Machinery Industry

We remain extremely cautious on the machinery sector.

As foreign economies deal with weaker exports to the U.S and Europe, industrial customers are cutting back on capital spending. Equipment orders are decelerating in almost every end-market -- from machines used in construction, infrastructure, agriculture to base metal projects.

There are several data points that help to paint the picture of a sharply deteriorating global economic backdrop. Japan's core machine orders fell 1.7% in December, and fell in 8 months of the full year 2008.

What's more, according to the cabinet office in Japan, overseas orders fell a whopping 26.8% in December and 16.7% for the fourth quarter of 2008. While a manufacturing survey conducted by the cabinet office indicated core orders would rise 4.1% in the first quarter of 2009, we think this forecast may prove to be too optimistic. We would not be surprised to see core orders decline in each quarter of 2009. Japanese industrial production fell 9.6%. Exports fell 35.1%.

Also, according to the VDMA machine makers association, German plant and machinery orders fell a massive 40% in December from the same period a year ago, with export orders declining 30%. While mining-machinery orders are expected to increase in 2009, we believe the outlook could become more pessimistic with a further decline in commodity prices.

Separately, in December, German output fell 12%, production of intermediate goods fell 8.2%. November exports fell 10.8% relative to October levels. Further, manufacturing orders fell for the fourth consecutive month in December.

The domestic picture appears to be no brighter. In a recent blog, Zacks Director of Equity Research Dirk van Dijk noted, "Total industrial production fell 1.8% in January, following a decline of 2.4% in December and a 1.2% decline in November. It is now down 10.0% on a year-over-year basis. If one only looks at manufacturing output, the picture is even worse, with a 2.5% monthly decline following declines of 2.9% and 2.2% in December and November, respectively.

"On a year-over-year basis, manufacturing output is down 12.9%. Colder-than-normal weather has been propping up the output of Utilities, where production rose 2.7% in January, following a 0.2% decline in December and a 2.0% increase in November.

"Capacity Utilization also fell sharply in January, down to 72.0% from 73.3% in December for the overall index. A year ago, the country’s factories, power plants and mines were working at 81.0% of capacity, which is in line with the long-term average (1972-2008) of 80.9%.

"The picture is even worse if one only considers manufacturing, where capacity utilization dropped to 68.0% from 69.7% in December and 79.1% a year ago. The current figures are the lowest since 1983."

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. These monetary conditions may eventually help to stabilize commodity prices. We would become more constructive on commodity stocks such as Freeport McMoRan (FCX - Analyst Report), on signs reflation measures were working their way into the real economy.

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 low consumer confidence readings does not appear to add to the pool of available homebuyers.

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