Clouds Darken Over the Smokestack Sector

Hard times have arrived for the heavy industrials as the recession drags on, and a turnaround may not be coming soon for many manufacturers.
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The first wave of the recession has been evident for some time as lenders, home builders, retailers and automakers pulled back the curtains on their crumbling businesses.

But now the second wave of the downturn has begun to take shape, as industrial companies cut production, lay off workers, warn about waning profits or seek bankruptcy protection.

The U.S. industrial benchmark,

General Electric

(GE) - Get Report

, was among the first to show signs of stress as its financing operations struggled in the troubled credit markets, with consumers beginning to default on loans. Since December, industrial firms that ran the gamut from chemical companies like

DuPont

(DD) - Get Report

to equipment-makers like

Caterpillar

(CAT) - Get Report

to metal-producers like

Alcoa

(AA) - Get Report

have begun to slash jobs, cut executive compensation, curtail production and warn of impending losses.

At the extreme end, European chemical-maker

LyondellBasel

said on Tuesday that its U.S. operations and one European holding company would file for

Chapter 11

to restructure debt, citing "a dramatic softening in demand for our products and unprecedented volatility in raw materials costs."

While some industrial stocks had held up relatively well, experts are predicting more pain ahead as the recession drags on at least through the end of 2009. Robert Shapiro, chairman of Sonecon and former undersecretary of commerce under President Bill Clinton, says the outlook for the industrial sector is "definitely discouraging," as demand from businesses and consumers alike "is certain to remain depressed for some time, both U.S. and global."

As consumers and businesses pulled back on demand, overall industrial production slumped at a 6% annual rate during the third quarter. The

auto industry's woes

helped push capacity utilization for raw steel production down to 65.2% in the week ended Nov. 8, down from 88.5% a year earlier. As a result, steelmakers have started to shutter 17 of the country's 29 blast furnaces, according to a recent report by consulting firm Booz & Co.

"Declining demand throughout the consumer and business sectors will hit industrials hard," say the report's authors, Barry Jaruzelski and Matthew Ericksen.

The manufacturing sector has already lost 604,000 jobs since the start of the recession in December 2007, according to the Labor Department.

ADP's horrifying employment report

on Wednesday, combined with recent layoff announcements from the industrial sector, promises more economic pain ahead.

Panos Kouvelis, a professor at Washington University's Olin Business School, who specializes in manufacturing and management, says what's coming out of the industrial space is actually "old news" that started to take shape at the front-end of the economy in September, and has now made its way down.

"It's more or less along a supply chain that you go from the retailers or customer-oriented businesses and then you start going backwards and hear from the suppliers," says Kouvelis. "So, if you think the retailers will recover in six months to a year, then these guys sitting at the back end will take another six months to a year after that."

The stimulus package to be unveiled by incoming president Barack Obama, along with all the other fiscal and monetary policies already installed, and the president-elect's plans to boost alternative energy, will undoubtedly help many players in the industrial space. In addition, business-tax cuts could help keep costs down as these projects get underway.

But of course, the industrial area has vast array of players who make and do widely different things, and the outlook can vary dramatically even within the same subsector. For instance,

Nucor

(NUE) - Get Report

,

U.S. Steel

(X) - Get Report

and Alcoa all operate in the metals space. But Alcoa makes aluminum products that are used mostly for consumer goods, whereas the other two make steel products used for building, heavy machinery and the like.

Bernard Layton, who leads the North American industrial group of the executive recruiting firm Stanton Chase International, agrees that the outlook for the industrial space is company-specific. Some firms are more heavily reliant on the consumer, some have burdensome debt loads, and others are anxiously watching commodity prices, which cut into their bottom line. Variables exist among those elements, but companies betting on stimulus dollars to line their coffers may have a long while to wait.

"There are areas where the planning and delivery of the packages -- roads, bridges, tunnels, those kinds of things -- they have approval processes in the way," says Layton. "It's going to take some time to get these things started, so I'd predict a period of 12-to-18 months to see a period of growth for those subsegments."

Layton notes that firms who preemptively cut production at the start of the downturn will do better than others. He cites the difference between

Ford

(F) - Get Report

, which didn't need federal rescue dollars because it took steps to prepare for weaker consumer demand, and

General Motors

(GM) - Get Report

, which teetered on the brink of collapse before Uncle Sam stepped in with a loan.

As the case of GM, and more recently LyondellBasel, made evident, aggressive, proactive management will be key for industrial firms to weather the economic storm. Robert Pavlik, chief investment officer of Oaktree Asset Management, suggests investors take a bottom-up approach and pick companies light on debt, heavy on free-cash flow, with decent earnings and revenue growth. He also says investors should view heavy-handed cost-cutting measures and profit warnings not as blanket bad news, but as responsible management of firms during a recession.

"Obviously if the economy worsens from here by a tremendous amount, I think more and more companies will start to take a closer look at their dividends," he says. "A lot of companies don't like to cut their dividends, but if you're in a different situation and you have to preserve cash, you need to take these steps."

Another reality industrial firms are facing is that while the government can grease the wheels, it can't pull the economic wagon on its own. As a result, investors taking a look at the industrial space may want to be selective and cautious until there is more clarity on the stimulus plan, who stands to benefit most, and when.

"Just putting the shovel in the ground is going to take some time to happen," says Ben Halliburton, chief investment officer of Tradition Capital Management. "These companies, on a global basis, are announcing their layoffs, announcing their dramatic capex cuts and I don't think the stimulus plan is going to help that right now. And while the government is an important consumer of these products, the private sector is much larger."