3 Industrial Stocks Showing They Can Handle a Slowdown

AMETEK (AME -0.24%) certainly isn't one of the most high-profile or glamorous stocks on the market, but who cares when the stock continues to set all-time highs? The stock prices of its fellow industrial companies Roper Technologies (ROP -2.52%) and Parker-Hannifin (PH 0.78%) are also close to their all-time highs. The question now is: What's going on in a sector that many believe is possibly entering a recession, and can the stock prices keep rising?

Image source: Getty Images.

Slowing end markets

Here's an example of what many commentators are fearful of. The chart shows the widely followed Institute for Supply Management business survey data -- a reading below 50 indicates contraction in the industrial economy. 

The data shows a sharp slowdown in activity in 2019,  matched by a slew of industrial companies, from Illinois Tool Works through to Caterpillar and Parker-Hannifin the railroad stocks have either cut full-year guidance or are warning of deteriorating conditions -- important considering that railroad stocks are always a useful bellwether.  

US ISM Manufacturing PMI data by YCharts.

There are three key mitigating factors to consider:

• This year was always going to be a slower year anyway, but the optics have been clouded due to the repercussions of trade tensions and natural cyclical slowing in industries such as automotive production.
• Broad-based slowing has occurred, but there are still pockets of industrial strength (aerospace, life sciences, process industries, pulp & paper, and food & beverage, for example) to offset weakness in others (industrial automation & robotics, semiconductors, consumer electronics).
• Companies with excellent management and business models such as Roper Technologies, Parker-Hannifin and AMETEK can do particularly well in this environment as their cash flow generation means they can make value-enhancing acquisitions.

Clouded optics

The first point is illustrated by looking at AMETEK's guidance through the year. Going back to the start of the fiscal year, AMETEK had just reported a year of 7% organic sales growth in 2018, and management was expecting full-year 2019 organic sales growth of 3% to 5%. Move ahead to the recent third-quarter earnings report and management is now expecting full-year organic sales growth of 3%. The point here is that growth was already expected to slow in 2019; it's just that it's slowing more than expected.

AMETEK CEO David Zapico's answer to a question on the earnings call helped shed some light on matters:

This doesn't feel like the prior downturn to us. And, but there is -- this one is our self-induced. And it's different. And it's really trade-related. 

The "prior downturn" that Zapico is referring to is the 2015-2016 period -- AMETEK's sales declined 3.4% in 2016 due to lower sales in its "process businesses that have exposure to oil and gas markets, and in its engineered materials, interconnects and packaging businesses that have exposure to metals markets," according to the company's filings with the Securities and Exchange Commission.

It's an important point to digest, because the last slowdown was guided by a dramatic slump in commodities prices, while this one is characterized by reactionary events from trade tariffs -- suggesting that underlying conditions are still positive, and growth could bounce back given a resolution to the trade conflict.

Indeed, Parker-Hannifin's CEO Thomas Williams recently said that he expected that his company's organic sales growth would start bottoming out a some point between its fiscal second and third quarters of 2020 -- for reference the company's first-quarter 2020 end recently in September. Note that this doesn't mean that sales will turn positive, but rather that the trend will start to turn positive from being in negative territory. 

Pockets of growth

The asymmetric nature of the slowdown is also evident in the third-quarter sales by product and services. Indeed, Zapico outlined that areas like aerospace, medical, and process automation remain strong and are offsetting weakness in industrial automation and the Asia region -- both related to the trade war.

Data source: AMETEK presentations.

Meanwhile, Parker Hannifin's organic sales declined 3% in its most recent quarter, but Williams said  "Aerospace continues to be very strong, lawn and turf, forestry and marine." https://www.fool.com/premium/coverage/earnings/call-transcripts/2019/10/31/parker-hannifin-corp-ph-q1-2020-earnings-call-tran.aspx

Roper's more cyclical process technologies and measurement & analytical solutions segments both had organic sales declines in its recent third-quarter, but were offset by good growth in its software segments leading to 2% year over year organic growth in the quarter.

When the going gets tough

Adverse conditions can also create opportunities, and this is where highly cash-generative and acquisitive business models like AMETEK, Parker-Hannifin, and Roper Technologies can thrive. AMETEK has a history of earnings-enhancing acquisitions and has never had a goodwill write-off relating to an acquisition, according to Zapico.

Indeed, AMETEK has deployed $1.1 billion in 2019 on two acquisitions -- $125 million on thermal management technology company PDT and then the $925 million on life-science technology company Gatan -- incidentally bought from Roper Technologies. The latter has been shifting toward software-based business for a while, which explains Roper's $1.63 billion purchase of life insurance and annuity industry software company iPipeline. 

Roper's sale of Gatan is another pragmatic decision by a company that is increasingly moving toward generating recurring revenue from its technology businesses.

Parker-Hannifin has also joined in on the acquisition trend. It recently bought adhesives, coatings, and motion control company LORD for $3.68 billion. In a nutshell, all three have been using their strong cash flow generation to take advantage of weaker end market conditions in order to make value enhancing acquisitions.  

AME Price to Free Cash Flow (TTM) data by YCharts.

Time to buy?

As you can see in the chart above, AMETEK doesn't look like a cheap stock on a conventional basis, and it's hard not to think that investors aren't getting much of a discount to reflect an uncertain economic environment. Nevertheless, if the arguments above apply and the industrial slowdown isn't likely to become a recession, then investors might want to take a look at a value option like Parker-Hannifin instead.

There are pockets of growth out there, and the trade war is making what is possibly just a midcycle slowdown start to look like something more ominous. But good-quality companies like AMETEK, Roper, and Parker-Hannifin continue to do well.