The American manufacturing business continues to gather steam amid tariff related uproar rooted by President Trump and other overseas countries.
The Institute for Supply Management (ISM) manufacturing index marginally dipped to 58.1% in July from 60.2% recorded in the previous month. Nevertheless, a higher-than-50 reading indicates that the bulk of manufacturing companies within the economy are gaining strength.
Corporate spending across manufacturing industries is shoring up at a healthy pace on the back of robust domestic and global demand. Nonetheless, ongoing issues like shortage of skilled laborers and material cost inflation, resulting from higher tariff and transportation expenses, remain major causes of concern for U.S. manufacturers.
The latest industrial production report of the Federal Reserve revealed that aggregate production of electronic products in the United States logged month-over-month growth of 1.3% this July. This clearly indicates that the electronic manufacturing stocks will likely gain in the months ahead irrespective of tariff-related apprehensions. However, cost inflation remains a major drag.
Industry Returns Outpace Sector's Yield
The Zacks Manufacturing-Electronics industry, which is a 20-stock group within the broader Zacks Industrial Products sector, has underperformed the benchmark S&P 500 group but outpaced the sector over the past year.
While the stocks in this industry have collectively rallied 14.2%, the Zacks S&P 500 Composite and Zacks Industrial Products Sector have gained 17.8% and 10.7%, respectively (the blue line in the chart below represents the industry).
One-Year Price Performance
As you can see, the industry's stock market performance peaked this January, as did the broader market. Nevertheless, it has failed to get back to those levels ever since, most likely underlining the industry's exposure to certain headwinds. Ongoing troubles like workforce shortage, soaring transportation costs and inflation in the prices of inputs, like steel and aluminum, due to higher tariffs, might have thwarted the group's recent performances.
Electronic Stocks Appear Pretty Expensive
Since the electronic-product manufacturing companies are debt laden, it makes sense to value these based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio. This is because the valuation metric takes into account not just equity, but also the level of debt. For capital-intensive companies, the EV/EBITDA is a better valuation metric because it is not influenced by changing capital structures and ignores the impact of non-cash expenses.
Owing to the industry outperformance over the past year, the valuation is really expensive now. The industry currently has a trailing 12-month EV/EBITDA ratio of 15.3X, which is marginally below the high of 16.9X for the past year, but almost in line with the median level. Clearly, the aggregate valuation picture for the space appears rich.
The space looks quite pricey when compared to the market at large, as the trailing 12-month EV/EBITDA ratio for the S&P 500 is 11.7X and the median level is 11.5X.
Enterprise Value/EBITDA Ratio (TTM)
Earnings Outlook Looks Encouraging & Stable
Robust industry fundamentals and expectations of solid top-line growth will likely help the electronic-product manufacturing stocks generate higher shareholder returns in the near future.
Efforts to keep pace with the rising demand for technologically-advanced products are prompting companies to invest in innovative projects. New products in the market will help tap demand from the existing customer base, as well as attract new customers. This, along with sound economic health of the nation, will drive the top line for multi-sector companies, moving ahead.
But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. The earlier valuation discussion shows that market participants might be interested in gaining exposure in the stock at current levels.
One reliable measure that can help investors understand the industry’s prospects for a solid price performance, going forward, is the industry's earnings outlook. Empirical research shows that earnings outlook for the industry, a reflection of the earnings revisions trend for the constituent companies, has a direct bearing on its stock market performance.
The Price & Consensus chart for the industry below shows the market's evolving bottom-up earnings expectations for the industry and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019, while the light blue line represents the same for 2018.
Price and Consensus: Zacks Manufacturing-Electronics Industrial Industry
This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.
Please note that the $2.13 'EPS' estimate for the industry for 2018 is not the actual bottom-up dollar EPS estimate for every company in the Zacks Electronics industry, but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the dollar earnings of $2.13 'per share' of the industry for 2018, but how this dollar number has evolved recently.
Current Fiscal Year EPS Estimate Revisions
As you can see here, the $2.13 'EPS' estimate for 2018 is slightly up from $2.12 at the end of June and $2.10 at the end of August 2017. In other words, it seems that the analysts are now gaining confidence in the industry’s earnings potential. (earnings estimates remained fairly stable since Feb this year)
Zacks Industry Rank Unfavorable
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates underperformance in the near term as the industry battles trade tariffs and higher input cost inflations.
The Zacks Manufacturing-Electronics industry currently carries a Zacks Industry Rank #174, which places it at the bottom 32% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.
Notably, our proprietary Heat Map shows that the industry’s rank has remarkably deteriorated in the last two weeks. However, the industry has remained in the top half of the rank list for the majority of the period in the past eight weeks.
Industry Heat Map
Electronics Industry Assures Long-Term Growth
The long-term prospects for the industry are alluring. When compared with the broader Zacks S&P 500 composite, the long-term (3-5 years) EPS growth estimate for the Zacks Electronics industry appears promising.
The group’s mean estimate of long-term EPS growth rate has been rising since mid of November 2017 and has remained stable in the past couple of months to reach the current level of 10.1%. This compares favorably to 9.8% for the Zacks S&P 500 composite.
Mean Estimate of Long-Term EPS Growth Rate
In fact, the basis of this long-term EPS growth could be the recovery in top line that the Zacks Electronics industry has been displaying since the beginning of 2018.
Zacks Electronics Industry Revenues
Another important indication of the industry’s solid long-term prospect is improvement in the return on capital employed (ROIC). The image below clearly shows that the group’s ROIC has been improving since the end of 2017.
Zacks Electronics Industry ROIC
This outlook analysis shows that on an average, stocks within the Zacks Manufacturing- Electronics industry have yielded higher returns than the sector over the past year, but underperformed the broader market growth.
The industry is currently trading higher than the broader market. Also, we believe apprehensions regarding material-cost inflation and elevated transportation expenses might have dragged down the industry’s Zacks Rank over the past two weeks.
Nonetheless, the industry will likely keep its earnings streak alive in the upcoming quarters, driven by robust top-line growth prospects.
In sync with this, we have focused over four electronic-product manufacturing stocks below, which, we believe, will embrace promising near-term prospects in the middle of the prevalent issues troubling the U.S. manufacturing market.
These picks carry a Zacks Rank #1 (Strong Buy) or 2 (Buy), and have witnessed positive earnings estimate revisions for the last 60 days.
AZZ Inc. (AZZ - Free Report) provides metal coating and galvanizing services, highly engineered services, and specialty equipment to the refining, distribution, power generation and transmission markets. The Zacks Consensus Estimate for earnings has surged 9.5% to $2.20 per share for fiscal 2019 (ending February 2019). The company currently flaunts a Zacks Rank of 1. You can see the complete list of today’s Zacks #1 Rank stocks here.
ESCO Technologies Inc. (ESE - Free Report) manufactures and sells engineered systems and products for industrial, aerospace, utility, and commercial applications market in the global form. The company currently carries a Zacks Rank #2. The Zacks Consensus Estimate for earnings has surged 1.1% to $2.68 per share for fiscal 2018 (ending September 2018).
A. O. Smith Corporation (AOS - Free Report) produces and sells commercial and residential gas, electric water boilers, heaters, and water treatment products across the globe. The company currently carries a Zacks Rank #3. The Zacks Consensus Estimate for earnings has surged 0.8% to $2.61 per share for 2018.
Emerson Electric Co. (EMR - Free Report) offers various solutions to the commercial, residential and industrial markets globally. The company currently carries a Zacks Rank #3. The Zacks Consensus Estimate for earnings has surged 0.3% to $3.19 per share for fiscal 2018 (ending September 2018).
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