Construction in the U.S. heats up
As of early November, many leading indicators are suggesting 2014 will be a good year for the U.S. construction industry. Purchasing managers indices (PMIs) have been very strong for the three months leading up to this report, and the positive outlook for housing and auto activity—the two most important consumer sectors for construction end markets—has been encouraging.
Housing has decelerated in recent months but has shown extremely strong growth in the past year, and we have good guidance around new communities in the works for next year. After positive years in both 2012 and 2013, housing will likely continue to improve, and associated industries may see additional growth as the level of activity increases further.
Residential housing tends to lead nonresidential construction, which is now beginning to heat up. One key leading indicator of nonresidential activity is the Architecture Billings Index, which reached a six-year high earlier in the year (see Exhibit 1, right). Like housing, nonresidential construction is a regional business, and will likely grow in some areas more quickly than in others. There is also a range of nonresidential market segments, including energy, public construction, hospitality, office, and retail, each with its own cyclical pattern.
In this phase of the overall business cycle, I look for companies with good management, a strong balance sheet, and the right combination of geographical and end-market exposure. Engineering and construction companies have tended to be big beneficiaries as nonresidential construction grows. Electrical equipment and machinery companies have also tended to increase revenues quickly as the construction cycle matures. The machinery industry is likely to benefit as energy and chemical companies build out for the current wave of domestic natural gas and shale oil production.
Planned plant capital expenditures, a leading indicator for the engineering and construction industry in particular, have risen. In one subset of the energy industry alone, the planning phase for plants to liquefy and export natural gas suggests massive potential investment, with only four LNG export applications currently approved by the government and approximately 20 still pending.1 Liquifaction plants would cost $1 billion to $2 billion for “brownfield” conversions (renovations of existing facilities) and upward of $4 billion for “greenfield” (new construction) plants.2 Engineering and construction companies may benefit greatly for several years when these huge construction projects get started. I expect the investment phase to begin ramping up in earnest in 2014.
Secular theme: energy efficiency
Another ongoing investment theme in the industrials sector has been energy efficiency. Manufacturers that make more energyefficient products may possess a real market advantage, thanks to quick economic payback combined with government regulation (current and potential) and subsidies. Fifteen years ago, many businesses had never heard of a “carbon footprint”; now, most companies publish annual sustainability reports, and have energyefficiency goals that help drive management decisions.
If a business can upgrade its lighting or air conditioning systems and get a payback in three years on energy savings, there is a strong incentive to do so. An energy-saving product will thus build market share very quickly, particularly if it has a strong lead on competitors. In addition, companies serving markets where efficiency standards are increasing may benefit even without share gains, because energy-efficient products tend to have higher margins.
Such energy-efficient products run the gamut from multimilliondollar components to everyday objects, and each has its own market dynamic. For example, not many companies will risk more than a billion dollars and many years of R&D to develop a highly efficient turbojet engine, but doing so successfully may mean huge market share gains in new aircraft platforms, with secure revenues likely lasting for a decade or more. At the other end of the spectrum, the development of inexpensive LED lighting technology will likely lead to a race to build costly manufacturing plants that can churn out millions of bulbs, because payback dynamics and sustainability goals may encourage businesses to upgrade their lighting—not a bulb at a time, but all at once, in dozens of facilities across the nation. With high barriers to entry (extensive R&D, complex plants), companies poised to own particular pieces of the energy-efficiency market stand to reap outsized share gains in the future. I think we will continue to see this theme extend through 2014.
Global economic improvement
As we approach 2014, many leading indicators for the global economy are favorable, particularly in developed economies. PMIs are up, and incremental growth in Europe and Japan in particular may boost revenues for internationally exposed industrials companies. Because inventories are already low, new incremental production growth should lead to higher revenues and earnings.
In emerging economies, the stabilization of China has been a key driver of demand for both industrial products and inputs. However, as the Chinese industrial sector evolves, we are seeing less emphasis on “one China” and more differentiation between industries and sub-industries. As a result, although the overall growth trend in China is very likely to continue improving, some companies may be better positioned than others, based on their end-market exposure.
Risks: What to watch in 2014
Continued defense budget cuts
With no end to government gridlock in immediate sight, the next round of the sequester’s mandatory cuts may very well occur. Those cuts, along with additional planned reductions in the defense budget, could create a significant challenge for the defense industry in 2014.
In 2013, many defense contractors have done an admirable job reducing costs to offset the downturn in revenues, and have used their strong cash flows and balance sheets to help maintain earnings growth. However, if revenues continue to shrink through 2014, these companies may find it difficult to increase or maintain economic earnings.
The Pentagon has warned that budget cuts may hit procurement and R&D accounts hardest, which could likely delay or eliminate many smaller programs.3 Larger, high-priority programs may find some protection, which could cushion the revenue declines for some of the established defense contractors. Smaller contractors and suppliers, however, may have fewer ways to offset the cuts. Companies with stronger balance sheets will likely weather a downturn better than others.
Valuations near average; capital return to shareholders high
Valuations in the sector are close to long-term averages, and many of the higher-returning, higher-executing businesses are now priced above the averages. As a result, few companies appear to be classic value buys at this point in the cycle, and investors may need to take a longer-term view to find inexpensive opportunities.
In general, companies have been using cash to increase shareholder return through dividends and share buybacks. With slow economic growth during this past year and light merger and acquisition (M&A) activity, shareholder-friendly capital allocation may have been the best strategy for 2013. However, as growth likely picks up, companies may need to increase capital expenditures to support customer demand. Higher growth may also lead to increased M&A activity, as sellers are more likely to realize expected value for shareholders.