Parsing the 'High Watermark'

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(Bloomberg) -- The industrial earnings cycle “has not peaked,” according to Emerson Electric Co. CEO Dave Farr. And that’s true — if you are Emerson Electric Co. 

For industry watchers, those upbeat words were a welcome counterweight to Caterpillar Inc.’s now infamous declaration that first-quarter profit would be the “high watermark for the year.” But Emerson and its rosy view may be more the exception that proves the rule when it comes to calling a turning point in earnings growth for U.S. multi-industrial companies. 

On the whole, investors haven’t been particularly impressed with industrial earnings this quarter. Of the 55 companies in a Bloomberg Intelligence basket of North American multi-industrials that had reported earnings through Thursday evening, only about a handful missed analysts’ estimates, but about 60 percent have seen their stocks fall in response. It’s telling that some of the biggest gains came at General Electric Co. and Johnson Controls International Plc, where expectations were very low, whereas the likes of Illinois Tool Works Inc. got panned despite raising guidance.

The quality of the earnings beats and outlook boosts was an issue, as always, with investors in no mood to reward companies for the benefits of a lower tax rate. But what seemed to get industrials in the most trouble were concerns about slowing margin expansion as rising material and labor costs start to eat into profitability and signs of a peak in revenue growth. And that’s where Emerson’s results can be instructive to understanding what’s going on here. 

Emerson reported an impressive 8 percent climb in organic revenue, or sales excluding currency swings and acquisitions. But the bulk of the growth came in its automation division, which caters to the recovering oil and gas industry, among others. At Emerson’s climate-control and tools unit — where sales had increased at a more stable rate the past few years — organic sales growth actually decelerated to 4 percent from the 5 percent expansion seen in the previous quarter and the year-earlier period. In North America, organic revenue increased just 1 percent at that unit.

This exemplifies a bifurcation in growth trends for the parts of multi-industrial companies that tend to benefit from the early stages of an industrial recovery and those that typically outperform on the back end, says Barclays Plc analyst Julian Mitchell. For the former, growth may have in fact peaked, whereas businesses such as Emerson’s process-automation operations are still in the early innings of expansion.

Shorter-cycle businesses — think 3M Co.’s consumer unit — had a median organic growth rate of 2.9 percent in the first quarter, compared with 5.2 percent in the fourth quarter of 2017, according to a May 2 report from Mitchell. By comparison, longer-cycle operations — such as United Technologies Corp.’s aerospace divisions — saw growth accelerate. Everything is still growing, but this divergence in momentum suggests that we’re closer to the end of this industrial growth cycle than the beginning.

That helps explain why Emerson’s CEO is right, but also why 3M delivered a guidance cut early in the year (and just a month after incoming CEO Michael Roman affirmed the old outlook). It’s a bit jarring to think we’re seeing industrial momentum fade so soon after the slump of 2015 and 2016. But that downturn didn’t affect all industrial businesses evenly.

Mitchell estimates that end markets accounting for 50 percent-plus of multi-industrial sales are in the sixth year or more of expansion — businesses like health care, HVAC and commercial jet engines, which weren’t as pressured by the downturn in oil and gas prices.

That’s a problem because for many of these companies, investors were pricing in an ongoing acceleration in profit and sales growth that may not actually materialize. Hence, the big stock drops that have been a recurring theme this earnings season. In addition to those companies seeing decelerating growth, others are starting to feel the pinch of rising material costs. Caterpillar, for instance, raised its full-year adjusted earnings outlook, but signaled that input costs will outpace its ability to push through price increases in the remainder of this year, one reason for the “high watermark” comment. The other is a ramp up in R&D spending and investments in digital, which I flagged here as a watch item in terms of Caterpillar’s profitability potential.

So have industrial companies passed the “high watermark” or not? It’s not the most satisfying conclusion, but the answer may be: It depends.  

©2018 Bloomberg L.P.

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