For U.S. industrial companies, this quarter's earnings season could bring the first concrete evidence an awaited economic recovery has arrived.
Industrial stocks have outperformed the broader market heading into the earnings season amid expectations many will beat Wall Street forecasts and tell investors to expect better times ahead.
Such companies face a number of positive factors this quarter. Deep cost cuts during the downturn mean better margins will exaggerate earnings growth with even modest increases in revenue. Export markets like China and Brazil are booming. And early-cycle markets in the United States, including those tied to the consumer, appear to be staging a comeback.
Jim Owens, boss of heavy equipment maker Caterpillar Inc., is sounding more optimistic about the world economy than he has in years.
"We're seeing a pretty sharp V in demand for a lot of our products," Owens told President Barack Obama's Economic Recovery Advisory Board in Washington.
Owens is hardly alone. That upbeat mood has carried over into the stock performance of cyclical manufacturing companies, whose shares typically move up and down with the economy.
A chart of industrial stocks resembles a V: An S&P cap goods index has more than doubled from March 2009 lows, beating the broader S&P 500. Industrials have also outperformed since the last earnings season, leading some investors to question whether valuations are overly bullish.
Most industrial companies will meet or beat expectations, predicts David Weaver, president of investment company Adams Express Co., which is overweight in industrials like GE, Emerson, United Technologies, and Illinois Tool Works.
"I'll be watching, will they show enough confidence to raise the full year, or do they even start talking about dividend increases," Weaver said.
Jensen Investment Management has added to its industrial holdings companies United Tech, Emerson and 3M.
"Industrial names have looked more attractive," said Jensen Principal Eric Schoenstein. "For the time being, everything is in pretty good shape."
While year-over-year improvements will likely be strong, more telling will be sequential earnings growth, he said. Rather than looking for higher profit guidance, Schoenstein hopes for signs companies are putting cash to work, for example by increasing merger and acquisition activity. That would signal management's confidence in the recovery.
Even if the season brings good results, stumbling blocks await. Inflation could become a threat, interest rates have nowhere to go but up, and worries persist over U.S. commercial real estate, a key market for many manufacturers. Then there is the prospect that China will overheat; its economy is growing at an annual rate of nearly 12 percent.
Another earnings uncertainty lingers: whether companies can charge higher prices to offset costs. So far, signs are that they can, said analyst Holden Lewis of BB&T Capital markets. Regal-Beloit Corp., Fastenal Co., and Baldor Electric Co. have cited pricing power.
"Come second half, raw materials will present a problem if you can't move pricing through," Lewis said.
Commodity inflation can trip up manufacturers that use raw materials to produce and ship their goods. Copper has doubled from a year ago; oil has stayed above $80 a barrel throughout April. Steel prices are lower than before the recession amid reduced auto demand, but they, too, have rebounded.
"Bigger than anything else is what happens to oil, as consumption resumes," said Tom Villalta of Jones Villalta Funds, who also sees a potential obstacle from the rise of the U.S. dollar, especially against the euro. The dollar's strength could become "a headwind" for U.S. exporters if debt problems spread from Greece to other European economies.
Profit expectations have risen, making shares more expensive, since Honeywell and Danaher raised first-quarter estimates in late March. Danaher, GE and Eaton sell for about 19 times expected earnings, well ahead of the S&P 500's price-earnings ratio of about 14, according to Reuters data. Industrial stocks have more than doubled from the bottom, even as long-term 2011 earnings estimates have only nudged up by 15 percent, note analysts at FBR Capital Markets.
During the downturn, companies like SPX, Cooper, Crane and ITW cut workforces by 15 percent or more. That will now drive margins. For SPX and Tyco, earnings per share will likely go up more than 3 percent for every 1 percentage point increase in sales, according to FBR.
Such optimism is increasingly widespread. A quarterly business outlook survey by the Manufacturers Alliance/MAPI, an industrial leading indicator, is at its highest level since June 2004; its profit margin index doubled from December. A Conference Board gauge of the economy's prospects rose for the 12th straight month in March to a record.
One sign of the recovery is that some early-cycle companies — such as Grainger, MSC Industrial and Lincoln Electric — are already seeing higher costs, such as reinstating 401(k) matches or bonuses, BB&T's Lewis said.
Evidence of recovery is not limited to industrials, said Peter Zuger of Lee Munder Capital, manager of the Touchstone Mid Cap Value Fund. Retail same-store sales are up, railroads like CSX are shipping more goods, and demand for trucks is returning. All point to a "decent recovery," he said.
Still, expectations may be getting ahead of themselves. Zuger cited shares of iron ore company Cliffs Natural Resources, a stock that more than tripled between its low a year ago and its 52-week high this month.
"At some point, I worry it may be hard for even a good recovery to deliver," Zuger said. "It may be the early stages of some irrational exuberance."
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