Morningstar Advisor - June/July 2009 - 59

HK: Your team recently published a study on President Obama’s plan to raise taxes on overseas corporate income. What were your conclusions and how much of a hit would this be to industrials stocks? AF: We’ve found that a large number of our firms would be affected, from some of the largest diversified industrials like General Electric and Eaton ETN to some of the most-niche operators like Tidewater TDW. The issue revolves around taxes on overseas income, which is typically taxed at a lower foreign tax rate. The current tax code allows those companies that don’t repatriate the income to not pay the difference between that lower rate and the U.S. statutory 35% corporate rate. Obama has proposed in vague language to force U.S.-based companies that enjoy this tax break to pay higher U.S. tax rates on overseas income regardless of whether or not it’s brought back home. The thinking is that this will discourage offshoring, but we’re not so sure. HK: Let’s turn to happier thoughts. Are there HK: If I screen for industrials stocks with price/ cash-flow multiples less than 10, I get pretty much the entire sector. Is that even a good way to look at the sector right now? Do those cash flows have a lot of room to fall? JK: We tend to look at price/sales more than price/cash flow, but both are reasonable measures to value the sector, and both would suggest the sector is relatively cheap at current prices. With revenues and operating margins likely to contract further over the near term, we believe that cash flows do have room to fall. That said, we think cash flows will hold up better than earnings because of more-efficient working-capital-management initiatives implemented over the past several years. In past downturns, we saw inventories balloon and subsequently consume vast amounts of cash because of softened demand. With leaner operating practices and a heightened focus on working capital needs, the variability in cash-flow changes has been mitigated to a certain degree compared with that of earnings. HK: If I wanted a list of five industrial stocks to own for the next five years—currently undervalued, great balance sheets, long-term growth potential—what would they be? JK: Caterpillar and 3M are two names we think DH: A lot of GE’s valuation boils down to how much of a diversion GE’s bank, GE Capital, becomes. In an optimistic case, the bank will require no more capital from the parent company and management’s restructuring of the division will result in meaningful earnings contribution by the end of 2010. In this case, industrial cash flows can be used for reinvestment in promising green infrastructure areas. A fair value of $40 per share is not unrealistic in this scenario. Holding us back, though, is the fact that GE’s bank unit has yet to face the eye of the hurricane in terms of losses. In a pessimistic case, which takes the loan losses in the bank through 2011, the parent may have to send over more cash to the bank. This would potentially stunt the growth of the industrial businesses, leading to a fair value around $15 per share. HK: Where does the Morningstar industrials team deviate from consensus the most? DH: Because our time horizon is longer than most, we are going to be a bit more optimistic at the bottom of the cycle and pessimistic at the top of the cycle. Take GE. As soon as you are able to rule out liquidity and financial distress, the long-run earnings potential of the entire enterprise suggested that a $6 stock price was way too low. While today’s challenges are nothing to scoff at, there will be a tomorrow, and by forecasting beyond 2010 we are able to pick up value that other market participants may be unwilling to pursue. One of our guiding philosophies is that it’s tough to make money doing the same thing as everybody else. Only when you employ independent thinking can you expect to outperform. As simple as it sounds, thinking long-term is a key component in our toolbox. You’d be surprised how few actually do it. HK: Thank you, gentlemen. K Haywood Kelly, CFA, is vice president of equity research at Morningstar. any names that you think will come out of the downturn in better competitive shape—because competitors are struggling or for other reasons? John Kearney: One name we think has the potential to emerge from the downturn with a better competitive position is Mohawk Industries MHK. Mohawk is one of two floor-covering manufacturers that dominate an otherwise highly fragmented industry. While the company has seen its profitability deteriorate with the rest of the industry, Mohawk has the wherewithal to make it to the other side of the trough. Conversely, we believe the current economic malaise will drive a number of its smaller, capital-constrained competitors out of business, providing an opportunity for Mohawk to buy these firms at bargain prices. In either case, we believe that the company can further expand its market-leading position in the flooring space as it emerges from this protracted downturn. should top that list. They are excessively cheap because of short-term profit concerns, but both have strong credit ratings and robust long-term earnings power. Illinois Tool Works is another one of our longtime favorites that rarely goes on sale but looks very attractive at current prices. We also like beaten-down transportation firms like Expeditors International of Washington EXPD and Norfolk Southern NCS, which could be early beneficiaries in a recovery. HK: Daniel, you cover the biggest name in the sector, GE, and just about everyone owns it either directly or through a fund. Your fair value estimate is $22. Walk us through potential downside and upside fair values. MorningstarAdvisor.com 59

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Morningstar Advisor - June/July 2009

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