NEW YORK (TheStreet) -- The industrial stocks are one of my favorite sectors in the S&P 500 and have been over the past several months.
We own quite a few in Action Alerts PLUS, Jim Cramer's Charitable Trust, with our two largest positions being Eaton (ETN) and Johnson Controls (JCI). The industrial sector is one of the most levered to an improving economy and also to higher interest rates.
Over the last few weeks, I've been encouraged to see the pickup in several manufacturing economic data points. The Chicago PMI, the National PMI, ISM, Industrial Production and Capacity Utilization figures have all ticked higher and came in ahead of consensus. Confirming the macro trends, several companies like 3M (MMM), Ingersoll Rand (IR) and Honeywell (HON) at the Bank of America/Merrill Lynch Industrials conference last week said the U.S. was improving (albeit slowly) and what really caught my attention was that March had more than made up for the slow January and February months, which were plagues with unusually cold and wet weather. They stopped short of saying the economy was growing quickly, but they did see an improvement. I think we will continue to see improvement throughout 2014, which is why I want to have exposure via the industrials.
These managements also indicated that Europe was beginning to turn as well and that Asia had stabilized. Within industrials, I've liked the aerospace cycle for several years and the replacement cycle story in autos and trucks, as well as the rental equipment market. For 2014, my favorite end market is the non-residential construction theme, given that it has lagged the residential recovery, which is expected to grow 9% this year and 15% next. Resi almost always leads non-resi spend.
One name that I think is worth owning is Emerson Electric (EMR) under the leadership of David Farr, who is one of the strongest CEOs in the sector. Throughout his tenure he has overseen several restructurings, operating margin improvements and boosts in shareholder value via dividends and buybacks. He's right up there with Sandy Cutler at Eaton and Dave Cote at Honeywell in terms of consistent execution.
EMR is about as industrial as you get. It's a global manufacturer of power equipment, HVAC gear, industrial and process automation equipment and tools and storage products. It operates in five segments: process management (36% of revenue), industrial automation (20% of total), network power (20%), climate technologies (16%) and commercial & residential solutions (8%). Some of its key end markets include residential and nonresidential HVAC, residential and non-residential construction, oil & gas, autos and communications, pretty much exposed to where we are seeing the turn.
It's also geographically diversified, with 45% of its sales in the U.S., 20% in Europe and 24% in Asia. It has a third of its sales coming from emerging markets and has proactively reduced its exposure to China to 9% from 13%, given the slowdown that is occurring in this region. I like the mix. The U.S. and Europe, as well as Japan, exposure positions it well, as these economies recover while the longer-term optionality will be in above-average growth from the emerging markets.
At its recent analyst meeting in February, the company said it expects to see 3% of gross fixed investment CAGR (2013-2016) in developed markets and 5% in emerging markets. For the next few years, management sees the primary growth coming from the U.S. and Europe and pockets from Mexico and the Middle East. Longer term, it will be emerging markets. Specifically in North America it sees demand improving in residential and non-resi pickup, which will benefit its climate tech and C&R units. It also was very optimistic about the U.S. oil and gas capex cycle (not including the possible approval of the Keystone pipeline), the Canadian oil sands recovery and the opportunities from Mexico's Pemex increased investment cycle (one of Emerson's largest customers) which will help the process management division. The Middle East region is a small-but-growing region, given the increased demand from its infrastructure buildout and should increase in importance over time. It accounts for just 5% of total sales.
Over the last several quarters, the company has prioritized its investments, shifted its asset allocation and divest noncore businesses. It has expanded its addressable markets, created a lean cost structure and is positioned well for the manufacturing recovery in the U.S., Europe and Japan. It's made significant investments in Asia to drive growth for the long haul. The growth at the company will be in its technologies and building off the current strong product line into its large installed base (things like wireless sensors in its process automation segment, discrete control solutions in industrial automation, new refrigerants and variable speed compressor technology in climate and data center monitoring in network power). Plus, there is more it can do within the C&R division and in particular strong branding and market share potential of two of its key segments, InSinkErator in dispensers and waste disposal, which is only 52% penetrated currently, and Ridge Tools as it synergizes with its electrical product lines.
The company has near-term and longer-term goals for earnings, margins and cash flow and all were just reiterated by the management at its analyst meeting. For 2014, $3.68-3.80 with core organic growth of 3-5% vs. the 2% posted in 2013. The highlight will be in process controls with 7-8% growth, followed by limate at 4-6%, C&R at 3-5% and a stabilization in network power at 1-3% after years of declines and restructuring. Since process and C&R carry the highest margins, this is a good mix for the company's overall margin. Longer term, management expects to see 3-6% CAGR sales growth between 2013-2016 with targets of $27-$29 billion in sales, 42.3% in gross margin (200 bps ahead of today), and EBIT margin of 17.5%. This puts earnings for 2016 at $4.40-4.60. It will generate $11 billion in operating cash flow between 2013-2016 and use $4 billion towards dividends, $2-3 billion in buybacks and $2-3 billion in acquisitions. It also expects to divest $1-1.5 billion of sales over this timeframe.
Having lagged the group year to date and trading at the midpoint of its historical range (currently 16x 2014 estimates vs. its 10-24x average), I like the risk/reward and can see shares approach $80 over the next 12 months.
--Written by Stephanie Link in New York.
Action Alerts PLUS, which Link co-manages as a charitable trust, was long JCI and ETN at time of publication.