Machinery Industry

Despite the significant equity market rally off the March lows and the talk of "green shoots," we still see a challenging global economic backdrop and a less than robust environment for the Machinery sector. In fact, what we have seen is certain economies stabilize at much lower levels from peak cycle activity, rather than any sort of V-shaped recovery. As foreign economies deal with weaker exports to the U.S and Europe, industrial customers are cutting back on capital spending. On a y-o-y basis, equipment orders continue to decelerate in almost every end-market -- from machines used in construction, infrastructure, and agriculture. On the bright side, production cuts have helped reduce inventory levels. As a result, we should see less of a near-term drag on output. But let’s not confuse a potential inventory rebuild and fiscal stimulus with a real, sustained U.S consumer-led recovery. The combination of U.S job cuts, minimal income growth and less consumer credit availability tells us that global exporting countries must try to stimulate their own domestic demand. Before getting into some global data points, we believe that most of positive industrial news headlines are the result of sequential data comparisons rather than y-o-y comps. From peak levels, the data looks less than inspiring. There are several data points that help to paint the picture of a weak global industrial backdrop. Japan's core machine orders fell 1.3% in April from March levels, but on a y-o-y basis orders fell 22.2%. Orders have fallen in 10 of the last 15 months. What's more, according to the cabinet office in Japan, overseas orders fell 48.7%. Japanese machine orders are still far below 2008 levels, and have yet to recover to 2004-2007 levels. Furthermore, a manufacturing survey conducted by the cabinet office indicated second quarter core orders would decline 5% from the prior quarter. We agree with this assessment. We would not be surprised to see core orders decline in each quarter of 2009. Also, in April, Japanese industrial production increased 5.2%. However, on a y-o-y basis, output is down 34%. Again, it is easy to get a decent sized month-to-month bounce from severely depressed levels. Also, according to the VDMA machine makers association, German plant and machinery orders fell a record 58% in April compared to the same period a year ago, with export orders down 60% and domestic demand down 52%. The Industrial weakness went well beyond German borders. Italy saw March output decline 23.8%, Spain -24.7%, Luxembourg -29.6%, and Estonia -29.7%. In fact, the whole euro region saw March industrial production fall 20.2%. The chart below (source: ECB statistical data warehouse) shows the industrial production decline for the Euro area 16 takes it back to 1998-1999 levels. The domestic picture appears to be no brighter. According to Zacks Director of Equity Research Dirk Van Dijk, CFA, total industrial production fell 0.5% in April, following a decline of 1.7% in March and a decline of 1.4% in February. On a year-over-year basis, total industrial output is down 12.5%, and is 16.0% below its peak. Manufacturing output fell 0.3% on the month following a 2.1% decline in March (revised from -1.7%), and was down 14.5%.

Output from the nation's mines tumbled 3.2% following a 2.6% decline in March, and is 8.6% below year-ago levels. In contrast, Utility output rose 0.4% on the month following a 1.9% rise in March and is down just 3.2% from a year ago. Overall capacity dropped to yet another all-time record low of 69.1% from 69.4% in March (revised from 69.3%). A year ago, overall capacity utilization was 79.2%.

The year-ago level was about normal. In an economic boom, Dirk Van Dijk points out that capacity utilization gets up to about 85%, and historically a level of 75% indicates a very severe recession. We are in uncharted territory.

When looking at the global macro backdrop for industrial production and machinery orders amid weaker U.S consumption, we expect a continued slowdown in capital spending.

OPPORTUNITIES

While the credit crunch and slower economic growth dampens private sector spending, fiscal expenditures appear ready to play a counter-cyclical role. China announced a rather large stimulus package in November.

Also, the U.S Congress passed a stimulus package that President Obama signed on Tuesday, February 17, 2009. The bill contains money that will flow into infrastructure spending. The only issue is the timeframe of the spending. For example, according to CBO estimates, of the $27.5 billion in the budget for highway spending (Title XII - Transportation and Housing and Urban Development Highway Construction), $9.625 billion will be spent by the end of FY2010. This equates to 35% in the first two (FY) years and the remaining portion realized through the (FY) years 2011-2016.

Amid the current global economic slowdown, there may be a silver lining. Central bankers have gone from raising interest rates and fighting inflation to slashing rates and flooding the system with liquidity. Specifically, the U.S Federal Reserve has engaged in quantitative easing (QE). In March, the FED announced it would spend over $1 trillion to buy mortgages-backed securities, agency debt and Treasury securities. In our view, these monetary conditions have helped to put a bid into commodity prices. We would become more constructive on commodity stocks, such as Freeport McMoRan (FCX - Analyst Report), on signs reflation measures were sustainable into 2010.

WEAKNESSES

We remain cautious on the U.S residential construction (& related) space. In our view, there is still too much existing and new home inventory to justify a new up-cycle in starts, which partially impacts the order flow of machinery companies that sell or lease equipment to the homebuilders. On the demand side, the combination of a weaker U.S labor market and the recent rise in mortgage rates (although from historically low levels) does not appear to add to the pool of available homebuyers.