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War in the Gulf Again Imperils Factory Sector

Odette Galli

Maybe the handwriting was on the wall. In the last war with Iraq, the economy came to a virtual standstill, with industrial production declining steadily from September 1990 until March 1991, when it hit bottom, falling nearly 4% year over year.

We probably shouldn't be surprised, then, to find that manufacturing activity seems to be grinding to a halt during Iraq redux as well. The anecdotal data, no matter how volatile or reliable, aren't particularly encouraging. February new-home sales plunged 8.1% to their lowest level since August 2000. Durable goods orders for last month were also weak, falling 1.2%, or 2.7% if you exclude strong results in the defense sector.

With the travel industry paralyzed and airlines in financial distress, it's no secret that the commercial aerospace market is in a deep recession. And when auto sales are released next week, there probably won't be much to get excited about there, either. Usually, this would mark a good time to be buying industrial stocks, which have fared poorly relative to the overall market for quite some time. Many now trade at attractive valuations, particularly for longer-term investors.

But don't be surprised if we see another 10% to 15% pullback -- down to the October lows -- because that's where the stocks would trade using the historical low price-to-earnings ratios applied to the low or "worst case" estimates on Wall Street for this year.

Better Days

Surely the worst performance for the sector is behind it. Over the last 52 weeks, the Dow Jones Diversified Industrial Index is down 28%, compared with a 22% decline in the market overall. The underperformance picked up speed in the first three months of this year as war became more likely. Shares of industrial stocks such as Honeywell (HON Quote), Ingersoll-Rand (IR Quote), Emerson (EMR Quote) and Parker-Hannifin (PH Quote), for example, are all down between 5% and 10% year to date, compared with just a modest decline for the market overall.

Unfortunately, things could get worse on the economic front, as long as the war has a paralyzing effect on consumer and business decisions. The latest figures for industrial production show that it was still on the rise, albeit modestly, through February of this year. Chances are the next reading will be down, and there could be months to go before it bottoms.

However, it now appears that much of this presumed economic weakness is already reflected in the industrial stocks. In just the last week, a slew of analysts lowered their earnings estimates or ratings on shares of Honeywell, Parker Hannifin and Emerson, to name a few. With March quarter conference calls coming up in the next few weeks, we should expect to hear outlooks that are anything but encouraging.

Best Bet

For more risk-averse investors, Emerson is still probably the safest way to play a manufacturing sector recovery at the moment, because there's so much uncertainty over when it will materialize. The shares are down 5.1% so far this year and now trade at a P/E ratio of 18 times 2003 estimates of $2.61 -- below the company's historical average multiple of about 20.

Even so, the stock still may be vulnerable to estimate revisions. Emerson reported February orders today, and they showed little, if any, improvement from January or from the same month a year ago. Should Emerson have to lower guidance, or if weak data emerge from the manufacturing sector, the shares could trade back down another 13% to their October lows of about $41. At that point, Emerson would trade at a P/E of 16 (the low end of its historical range of 16 to 23) on earnings of $2.55 a share -- the low estimate on Wall Street, which would also be roughly flat with what the company earned last year.

Should that happen, I have a hard time seeing the stock staying there. With strong free cash flow and a dividend yield of 3.2%, Emerson may be worth the wait.

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