregated into 4 sub-industries: Air Freight and Logistics, Airlines, Marine, Road and Rail, and Transportation Infrastructure. Performance of these companies is highly integrated with the health of the overall economy and international trade.

Sub-Industries

Air Freight and Logistics: The Air Freight and Logistics Industry in the Industrials Sector includes companies providing air freight transportation, courier, and logistics services (including package and mail delivery and customs agents). It does not include companies classified in the Airlines, Marine, or Trucking industries.1

Airlines: The Airlines Industry in the Industrials Sector includes companies providing primarily passenger air transportation.1

Marine: The Marine Industry in the Industrials Sector includes companies providing goods or passenger maritime transportation. It does not include cruise ships classified in the Hotels, Resorts & Cruise Lines. 1

Road and Rail: The Road and Rail Industry in the Industrials Sector includes companies primarily providing goods and passenger railroads and trucking transportation (including vehicle rental and taxi companies). 1

Transportation Infrastructure: The Transportation Infrastructure Industry in the Industrials Sector includes operators of airports and companies

providing related services, owners and operators of roads, tunnels, and rail tracks, and marine ports owners and operators.1

Valuation Metric Air Freight and Logistics Airlines Marine Road

and Rail

Transportation Infrastructure

P/E (Last Year GAAP Actual) 28.63 12.45 0 16.45 13.76 P/E (This Year's Estimate) 64.01 7.62 0 16.24 49.34 EPS Growth (TTM vs. Prior TTM) -6.24% 48.21% -13.44% 22.33% 3.2655 Revenue Growth (TTM vs. Prior TTM) 7.71% 1.27% 21.08% 3.09% 19.56% Return on Equity (TTM) 70.43% 43.21% 5.57% 22.66% 18.98% Return on Investment (TTM) 8.86% 13.70% 2.43% 9.70% 12.52% Total Debt/Equity (TTM) 42.38 174.95 101.06 84.49 55.08 Dividend Yield 1.93% 1.08% 6.54% 1.86% 3.83%

24%

28%

2%

43%

3% Air Freight andLogisticsAirlines

Marine

Road and Rail

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* As of 8/6/2015 1[Source:https://eresearch.fidelity.com]

P/E: Dow Jones Transportation Average vs. S&P 500

Comments: From 2011 to the first half of 2014, transportation equities traded at P/E multiples above the general market (as measured by the S&P 500). Transportation stocks are now trading at P/E’s below the S&P 500, which could indicate that the industry is undervalued.

P/B: Dow Jones Transportation Average vs. S&P 500

EV/Sales: Dow Jones Transportation Average vs. S&P 500

Comments: EV/Sales multiples for the S&P 500 and the Dow Jones Transportation Average have been diverging since 2011, with the market sales appearing more expensive, relative to Transportation equities, then they’ve been in the last 4 years. Again, this could indicate that Transportation equities are undervalued relative to the rest of the market.

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EV/EBITDA: Dow Jones Transportation Average vs. S&P 500

Comments: EV/EBITDA multiples for the S&P 500 have been trending upwards for the past 4 years, while the enterprise multiple for the Dow Jones Transportation Average has been relatively flat, with the gap between the multiples widening. This supports trends seen in the P/E and EV/EBITDA multiples where Transportation stocks appear undervalued relative to the overall market.

Dividend Yield: Dow Jones Transportation Average vs. S&P 500

Macroeconomic Indicators Analysis

Oil Prices

The World Bank forecast for oil prices shows a steady increase from a low in 2015, but these projected prices remain below $70/bbl through to 2019. The increased energy output in North America and the Middle East is complimented by reduced demand for crude oil in Asia, largely as a result of a slowdown in Chinese economic growth. The deal brokered with Iran could also bring their oil reserves into play, further increasing supply and contributing to the downward pricing pressure.

Oil prices represent a large cost of production for businesses within the Transportation industry, whose cost structure is primarily fixed, so these lower fuel prices have a direct impact on the industry’s margins. The Airline sub-industry will likely see the greatest benefit from lower oil prices, as fuel can represent as much as 30% of their costs. Additionally, airline carriers aren’t under any pressure to pass these savings on to the consumer, as airline ticket prices are largely subject to consumer demand. Mitigating these returns are any long-term hedging contracts that carriers initiated to protect

themselves from oil price volatility.

The Rail sub-industry stands to gain from reduced oil prices as well, but the effect is muted by the fact that market participants tend to share the cost of oil with their clients in the form of oil price surcharges. Therefore, they are more likely to share the savings with their clientele.

[Source: World Bank via Knoema.com]

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Looking Forward

Outside of oil price volatility and the overall health of the economy, a significant trend affecting Transportation businesses is the slow, but steady, transition away from petroleum towards biofuels and natural gas. Close attention must be paid to changing regulations as governments look to limit greenhouse emissions. New standards could increase costs for the Transportation industry as businesses may be forced to adopt more strict emissions standards.

Outlook

Although valuation multiples, such as P/E, EV/EBITDA, and EV/Sales suggest that Transportation equities, as measured by the Dow Jones Transportation Average, are undervalued relative to the overall market, the global economic uncertainty owing to China’s slumping economy tempers any prospects of industry growth. The recommendation is to invest sparingly in the Transportation industry, limited to individual stocks deeming to be undervalued and standing to benefit most from lower energy costs (those that have not hedged against oil price volatility).

[Source: http://time.com]