Monday Morning Musings: The Still Untold Industrial Production...
Analyst: Tobias M. Levkovich
SALOMON SMITH BARNEY Industry Note
Institutional Equity Strategy Monday Morning Musings: The Still Untold Industrial Production Story
May 3, 2002 SUMMARY * IP drives earnings pretty consistently Tobias M. Levkovich * IP tends to reflect not only manufacturing activity but also drives services. * Inventory collapse cannot continue indefinitely * Semi demand is also affected by industrial activity. * Things look primed for a pickup
OPINION
(*) An immediate family member of Tobias Levkovich holds a long position in the securities of Intel.
We have attempted over the past nine months to educate investors about a simple fact -- industrial production (or factory sales) is one of the most reliable indicators of earnings trends over the past 30-plus years (Figure 1). Fascinatingly, despite all of its flaws, especially the fact that manufacturing has become a smaller part of GDP, this driver has survived periods of a strong and weak dollar, high and low interest rates, the 1970s energy sector frenzy, the LBO craze of the late 1980s and tech-mania of the late 1990s. The rationale for this relationship is also quite reasonable and has significant and credible accounting basis; overhead cost absorption variances. Accordingly, the rush to clean up inventory last year meant meaningful under-absorption of often fixed overhead cost even though variable labor costs benefited from productivity gains. Note that one of the first rules in managerial accounting is that a firm should never produce goods or provide services when it cannot cover the variable cost associated with that activity; consequently, it is overhead cost that can be one of the greatest determinants of profit swings. In addition, during periods of inventory liquidation (i.e., production declines), pricing trends often falter and exacerbate profit erosion trends.
Figure 1: (Figures can be seen in PDF format)
Source: DRI and Salomon Smith Barney
Indeed, another way to look at this issue is to assess profits versus capacity utilization with the knowledge that capacity utilization is an alternative way to think of overhead cost (the expense of maintaining existing plant capacity or key employees) being absorbed by production (Figure 2).
Figure 2: (Figures can be seen in PDF format)
Source: DRI and Salomon Smith Barney
Interestingly, while industrial production did decline again year-over-year in 1Q02, the decline was not as severe as experienced in 4Q01, which itself was an improvement from the sharp year-over-year drop in 3Q01. While we do not yet have the national income accounts data for 1Q02, it is illuminating to see that in 4Q01, corporate margins (Figure 3) already began to bounce off lows seen in 3Q01 -- in other words, as the trends improve sequentially and the year over year dips turn into gains, margins (and earnings) rebound. If the drop was caused by massive inventory liquidation (and not just the tech capital spending slowdown), then a rebuilding of inventory should cause a substantive profits snapback. To a great degree, we strongly doubt that most investors even believe that 4Q01 margins bounced higher, let alone 1Q02 corporate margins, despite a 1Q02 survey by the National Association of Business Economics that suggests they did and the 4Q01 NIPA data that one can see in Figure 3.
Figure 3: (Figures can be seen in PDF format)
Source: DRI and Salomon Smith Barney
One of the greatest questions we get on this industrial/manufacturing production issue is; how can such a small part of the economy generate so much impact on overall S&P 500 EPS? While we might raise that same question for all of the tech sector obsessed investors (since the manufacturing economy is about 4x the size of the tech industry's contribution to GDP and almost 10x its contribution to industrial production), we think that one has to understand the "multiplier" effect on services when it relates to production. When more goods are produced, they must be shipped (generating incremental transportation services) and they must be financed in terms of working capital investment (financial services), not to mention sold at the retail level. In addition, producing more goods often means adding workers (and temp staffing companies are suggesting that this has begun to occur over the past two months), which, in turn, should translate into more consumer spending. Thus, the impact of increased production is much more significant than many might think at first blush.
As can be seen in Figure 4, Financials, which account for more than a quarter of S&P 500 EPS tend to have a meaningful relationship to industrial activity, especially the banks, given that commercial & industrial loan activity seems to lag production slightly. Hence, those who claim that ending activity remains weak should recognize that this is pretty much par for the course. While net interest margin growth probably sustained earnings for the financial sector last year (and will most likely not be able to continue to do so going forward), the bigger driver will be credit costs and some renewed loan growth, which again has pretty decent consistency over many years. Thus, this is not one of those often speculative "it's different this time" arguments. We consider it to be very much the same!
Figure 4: (Figures can be seen in PDF format)
Source: DRI and Salomon Smith Barney
In the Consumer Discretionary sector, earnings fell about $7 billion last year (or roughly 15% year-over-year), with the auto industry accounting for most of the decline and auto production rebounding which should translate into renewed earnings vigor. As Figure 5 demonstrates, auto earnings are very much driven by production and the auto sector is generally a respectable lead indicator for overall industrial production.
Figure 5: (Figures can be seen in PDF format)
Source: DRI and Salomon Smith Barney
Note that the Materials sector also got crushed by production cutbacks and thereby much lower commodity prices (associated with ample supply facing much lower demand). Thus, this sector experienced a near 55% decline in profits, which we think should begin to turn in 2002 and more impressively in 2003.
To be fair, the Telecom Services sector and the Information Technology sectors earnings also got crushed. To a certain degree, the Telecom arena is a bit different in terms of the pricing impact from disruptive new technologies and the excess of capacity that came on in the past few years that still may take some time to be absorbed. Within IT, the environment is affected by industrial production in three ways: 1) Tech does account for about 7% of industrial production and that collapsed as the industry attempted to cut excess inventories also; 2) Many other industrial markets use semiconductors -- for instance, the auto sector uses more semis in dollar value per vehicle than steel today; and, 3) When industrial activity slides and earnings dip, capital spending gets deferred. Since industrial production dropped for 18 months straight, it should not shock anyone that 2001 was a tough capital investment year for IT and other capex-related products.
As can be seen in Figure 5, IT sector earnings collapsed $45 billion in 2001, with the key culprits being telecom equipment and semiconductors (Figure 6). While the telecom equipment market is likely to stay soft possibly through 2003, semiconductors are projected to experience strong EPS recovery in 2002 and 2003. Keep in mind that industrial/automotive and consumer electronics markets account for more than 30% of semiconductor industry shipments vs. 46% for computer hardware; thus a pickup in consumer and industrial markets have much more impact on semiconductor recovery than simply capital spending might have for areas like telecom equipment, PC upgrade cycles or CRM software.
Figure 5: (Figures can be seen in PDF format)
Source: I/B/E/S and Salomon Smith Barney
Figure 6: (Figures can be seen in PDF format)
Source: I/B/E/S and Salomon Smith Barney
Nonetheless, in what we consider to be somewhat outrageous claims in some quarters, the Chicago PMI data and the ISM data for April were interpreted by some as proof of an imminent economic slowdown (which imperils the earnings outlook), despite the fact that the new orders data registered satisfactory expansion and inventories continued to contract, setting the stage for needed production (and thereby, earnings) increases. In very simple terms, the U.S. economy cannot end up like Old Mrs. Hubbard with nothing left in the cupboard. Thus, as industrial production climbs, so will profits, thereby generating (internally) the cash flow for capital spending recovery in late 2002 and into 2003.
We do not consider this approach to be much different than what we have seen happen before. The big difference was that consumers never faltered, but the consumer had to deplete excess inventory along with the production cuts. As a result, we are now shifting into the production pick-up portion of recovery and by late 2002, we probably will enter the cyclical (not secular) capital investment pickup period.
Thus, as we go though production pick-up, auto companies, component manufacturers, industrial products makers, steel and aluminum producers, specialty chemicals, semiconductors and financial companies benefit, as do their earnings. Back in 1998 and 1999, investors were told to "follow the cash," in other words, to look at where the cash-rich dot-com and next generation telecom startups would spend their newfound money. Thus, demand for computers, telecom equipment, fiber, etc. soared as did stock prices. Now, the initial cash (that, in some cases, must be raised through financial intermediaries) will be spent to replenish vastly depleted inventories, so the manufacturers benefit and eventually so will the capital spending beneficiaries. Thus, despite their current lack of popularity, we still want to own names like Ford and GM as well as Borg Warner and Magna International. Plus, American Express, Bank of America, JP Morgan, Bank One and Lehman Brothers make sense to us, as do Ingersoll Rand, Deere, SPX, Canadian National, Nucor, Alcoa and Air Products. Furthermore, select semiconductor and retail names continue to hold appeal including Intel, Analog Devices, and Target, not to mention special situations like Apple Computer. Travel sensitive names like Continental and Hilton still are attractive to us as well.
To be fair, investors chose to look for the bad on Friday by focusing on the 6% unemployment rate (due to a surge in new job seekers, not fewer actual jobs) and the fact that the non-manufacturing ISM numbers did not show a jump (but still showed expansion). The overtime data for the 132 million people who have jobs (and its associated higher pay) means that consumption can be sustained and that companies are still cautious on hiring (not a big surprise at economic inflection points). One should not and cannot expect that every data point will be positive every day and, in fact, it seems like more attention is being paid to the slant or bias on those data points anyway rather than the actual numbers themselves. If one can look out beyond the next day or two, the industrial production factor seems to have a much bigger and more lasting impact.
Indeed, one of the lead indicators for production, freight tonnage (transportation services), has broken into positive territory and seems as if it is trying to edge higher (Figure 7), which we think could be positive and indicative of a coming production pop. In fact, the only time we saw this not be a decent indicator for production coming off the bottom was back in the early 1980s due to inflation/monetary policy issues that simply do not seem to be recurring.
Figure 7: (Figures can be seen in PDF format)
Source: DRI and Salomon Smith Barney
Companies Mentioned
(*) An immediate family member of Tobias Levkovich holds a long position in the securities of Intel.
Air Products & Chemicals Inc. (APD-$50.69; 1M)
Alcoa Inc.# (AA-$34.43; 1M)
American Express Company (AXP-$42.22; 1M)
Analog Devices, Inc. (ADI-$36.16; 1H)
Apple Computer (AAPL-$23.69; 1H)
Bank One# (ONE-$41.50; 1M)
Bank of America# (BAC-$73.55; 1M)
BorgWarner (BWA-$63.70; 1M)
Canadian National Railway Company (CNI-$49.80; 1M)
Continental Airlines Inc.# (CAL-$25.00; 1H)
Deere & Company# (DE-$44.20; 1H)
Ford# (F-$16.10; 1M)
General Motors# (GM-$66.24; 2M)
Hilton Hotels Corp.# (HLT-$16.09; 1H)
Ingersoll-Rand Co.# (IR-$49.96; 1H)
Intel Corporation (INTC-$27.87; 1M) (*)
JP Morgan Chase# (JPM-$36.25; 1M)
Lehman Brothers# (LEH-$62.12; 1H)
Magna# (MGA-$77.38; 1M)
Nucor Corporation (NUE-$59.69; 1M)
SPX Corporation (SPW-$132.00; 1M)
Target Corporation# (TGT-$44.12; 1M)
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