Industrial CEOs aren’t sounding the recession alarms just yet, but they seem to be spending an increasing amount of time thinking about one.
Leaders of some of the top industrial companies gathered this week in Coral Gables, Florida, for an annual spring confab that’s known almost as much for its golf rounds as for its revelations about M&A and strategic overhauls. One thing this year’s Electrical Products Group Conference was notably light on was fresh macroeconomic insights – but not for a lack of questioning from analysts and investors. Wary perhaps of reigniting the panic sparked last year when Caterpillar Inc. warned of a “high watermark” in its profits, some CEOs just dodged the subject. W.W. Grainger Inc.’s D.G. Macpherson waved away a question about April and May sales trends, preferring instead to simply agree with an analyst’s characterization of recent data as “lumpy.” Another analyst joked to DowDuPont Inc. CEO Ed Breen on Tuesday that after a day and a half of presentations, no one had offered any macroeconomic views worth writing about and “we need content.”
Part of the issue may be that while a lot has happened on the U.S.-China trade-war front since we last heard from CEOs on their first-quarter earnings calls, it has really only been about a month; meanwhile, economic data has been zig-zagging all over the place. No one seems quite sure what to make of things beyond the familiar refrain of slumping demand for automotives and electronics in China and generally lackluster growth in Europe, with the bright spot continuing to be the strength in aerospace and other markets with longer selling cycles. On the positive side, Stanley Black & Decker Inc. CEO Jim Loree – who in January said “reality is setting in” on a slower-growth environment – is now less concerned about a recession in 2019 because he thinks politicians are incentivized to have a good economy going into the U.S. election. But he sees the trade war as the biggest wild card. Overall, CEOs seemed cautious –nervous even. Parker-Hannifin Corp.’s Tom Williams said he expects inventory pileups to continue to dent growth in the current quarter and then “we’ll see what happens.” DowDuPont’s Breen said he’s ready to cut costs to protect his Ebitda forecast if a revenue rebound doesn’t materialize, while Emerson Electric Co. is accelerating restructuring and CEO Dave Farr reportedly said some customers had pushed projects into fiscal 2020.(1)
What was especially interesting was the number of executives who either got asked about or felt compelled to point out that their business could be resilient in a recession. That suggests that while a downturn hasn’t yet arrived, in some CEOs’ minds it’s already in the mail. Parker-Hannifin’s Williams said his company could achieve its fiscal 2023 margin targets despite what he characterized as a “low-growth environment right now.” Eaton Corp.’s Craig Arnold said cash flow should be stable even in a slump, which gives the company share buyback ammunition that could keep earnings per share flat in a standard recession. Honeywell International Inc. CEO Darius Adamczyk and Fortive Corp.’s Jim Lico pointed out they had divested the parts of their business most vulnerable to economic swings, with Adamczyk also noting that his company’s efforts to fund its pension and reduce environmental liabilities had left its balance sheet in better shape to weather a slump. Contrast that with General Electric Co., which has one of the largest unfunded pension balances on the Standard & Poor’s 500 and a long-term care insurance liability that could balloon further if interest rates drop, but also to 3M Co., which is embroiled in litigation over the manufacturing of per- and polyfluoroalkyl substances (PFAS) that have been linked to cancer. The advantages of a more pristine balance sheet are clear; I’m less convinced by pledges of margin and earnings resiliency and worry that the recent spate of breakups may leave companies exposed to more targeted pain in a downturn. But if CEOs’ recession-planning talk is a guide – not to mention the first monthly contraction in IHS Markit’s gauge of new U.S. manufacturing orders since 2009 – we may get to test that theory sooner rather than later.
DIGITAL OVERLOADAnother big topic at EPG this year – and an oft-cited reason for why companies might be more defensive in a downturn – was digital investments. There was a lot of talk about modernizing internal software systems and developing more user-friendly online interfaces for customers, which raises interesting questions about how pricing power will hold up for companies whose goods are more commoditized. And just about everyone, from Parker-Hannifin to electrical-enclosure maker nVent Electrical Plc., has some kind of strategy to extract data from their equipment and profit off of whatever insights are gleaned from that information. Xylem Inc. CEO Patrick Decker said the water-treatment company was booking $10 million of software-related business two years ago; now, it’s more than $125 million. In general, companies seem to have learned the lessons of GE’s digital flop: Honeywell’s Adamczyk says he won’t give his company’s digital arm an open checkbook and expects it to pay for itself, while Rockwell Automation Inc.’s Blake Moret defended partnerships with PTC Inc. and Schlumberger Ltd. because “no one company is going to have all the answers top to bottom.” While I agree that it’s unlikely there will be one digital industrial champion, I also wonder whether we are reaching the point of too many options. My colleague Tara Lachapelle has written about this in regard to streaming-video products that are now so numerous that the cost of buying all the ones you need starts to make a cable package look attractive again. Similarly, no industrial company is going to want a different software-analytics suite for every piece of equipment; half of them probably have their own digital strategy anyway. Eventually, a handful of winners may emerge, but given the competitive backdrop, it remains unclear to me how you package software services in a way that doesn’t render the product a commodity.
CHINA NEEDS ME, CHINA NEEDS ME NOTSiemens AG CEO Joe Kaeser returned to EPG for the first time in six years because “this time we have got something to tell.” That something is Kaeser’s plan to continue his slow-rolling breakup of Siemens with the carve-out of the company’s power, oil and gas and renewable-energy businesses. It’s a smart move that will help focus investors on Siemens’ faster-growing, more profitable industrial software and factory-automation operations. Another way to read it is an essential admission of defeat on the long-term attractiveness of the gas turbine business, particularly in the context of Siemens’ expanded technology-sharing partnership with China’s State Power Investment Corp. Kaeser said this week that he believes China’s desire to scale back its reliance on coal-fired plants will make it by far the biggest market for combined-cycle gas power from 2025 onward, but the country will want to capitalize on that by investing in its own national champion for high-efficiency technology. China has taken a similar approach in its push into telecommunications and railroad markets and made notable strides in picking up market share in international territories. It didn’t do this by being particularly disciplined on price. As such, growing competition from the country in gas turbines would seem to bode poorly for GE’s efforts to stabilize its own power unit. Also speaking at EPG, GE CEO Larry Culp was somewhat dismissive of the threat posed by China’s ambitions. GE will continue to invest in innovation to distinguish its technology, but Culp isn’t banking on demand from China to drive a turnaround in the power business. For me, that raises troubling questions about what level of improvement in the unit’s depressed financials constitutes a “turnaround” in GE’s mind.MORE BUMPS FOR BOEING The U.S. Securities and Exchange Commission is reportedly investigating whether Boeing Co. properly disclosed issues related to the 737 Max to investors. To be honest, it would be more surprising if the SEC wasn’t looking into such a significant event where there are questions about what Boeing knew and when it knew it. Boeing has acknowledged its engineers discovered that a warning light intended to be standard didn’t operate as expected well before the first crash of the jet in October, and more recently discovered its simulators don’t accurately replicate the conditions pilots likely faced in both that incident and a second accident at Ethiopian Airlines in March. That doesn’t mean the SEC will find wrongdoing, but this adds another headache for Boeing; the company is already facing a separate criminal investigation into the Max’s original certification, lawsuits on behalf of the dead passengers and requests from airlines for compensation for the impact of a worldwide grounding. The latter bill obviously grows the longer the planes stay in warehouses. On that front, the Federal Aviation Administration gathered foreign regulators in Texas this week to discuss a potential road map for returning the Max to service. Acting FAA Chief Daniel Elwell said the talks were constructive, but there are conflicting messages about the timeline for recertification. Elwell has said there’s no timetable and he couldn’t necessarily say the Max would be back flying by October because regulators still need to determine what additional training, if any, will be required. But then Reuters reported FAA officials are telling the United Nation’s aviation agency they expect to recertify the Max as early as late June. Elwell also told the Seattle Times that the FAA won’t be compelled to wait for other regulators before lifting the grounding. Both the EU and Canada have signaled they will conduct their own safety reviews, and Indonesia said it may wait for those second opinions to make a decision. Getting regulators’ blessing is in some ways just the first step, too. Southwest Airlines Co.’s Max jets have now been sitting for so long – in the desert, mind you – that it will take about 120 hours to get each plane ready for service again. United Continental Holdings Inc. and Southwest are bracing for at least some consumer pushback, with both saying they would rebook passengers who wanted to switch to a different plane model.
DEALS, ACTIVISTS AND CORPORATE GOVERNANCECrane Co. said Circor International Inc. had rejected its takeover offer of $1.7 billion, forcing it to air its proposal publicly to shareholders in the hopes of cajoling the board into negotiations. Circor, which makes valves, gauges and other industrial parts, said the $45-a-share all-cash bid was opportunistic and undervalued the company. Circor shareholders may disagree with that contention, seeing as the stock has been trending generally downward for much of the pastfive years and closed at just above $30 before Crane publicized its latest offer. As a testament to this, Mario Gabelli, whose firm Gamco Investors Inc. is one of Circor’s biggest holders and also a Crane investor, called in to Crane’s conference call on the proposal and said a deal would be “good for both companies.” He also pointed out that Circor, which received Crane’s bid on April 30, held its annual meeting a week later and failed to mention the offer as shareholders re-elected two directors on the staggered board. Gamco later said it would seek candidates for possible nomination to Circor’s board and explore ways to improve corporate governance. Stifel Financial Corp. analyst Nathan Jones raised the specter of ITT Inc. or Flowserve Corp. making a competing offer for Circor. But this is the third time in eight years that Crane has tried to buy Circor, so it would appear the company wants this deal badly. Also, the implied forward Ebitda multiple of nearly 14 times is already quite rich, particularly if you think the economy is slowing down.United Technologies Corp. CEO Greg Hayes, speaking at the EPG conference, said the window of opportunity for exploring alternatives to spinoffs of its Carrier building controls and Otis elevator divisions is now officially shut. United Technologies plans to have the units operationally independent by the end of 2018, paving the way for the spinoffs to happen as early as March, pending tax verdicts. Hayes doesn’t want to mess up that timeline with an M&A adventure, but he went into a decent amount of detail on what types of transactions the two businesses could consider once they stand alone. Carrier could divest its fire and security operations and its commercial refrigeration arm to become more of an HVAC pure-play, he said. That could be done either in conjunction with or separate from a combination with the likes of Johnson Controls International Plc or Lennox International Inc. A merger between Otis and the elevator unit Thyssenkrupp AG is spinning off “makes a lot of sense” but would require significant divestitures and could be a hard sell to regulators, Hayes said. That’s also true of a merger between Thyssenkrupp’s elevator arm and Kone Oyj, he said. Hayes also detailed the debt each unit would likely bear, with the goal of each being investment grade. Otis will take $6 billion to $8 billion, Carrier $12 billion to $13 billion and then the remaining burden of roughly $25 billion will stick with the aerospace businesses.Honeywell CEO Adamczyk said it’s unlikely he’ll pursue a $5 billion-plus takeover of a software company. He’s more interested in smaller transactions because there’s still work to be done internally to develop the skill-sets necessary to run software businesses. “I’m not sure I’m necessarily hunting for the signature acquisition,” he said. “Sometimes when you do that you can really fall flat on your face.” Wise words. Xylem CEO Decker also signaled he would hold off on large M&A for the time being, saying a deal on the scale of the company’s $1.7 billion takeover of Sensus USA Inc. in 2016 likely wouldn’t happen until 2020. But there are 12 small startups in Xylem’s deal pipeline and the company is focusing on targets with a digital bent, as well as the industrial water services and treatment sectors. Eaton’s CEO Arnold said he’s heard from parties interested in acquiring the company’s lighting business and that potential tax liabilities wouldn’t be significant enough to argue against a sale; for now, though, that business remains on track to be spun off by the end of the year. Arnold said he knows that Eaton’s hydraulics unit is its weakest link right now and he has no reservations about divesting that should it continue to underperform relative to the company’s targets. Roper Technologies Inc. CEO Neil Hunn said he’s not opposed to divestitures of the company’s legacy industrial businesses, but given the high quality of those assets, he would need a “screaming” price to justify paying the associated taxes and putting shareholders through the risks of a sale process.
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(1) I say “reportedly” because that is what analysts reported back as Emerson is one of the few companies that doesn’t webcast its EPG presentations. Farr has said in the past that this is because he thinks people should make the effort to get to Florida, but that ignores the fact that media isn’t allowed to attend.
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Brooke Sutherland is a Bloomberg Opinion columnist covering deals and industrial companies. She previously wrote an M&A column for Bloomberg News.
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