Industrials: Building on Strength. The earnings coming out of the S&P 500 Industrials sector during the current earnings season indicate that all’s well with the US and world economies despite the recent selloff in US stocks. During the year ahead, the sector should continue to enjoy solid global economic growth, in addition to the benefits of lower taxes and the repatriation of billions of dollars stashed overseas. The sector also stands to benefit if President Donald Trump can push through his proposal to spend $1.5 trillion on infrastructure and boost defense spending.
The sector’s Q4-2017 operating earnings is expected to rise 6.2% y/y, which is two percentage points higher than analysts expected at the start of the year. The results look even better—14.6%—when the losses from General Electric are taken out of the mix. The upbeat outlook continues for Industrials in both Q1 and the full year 2018. The sector is expected to grow operating earnings by 12.9% in Q1 and 15.9% in 2018, according to analysts polled by Thomson Reuters. When GE’s expected results are excluded from the estimates, the Industrials sector’s estimated earnings growth pops up to 17.1% in Q1 and 18.0% in 2018.
Here’s how Industrials’ 2018 earnings growth estimate compares to those of the 10 other sectors in the S&P 500: Energy (58.6%), Financials (28.1), Materials (20.7), S&P 500 (17.0–17.2 without GE), Industrials (15.9–18.0 without GE), Consumer Discretionary (15.3), Tech (14.0), Consumer Staples (10.7), Telecom (10.4), Health Care (10.1), Real Estate (6.1), and Utilities (4.8).
Roughly half of the companies in the S&P 500 Industrials sector have reported Q4 earnings. About 78% of those earnings results were above estimates, and only 17% were below. Here are Jackie’s highlights from the quarterly conference calls of Honeywell, Lockheed Martin, and Illinois Tool Works, which occurred over the past week.
Their CEOs had much to say about taxes and the business environment:
(1) Honeywell (HON). Executives spent much of the Q4 conference call discussing the implications of tax reform in 2018 and beyond. Some of the impacts are easily quantifiable: Honeywell’s effective tax rate of 25%-26% will fall to 22%-23%. As a result, the company boosted its 2018 earnings forecast by 20 cents to $7.75-$8.00 a share, which represents a 9%-13% y/y increase.
Honeywell also announced plans to repatriate within the next two years about $7 billion of the $10 billion it holds overseas. Investors should expect additional cash to be repatriated as it’s earned abroad.
CFO Thomas Szlosek explained what the repatriation will mean to Honeywell: “This new global mobility of our cash allows us to continue investing in our businesses in the US, to pay a competitive dividend, to more aggressively seek out M&A, particularly in the US, and to repurchase our own shares. Our preference is for attractive bolt-on acquisitions in our core markets. But to the extent M&A opportunities do not materialize, we will gradually accelerate share repurchases as we did in 2017.”
The company also announced plans to use its tax savings to increase its 401(k) employer match for its US employees. “This change represents a sustained long-term commitment to provide enhanced financial security in retirement, which we believe is extremely valuable and important to employees. Honeywell remains committed to being an employer of choice,” explained CEO Darius Adamczyk on the conference call. In Q4, the company also decided to increase its dividend by 12%, and it repurchased 10.3 million shares.
It’s notable that Honeywell does not plan to use the tax savings to increase capital spending. Capex has run north of $1.1 billion in 2014-2016. It will be down “in the $900 million range or less” this year, and it will continue to decline. “[I]t’s important to note we’re not constraining capex; it’s just that we have gone through a fairly substantial investment cycle, and we just see that waning a bit. But if we see great projects, we’re going to continue to invest,” explained Adamczyk.
That said, he expects his customers to spend more on capex, which should benefit Honeywell. We “certainly see a much greater level of bullishness on the part of our customers, which should translate to continued investment. And you’re right, their capex is our revenue, and we do expect some level of investments to accelerate, said Adamczyk.
Scott Davis, an analyst at Melius Research, raised one of the most interesting subjects in the conference call when he questioned whether Honeywell could simplify its corporate structure or supply chain now that it doesn’t need various corporate entities around the world to shelter income from US taxes. Turns out, Honeywell has started looking at simplifying its legal entities.
CEO Adamczyk explained: “[I]t will require us to restructure ourselves, and we do believe that new structure long term will be simplified, will cost us less, will make it a lot easier to do business. Can I quantify that for you right now? I can’t, because we literally just started our work a couple of weeks ago. But I do anticipate there will be a source of value for Honeywell and our shareholders.” Should tax attorneys start looking for a new area of expertise?
As for Q4, Honeywell reported organic sales growth of 6% and operating EPS growth of 6%, excluding a $3.8 billion charge related to the Tax Cuts and Jobs Act (TCJA). The results beat analysts’ estimates, and each of the company’s divisions—Aerospace, Home and Building Technologies, Performance Materials and Technologies and Safety and Productivity Solutions—reported organic sales growth.
Honeywell is a member of the S&P 500 Industrial Conglomerates, which has declined by 7.8% y/y through Tuesday’s close because of the downward pull of GE (Fig. 1). The industry is expected to have forward revenue growth of 3.4% and forward earnings growth of 3.3%, again due to GE (Fig. 2). Despite the drop in GE, the industry continues to trade at a lofty forward P/E of 20.3. It has traded near that level for the past two years, and only during the heady late 1990s has it traded much higher (Fig. 3).
(2) Lockheed Martin (LMT). Thank you, Uncle Sam. Defense spending has risen steadily in recent years, and it’s expected to continue to do so. President Trump has requested $626 billion in baseline defense spending in addition to $65 billion in overseas contingency spending for fiscal 2018—up from $591 billion in fiscal 2017—but he still needs spending authorization from Congress. Longtime defense analyst Rick Whittington expects the President to up the ante again by requesting $716 billion in defense spending in fiscal 2019.
Lockheed Martin—which makes F-35s, Sikorsky helicopters, and missile and missile defense systems—has benefitted from the surge of defense spending. Q4 sales rose 10.1%, and operating earnings jumped by 32.3% before a $1.9 billion charge related to the TCJA. The high end of the company’s 2018 forecast range has sales rising by as much as 3% and earnings jumping 16.5%.
Lockheed also talked taxes in its 1/29 conference call. Under the Trump tax cuts, its tax rate should drop to 17%-18%, down from roughly 27% last year. The new tax regime prompted the company to make a $5 billion contribution to its pension plans, essentially prepaying its 2018, 2019, and 2020 pension plan obligations to maximize the related tax deduction.
The 1/9 WSJ explains: “U.S. companies have until mid-September to benefit from the higher 35% corporate tax rate when deducting their defined-benefit pension plan contributions from their tax bill. A $1 million pension plan contribution made during this time can still count toward the 2017 tax bill and will result in a $350,000 tax deduction. The value of the deduction falls to $210,000 for contributions of the same size made under the new tax rules for 2018.”
Lockheed also plans on boosting R&D and capital spending this year by a combined $200 million. Lockheed spent almost $1.2 billion on capex last year, a record level. The company will also increase the Lockheed Martin Ventures investment fund, which makes strategic investments in early-stage companies that are developing technologies in areas important to Lockheed.
There are additional initiatives under consideration. CEO Marillyn Hewson said on the conference call: “Some of these initiatives include increasing our employee training and educational offerings to drive critical skill development [and] increasing our charitable contributions in science, technology, engineering, and math, or STEM, programs—the life blood of our future talent pool—including the creation of a STEM scholarship fund to encourage participation in these important fields of study.”
Before the company spends its tax windfall, management should read a 1/29 WSJ article questioning whether federal officials would require defense contractors to pass the tax savings back to Uncle Sam in the form of lower prices. Uncle Sam giveth, Uncle Sam taketh away?
Lockheed is part of the S&P 500 Aerospace & Defense stock index, which has risen 49.8% over the past year (Fig. 4). The industry’s revenue is expected to grow 3.7% over the next 12 months, and earnings are forecasted to climb 12.8% over the same period (Fig. 5). Of possible concern: The industry’s forward P/E of 22.2 is higher than it’s been since 1995 (Fig. 6).
(3) Illinois Tool Works (ITW). ITW enjoyed a strong Q4, with organic revenue increasing 4%, margins improving, and operating EPS jumping 17%. The growth was broad based, as six of the company’s seven segments and all of its major geographies enjoyed organic revenue growth: 4% in North America, 3% in Europe, and 5% in Asia-Pacific, which includes a 7% pop in China.
Domestically, ITW had started to see business investment accelerate in Q4, prior to the passage of the tax legislation, said CFO Michael Larsen in the company’s 1/24 conference call. “[T]his new tax legislation has great potential to add some further momentum and stimulation to the economy overall and in particular to business investment.” The company forecasts 3%-4% organic revenue growth this year.
The tax changes will lower ITW’s tax rate to 25%-26% this year, down from 28.3% last year. Lower taxes will boost earnings by $0.35 per share, or 5% this year. As a result, the company is targeting 2018 EPS of $7.45-$7.65, a 15% y’y jump if the middle of the range is achieved.
ITW took a $658 million charge in Q4 related to the tax changes, which equates to $1.92 per share. The company plans to repatriate about $2 billion to the US by the end of this year, but declined to lay out what it will do with that cash. In December, however, ITW did accelerate its previously announced plan to increase its dividend payout ratio to 50% of free cash flow in August instead of by 2020. The current dividend ratio is 43%.
ITW regularly spends 2% of sales on capex, and executives don’t seem likely to increase that because of the tax changes. “We [were] already [fully] invested in businesses and in our strategy before the passage of this tax legislation. So there's nothing that we would do or could do now that we didn't do … any changes on the tax side …don’t have any impact there,” noted CEO Scott Santi.
ITW’s pension funds are fully funded after the company made an extra payment of about $150 million last year.
One interesting line of questioning addressed inflation. Larsen said there “certainly is some inflation that is being addressed in our business units. But I think we have it well covered in our current guidance. … [our strategy] is to offset any material cost inflation dollar for dollar with price [increases], and we have been able to do that successfully at the enterprise level.”
ITW is a member of the S&P 500 Industrial Machinery Index, which has risen 28.8% y/y through Tuesday’s close (Fig. 7). Revenue over the next 12 months is expected to grow 5.7%, while forward earnings is forecast to climb 12.4% (Fig. 8). Growth in this industry also doesn’t come cheap, as the industry’s forward P/E is 20.8. That’s the high end of the P/E range in which the stock has traded since 1995 (Fig. 9).
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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