It's not shaping up to be a great year for the industrial sector, but that doesn't mean investors can't find industrial stocks to buy at attractive prices. There's no doubt that railroad Union Pacific (NYSE:UNP), diversified manufacturer Dover Corporation (NYSE:DOV), and industrial software company Dassault Systemes (OTC:DASTY) are facing significant earnings headwinds in 2020, but there are strong arguments for their being good values for long-term investors.
Railroads are the veins and arteries of the U.S. industrial sector. If the U.S. economy is in good shape, then so are the railroads. That means railroads are certain to take a major hit from the COVID-19 pandemic and the measures taken to contain it. But railroads will surely benefit when the economy turns up.
First, the bad news. The latest rail traffic data from the Association of American Railroads (through April 11) shows total carloads are down 8.2% year to date, compared to the same period last year. Moreover, they are down 23.8% in the week ending on April 11 compared to the same week a year ago.
Clearly, Union Pacific and other railroads are heading for bad news in the short term, but long-term investors need to consider a few things:
- Railroad traffic is so integral to the economy that when activity picks up, they can have a high degree of confidence that the railroads will start to see it in their revenue.
- North America's Class 1 railroads own their infrastructure and function as effective duopolies in their respective geographies, setting up a system of little competition, so Union Pacific is highly likely to emerge from the downturn with its market position intact.
- All seven Class 1 railroads have the opportunity to generate underlying improvements in their profitability thanks to the adoption of Precision Scheduled Railroading management techniques.
In common with the other U.S. railroads, Union Pacific's PSR initiatives have thus far demonstrably improved profitability. Before the COVID-19 pandemic, CSX, Kansas City Southern, Norfolk Southern, and Union Pacific were predicting an improvement in profit margin in 2020.
Unsurprisingly, Union Pacific has now withdrawn its full-year guidance. In a sign of the underlying improvement, though, the railroad reported its lowest ever operating ratio (expenses divided by revenue, so a lower number is better) in its recently reported first quarter. https://www.up.com/cs/groups/public/@uprr/@investor/documents/investordocuments/pdf_1q20_er_slides.pdf
The recent dip in Union Pacific's share price means the stock comes with a 2.6% dividend yield. As you can see below, the payout ratio (dividend divided by earnings) is still relatively low, and free cash flow is easily covering dividends. This suggests Union Pacific's dividend is safe, and given that the 10-year Treasury yield is just 0.6%, Union Pacific is a good option for income-seeking investors.
This engineered products company and Dividend Aristocrat will certainly take a hit from the COVID-19 pandemic, but it has an opportunity to bounce back in due course. There are two main reasons why. First, as the chart below shows, Dover is exposed to a wide range of end markets, and many of them are in areas that are likely do well during a recovery.
For example, retail fueling and the automotive aftermarket are likely to do well when cars get back on the road, especially as gasoline prices have fallen significantly. In addition, while food retail and waste management are not often seen as defensive sectors to invest in, strength in those areas will help offset weakness in industrial applications, hospitality, restaurants, and oil and gas. The latter is an area Dover has significantly reduced its exposure to in recent years.
The second reason comes from management's initiatives to reduce selling, general, and administrative (SG&A) costs in order to improve operating margins. The plan also calls for reinvestment to encourage growth and improve profitability.
The chart below shows the progress the company has made in the last couple of years. Management plans to generate more improvements in 2020.
While its impossible to know if revenue in 2021 will be higher than in 2019, management recently gave its first-quarter 2020 earnings report and indicated that the second quarter of 2020 would be the weakest quarter under the current forecast and it expects "incremental improvement through Q4." In other words, the trend should turn upward by the third quarter of 2020 and Dover could be growing revenue in 2021. Throw in the prospect of higher margin due to ongoing cost cuts and Dover could be in relatively good shape, provided the economy is growing. That makes it a stock to buy.
Engineering software company Dessault Systemes is also highly likely to see its sales impacted by the COVID-19 pandemic. After all, companies tend to cut back on investments in developing new products when their own sales growth is in reverse. But Dassault has a number of long-term trends behind it that should enable strong growth to resume after the pandemic is contained.
In a nutshell, the growth of the Internet of Things (IoT) and the digitization of factories are creating significant growth opportunities for companies like Dassault. It's not always appreciated, but industrial companies are set to be big winners from the IoT revolution.
Before web-enabled technologies were in place, companies would use industrial software like Dassault's computer-aided design or simulation software to better engineer solutions. However, with the advent of the IoT, these solutions can now be fully integrated into a product lifecycle management (PLM) approach.
PLM is the cycle in which a product, say an airplane or piece of mining equipment, is conceived, designed, and ultimately manufactured. Thanks to the use of the IoT, and Dassaut's software platforms, this process can be made more efficient. These advances also allow different departments of the company to collaborate on the engineering and development of new products.
Before COVID-19 spread around the world, industrial software sales were growing strongly on an industry-wide basis. A further indication of the strength of the underlying market comes from Dassault's recent first-quarter results. Although management downgraded revenue growth expectations to 12%-13% from a previous estimate of 21%-23%, that's would still be a strong performance in what's likely to be a tough year for the industrial economy.
All told, growth in the industrial software sector is likely to outperform when the recovery occurs, and Dassault is well-positioned to take advantage of that trend.