It's not just Halloween that's spooking investors

Industrial Strength

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Even for the week before Halloween, the spooky vibes stood out in the industrial sector. A spike in coronavirus cases and renewed lockdown measures in two of Europe's biggest economies this week certainly didn't help. And I don't know if you've heard, but there's also a presidential election in the U.S. on Tuesday, with potentially wide-reaching ramifications on everything from tax rates and tariffs to perhaps even the future of the country's democracy. It also rained a lot on the East Coast. Put all those things together, and investors were in no mood to give the benefit of the doubt. 

This feeling had been building up for a while. Of the 56 members of the S&P 500 Industrial Index that have reported results since the beginning of September, the average earnings beat relative to analysts' expectations was more than 20%. The average stock reaction, however, was a decline of about 1%. It was always going to be a challenge to impress investors this earnings season, given the elevated valuations many companies had going in. There were some standouts, but about two-thirds of the way into the reporting calendar for industrial companies, many companies were the victim of expectations that raced too high, too fast amid a manufacturing recovery that appears to be losing some momentum. Depending on who wins the presidential election, many of these industrial companies could be looking at a higher tax rate, which would weigh on their earnings and valuations. With that in the background, it's hard for investors to justify topping up already heady stock prices without a very good reason.

NOTE: Honeywell and L3 Harris performance are as of noon Friday

Consider bellwethers Caterpillar Inc. and 3M Co. Neither was willing to provide formal guidance for this year or next. The commentary they did give seemed to point to a more gradual rebound than investors might have hoped. Caterpillar's retail machinery sales fell 20% in September, the same decline the company saw in August and July. 3M saw organic sales growth of about 1% in the third quarter. That implies a weaker-than-expected showing in September, especially after adjusting for the benefits of additional selling days this go-around and backing out a boost from currency swings and M&A, Barclays Plc analyst Julian Mitchell estimated. For October, 3M anticipates total sales will be flat to up low-single digits, reinforcing the narrative of a slow-moving recovery. Shares of 3M and Caterpillar both fell about 3% on earnings day.

For those companies that have been faring relatively well in the pandemic, the conversation has now shifted to whether those pockets of growth are sustainable. Stanley Black & Decker Inc., for example, reported 11% organic sales growth in its tools business as still-stuck-at-home consumers busied themselves with DIY projects. But the company is modeling a slight deceleration in the fourth quarter, despite certain holiday-related promotional shipments for this division shifting out of September and into October. That partly reflects a slowdown in Europe and emerging markets, executives said. Another quarter of booming sales growth wasn't enough for United Parcel Service Inc. investors, either, as the cost of getting that revenue — from protecting and hiring workers to investing in faster deliveries — weighed on profit margins. 

And then there were those companies who seemed to do everything right and still saw their stocks fall victim to a general market malaise. Norfolk Southern Corp., for example, was able to cut expenses by more than its sales declined, resulting in record productivity at the railroad. Executives said the company should be on track to bring its operating ratio down to 60% next year (a lower number is better for this metric), even with expectations for a prolonged slump in lucrative coal shipments across the industry and a lackluster view for energy volumes. Unlike peers who paused share buybacks during the worst of the coronavirus rout, Norfolk Southern kept up a steady pace, which meant the company wound up with some pretty good deals relative to its own stock price. And it plans to continue that. These are all the kinds of things shareholders normally like to hear and yet the stock was down more than 2% on earnings day.

It says a lot that one of the best- performing stocks on earnings this week was General Electric Co., which has successfully set such a low bar for itself that the mere presence of positive free cash flow was enough to overcome still-ugly results in its marquee aerospace business. CEO Larry Culp's turnaround efforts are finding new traction despite the pandemic and that was one of the few outcomes that wasn't already priced in to industrial stocks.

Changing the World, One Air Conditioner at a Time

I hope you all enjoyed the special edition of Industrial Strength on Monday. I may do this from time to time to highlight bigger projects. For those of you who missed it, I spoke with Trane Technologies Plc CEO Mike Lamach over the summer to learn more about the transformation of the company under his watch. I originally wanted to write about Lamach because he was a fan favorite of some of the smartest industrial investors and analysts I know. But it's clear within five minutes of talking to him that there's more to his success and worldview than a stock price. "I believe that profits follow purpose and if you do the right things, you'll find a way to earn a lot of money," Lamach said in a follow-up livestream Q&A on Wednesday. Solving for an air conditioning solution that wouldn't require customers to make a tradeoff between being green and saving money "created an innovation advantage for us that we've been continuing to press," Lamach said. That was evident in the company's third-quarter earnings report on Wednesday: A surprise sales gain in the period seemed attributable in part to market-share gains, said Melius Research analyst Scott Davis. Trane's commercial-facing business saw flat revenue, a better showing than his expectations for a 5% decline for the broader market. Trane shares gained 3.4% on the earnings news, despite a downbeat day for stocks as a whole. You can read the full profile here and watch our post-earnings livestream Q&A from Wednesday here

Deals, Activists and Corporate Governance

Siemens AG agreed to sell its Flender mechanical-drive unit to private equity firm Carlyle Group Inc. for 2 billion euros ($2.4 billion). The deal is expected to be one of the final divestitures in a years-long unwind during CEO Joe Kaeser's tenure. His successor Roland Busch assumed some responsibilities this month following the spinoff of Siemens's energy division, and Kaeser is expected to formally step down next year. Siemens had explored a spinoff of Flender before ultimately opting for the sale. The business makes gears and transmissions used in everything from wind turbines to beer making and has annual revenue of about 2.2 billion euros. 

Blackstone Group Inc. added more assets to a burgeoning portfolio of logistics businesses with a pair of deals this week. The private equity firm agreed to buy Simply Self Storage from Brookfield Asset Management for $1.2 billion and a package of industrial real estate in the U.K. from Prologis Inc. for 473 million pounds ($618 million). The Prologis deal includes 4.3 million square feet of existing facilities and 31 acres of developable land. Warehouses and self-storage are considered some of the most resilient sectors in the real estate market right now. Concerns that an economic downturn might fizzle the e-commerce boom have turned out to be unfounded as the pandemic motivates people to avoid crowded stores. Meanwhile, any sustained migration out of major cities could drive demand for self-storage in other parts of the country. Blackstone says the Simply Self Storage deal will make it the U.S.'s third-largest owner of storage not listed on a stock exchange.  

Raytheon Technologies Corp. this week disclosed it had received a criminal subpoena on Oct. 8 from the Department of Justice for records at its missile business going back to 2009. At issue are accounting and other reporting matters, although the company says it doesn't expect the results of this inquiry will have a material adverse effect on its operations or finances. Also in the third quarter, Raytheon said it received an additional subpoena from the Securities and Exchange Commission related to a previously disclosed investigation of potential improper payments by a joint venture with Thales SA in certain Middle Eastern countries starting in 2014. The disclosures appeared to spook the market but it's hard to read too much into that in a week when the market was easily spooked. Elsewhere in SEC matters, GE said it had set aside $100 million to cover all matters under investigation by the regulator — including a surprise $15 billion shortfall in its insurance business, its accounting around long-term service agreements and a $22 billion goodwill writedown in its power unit. If a $100 million fine is the extent of the probes' outcome, that will likely be viewed as a win by shareholders. 

Northrop Grumman Corp. is reportedly exploring a sale of its technology-services business. Any deal is likely to involve at least a $3 billion price tag, people familiar with the matter told Bloomberg News. That equates to about 6.5 times the business's operating income last year. This is not the first time Northrop has sought to sell this business; its sales have come under pressure in recent years as certain IT programs sunset and margins lag slightly behind the corporate average, notes Bloomberg Intelligence analyst Douglas Rothacker.

PSA Group and Fiat Chrysler Automobiles NV again tweaked the terms of their merger in an attempt to win regulatory approval. Peugeot maker PSA will now be allowed to sell as much as 7% of French auto-parts supplier Faurecia SE before the deal is completed. Fiat in September had agreed to shrink a dividend for its shareholders to bolster the combined company's financial cushion during the pandemic and had offered those investors a stake in Faurecia to make up for the reduced payout. Allowing PSA to sell a stake beforehand will prevent the merged company from having control of Faurecia, allaying any market share concerns. The proceeds will be distributed to shareholders. As of now, it appears the automakers will be able to avoid more significant divestitures. 

Bombardier Inc. agreed to rejigger the terms of the sale of certain airplane-structure operations to Spirit AeroSystems Holdings Inc. The cash consideration in the deal will drop to $275 million from $500 million. This is not great news for Bombardier which already had to accept a lower price on the divestiture of its train unit and now has less cash to pay down debt and try to make something of itself as a standalone business-jet company. But something is better than nothing. Spirit has already canceled a takeover of airplane-wing supplier Asco Industries. The Bombardier deal is expected to close Oct. 30. 

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United Plans Newark-London Virus Testing as Tool to Spur Travel
Amazon, FedEx Help Boost U.S. Warehouse Jobs Amid Online Boom
Mercedes Offers a First-Class Drive in a Pandemic: Chris Bryant
Airplane Parking Lot in Middle of Nowhere Has Never Been Busier
Zero Hour Is Coming for Emissions. Believe It: David Fickling
With Robotaxis Still a Distant Dream, Lidar Makes Itself Useful

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