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Below is a report revolving around GE [in context with a Median Line
post] as well as their PE analysis and state of the economy. Hope it
is of interest. As the saying goes "As goes GE so goes the S&P"
John
S a l o m o n S m i t h B a r n e y R e s e a r c h
Introducing Our New Rating System
General Electric Co(GE)
Rating: 1L
As of 09/08/2002
Last Changed 09/07/1999
The Salomon Smith Barney Equity Research Department
changed their Stock and Industry Ratings System as of September 7,
2002. Click here for more information.
Salomon Smith Barney ~ September 7, 2002
See last pages for Important Disclosures
Multi-industry
Introducing Our New Rating System
September 6, 2002 SUMMARY
* We are introducing a new "relative" ratings
system for
Jeffrey T. our coverage list in accordance w/ SSB's new
research
Sprague, CFA guidelines which requires our universe of stocks
to be
ranked in preference relative to each other.
For the
purposes of this note our entire coverage list
is being
John Roselli, CFA considered "multi-industry".
* We believe our industry will outperform the S&P
500
over the coming year. We would Overweight the
Mark Wilterding multi-industry group because the group typically
outperforms in the earlier stages of an economic
cycle
and valuations in general are below historical
averages.
* Although the nomenclature is changed, our view
on our
industry and stocks is essentially unchanged.
Our
Outperform-rated stocks in order of preference
are Tyco,
SPX Corp, GE, and Danaher.
OPINION
We rate our Multi-Industry group overweight versus the S&P 500. Our
group
typically out performs the S&P 500 in the early portion of economic
recoveries. For example, in the 1991-1993 time frame our group
appreciated
76% compared to a rise of 41% for the S&P 500. Often in the early
stages of
recoveries the fundamentals actually still look quite grim and
earnings can
remain disappointing. We appear to be in that type of environment
currently.
However, the "promise" of recovery, which often manifests itself in
small and
uneven hints of impending improvement, can drive the stocks. When a
robust
recovery is actually underway the group's relative performance tends
to
moderate. Valuations also support our overweight position. Our
group on
average is trading at ~15X forward earnings compared to a historical
average
forward P/E of ~17X. We believe valuations have room to expand as
nascent
signs of economic improvement emerge over the next 6-12 months.
The SSB strategy team forecasts approximately 19% total return
potential in
the S&P 500 to December 2003. We do not know if that forecast will
prove
accurate but, we believe our group can outperform the S&P 500 over
that
period of time. Our coverage universe has gone through massive
restructuring
the past 2 years that provides significant earnings leverage even if
revenues
up tick only slightly. Although the earnings outlook remains
difficult the
majority of our companies have stopped missing estimates and downward
earnings revisions have moderated significantly. Earnings and order
comparisons are easy from Q3 onward. Additionally, most companies on
our
list have healthy balance sheets and good cash flow providing the
opportunity
to augment growth with acquisitions or share repurchase.
For the purposes of this note and the ratings of our stocks our entire
coverage list is being named Multi-Industry including stocks such as
GE,
Emerson and Hubbell, which have been traditionally described
as "Electrical
Equipment". At some later date within the SSB system the group will
be
renamed Electrical Equipment & Multi-Industry to provide a more
precise
description. However, this impending change is a housekeeping item
and in
isolation signals no future change in the ratings and thesis provided
in this
note.
The new SSB rating system requires that stocks in an analysts
coverage list
be rated relative to each other under the 3 ratings
of "outperform", "in-
line" and "underperform", replacing the previous 5 tiered rating
system.
Given this type of format our ratings will have a generally even
dispersion
across the three ratings categories. Although the ratings
nomenclature has
changed, our view on our industry and the individual stocks is
essentially
unchanged. However, we can envision more frequent ratings changes
under this
new system since big price moves up or down by individual stocks will
require
a more overt re-evaluation of their relative standing in the group.
Additionally, our ratings will have a more clinical nature.
The "best"
companies in the group are more likely to be rated In-line or
Underperform
from time to time based on their relative valuations while weaker
companies
will be more likely to be rated outperform if they get excessively
cheap.
Our initial application of the new ratings results in a dispersion of
4
"outperforms", 7 "in-lines" and 4 "underperforms".
Our Outperform-rated stocks in order of preference are Tyco, SPX
Corp, GE and
Danaher. Tyco, GE and SPX were all rated "buy", while Danaher was
rated
"outperform" under the previous rating system. We've long maintained
that
"story" stocks tend to be the best performers in our group and most
of our
outperforms fit this criteria. Tyco is undergoing a cleansing by a
new CEO
following the resignation of the former CEO. We believe
this "healing"
process will drive the valuation higher as investors refocus on the
value of
the business franchises. SPX remains on a path to emerge as a premier
company in the group and improving cash flow supports valuation
expansion.
Danaher continues to distinguish itself with excellent execution
during the
current industrial downturn. While not cheap, its strong balance
sheet gives
it the dry powder to augment growth with acquisitions. GE is
somewhat of a
special case. The stock has been crushed over the past 2 years given
concerns about numerous issues such as succession and the outlook for
Power.
However, the fact remains that GE is a premier global company with
returns on
capital essentially double our group average. As we roll into 2003,
we
believe the market will begin to anticipate acceleration in earnings
growth
in 2004 as the headwinds from Power and Aerospace moderate and short
cycle
growth and acquisitions play a larger role.
Our "in-line" rated stocks are ITT Corp, Honeywell, American Standard,
Emerson, Maytag, Cooper and Whirlpool. Since we are carrying
an "overweight"
on our group we believe all of these stocks are candidates to
outperform the
market. Previously ITT, Honeywell Maytag and American Standard were
rated
"outperform" while Emerson, Cooper and Whirlpool were rated neutral.
We
remain very positive on the outlook and internal improvements
underway at
ITT. However, the stock has strongly outperformed everything in our
group
this year and is now at a premium valuation. A price pullback would
be cause
to re-evaluate our rating. American Standard continues to impress us
with
good internal execution and above average organic growth. Honeywell
faces
near term pressures due to the dismal outlook for commercial aviation
and
weak industrial capital spending, but has significant leverage to
eventual
recovery and is reasonably valued. On Emerson, earnings visibility
is still
limited, but we believe estimates have hit bottom and comparisons are
beginning to get easy. Additionally, Emerson's orders have turned
positive
(largely easy comps) after 15 months of declines. Maytag is a
consumer play
and we favor it because we believe margins have significant upside
even if
industry appliance shipments do not rise from current levels. Cooper
and
Whirlpool are in this new "in-line" group because their very low
valuations
limit downside, but our fundamental cautious view on both companies is
unchanged.
Our "underperform" rated stocks are Hubbell, Rockwell, ITW and
Textron and
all were rated "neutral" under the previous rating system. These are
some of
the most expensive stocks in our universe (TXT looks cheap on P/E, but
expensive on cash flow, by our analysis) all have outperformed our
group (and
the S&P 500) year to date suggesting that relative upside versus the
remainder of the group is limited. However, given our view that the
group
will have an upside bias over the next twelve months, these stocks
could
trade higher in absolute terms. Additionally, all of our
underperforms
except ITW have dividend yields above the S&P average suggesting good
downside protection.
Rating Price
Target
Company (Price) Symbol New System Old System
New Old
MULTI-INDUSTRY
Danaher ($60.15) DHR 1M -- Outperform 2M -- Outperform
$74 $74
General Electric ($30.15) GE 1L -- Outperform 1L -- Buy
$38 $38
SPX Corporation ($108.60) SPW 1M -- Outperform 1M -- Buy
$140 $140
Tyco International ($15.69) TYC 1S -- Outperform 1S -- Buy
$22 $22
American Standard ($71.63) ASD 2H -- In-Line 2H -- Outperform
$80 $80
Cooper Industries ($32.72) CBE 2M -- In-Line 3M -- Neutral
$35 $35
Emerson ($48.78) EMR 2M -- In-Line 3M -- Neutral
$54 $50
Honeywell ($29.95) HON 2H -- In-Line 2H -- Outperform
$36 $42
ITT Industries ($67.98) ITT 2M -- In-Line 2M -- Outperform
$74 $74
Maytag ($32.64) MYG 2H -- In-Line 2H -- Outperform
$42 $52
Whirlpool ($55.31) WHR 2H -- In-Line 3H -- Neutral
$65 $68
Hubbell Incorporated HUBB 3M -- 3M -- Neutral
$35 $35
($32.10) Underperform
Illinois Tool Works ($68.52) ITW 3M -- 3M -- Neutral
$68 $68
Underperform
Rockwell Automation ($18.42) ROK 3M -- 3M -- Neutral
$20 $20
Underperform
Textron ($38.85) TXT 3H -- 3H -- Neutral
$45 $50
Underperform
Note: Prices are as of market close on August 30, 2002
VALUATION AND RISKS
Danaher (DHR--$60.15; 1M)
Valuation
Danaher's stock is not cheap, trading at nearly 19X our 2003 estimate
versus
a group average of 14X. However, the company has perennially been a
top cash
flow generator which supports a premium P/E valuation. On a
price/free cash
flow basis the stock is at a modest 10% premium to our group.
Management's
ability to take out costs, drive margin improvement, and deliver
strong cash
flow despite severe pressure on core revenues enforces our confidence
in the
company. Similar to other companies in our universe, DHR has seen
hints of
an economic bottom, but does not anticipate an meaningful cyclical
recovery
until late '02 at the earliest. Acquisitions consummated earlier in
the year
and restructuring savings should support earnings even if the top line
remains sluggish. Our price target of $74 equates to the 5 year
average P/E
of ~23 applied to our $3.20 estimate for 2003.
Risks
Potential risks include the ability to integrate recent acquisitions
into the
portfolio. Since the beginning of the year, DHR has closed three
sizeable
deals that will add a combined total of ~$900 million in annualized
revenues.
Sluggish industrial capital spending levels and depressed utilization
rates
could also pressure many of the company's general industrial
businesses.
Within DHR's Motion Control segment, continued weakness in key end
markets
such as semiconductors, electronic assembly, and telecom, which
collectively
account for ~25% of segment revenues, may pose a risk to estimates.
Furthermore, declines in consumer spending may adversely impact
certain hand
tool businesses including Delta and Craftsman. A prolonged downturn
in
Danaher's relatively volatile Power Quality businesses may also
result in
downward earnings pressure.
General Electric (GE--$30.15; 1L)
Valuation
Our 2003 estimate of $1.78 equates to about 8% EPS growth, which is
below
GE's stated goal of "double digits". We are not ruling out hitting
10%+ EPS
growth in 2003 but we do not have the visibility to maintain our
forecast at
that level. If the economy rebounds strongly in 2003 and GE's
acquisition
program remains successful our estimates have upside. Furthermore, we
believe GE can post accelerating earnings growth in 2004, assuming we
are
well into a recovering economy at that point and other businesses (and
acquisitions) are better able to offset the long cycle headwind at
Power and
Aircraft. Although 2004 is a long way off, the market has been
fretting
about GE's '03 earnings outlook since at least the middle of 2001.
As we
approach year-end and roll into 2003 the debate will begin to shift
away from
2003 to 2004. Power and Aircraft will still face pressures in 2004,
but
their relative drag should diminish and as mentioned above other
pieces of
the portfolio should be on a better stride.
Our $38 target assumes a 21X P/E on our '03 estimate, or about a 25%
premium
to the market multiple. The stock may remain stuck in a trading
range until
more short cycle visibility emerges, but we believe the stock can
outperform
the market over the next 12 months. We believe that GE deserves to
trade at
a premium to the market multiple given the company's extraordinary
ROIC,
solid balance sheet, leading businesses and above average growth
potential.
Furthermore, in an age of corporate governance concerns and management
credibility issues, GE appears well suited to defend any criticism
that may
arise.
Risks
GE is one of the world's largest companies and as a result has
exposure to
numerous global economic and political risks. Primary specific risks
in the
near term include the potential for a further fall-off in the Power
business
due to the distressed nature of GE's customers. GE is also exposed
to the
troubled airline industry through its engine and leasing businesses.
We
believe it has managed its airline risks well, but the potential for
further
industry deterioration remains a risk. Finally, continued
improvement in
short cycle businesses, especially Plastics, is key to offsetting
declining
earnings in Power Systems.
SPX Corporation (SPW--$108.60; 1M)
Valuation
SPX remains one of our top picks. The company has consistently hit
earnings
expectations and appears solidly on track in 2002. Free cash flow
should be
strong again in 2002 at ~$350mm or approximately 95% of net income
(over 100%
on a pre-FAS142 basis). Even if we assume $1.00 of EPS dilution due
to LYONs
conversion with no offsetting cost reductions, the stock looks cheap
at ~11X
our '03 forecast. The company continues to execute well in a
difficult
environment and we believe the stock remains undervalued. Our $140
target
assumes that the stock trades at a slight discount to the average P/E
multiple for our group of 14-15X our 2003 estimates. Historically,
the stock
has traded at a discount to our group, but it is difficult to rely on
history
given the substantial change the company has undergone over the past
5 year.
In 2001, SPW was one of the top organic growers and top cash
generators in
our coverage list and we believe it will rank similarly in 2002. We
believe
this continued group beating performance warrants a multiple in line
with our
group and positions the company to possibly obtain a premium
valuation over
time.
Risks
One potential risk to SPX stock is the potential dilution from its
equity-
linked notes (LYONs), which were issued in February and May of 2001
for a
combined face value of $1.41 billion. If/when the LYONs are
triggered, the
potential converted shares must be added to SPX's diluted share
count. We
estimate that adding these shares, if included for the full year,
would
result in dilution of ~$1.00 to our 2003 estimate. However, we
believe SPX
will be able to largely offset this dilution through additional cost
savings
from UDI, bolt-on deals such as Balcke, and upside leverage in an
improving
economy. We believe another possible investment risk to SPX concerns
the
impending slow-down at the company's power transformer business,
Waukesha
Electric. Going forward, we expect this business, which is the
largest in
the Industrial Products segment, to continue rolling over and
experience
significant revenue declines in 2H02 and 2003, reflecting the sharp
downturn
in the power industry following several years of prosperity. Sluggish
industrial capital spending levels and depressed utilization rates
could also
pressure many of the company's general industrial businesses. It
should also
be noted that SPX is thinly traded with a small float relative to
other names
in our universe. As a result, the stock has demonstrated very high
volatility. SPX also maintains the highest short interest in our
group with
roughly 8% of the float in the hands of shorts.
Tyco International (TYC--$15.69; 1S)
Valuation
We are encouraged by the speed at which new CEO Ed Breen is moving to
restore
credibility. In addition to the two internal investigations, Mr.
Breen has
moved to change CFOs, added a new independent board member and
created a new
executive corporate governance position. Our price target remains
$22, which
represents a sum-of-the parts valuation using the lowest valued peer
for each
segment. We believe a revenue-based valuation is the most
conservative
approach since revenues are more black and white than GAAP earnings.
Our
target implies a P/E multiple of ~10X our FY03 estimate, or a 30%
discount to
our coverage group average.
Risks
Tyco shares are only for investors with the highest risk tolerance.
Tyco has
gone through tremendous turmoil in 2002 culminating in the
resignation of its
former CEO. However, with a well-respected new CEO hired and CIT
disposed
the risks are reduced. We still have concerns that damaging
revelations
could be revealed during the course of internal and external
investigations.
We cannot rule out some type of earnings restatement or negative
corporate
governance revelations. Tyco shares are likely to remain very
volatile with
high "headline risk." We will be closely scrutinizing Mr. Breen's
actions
and considering any corporate revelations constantly. It remains
possible
that something so damaging could be revealed that will cause us to
reconsider
our rating. Additional risks could arise from sluggish industrial
capital
spending levels and depressed utilization rates. Tyco's exposure to
the
volatile connector market is also a potential risk. Although year-
over-year
sales declines have moderated in recent months and book/bill trends
have
improved, the connector industry is not out of the woods yet. A
subsequent
downturn in industry sales coupled with intensified competition could
result
in an earnings shortfall at Tyco.
American Standard (ASD--$71.63; 2H)
Valuation
We believe continued operational improvements and deleveraging at
American
Standard can drive the stock price and valuation higher over time.
However,
the valuation is no longer compelling in our view following the
significant
upward revaluation the company has enjoyed over the past couple
years. We
value ASD relative to our group and on a sum-of-the parts basis. We
do our
sum-of-the-parts work using 3 approaches: Total Enterprise Value
(TEV)/Sales,
TEV/EBITDA and P/E. We favor the TEV approaches because they fully
capture
the comparative capital structures of the peers. The stock is
trading near
all-time highs versus our group at about a 10-12% P/E discount. We
believe
the stock can ultimately move to parity or even a slight premium as it
deleverages given its strong organic growth profile. Our 12-18 month
price
target of $80 is based on our coverage universe average TEV/EBITDA
multiple
of ~8.0X applied to our '03 EBITDA estimate for American Standard.
Risks
Investors in American Standard shares should consider numerous
potential
risks. The company has benefited from the surprising resilience in
new and
existing home sales which has been a strong driver of residential air
conditioning and plumbing products. About 65%-75% of activity in
these
markets is driven by remodeling activity. We believe the company can
continue gaining share, which would mute a downturn in residential
markets,
but the company would still be impacted. Commercial construction
markets
also remain a risk. There are also numerous environmental and
regulatory
requirements such as the use of particular refrigerants or minimum
efficiency
requirements that constantly impact the air conditioning market. ASD
also
has significant overseas exposure, which remains a risk given the
uncertain
pace of economic recovery. The company is also highly leveraged on an
historical book basis although its coverage ratios and liquidity
appear more
than adequate. Nevertheless, in a severe downturn, cash flow could be
negatively impacted and the company could find it difficult or
expensive to
refinance maturing debt obligations. Asbestos also poses a risk to
the
company, although we believe the company's exposure is relatively
minor. The
company has never paid a claim out of its own pocket to date and
claims it
holds ample insurance coverage.
Cooper Industries (CBE--$32.72; 2M)
Valuation
Our price target of $35 equates to ~10X our 2003 EPS estimate, which
is at a
significant discount to the company's average forward multiple of 13X
over
the last five years and represents modest improvement over current
levels.
We have taken into account lower peer valuations, recently lowered
guidance,
and management's expectations of no material recovery in its served
end
markets in 2002. With the reincorporation in Bermuda behind it, the
company
may be in a position to leverage its lower tax rate, and subsequently
greater
cash flow, to become more effective in the markets in which it
competes.
Risks
The primary risk to CBE's near term performance is continued weakness
across
end markets through H202 and possibly beyond. While it appears
declining
demand trends have in general bottomed, continued weak demand in
commercial
and industrial construction, as well as tool dependent industries,
into H202
could signal a slower and/or delayed recovery. The company also has
exposure
to asbestos litigation. The trend in settlement activity has been
encouraging but it is impossible to forecast future developments.
Finally,
there is the possibility that anti-repatriation bills in the House
and Senate
gain traction and put CBE's recent headquarters' move to Bermuda in
jeopardy.
Emerson (EMR--$48.78; 2M)
Valuation
The stock is not cheap at 19X and 17X our FY2002 and FY2003 estimates,
respectively. However, we are bumping our price target to $54 from
$50 which
equates to ~18X our calendarized 2003 estimate which is in line with
the 10
year average P/E. Our previous target of $50 was derived from the 15
year
average P/E of ~17X. With comparisons becoming easier and orders
turning
positive, we believe a slightly less conservative target is
warranted. We
believe Emerson is on the right track internally with its
restructuring
program and its drive to lower the capital intensity of the
portfolio. These
actions should lead to a faster growing and more profitable company
over the
next several years.
Risks
While it appears that EMR's Electronics business has stabilized, there
remains only early indications that underlying demand has improved.
The
business has at least one more quarter of difficult comps before
lapping last
year's declines. A prolonged downturn in the company's Electronic
businesses
(which account for roughly 20% of consolidated sales) may result in
downward
earnings pressure. It should also be noted that EMR's industrial
businesses
(Process Control, Industrial Automation) are closely tied to capital
spending
levels and utilization rates. Continued weakness stemming from
either metric
could pressure results going forward. In addition, a slow-down in
new and
existing home sales could lead to a decline in residential HVAC sales.
Despite the potential risk to earnings, we believe EMR is on the
right track
internally with its restructuring program and its drive to lower the
capital
intensity of the portfolio. These actions should lead to a faster
growing
and more profitable company over the next several years. It should be
acknowledged that uncertainty associated with the plan could pose a
risk to
the stock. Management's savings run rate expectations are dependent
upon
successful execution. Delays and/or difficulties in implementation of
restructuring efforts could negatively impact results.
Honeywell (HON--$29.95; 2H)
Valuation
Trading at less than 12X our 2003 estimate, we believe downside risk
is
limited. Airline industry weakness is well understood by investors
and
largely incorporated into HON's stock price, in our opinion. The
stock is
currently trading a 19% discount to our coverage group and 30%
discount to
the S&P 500 based on '03 EPS estimates. While headline risk may keep
a lid
on the stock in the near-term, we view it as an attractive investment
for
patient investors with a 12-month time horizon. We reiterate our 2H
rating.
We are trimming our price target to $36 from $40 to reflect HON's 15-
year
average forward P/E of ~14X applied to our 2003 estimate of $2.55.
Our prior
target applied HON's higher 10 year average P/E to our estimates, but
in
light of very tough aerospace fundamentals, we believe a more
conservative
target is warranted.
Risks
Investors in Honeywell should consider several risks. First, we
remain
concerned that the current commercial aerospace downturn will linger
well
into 2003 with the depth and duration of the downturn still in
question.
Honeywell's relative upside could be restrained by its commercial
aerospace
business, which represents roughly 25% of total HON revenues and a
higher
portion of profits. In addition, while management expects that
restructuring
charges are now behind the company, we can't ignore the potential
valuation
impact of over $4.0 billion in cumulative below-the-line restructuring
charges taken over the past three years. HON also has asbestos
exposure that
we believe is widely known by the market. However, an adverse ruling
against
HON or another company could cause stock price weakness. HON seems
to have
strong insurance protection, but we cannot forecast the velocity of
new cases
or the future size of settlements or judgments.
ITT Industries (ITT--$67.98; 2M)
Valuation
ITT continues to impress us with its consistent performance and
improving
fundamentals. As we look ahead to the rest of 2002 and into 2003, we
believe
the company could be facing an extended period of prosperity. The
company is
currently trading at roughly 17X our 2003 estimate of $4.05, which
equates to
a 15% premium to our group average. Our price target of $74 reflects
the
high end of our sum of the parts valuation range on a TEV/Sales and
TEV/EBITDA basis, which suggests a value between $71-74. Our 2M
rating
reflects ITT's expanded valuation versus its peers, which could limit
relative upside from current levels. The stock has been the strongest
performer in our coverage list year to date by a wide margin.
Risks
Key risks to our investment thesis on ITT are primarily economic.
While 60%
of ITT revenues come from recession-resistant industries such as
defense and
water/wastewater, the remaining 40% are cyclical and subject to
swings in
revenue and profitability. Cyclical businesses include ITT's
Electronic
Components business, the Motion & Flow Control Platform and about a
third of
the Fluid Technology market. Further weakness in any of these markets
relative to expectations could result in downward estimate
revisions. As the
defense industry enters a new phase of growth, ITT's core strengths
(communications, electronic warfare, engineering) are positioned at
the
forefront of the Depart of Defense's procurement plans.
Nevertheless, the
loss of a key defense contract to a competitor could result in
downward
pressure on the stock.
Maytag (MYG--$32.64; 2H)
Valuation
We continue to view the company as a turn-around and margin expansion
story
given the opportunity to restore profitability in its core business
and
further margin upside at Amana. MYG is currently trading at 11X and
10X our
2002 and 2003 EPS estimates, respectively. This is toward the low
end of the
company's historical trading range. Truncating historical valuation
extremes, the stock has generally traded in a range of 10-20 times
forward
earnings over the past 15 years. The average forward valuation over
this
time frame is about 15X EPS. However, we believe a 20% discount
applied to
this mean is justified in order to take into account the uncertainty
that the
pace of consumer spending and growth in residential housing markets
will be
able to continue at current levels. We therefore believe our target
should
be based on a more conservative 12X multiple, resulting in our price
target
dropping to $42 from $52.
At these levels, we believe the stock could be considered cheaply
valued if
strong consumer demand continues, residential housing remains
resilient, and
the company maintains a steady stream of innovative and value-added
new
product introductions. Longer term, continued strong internal
execution and
improvements in profitability could justify the stock moving closer
to the
mid point of its historical forward multiple range.
Risks
Although appliance shipments in the categories that the company
competes, the
so-called "Core 6", have been remarkably resilient, MYG is almost
entirely
dependent upon U.S. appliance demand. The possibility of Fed Funds
rates
rising next year could have a significant cooling effect on the
domestic
housing market. Slower than expected economic recovery could also
have a
negative effect on consumer demand. Competition based risk comes
primarily
from WHR as the company nears the end of a significant restructuring
program.
This is expected to result in more efficient internal operations and
therefore presumably more room to price product competitively, and
acceleration in feature laden premium product introductions targeted
at the
high-end consumer, which is MYG's primary stomping grounds. Our
earnings
forecast is also dependent on deriving further cost synergies from
the 2001
acquisition of Amana.
Whirlpool (WHR--$55.31; 2H)
Valuation
WHR appears fairly, or even cheaply, valued at 9X and 8X our 2002 and
2003
EPS estimates at present. Excluding historical outliers, the stock
has
traded between 8X-16X forward earnings over the last 20 years with an
overall
mean of 12.7X. We are encouraged by modest improvement in Europe,
but are
still concerned about economic instability in Latin America. There
are also
the issues of tougher comps going forward, the possibility of raw
material
pressures that could begin to have some impact in 2003, and the
potential of
rising Fed funds, although the near term possibility has diminished
considerably as of late.
We are lowering our price target to $65 from $68, which equates to
9.6X our
'03 EPS estimate. This is at the lower end of its 5-year forward P/E
range
and represents a ~25% discount to the stock's historical mean of
~13X, which
takes into account concerns about earnings quality, weak cash flow and
exposure to troubled Latin America. However, the stock could be
considered
cheaply valued if strong consumer demand continues, residential
housing
remains resilient, and the company continues to introduce a steady
stream of
innovative and value-added new products. Our previous target of $68
assumed
the multiple could expand closer to the mid point of its historical
range
with the prospect of a stronger economy. We believe that assumption
is now
too optimistic given the macro-backdrop.
Risks
Although domestic appliance shipments have been surprisingly
resilient for
almost a year now, WHR derives over 30% of its revenues from
overseas. A
fragile European recovery and tenuous political climate and currency
devaluations in Latin America continue to cast a cloud of uncertainty
over
international contributions. Domestically, primary risk revolves
around
economic recovery and concerns of slipping consumer confidence.
Competition
based risk comes predominantly from MYG as the company continues to
make
progress with its turnaround efforts and refocuses on turning out
high value
added appliances. GE has also intensified its competitive efforts in
the
Appliance sector. Having solved its U.S. based refrigeration
production
issues, Electrolux could be in a position to threaten existing
refrigeration
product markets shares.
Hubbell Incorporated (HUBB--$32.10; 3M)
Valuation
We are encouraged by HUBB's restructuring efforts but we remain
cautious on
the fundamental outlook given little evidence at present of any
noticeable
recovery in Hubbell's end markets. Our 12-month price target of $35,
could
be considered rich, but in our opinion is justified for a number of
reasons.
Our target represents a multiple of 17.5X our FY03 estimate and is
barely
above its 10-year average forward historical multiple of 17.1X. We
believe
the valuation is justified given the prospect for accelerated revenue
and EPS
growth driven by the current acquisition program. Furthermore, the
restructuring plan announced in Q401 appears to be on track and should
eventually lead to a more profitable company.
Risks
HUBB's stated desire to grow revenues to $3-$5 billion by 2007 opens
the
company to acquisition related risks that have been less of an issue
in the
past. While management has stated that the Hawke International and
LCA Group
acquisitions are immediately accretive, there always exists
integration and
synergy risk. Future acquisitions of the size needed to reach the
company's
top line goal expose HUBB to further similar risk. As with any
restructuring
plan, there is also uncertainty associated with the plan the company
announced in Q401. Management's savings run rate expectations are
dependent
upon successful execution. Delays and/or difficulties in
implementation of
restructuring efforts could negatively impact results. Sluggish
industrial
capital spending levels and depressed utilization rates could also
pressure
many of the company's general industrial businesses.
Illinois Tool Works (ITW--$68.52; 3M)
Valuation
While orders have recently improved in several of ITW's businesses, a
sustainable recovery is still uncertain. At 22X and 20X our '02
and '03
estimates, we believe the stock is fully valued. Our price target
of $68
reflects a 19X-20X multiple on our 2003 EPS estimate and is the
average
forward multiple over the last ten years. Although this average
jumps to 22X
if we look at the last five years, we believe there is still
sufficient
uncertainty to warrant caution and a more conservative valuation. We
will
continue to watch for signs of recovery in ITW's key commercial
construction
and capital goods markets that could signal the increasing volume
necessary
for us to become more bullish on the stock.
Risks
Despite being composed of over 600 individual operating identities,
ITW is
heavily dependent upon the construction and automotive markets.
Although
weak commercial and industrial construction has been partially offset
by a
stronger residential market and healthy automotive sales, a rise in
interest
rates could cool strong demand putting further pressure on ITW's
Engineered
Products -- North America business. Additionally, demand in its
capital
goods related end markets appears to be firming but is still very
weak.
Finally, ITW's growth through acquisition blueprint leaves the
company open
to risks associated with integration difficulties and lower than
expected
cost savings and/or synergies.
Rockwell Automation (ROK--$18.42; 3M)
Valuation
Rockwell stock has had a strong run relative to the S&P year to date
(up ~4%
vs S&P down ~22%), reflecting the company's position as a leveraged
upside
play on an economic recovery. However, given the lack of earnings
visibility, especially abroad, and a relatively full valuation (~20X
our
calendar '02 estimate), we prefer to remain on the sidelines. At
15X, the
stock looks reasonably valued on our '03 estimate, but at this
juncture there
is very little visibility to improvement in '03. Our $20 target
assumes a
~17X P/E on our '03 estimate or roughly in-line with the S&P 500
multiple.
Risks
Until a sustained recovery in industrial capital spending and capacity
utilization rates returns, we believe ROK's earnings could remain
below
historical levels. Although we are encouraged by recent trends
signaling a
sequential increase in demand at certain end markets, we remain
hesitant
until further clarity emerges. While it appears declining demand
trends have
generally bottomed, continued weak demand in automotive and consumer
products
in 2H02 could signal a slower and/or delayed recovery. The company
currently
derives 55% of consolidated sales from consumer and automotive
related end
markets. Economic conditions abroad could also pose a risk to future
earnings in the form of foreign currency exposure.
Textron (TXT--$38.85; 3H)
Valuation
Textron's massive restructuring effort and integration of Six Sigma
initiatives appear to be gaining traction, but it is too early to
declare
victory. With the company's operations at such depressed levels, the
potential for upside is tremendous. However, the company has
struggled with
execution in the past and fundamentals in the company's industrial
businesses
are very difficult. Additionally, weakness in the business jet
market could
limit upside leverage to a recovery, whether it occurs in late 2002 or
sometime in 2003. Nevertheless, we are encouraged by Cessna's share
gains in
such a competitive environment and will be watching orders closely.
While
downside may be limited with the stock at less than 11X our '03
estimate,
execution risk, sub-par cash flow and Cessna uncertainty keeps us on
the
sidelines. We reiterate our 3H rating and $45 price target. At $45,
the
stock would be trading at the low end of its historical forward
valuation
average (~12X) but at a premium relative to price/free cash flow (24X
versus
group average of ~18X).
Risks
Textron has considerable exposure to the business jet sector through
its
Cessna subsidiary, which accounts for ~ 30% of total Textron revenues
and
~40% of operating profit. The health of the business jet market
remains
uncertain, following the economic downturn and tragedy of 9/11.
Orders have
been depressed for over a year, but the company still has more than a
year of
production left in its backlog, assuming no further cancellations.
Another
risk is the industrial economy. Low capacity utilization, tight
capital
spending budgets and continued global weakness could continue to
pressure our
estimates beyond our current assumptions. Finally, Textron's massive
restructuring effort carries execution risk. The restructuring and
integration of Six Sigma initiatives appear to gaining traction, but
it is
too early to declare victory. The company has struggled with the
execution
in the past and it is hard to overlook the company's serial
restructuring
charges and several disappointing or ill-timed acquisitions although
we
believe the company has strengthened its acquisition discipline plan.
ANALYST CERTIFICATION
I, Jeffrey Sprague, hereby certify that the views expressed in this
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report accurately reflect my personal views about the subject
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expressing the
specific recommendations in this report.
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Date: 09/08/2002 09:18am
~ Salomon Smith Barney
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S a l o m o n S m i t h B a r n e y R e s e a r c h
Introducing Our New Rating System
General Electric Co(GE)
Rating: 1L
As of 09/08/2002
Last Changed 09/07/1999
The Salomon Smith Barney Equity Research Department changed their Stock and Industry Ratings System as of September 7, 2002. Click here for more information.
Salomon Smith Barney ~ September 7, 2002
See last pages for Important Disclosures
Multi-industry
Introducing Our New Rating System
September 6, 2002 SUMMARY
* We are introducing a new "relative" ratings system for
Jeffrey T. our coverage list in accordance w/ SSB's new research
Sprague, CFA guidelines which requires our universe of stocks to be
ranked in preference relative to each other. For the
purposes of this note our entire coverage list is being
John Roselli, CFA considered "multi-industry".
* We believe our industry will outperform the S&P 500
over the coming year. We would Overweight the
Mark Wilterding multi-industry group because the group typically
outperforms in the earlier stages of an economic cycle
and valuations in general are below historical averages.
* Although the nomenclature is changed, our view on our
industry and stocks is essentially unchanged. Our
Outperform-rated stocks in order of preference are Tyco,
SPX Corp, GE, and Danaher.
OPINION
We rate our Multi-Industry group overweight versus the S&P 500. Our group
typically out performs the S&P 500 in the early portion of economic
recoveries. For example, in the 1991-1993 time frame our group appreciated
76% compared to a rise of 41% for the S&P 500. Often in the early stages of
recoveries the fundamentals actually still look quite grim and earnings can
remain disappointing. We appear to be in that type of environment currently.
However, the "promise" of recovery, which often manifests itself in small and
uneven hints of impending improvement, can drive the stocks. When a robust
recovery is actually underway the group's relative performance tends to
moderate. Valuations also support our overweight position. Our group on
average is trading at ~15X forward earnings compared to a historical average
forward P/E of ~17X. We believe valuations have room to expand as nascent
signs of economic improvement emerge over the next 6-12 months.
The SSB strategy team forecasts approximately 19% total return potential in
the S&P 500 to December 2003. We do not know if that forecast will prove
accurate but, we believe our group can outperform the S&P 500 over that
period of time. Our coverage universe has gone through massive restructuring
the past 2 years that provides significant earnings leverage even if revenues
up tick only slightly. Although the earnings outlook remains difficult the
majority of our companies have stopped missing estimates and downward
earnings revisions have moderated significantly. Earnings and order
comparisons are easy from Q3 onward. Additionally, most companies on our
list have healthy balance sheets and good cash flow providing the opportunity
to augment growth with acquisitions or share repurchase.
For the purposes of this note and the ratings of our stocks our entire
coverage list is being named Multi-Industry including stocks such as GE,
Emerson and Hubbell, which have been traditionally described as "Electrical
Equipment". At some later date within the SSB system the group will be
renamed Electrical Equipment & Multi-Industry to provide a more precise
description. However, this impending change is a housekeeping item and in
isolation signals no future change in the ratings and thesis provided in this
note.
The new SSB rating system requires that stocks in an analysts coverage list
be rated relative to each other under the 3 ratings of "outperform", "in-
line" and "underperform", replacing the previous 5 tiered rating system.
Given this type of format our ratings will have a generally even dispersion
across the three ratings categories. Although the ratings nomenclature has
changed, our view on our industry and the individual stocks is essentially
unchanged. However, we can envision more frequent ratings changes under this
new system since big price moves up or down by individual stocks will require
a more overt re-evaluation of their relative standing in the group.
Additionally, our ratings will have a more clinical nature. The "best"
companies in the group are more likely to be rated In-line or Underperform
from time to time based on their relative valuations while weaker companies
will be more likely to be rated outperform if they get excessively cheap.
Our initial application of the new ratings results in a dispersion of 4
"outperforms", 7 "in-lines" and 4 "underperforms".
Our Outperform-rated stocks in order of preference are Tyco, SPX Corp, GE and
Danaher. Tyco, GE and SPX were all rated "buy", while Danaher was rated
"outperform" under the previous rating system. We've long maintained that
"story" stocks tend to be the best performers in our group and most of our
outperforms fit this criteria. Tyco is undergoing a cleansing by a new CEO
following the resignation of the former CEO. We believe this "healing"
process will drive the valuation higher as investors refocus on the value of
the business franchises. SPX remains on a path to emerge as a premier
company in the group and improving cash flow supports valuation expansion.
Danaher continues to distinguish itself with excellent execution during the
current industrial downturn. While not cheap, its strong balance sheet gives
it the dry powder to augment growth with acquisitions. GE is somewhat of a
special case. The stock has been crushed over the past 2 years given
concerns about numerous issues such as succession and the outlook for Power.
However, the fact remains that GE is a premier global company with returns on
capital essentially double our group average. As we roll into 2003, we
believe the market will begin to anticipate acceleration in earnings growth
in 2004 as the headwinds from Power and Aerospace moderate and short cycle
growth and acquisitions play a larger role.
Our "in-line" rated stocks are ITT Corp, Honeywell, American Standard,
Emerson, Maytag, Cooper and Whirlpool. Since we are carrying an "overweight"
on our group we believe all of these stocks are candidates to outperform the
market. Previously ITT, Honeywell Maytag and American Standard were rated
"outperform" while Emerson, Cooper and Whirlpool were rated neutral. We
remain very positive on the outlook and internal improvements underway at
ITT. However, the stock has strongly outperformed everything in our group
this year and is now at a premium valuation. A price pullback would be cause
to re-evaluate our rating. American Standard continues to impress us with
good internal execution and above average organic growth. Honeywell faces
near term pressures due to the dismal outlook for commercial aviation and
weak industrial capital spending, but has significant leverage to eventual
recovery and is reasonably valued. On Emerson, earnings visibility is still
limited, but we believe estimates have hit bottom and comparisons are
beginning to get easy. Additionally, Emerson's orders have turned positive
(largely easy comps) after 15 months of declines. Maytag is a consumer play
and we favor it because we believe margins have significant upside even if
industry appliance shipments do not rise from current levels. Cooper and
Whirlpool are in this new "in-line" group because their very low valuations
limit downside, but our fundamental cautious view on both companies is
unchanged.
Our "underperform" rated stocks are Hubbell, Rockwell, ITW and Textron and
all were rated "neutral" under the previous rating system. These are some of
the most expensive stocks in our universe (TXT looks cheap on P/E, but
expensive on cash flow, by our analysis) all have outperformed our group (and
the S&P 500) year to date suggesting that relative upside versus the
remainder of the group is limited. However, given our view that the group
will have an upside bias over the next twelve months, these stocks could
trade higher in absolute terms. Additionally, all of our underperforms
except ITW have dividend yields above the S&P average suggesting good
downside protection.
Rating Price Target
Company (Price) Symbol New System Old System New Old
MULTI-INDUSTRY
Danaher ($60.15) DHR 1M -- Outperform 2M -- Outperform $74 $74
General Electric ($30.15) GE 1L -- Outperform 1L -- Buy $38 $38
SPX Corporation ($108.60) SPW 1M -- Outperform 1M -- Buy $140 $140
Tyco International ($15.69) TYC 1S -- Outperform 1S -- Buy $22 $22
American Standard ($71.63) ASD 2H -- In-Line 2H -- Outperform $80 $80
Cooper Industries ($32.72) CBE 2M -- In-Line 3M -- Neutral $35 $35
Emerson ($48.78) EMR 2M -- In-Line 3M -- Neutral $54 $50
Honeywell ($29.95) HON 2H -- In-Line 2H -- Outperform $36 $42
ITT Industries ($67.98) ITT 2M -- In-Line 2M -- Outperform $74 $74
Maytag ($32.64) MYG 2H -- In-Line 2H -- Outperform $42 $52
Whirlpool ($55.31) WHR 2H -- In-Line 3H -- Neutral $65 $68
Hubbell Incorporated HUBB 3M -- 3M -- Neutral $35 $35
($32.10) Underperform
Illinois Tool Works ($68.52) ITW 3M -- 3M -- Neutral $68 $68
Underperform
Rockwell Automation ($18.42) ROK 3M -- 3M -- Neutral $20 $20
Underperform
Textron ($38.85) TXT 3H -- 3H -- Neutral $45 $50
Underperform
Note: Prices are as of market close on August 30, 2002
VALUATION AND RISKS
Danaher (DHR--$60.15; 1M)
Valuation
Danaher's stock is not cheap, trading at nearly 19X our 2003 estimate versus
a group average of 14X. However, the company has perennially been a top cash
flow generator which supports a premium P/E valuation. On a price/free cash
flow basis the stock is at a modest 10% premium to our group. Management's
ability to take out costs, drive margin improvement, and deliver strong cash
flow despite severe pressure on core revenues enforces our confidence in the
company. Similar to other companies in our universe, DHR has seen hints of
an economic bottom, but does not anticipate an meaningful cyclical recovery
until late '02 at the earliest. Acquisitions consummated earlier in the year
and restructuring savings should support earnings even if the top line
remains sluggish. Our price target of $74 equates to the 5 year average P/E
of ~23 applied to our $3.20 estimate for 2003.
Risks
Potential risks include the ability to integrate recent acquisitions into the
portfolio. Since the beginning of the year, DHR has closed three sizeable
deals that will add a combined total of ~$900 million in annualized revenues.
Sluggish industrial capital spending levels and depressed utilization rates
could also pressure many of the company's general industrial businesses.
Within DHR's Motion Control segment, continued weakness in key end markets
such as semiconductors, electronic assembly, and telecom, which collectively
account for ~25% of segment revenues, may pose a risk to estimates.
Furthermore, declines in consumer spending may adversely impact certain hand
tool businesses including Delta and Craftsman. A prolonged downturn in
Danaher's relatively volatile Power Quality businesses may also result in
downward earnings pressure.
General Electric (GE--$30.15; 1L)
Valuation
Our 2003 estimate of $1.78 equates to about 8% EPS growth, which is below
GE's stated goal of "double digits". We are not ruling out hitting 10%+ EPS
growth in 2003 but we do not have the visibility to maintain our forecast at
that level. If the economy rebounds strongly in 2003 and GE's acquisition
program remains successful our estimates have upside. Furthermore, we
believe GE can post accelerating earnings growth in 2004, assuming we are
well into a recovering economy at that point and other businesses (and
acquisitions) are better able to offset the long cycle headwind at Power and
Aircraft. Although 2004 is a long way off, the market has been fretting
about GE's '03 earnings outlook since at least the middle of 2001. As we
approach year-end and roll into 2003 the debate will begin to shift away from
2003 to 2004. Power and Aircraft will still face pressures in 2004, but
their relative drag should diminish and as mentioned above other pieces of
the portfolio should be on a better stride.
Our $38 target assumes a 21X P/E on our '03 estimate, or about a 25% premium
to the market multiple. The stock may remain stuck in a trading range until
more short cycle visibility emerges, but we believe the stock can outperform
the market over the next 12 months. We believe that GE deserves to trade at
a premium to the market multiple given the company's extraordinary ROIC,
solid balance sheet, leading businesses and above average growth potential.
Furthermore, in an age of corporate governance concerns and management
credibility issues, GE appears well suited to defend any criticism that may
arise.
Risks
GE is one of the world's largest companies and as a result has exposure to
numerous global economic and political risks. Primary specific risks in the
near term include the potential for a further fall-off in the Power business
due to the distressed nature of GE's customers. GE is also exposed to the
troubled airline industry through its engine and leasing businesses. We
believe it has managed its airline risks well, but the potential for further
industry deterioration remains a risk. Finally, continued improvement in
short cycle businesses, especially Plastics, is key to offsetting declining
earnings in Power Systems.
SPX Corporation (SPW--$108.60; 1M)
Valuation
SPX remains one of our top picks. The company has consistently hit earnings
expectations and appears solidly on track in 2002. Free cash flow should be
strong again in 2002 at ~$350mm or approximately 95% of net income (over 100%
on a pre-FAS142 basis). Even if we assume $1.00 of EPS dilution due to LYONs
conversion with no offsetting cost reductions, the stock looks cheap at ~11X
our '03 forecast. The company continues to execute well in a difficult
environment and we believe the stock remains undervalued. Our $140 target
assumes that the stock trades at a slight discount to the average P/E
multiple for our group of 14-15X our 2003 estimates. Historically, the stock
has traded at a discount to our group, but it is difficult to rely on history
given the substantial change the company has undergone over the past 5 year.
In 2001, SPW was one of the top organic growers and top cash generators in
our coverage list and we believe it will rank similarly in 2002. We believe
this continued group beating performance warrants a multiple in line with our
group and positions the company to possibly obtain a premium valuation over
time.
Risks
One potential risk to SPX stock is the potential dilution from its equity-
linked notes (LYONs), which were issued in February and May of 2001 for a
combined face value of $1.41 billion. If/when the LYONs are triggered, the
potential converted shares must be added to SPX's diluted share count. We
estimate that adding these shares, if included for the full year, would
result in dilution of ~$1.00 to our 2003 estimate. However, we believe SPX
will be able to largely offset this dilution through additional cost savings
from UDI, bolt-on deals such as Balcke, and upside leverage in an improving
economy. We believe another possible investment risk to SPX concerns the
impending slow-down at the company's power transformer business, Waukesha
Electric. Going forward, we expect this business, which is the largest in
the Industrial Products segment, to continue rolling over and experience
significant revenue declines in 2H02 and 2003, reflecting the sharp downturn
in the power industry following several years of prosperity. Sluggish
industrial capital spending levels and depressed utilization rates could also
pressure many of the company's general industrial businesses. It should also
be noted that SPX is thinly traded with a small float relative to other names
in our universe. As a result, the stock has demonstrated very high
volatility. SPX also maintains the highest short interest in our group with
roughly 8% of the float in the hands of shorts.
Tyco International (TYC--$15.69; 1S)
Valuation
We are encouraged by the speed at which new CEO Ed Breen is moving to restore
credibility. In addition to the two internal investigations, Mr. Breen has
moved to change CFOs, added a new independent board member and created a new
executive corporate governance position. Our price target remains $22, which
represents a sum-of-the parts valuation using the lowest valued peer for each
segment. We believe a revenue-based valuation is the most conservative
approach since revenues are more black and white than GAAP earnings. Our
target implies a P/E multiple of ~10X our FY03 estimate, or a 30% discount to
our coverage group average.
Risks
Tyco shares are only for investors with the highest risk tolerance. Tyco has
gone through tremendous turmoil in 2002 culminating in the resignation of its
former CEO. However, with a well-respected new CEO hired and CIT disposed
the risks are reduced. We still have concerns that damaging revelations
could be revealed during the course of internal and external investigations.
We cannot rule out some type of earnings restatement or negative corporate
governance revelations. Tyco shares are likely to remain very volatile with
high "headline risk." We will be closely scrutinizing Mr. Breen's actions
and considering any corporate revelations constantly. It remains possible
that something so damaging could be revealed that will cause us to reconsider
our rating. Additional risks could arise from sluggish industrial capital
spending levels and depressed utilization rates. Tyco's exposure to the
volatile connector market is also a potential risk. Although year-over-year
sales declines have moderated in recent months and book/bill trends have
improved, the connector industry is not out of the woods yet. A subsequent
downturn in industry sales coupled with intensified competition could result
in an earnings shortfall at Tyco.
American Standard (ASD--$71.63; 2H)
Valuation
We believe continued operational improvements and deleveraging at American
Standard can drive the stock price and valuation higher over time. However,
the valuation is no longer compelling in our view following the significant
upward revaluation the company has enjoyed over the past couple years. We
value ASD relative to our group and on a sum-of-the parts basis. We do our
sum-of-the-parts work using 3 approaches: Total Enterprise Value (TEV)/Sales,
TEV/EBITDA and P/E. We favor the TEV approaches because they fully capture
the comparative capital structures of the peers. The stock is trading near
all-time highs versus our group at about a 10-12% P/E discount. We believe
the stock can ultimately move to parity or even a slight premium as it
deleverages given its strong organic growth profile. Our 12-18 month price
target of $80 is based on our coverage universe average TEV/EBITDA multiple
of ~8.0X applied to our '03 EBITDA estimate for American Standard.
Risks
Investors in American Standard shares should consider numerous potential
risks. The company has benefited from the surprising resilience in new and
existing home sales which has been a strong driver of residential air
conditioning and plumbing products. About 65%-75% of activity in these
markets is driven by remodeling activity. We believe the company can
continue gaining share, which would mute a downturn in residential markets,
but the company would still be impacted. Commercial construction markets
also remain a risk. There are also numerous environmental and regulatory
requirements such as the use of particular refrigerants or minimum efficiency
requirements that constantly impact the air conditioning market. ASD also
has significant overseas exposure, which remains a risk given the uncertain
pace of economic recovery. The company is also highly leveraged on an
historical book basis although its coverage ratios and liquidity appear more
than adequate. Nevertheless, in a severe downturn, cash flow could be
negatively impacted and the company could find it difficult or expensive to
refinance maturing debt obligations. Asbestos also poses a risk to the
company, although we believe the company's exposure is relatively minor. The
company has never paid a claim out of its own pocket to date and claims it
holds ample insurance coverage.
Cooper Industries (CBE--$32.72; 2M)
Valuation
Our price target of $35 equates to ~10X our 2003 EPS estimate, which is at a
significant discount to the company's average forward multiple of 13X over
the last five years and represents modest improvement over current levels.
We have taken into account lower peer valuations, recently lowered guidance,
and management's expectations of no material recovery in its served end
markets in 2002. With the reincorporation in Bermuda behind it, the company
may be in a position to leverage its lower tax rate, and subsequently greater
cash flow, to become more effective in the markets in which it competes.
Risks
The primary risk to CBE's near term performance is continued weakness across
end markets through H202 and possibly beyond. While it appears declining
demand trends have in general bottomed, continued weak demand in commercial
and industrial construction, as well as tool dependent industries, into H202
could signal a slower and/or delayed recovery. The company also has exposure
to asbestos litigation. The trend in settlement activity has been
encouraging but it is impossible to forecast future developments. Finally,
there is the possibility that anti-repatriation bills in the House and Senate
gain traction and put CBE's recent headquarters' move to Bermuda in jeopardy.
Emerson (EMR--$48.78; 2M)
Valuation
The stock is not cheap at 19X and 17X our FY2002 and FY2003 estimates,
respectively. However, we are bumping our price target to $54 from $50 which
equates to ~18X our calendarized 2003 estimate which is in line with the 10
year average P/E. Our previous target of $50 was derived from the 15 year
average P/E of ~17X. With comparisons becoming easier and orders turning
positive, we believe a slightly less conservative target is warranted. We
believe Emerson is on the right track internally with its restructuring
program and its drive to lower the capital intensity of the portfolio. These
actions should lead to a faster growing and more profitable company over the
next several years.
Risks
While it appears that EMR's Electronics business has stabilized, there
remains only early indications that underlying demand has improved. The
business has at least one more quarter of difficult comps before lapping last
year's declines. A prolonged downturn in the company's Electronic businesses
(which account for roughly 20% of consolidated sales) may result in downward
earnings pressure. It should also be noted that EMR's industrial businesses
(Process Control, Industrial Automation) are closely tied to capital spending
levels and utilization rates. Continued weakness stemming from either metric
could pressure results going forward. In addition, a slow-down in new and
existing home sales could lead to a decline in residential HVAC sales.
Despite the potential risk to earnings, we believe EMR is on the right track
internally with its restructuring program and its drive to lower the capital
intensity of the portfolio. These actions should lead to a faster growing
and more profitable company over the next several years. It should be
acknowledged that uncertainty associated with the plan could pose a risk to
the stock. Management's savings run rate expectations are dependent upon
successful execution. Delays and/or difficulties in implementation of
restructuring efforts could negatively impact results.
Honeywell (HON--$29.95; 2H)
Valuation
Trading at less than 12X our 2003 estimate, we believe downside risk is
limited. Airline industry weakness is well understood by investors and
largely incorporated into HON's stock price, in our opinion. The stock is
currently trading a 19% discount to our coverage group and 30% discount to
the S&P 500 based on '03 EPS estimates. While headline risk may keep a lid
on the stock in the near-term, we view it as an attractive investment for
patient investors with a 12-month time horizon. We reiterate our 2H rating.
We are trimming our price target to $36 from $40 to reflect HON's 15-year
average forward P/E of ~14X applied to our 2003 estimate of $2.55. Our prior
target applied HON's higher 10 year average P/E to our estimates, but in
light of very tough aerospace fundamentals, we believe a more conservative
target is warranted.
Risks
Investors in Honeywell should consider several risks. First, we remain
concerned that the current commercial aerospace downturn will linger well
into 2003 with the depth and duration of the downturn still in question.
Honeywell's relative upside could be restrained by its commercial aerospace
business, which represents roughly 25% of total HON revenues and a higher
portion of profits. In addition, while management expects that restructuring
charges are now behind the company, we can't ignore the potential valuation
impact of over $4.0 billion in cumulative below-the-line restructuring
charges taken over the past three years. HON also has asbestos exposure that
we believe is widely known by the market. However, an adverse ruling against
HON or another company could cause stock price weakness. HON seems to have
strong insurance protection, but we cannot forecast the velocity of new cases
or the future size of settlements or judgments.
ITT Industries (ITT--$67.98; 2M)
Valuation
ITT continues to impress us with its consistent performance and improving
fundamentals. As we look ahead to the rest of 2002 and into 2003, we believe
the company could be facing an extended period of prosperity. The company is
currently trading at roughly 17X our 2003 estimate of $4.05, which equates to
a 15% premium to our group average. Our price target of $74 reflects the
high end of our sum of the parts valuation range on a TEV/Sales and
TEV/EBITDA basis, which suggests a value between $71-74. Our 2M rating
reflects ITT's expanded valuation versus its peers, which could limit
relative upside from current levels. The stock has been the strongest
performer in our coverage list year to date by a wide margin.
Risks
Key risks to our investment thesis on ITT are primarily economic. While 60%
of ITT revenues come from recession-resistant industries such as defense and
water/wastewater, the remaining 40% are cyclical and subject to swings in
revenue and profitability. Cyclical businesses include ITT's Electronic
Components business, the Motion & Flow Control Platform and about a third of
the Fluid Technology market. Further weakness in any of these markets
relative to expectations could result in downward estimate revisions. As the
defense industry enters a new phase of growth, ITT's core strengths
(communications, electronic warfare, engineering) are positioned at the
forefront of the Depart of Defense's procurement plans. Nevertheless, the
loss of a key defense contract to a competitor could result in downward
pressure on the stock.
Maytag (MYG--$32.64; 2H)
Valuation
We continue to view the company as a turn-around and margin expansion story
given the opportunity to restore profitability in its core business and
further margin upside at Amana. MYG is currently trading at 11X and 10X our
2002 and 2003 EPS estimates, respectively. This is toward the low end of the
company's historical trading range. Truncating historical valuation
extremes, the stock has generally traded in a range of 10-20 times forward
earnings over the past 15 years. The average forward valuation over this
time frame is about 15X EPS. However, we believe a 20% discount applied to
this mean is justified in order to take into account the uncertainty that the
pace of consumer spending and growth in residential housing markets will be
able to continue at current levels. We therefore believe our target should
be based on a more conservative 12X multiple, resulting in our price target
dropping to $42 from $52.
At these levels, we believe the stock could be considered cheaply valued if
strong consumer demand continues, residential housing remains resilient, and
the company maintains a steady stream of innovative and value-added new
product introductions. Longer term, continued strong internal execution and
improvements in profitability could justify the stock moving closer to the
mid point of its historical forward multiple range.
Risks
Although appliance shipments in the categories that the company competes, the
so-called "Core 6", have been remarkably resilient, MYG is almost entirely
dependent upon U.S. appliance demand. The possibility of Fed Funds rates
rising next year could have a significant cooling effect on the domestic
housing market. Slower than expected economic recovery could also have a
negative effect on consumer demand. Competition based risk comes primarily
from WHR as the company nears the end of a significant restructuring program.
This is expected to result in more efficient internal operations and
therefore presumably more room to price product competitively, and
acceleration in feature laden premium product introductions targeted at the
high-end consumer, which is MYG's primary stomping grounds. Our earnings
forecast is also dependent on deriving further cost synergies from the 2001
acquisition of Amana.
Whirlpool (WHR--$55.31; 2H)
Valuation
WHR appears fairly, or even cheaply, valued at 9X and 8X our 2002 and 2003
EPS estimates at present. Excluding historical outliers, the stock has
traded between 8X-16X forward earnings over the last 20 years with an overall
mean of 12.7X. We are encouraged by modest improvement in Europe, but are
still concerned about economic instability in Latin America. There are also
the issues of tougher comps going forward, the possibility of raw material
pressures that could begin to have some impact in 2003, and the potential of
rising Fed funds, although the near term possibility has diminished
considerably as of late.
We are lowering our price target to $65 from $68, which equates to 9.6X our
'03 EPS estimate. This is at the lower end of its 5-year forward P/E range
and represents a ~25% discount to the stock's historical mean of ~13X, which
takes into account concerns about earnings quality, weak cash flow and
exposure to troubled Latin America. However, the stock could be considered
cheaply valued if strong consumer demand continues, residential housing
remains resilient, and the company continues to introduce a steady stream of
innovative and value-added new products. Our previous target of $68 assumed
the multiple could expand closer to the mid point of its historical range
with the prospect of a stronger economy. We believe that assumption is now
too optimistic given the macro-backdrop.
Risks
Although domestic appliance shipments have been surprisingly resilient for
almost a year now, WHR derives over 30% of its revenues from overseas. A
fragile European recovery and tenuous political climate and currency
devaluations in Latin America continue to cast a cloud of uncertainty over
international contributions. Domestically, primary risk revolves around
economic recovery and concerns of slipping consumer confidence. Competition
based risk comes predominantly from MYG as the company continues to make
progress with its turnaround efforts and refocuses on turning out high value
added appliances. GE has also intensified its competitive efforts in the
Appliance sector. Having solved its U.S. based refrigeration production
issues, Electrolux could be in a position to threaten existing refrigeration
product markets shares.
Hubbell Incorporated (HUBB--$32.10; 3M)
Valuation
We are encouraged by HUBB's restructuring efforts but we remain cautious on
the fundamental outlook given little evidence at present of any noticeable
recovery in Hubbell's end markets. Our 12-month price target of $35, could
be considered rich, but in our opinion is justified for a number of reasons.
Our target represents a multiple of 17.5X our FY03 estimate and is barely
above its 10-year average forward historical multiple of 17.1X. We believe
the valuation is justified given the prospect for accelerated revenue and EPS
growth driven by the current acquisition program. Furthermore, the
restructuring plan announced in Q401 appears to be on track and should
eventually lead to a more profitable company.
Risks
HUBB's stated desire to grow revenues to $3-$5 billion by 2007 opens the
company to acquisition related risks that have been less of an issue in the
past. While management has stated that the Hawke International and LCA Group
acquisitions are immediately accretive, there always exists integration and
synergy risk. Future acquisitions of the size needed to reach the company's
top line goal expose HUBB to further similar risk. As with any restructuring
plan, there is also uncertainty associated with the plan the company
announced in Q401. Management's savings run rate expectations are dependent
upon successful execution. Delays and/or difficulties in implementation of
restructuring efforts could negatively impact results. Sluggish industrial
capital spending levels and depressed utilization rates could also pressure
many of the company's general industrial businesses.
Illinois Tool Works (ITW--$68.52; 3M)
Valuation
While orders have recently improved in several of ITW's businesses, a
sustainable recovery is still uncertain. At 22X and 20X our '02 and '03
estimates, we believe the stock is fully valued. Our price target of $68
reflects a 19X-20X multiple on our 2003 EPS estimate and is the average
forward multiple over the last ten years. Although this average jumps to 22X
if we look at the last five years, we believe there is still sufficient
uncertainty to warrant caution and a more conservative valuation. We will
continue to watch for signs of recovery in ITW's key commercial construction
and capital goods markets that could signal the increasing volume necessary
for us to become more bullish on the stock.
Risks
Despite being composed of over 600 individual operating identities, ITW is
heavily dependent upon the construction and automotive markets. Although
weak commercial and industrial construction has been partially offset by a
stronger residential market and healthy automotive sales, a rise in interest
rates could cool strong demand putting further pressure on ITW's Engineered
Products -- North America business. Additionally, demand in its capital
goods related end markets appears to be firming but is still very weak.
Finally, ITW's growth through acquisition blueprint leaves the company open
to risks associated with integration difficulties and lower than expected
cost savings and/or synergies.
Rockwell Automation (ROK--$18.42; 3M)
Valuation
Rockwell stock has had a strong run relative to the S&P year to date (up ~4%
vs S&P down ~22%), reflecting the company's position as a leveraged upside
play on an economic recovery. However, given the lack of earnings
visibility, especially abroad, and a relatively full valuation (~20X our
calendar '02 estimate), we prefer to remain on the sidelines. At 15X, the
stock looks reasonably valued on our '03 estimate, but at this juncture there
is very little visibility to improvement in '03. Our $20 target assumes a
~17X P/E on our '03 estimate or roughly in-line with the S&P 500 multiple.
Risks
Until a sustained recovery in industrial capital spending and capacity
utilization rates returns, we believe ROK's earnings could remain below
historical levels. Although we are encouraged by recent trends signaling a
sequential increase in demand at certain end markets, we remain hesitant
until further clarity emerges. While it appears declining demand trends have
generally bottomed, continued weak demand in automotive and consumer products
in 2H02 could signal a slower and/or delayed recovery. The company currently
derives 55% of consolidated sales from consumer and automotive related end
markets. Economic conditions abroad could also pose a risk to future
earnings in the form of foreign currency exposure.
Textron (TXT--$38.85; 3H)
Valuation
Textron's massive restructuring effort and integration of Six Sigma
initiatives appear to be gaining traction, but it is too early to declare
victory. With the company's operations at such depressed levels, the
potential for upside is tremendous. However, the company has struggled with
execution in the past and fundamentals in the company's industrial businesses
are very difficult. Additionally, weakness in the business jet market could
limit upside leverage to a recovery, whether it occurs in late 2002 or
sometime in 2003. Nevertheless, we are encouraged by Cessna's share gains in
such a competitive environment and will be watching orders closely. While
downside may be limited with the stock at less than 11X our '03 estimate,
execution risk, sub-par cash flow and Cessna uncertainty keeps us on the
sidelines. We reiterate our 3H rating and $45 price target. At $45, the
stock would be trading at the low end of its historical forward valuation
average (~12X) but at a premium relative to price/free cash flow (24X versus
group average of ~18X).
Risks
Textron has considerable exposure to the business jet sector through its
Cessna subsidiary, which accounts for ~ 30% of total Textron revenues and
~40% of operating profit. The health of the business jet market remains
uncertain, following the economic downturn and tragedy of 9/11. Orders have
been depressed for over a year, but the company still has more than a year of
production left in its backlog, assuming no further cancellations. Another
risk is the industrial economy. Low capacity utilization, tight capital
spending budgets and continued global weakness could continue to pressure our
estimates beyond our current assumptions. Finally, Textron's massive
restructuring effort carries execution risk. The restructuring and
integration of Six Sigma initiatives appear to gaining traction, but it is
too early to declare victory. The company has struggled with the execution
in the past and it is hard to overlook the company's serial restructuring
charges and several disappointing or ill-timed acquisitions although we
believe the company has strengthened its acquisition discipline plan.
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S a l o m o n S m i t h B a r n e y R e s e a r c h
Introducing Our New Rating
System
General Electric Co(GE)<A
href="https://www.salomonsmithbarney.com/port_hold/ratesys.html";>Rating: 1L<FONT
size=-1>As of 09/08/2002 Last Changed 09/07/1999
The
Salomon Smith Barney Equity Research Department changed their Stock
and Industry Ratings System as of September 7, 2002. <A
href="https://www.salomonsmithbarney.com/research/rating_system.html";>Click here for more
information.
Salomon Smith Barney ~ September 7, 2002
See last pages for Important Disclosures
Multi-industry
Introducing Our New Rating System
September 6, 2002 SUMMARY
* We are introducing a new "relative" ratings system for
Jeffrey T. our coverage list in accordance w/ SSB's new research
Sprague, CFA guidelines which requires our universe of stocks to be
ranked in preference relative to each other. For the
purposes of this note our entire coverage list is being
John Roselli, CFA considered "multi-industry".
* We believe our industry will outperform the S&P 500
over the coming year. We would Overweight the
Mark Wilterding multi-industry group because the group typically
outperforms in the earlier stages of an economic cycle
and valuations in general are below historical averages.
* Although the nomenclature is changed, our view on our
industry and stocks is essentially unchanged. Our
Outperform-rated stocks in order of preference are Tyco,
SPX Corp, GE, and Danaher.
OPINION
We rate our Multi-Industry group overweight versus the S&P 500. Our group
typically out performs the S&P 500 in the early portion of economic
recoveries. For example, in the 1991-1993 time frame our group appreciated
76% compared to a rise of 41% for the S&P 500. Often in the early stages of
recoveries the fundamentals actually still look quite grim and earnings can
remain disappointing. We appear to be in that type of environment currently.
However, the "promise" of recovery, which often manifests itself in small and
uneven hints of impending improvement, can drive the stocks. When a robust
recovery is actually underway the group's relative performance tends to
moderate. Valuations also support our overweight position. Our group on
average is trading at ~15X forward earnings compared to a historical average
forward P/E of ~17X. We believe valuations have room to expand as nascent
signs of economic improvement emerge over the next 6-12 months.
The SSB strategy team forecasts approximately 19% total return potential in
the S&P 500 to December 2003. We do not know if that forecast will prove
accurate but, we believe our group can outperform the S&P 500 over that
period of time. Our coverage universe has gone through massive restructuring
the past 2 years that provides significant earnings leverage even if revenues
up tick only slightly. Although the earnings outlook remains difficult the
majority of our companies have stopped missing estimates and downward
earnings revisions have moderated significantly. Earnings and order
comparisons are easy from Q3 onward. Additionally, most companies on our
list have healthy balance sheets and good cash flow providing the opportunity
to augment growth with acquisitions or share repurchase.
For the purposes of this note and the ratings of our stocks our entire
coverage list is being named Multi-Industry including stocks such as GE,
Emerson and Hubbell, which have been traditionally described as "Electrical
Equipment". At some later date within the SSB system the group will be
renamed Electrical Equipment & Multi-Industry to provide a more precise
description. However, this impending change is a housekeeping item and in
isolation signals no future change in the ratings and thesis provided in this
note.
The new SSB rating system requires that stocks in an analysts coverage list
be rated relative to each other under the 3 ratings of "outperform", "in-
line" and "underperform", replacing the previous 5 tiered rating system.
Given this type of format our ratings will have a generally even dispersion
across the three ratings categories. Although the ratings nomenclature has
changed, our view on our industry and the individual stocks is essentially
unchanged. However, we can envision more frequent ratings changes under this
new system since big price moves up or down by individual stocks will require
a more overt re-evaluation of their relative standing in the group.
Additionally, our ratings will have a more clinical nature. The "best"
companies in the group are more likely to be rated In-line or Underperform
from time to time based on their relative valuations while weaker companies
will be more likely to be rated outperform if they get excessively cheap.
Our initial application of the new ratings results in a dispersion of 4
"outperforms", 7 "in-lines" and 4 "underperforms".
Our Outperform-rated stocks in order of preference are Tyco, SPX Corp, GE and
Danaher. Tyco, GE and SPX were all rated "buy", while Danaher was rated
"outperform" under the previous rating system. We've long maintained that
"story" stocks tend to be the best performers in our group and most of our
outperforms fit this criteria. Tyco is undergoing a cleansing by a new CEO
following the resignation of the former CEO. We believe this "healing"
process will drive the valuation higher as investors refocus on the value of
the business franchises. SPX remains on a path to emerge as a premier
company in the group and improving cash flow supports valuation expansion.
Danaher continues to distinguish itself with excellent execution during the
current industrial downturn. While not cheap, its strong balance sheet gives
it the dry powder to augment growth with acquisitions. GE is somewhat of a
special case. The stock has been crushed over the past 2 years given
concerns about numerous issues such as succession and the outlook for Power.
However, the fact remains that GE is a premier global company with returns on
capital essentially double our group average. As we roll into 2003, we
believe the market will begin to anticipate acceleration in earnings growth
in 2004 as the headwinds from Power and Aerospace moderate and short cycle
growth and acquisitions play a larger role.
Our "in-line" rated stocks are ITT Corp, Honeywell, American Standard,
Emerson, Maytag, Cooper and Whirlpool. Since we are carrying an "overweight"
on our group we believe all of these stocks are candidates to outperform the
market. Previously ITT, Honeywell Maytag and American Standard were rated
"outperform" while Emerson, Cooper and Whirlpool were rated neutral. We
remain very positive on the outlook and internal improvements underway at
ITT. However, the stock has strongly outperformed everything in our group
this year and is now at a premium valuation. A price pullback would be cause
to re-evaluate our rating. American Standard continues to impress us with
good internal execution and above average organic growth. Honeywell faces
near term pressures due to the dismal outlook for commercial aviation and
weak industrial capital spending, but has significant leverage to eventual
recovery and is reasonably valued. On Emerson, earnings visibility is still
limited, but we believe estimates have hit bottom and comparisons are
beginning to get easy. Additionally, Emerson's orders have turned positive
(largely easy comps) after 15 months of declines. Maytag is a consumer play
and we favor it because we believe margins have significant upside even if
industry appliance shipments do not rise from current levels. Cooper and
Whirlpool are in this new "in-line" group because their very low valuations
limit downside, but our fundamental cautious view on both companies is
unchanged.
Our "underperform" rated stocks are Hubbell, Rockwell, ITW and Textron and
all were rated "neutral" under the previous rating system. These are some of
the most expensive stocks in our universe (TXT looks cheap on P/E, but
expensive on cash flow, by our analysis) all have outperformed our group (and
the S&P 500) year to date suggesting that relative upside versus the
remainder of the group is limited. However, given our view that the group
will have an upside bias over the next twelve months, these stocks could
trade higher in absolute terms. Additionally, all of our underperforms
except ITW have dividend yields above the S&P average suggesting good
downside protection.
Rating Price Target
Company (Price) Symbol New System Old System New Old
MULTI-INDUSTRY
Danaher ($60.15) DHR 1M -- Outperform 2M -- Outperform $74 $74
General Electric ($30.15) GE 1L -- Outperform 1L -- Buy $38 $38
SPX Corporation ($108.60) SPW 1M -- Outperform 1M -- Buy $140 $140
Tyco International ($15.69) TYC 1S -- Outperform 1S -- Buy $22 $22
American Standard ($71.63) ASD 2H -- In-Line 2H -- Outperform $80 $80
Cooper Industries ($32.72) CBE 2M -- In-Line 3M -- Neutral $35 $35
Emerson ($48.78) EMR 2M -- In-Line 3M -- Neutral $54 $50
Honeywell ($29.95) HON 2H -- In-Line 2H -- Outperform $36 $42
ITT Industries ($67.98) ITT 2M -- In-Line 2M -- Outperform $74 $74
Maytag ($32.64) MYG 2H -- In-Line 2H -- Outperform $42 $52
Whirlpool ($55.31) WHR 2H -- In-Line 3H -- Neutral $65 $68
Hubbell Incorporated HUBB 3M -- 3M -- Neutral $35 $35
($32.10) Underperform
Illinois Tool Works ($68.52) ITW 3M -- 3M -- Neutral $68 $68
Underperform
Rockwell Automation ($18.42) ROK 3M -- 3M -- Neutral $20 $20
Underperform
Textron ($38.85) TXT 3H -- 3H -- Neutral $45 $50
Underperform
Note: Prices are as of market close on August 30, 2002
VALUATION AND RISKS
Danaher (DHR--$60.15; 1M)
Valuation
Danaher's stock is not cheap, trading at nearly 19X our 2003 estimate versus
a group average of 14X. However, the company has perennially been a top cash
flow generator which supports a premium P/E valuation. On a price/free cash
flow basis the stock is at a modest 10% premium to our group. Management's
ability to take out costs, drive margin improvement, and deliver strong cash
flow despite severe pressure on core revenues enforces our confidence in the
company. Similar to other companies in our universe, DHR has seen hints of
an economic bottom, but does not anticipate an meaningful cyclical recovery
until late '02 at the earliest. Acquisitions consummated earlier in the year
and restructuring savings should support earnings even if the top line
remains sluggish. Our price target of $74 equates to the 5 year average P/E
of ~23 applied to our $3.20 estimate for 2003.
Risks
Potential risks include the ability to integrate recent acquisitions into the
portfolio. Since the beginning of the year, DHR has closed three sizeable
deals that will add a combined total of ~$900 million in annualized revenues.
Sluggish industrial capital spending levels and depressed utilization rates
could also pressure many of the company's general industrial businesses.
Within DHR's Motion Control segment, continued weakness in key end markets
such as semiconductors, electronic assembly, and telecom, which collectively
account for ~25% of segment revenues, may pose a risk to estimates.
Furthermore, declines in consumer spending may adversely impact certain hand
tool businesses including Delta and Craftsman. A prolonged downturn in
Danaher's relatively volatile Power Quality businesses may also result in
downward earnings pressure.
General Electric (GE--$30.15; 1L)
Valuation
Our 2003 estimate of $1.78 equates to about 8% EPS growth, which is below
GE's stated goal of "double digits". We are not ruling out hitting 10%+ EPS
growth in 2003 but we do not have the visibility to maintain our forecast at
that level. If the economy rebounds strongly in 2003 and GE's acquisition
program remains successful our estimates have upside. Furthermore, we
believe GE can post accelerating earnings growth in 2004, assuming we are
well into a recovering economy at that point and other businesses (and
acquisitions) are better able to offset the long cycle headwind at Power and
Aircraft. Although 2004 is a long way off, the market has been fretting
about GE's '03 earnings outlook since at least the middle of 2001. As we
approach year-end and roll into 2003 the debate will begin to shift away from
2003 to 2004. Power and Aircraft will still face pressures in 2004, but
their relative drag should diminish and as mentioned above other pieces of
the portfolio should be on a better stride.
Our $38 target assumes a 21X P/E on our '03 estimate, or about a 25% premium
to the market multiple. The stock may remain stuck in a trading range until
more short cycle visibility emerges, but we believe the stock can outperform
the market over the next 12 months. We believe that GE deserves to trade at
a premium to the market multiple given the company's extraordinary ROIC,
solid balance sheet, leading businesses and above average growth potential.
Furthermore, in an age of corporate governance concerns and management
credibility issues, GE appears well suited to defend any criticism that may
arise.
Risks
GE is one of the world's largest companies and as a result has exposure to
numerous global economic and political risks. Primary specific risks in the
near term include the potential for a further fall-off in the Power business
due to the distressed nature of GE's customers. GE is also exposed to the
troubled airline industry through its engine and leasing businesses. We
believe it has managed its airline risks well, but the potential for further
industry deterioration remains a risk. Finally, continued improvement in
short cycle businesses, especially Plastics, is key to offsetting declining
earnings in Power Systems.
SPX Corporation (SPW--$108.60; 1M)
Valuation
SPX remains one of our top picks. The company has consistently hit earnings
expectations and appears solidly on track in 2002. Free cash flow should be
strong again in 2002 at ~$350mm or approximately 95% of net income (over 100%
on a pre-FAS142 basis). Even if we assume $1.00 of EPS dilution due to LYONs
conversion with no offsetting cost reductions, the stock looks cheap at ~11X
our '03 forecast. The company continues to execute well in a difficult
environment and we believe the stock remains undervalued. Our $140 target
assumes that the stock trades at a slight discount to the average P/E
multiple for our group of 14-15X our 2003 estimates. Historically, the stock
has traded at a discount to our group, but it is difficult to rely on history
given the substantial change the company has undergone over the past 5 year.
In 2001, SPW was one of the top organic growers and top cash generators in
our coverage list and we believe it will rank similarly in 2002. We believe
this continued group beating performance warrants a multiple in line with our
group and positions the company to possibly obtain a premium valuation over
time.
Risks
One potential risk to SPX stock is the potential dilution from its equity-
linked notes (LYONs), which were issued in February and May of 2001 for a
combined face value of $1.41 billion. If/when the LYONs are triggered, the
potential converted shares must be added to SPX's diluted share count. We
estimate that adding these shares, if included for the full year, would
result in dilution of ~$1.00 to our 2003 estimate. However, we believe SPX
will be able to largely offset this dilution through additional cost savings
from UDI, bolt-on deals such as Balcke, and upside leverage in an improving
economy. We believe another possible investment risk to SPX concerns the
impending slow-down at the company's power transformer business, Waukesha
Electric. Going forward, we expect this business, which is the largest in
the Industrial Products segment, to continue rolling over and experience
significant revenue declines in 2H02 and 2003, reflecting the sharp downturn
in the power industry following several years of prosperity. Sluggish
industrial capital spending levels and depressed utilization rates could also
pressure many of the company's general industrial businesses. It should also
be noted that SPX is thinly traded with a small float relative to other names
in our universe. As a result, the stock has demonstrated very high
volatility. SPX also maintains the highest short interest in our group with
roughly 8% of the float in the hands of shorts.
Tyco International (TYC--$15.69; 1S)
Valuation
We are encouraged by the speed at which new CEO Ed Breen is moving to restore
credibility. In addition to the two internal investigations, Mr. Breen has
moved to change CFOs, added a new independent board member and created a new
executive corporate governance position. Our price target remains $22, which
represents a sum-of-the parts valuation using the lowest valued peer for each
segment. We believe a revenue-based valuation is the most conservative
approach since revenues are more black and white than GAAP earnings. Our
target implies a P/E multiple of ~10X our FY03 estimate, or a 30% discount to
our coverage group average.
Risks
Tyco shares are only for investors with the highest risk tolerance. Tyco has
gone through tremendous turmoil in 2002 culminating in the resignation of its
former CEO. However, with a well-respected new CEO hired and CIT disposed
the risks are reduced. We still have concerns that damaging revelations
could be revealed during the course of internal and external investigations.
We cannot rule out some type of earnings restatement or negative corporate
governance revelations. Tyco shares are likely to remain very volatile with
high "headline risk." We will be closely scrutinizing Mr. Breen's actions
and considering any corporate revelations constantly. It remains possible
that something so damaging could be revealed that will cause us to reconsider
our rating. Additional risks could arise from sluggish industrial capital
spending levels and depressed utilization rates. Tyco's exposure to the
volatile connector market is also a potential risk. Although year-over-year
sales declines have moderated in recent months and book/bill trends have
improved, the connector industry is not out of the woods yet. A subsequent
downturn in industry sales coupled with intensified competition could result
in an earnings shortfall at Tyco.
American Standard (ASD--$71.63; 2H)
Valuation
We believe continued operational improvements and deleveraging at American
Standard can drive the stock price and valuation higher over time. However,
the valuation is no longer compelling in our view following the significant
upward revaluation the company has enjoyed over the past couple years. We
value ASD relative to our group and on a sum-of-the parts basis. We do our
sum-of-the-parts work using 3 approaches: Total Enterprise Value (TEV)/Sales,
TEV/EBITDA and P/E. We favor the TEV approaches because they fully capture
the comparative capital structures of the peers. The stock is trading near
all-time highs versus our group at about a 10-12% P/E discount. We believe
the stock can ultimately move to parity or even a slight premium as it
deleverages given its strong organic growth profile. Our 12-18 month price
target of $80 is based on our coverage universe average TEV/EBITDA multiple
of ~8.0X applied to our '03 EBITDA estimate for American Standard.
Risks
Investors in American Standard shares should consider numerous potential
risks. The company has benefited from the surprising resilience in new and
existing home sales which has been a strong driver of residential air
conditioning and plumbing products. About 65%-75% of activity in these
markets is driven by remodeling activity. We believe the company can
continue gaining share, which would mute a downturn in residential markets,
but the company would still be impacted. Commercial construction markets
also remain a risk. There are also numerous environmental and regulatory
requirements such as the use of particular refrigerants or minimum efficiency
requirements that constantly impact the air conditioning market. ASD also
has significant overseas exposure, which remains a risk given the uncertain
pace of economic recovery. The company is also highly leveraged on an
historical book basis although its coverage ratios and liquidity appear more
than adequate. Nevertheless, in a severe downturn, cash flow could be
negatively impacted and the company could find it difficult or expensive to
refinance maturing debt obligations. Asbestos also poses a risk to the
company, although we believe the company's exposure is relatively minor. The
company has never paid a claim out of its own pocket to date and claims it
holds ample insurance coverage.
Cooper Industries (CBE--$32.72; 2M)
Valuation
Our price target of $35 equates to ~10X our 2003 EPS estimate, which is at a
significant discount to the company's average forward multiple of 13X over
the last five years and represents modest improvement over current levels.
We have taken into account lower peer valuations, recently lowered guidance,
and management's expectations of no material recovery in its served end
markets in 2002. With the reincorporation in Bermuda behind it, the company
may be in a position to leverage its lower tax rate, and subsequently greater
cash flow, to become more effective in the markets in which it competes.
Risks
The primary risk to CBE's near term performance is continued weakness across
end markets through H202 and possibly beyond. While it appears declining
demand trends have in general bottomed, continued weak demand in commercial
and industrial construction, as well as tool dependent industries, into H202
could signal a slower and/or delayed recovery. The company also has exposure
to asbestos litigation. The trend in settlement activity has been
encouraging but it is impossible to forecast future developments. Finally,
there is the possibility that anti-repatriation bills in the House and Senate
gain traction and put CBE's recent headquarters' move to Bermuda in jeopardy.
Emerson (EMR--$48.78; 2M)
Valuation
The stock is not cheap at 19X and 17X our FY2002 and FY2003 estimates,
respectively. However, we are bumping our price target to $54 from $50 which
equates to ~18X our calendarized 2003 estimate which is in line with the 10
year average P/E. Our previous target of $50 was derived from the 15 year
average P/E of ~17X. With comparisons becoming easier and orders turning
positive, we believe a slightly less conservative target is warranted. We
believe Emerson is on the right track internally with its restructuring
program and its drive to lower the capital intensity of the portfolio. These
actions should lead to a faster growing and more profitable company over the
next several years.
Risks
While it appears that EMR's Electronics business has stabilized, there
remains only early indications that underlying demand has improved. The
business has at least one more quarter of difficult comps before lapping last
year's declines. A prolonged downturn in the company's Electronic businesses
(which account for roughly 20% of consolidated sales) may result in downward
earnings pressure. It should also be noted that EMR's industrial businesses
(Process Control, Industrial Automation) are closely tied to capital spending
levels and utilization rates. Continued weakness stemming from either metric
could pressure results going forward. In addition, a slow-down in new and
existing home sales could lead to a decline in residential HVAC sales.
Despite the potential risk to earnings, we believe EMR is on the right track
internally with its restructuring program and its drive to lower the capital
intensity of the portfolio. These actions should lead to a faster growing
and more profitable company over the next several years. It should be
acknowledged that uncertainty associated with the plan could pose a risk to
the stock. Management's savings run rate expectations are dependent upon
successful execution. Delays and/or difficulties in implementation of
restructuring efforts could negatively impact results.
Honeywell (HON--$29.95; 2H)
Valuation
Trading at less than 12X our 2003 estimate, we believe downside risk is
limited. Airline industry weakness is well understood by investors and
largely incorporated into HON's stock price, in our opinion. The stock is
currently trading a 19% discount to our coverage group and 30% discount to
the S&P 500 based on '03 EPS estimates. While headline risk may keep a lid
on the stock in the near-term, we view it as an attractive investment for
patient investors with a 12-month time horizon. We reiterate our 2H rating.
We are trimming our price target to $36 from $40 to reflect HON's 15-year
average forward P/E of ~14X applied to our 2003 estimate of $2.55. Our prior
target applied HON's higher 10 year average P/E to our estimates, but in
light of very tough aerospace fundamentals, we believe a more conservative
target is warranted.
Risks
Investors in Honeywell should consider several risks. First, we remain
concerned that the current commercial aerospace downturn will linger well
into 2003 with the depth and duration of the downturn still in question.
Honeywell's relative upside could be restrained by its commercial aerospace
business, which represents roughly 25% of total HON revenues and a higher
portion of profits. In addition, while management expects that restructuring
charges are now behind the company, we can't ignore the potential valuation
impact of over $4.0 billion in cumulative below-the-line restructuring
charges taken over the past three years. HON also has asbestos exposure that
we believe is widely known by the market. However, an adverse ruling against
HON or another company could cause stock price weakness. HON seems to have
strong insurance protection, but we cannot forecast the velocity of new cases
or the future size of settlements or judgments.
ITT Industries (ITT--$67.98; 2M)
Valuation
ITT continues to impress us with its consistent performance and improving
fundamentals. As we look ahead to the rest of 2002 and into 2003, we believe
the company could be facing an extended period of prosperity. The company is
currently trading at roughly 17X our 2003 estimate of $4.05, which equates to
a 15% premium to our group average. Our price target of $74 reflects the
high end of our sum of the parts valuation range on a TEV/Sales and
TEV/EBITDA basis, which suggests a value between $71-74. Our 2M rating
reflects ITT's expanded valuation versus its peers, which could limit
relative upside from current levels. The stock has been the strongest
performer in our coverage list year to date by a wide margin.
Risks
Key risks to our investment thesis on ITT are primarily economic. While 60%
of ITT revenues come from recession-resistant industries such as defense and
water/wastewater, the remaining 40% are cyclical and subject to swings in
revenue and profitability. Cyclical businesses include ITT's Electronic
Components business, the Motion & Flow Control Platform and about a third of
the Fluid Technology market. Further weakness in any of these markets
relative to expectations could result in downward estimate revisions. As the
defense industry enters a new phase of growth, ITT's core strengths
(communications, electronic warfare, engineering) are positioned at the
forefront of the Depart of Defense's procurement plans. Nevertheless, the
loss of a key defense contract to a competitor could result in downward
pressure on the stock.
Maytag (MYG--$32.64; 2H)
Valuation
We continue to view the company as a turn-around and margin expansion story
given the opportunity to restore profitability in its core business and
further margin upside at Amana. MYG is currently trading at 11X and 10X our
2002 and 2003 EPS estimates, respectively. This is toward the low end of the
company's historical trading range. Truncating historical valuation
extremes, the stock has generally traded in a range of 10-20 times forward
earnings over the past 15 years. The average forward valuation over this
time frame is about 15X EPS. However, we believe a 20% discount applied to
this mean is justified in order to take into account the uncertainty that the
pace of consumer spending and growth in residential housing markets will be
able to continue at current levels. We therefore believe our target should
be based on a more conservative 12X multiple, resulting in our price target
dropping to $42 from $52.
At these levels, we believe the stock could be considered cheaply valued if
strong consumer demand continues, residential housing remains resilient, and
the company maintains a steady stream of innovative and value-added new
product introductions. Longer term, continued strong internal execution and
improvements in profitability could justify the stock moving closer to the
mid point of its historical forward multiple range.
Risks
Although appliance shipments in the categories that the company competes, the
so-called "Core 6", have been remarkably resilient, MYG is almost entirely
dependent upon U.S. appliance demand. The possibility of Fed Funds rates
rising next year could have a significant cooling effect on the domestic
housing market. Slower than expected economic recovery could also have a
negative effect on consumer demand. Competition based risk comes primarily
from WHR as the company nears the end of a significant restructuring program.
This is expected to result in more efficient internal operations and
therefore presumably more room to price product competitively, and
acceleration in feature laden premium product introductions targeted at the
high-end consumer, which is MYG's primary stomping grounds. Our earnings
forecast is also dependent on deriving further cost synergies from the 2001
acquisition of Amana.
Whirlpool (WHR--$55.31; 2H)
Valuation
WHR appears fairly, or even cheaply, valued at 9X and 8X our 2002 and 2003
EPS estimates at present. Excluding historical outliers, the stock has
traded between 8X-16X forward earnings over the last 20 years with an overall
mean of 12.7X. We are encouraged by modest improvement in Europe, but are
still concerned about economic instability in Latin America. There are also
the issues of tougher comps going forward, the possibility of raw material
pressures that could begin to have some impact in 2003, and the potential of
rising Fed funds, although the near term possibility has diminished
considerably as of late.
We are lowering our price target to $65 from $68, which equates to 9.6X our
'03 EPS estimate. This is at the lower end of its 5-year forward P/E range
and represents a ~25% discount to the stock's historical mean of ~13X, which
takes into account concerns about earnings quality, weak cash flow and
exposure to troubled Latin America. However, the stock could be considered
cheaply valued if strong consumer demand continues, residential housing
remains resilient, and the company continues to introduce a steady stream of
innovative and value-added new products. Our previous target of $68 assumed
the multiple could expand closer to the mid point of its historical range
with the prospect of a stronger economy. We believe that assumption is now
too optimistic given the macro-backdrop.
Risks
Although domestic appliance shipments have been surprisingly resilient for
almost a year now, WHR derives over 30% of its revenues from overseas. A
fragile European recovery and tenuous political climate and currency
devaluations in Latin America continue to cast a cloud of uncertainty over
international contributions. Domestically, primary risk revolves around
economic recovery and concerns of slipping consumer confidence. Competition
based risk comes predominantly from MYG as the company continues to make
progress with its turnaround efforts and refocuses on turning out high value
added appliances. GE has also intensified its competitive efforts in the
Appliance sector. Having solved its U.S. based refrigeration production
issues, Electrolux could be in a position to threaten existing refrigeration
product markets shares.
Hubbell Incorporated (HUBB--$32.10; 3M)
Valuation
We are encouraged by HUBB's restructuring efforts but we remain cautious on
the fundamental outlook given little evidence at present of any noticeable
recovery in Hubbell's end markets. Our 12-month price target of $35, could
be considered rich, but in our opinion is justified for a number of reasons.
Our target represents a multiple of 17.5X our FY03 estimate and is barely
above its 10-year average forward historical multiple of 17.1X. We believe
the valuation is justified given the prospect for accelerated revenue and EPS
growth driven by the current acquisition program. Furthermore, the
restructuring plan announced in Q401 appears to be on track and should
eventually lead to a more profitable company.
Risks
HUBB's stated desire to grow revenues to $3-$5 billion by 2007 opens the
company to acquisition related risks that have been less of an issue in the
past. While management has stated that the Hawke International and LCA Group
acquisitions are immediately accretive, there always exists integration and
synergy risk. Future acquisitions of the size needed to reach the company's
top line goal expose HUBB to further similar risk. As with any restructuring
plan, there is also uncertainty associated with the plan the company
announced in Q401. Management's savings run rate expectations are dependent
upon successful execution. Delays and/or difficulties in implementation of
restructuring efforts could negatively impact results. Sluggish industrial
capital spending levels and depressed utilization rates could also pressure
many of the company's general industrial businesses.
Illinois Tool Works (ITW--$68.52; 3M)
Valuation
While orders have recently improved in several of ITW's businesses, a
sustainable recovery is still uncertain. At 22X and 20X our '02 and '03
estimates, we believe the stock is fully valued. Our price target of $68
reflects a 19X-20X multiple on our 2003 EPS estimate and is the average
forward multiple over the last ten years. Although this average jumps to 22X
if we look at the last five years, we believe there is still sufficient
uncertainty to warrant caution and a more conservative valuation. We will
continue to watch for signs of recovery in ITW's key commercial construction
and capital goods markets that could signal the increasing volume necessary
for us to become more bullish on the stock.
Risks
Despite being composed of over 600 individual operating identities, ITW is
heavily dependent upon the construction and automotive markets. Although
weak commercial and industrial construction has been partially offset by a
stronger residential market and healthy automotive sales, a rise in interest
rates could cool strong demand putting further pressure on ITW's Engineered
Products -- North America business. Additionally, demand in its capital
goods related end markets appears to be firming but is still very weak.
Finally, ITW's growth through acquisition blueprint leaves the company open
to risks associated with integration difficulties and lower than expected
cost savings and/or synergies.
Rockwell Automation (ROK--$18.42; 3M)
Valuation
Rockwell stock has had a strong run relative to the S&P year to date (up ~4%
vs S&P down ~22%), reflecting the company's position as a leveraged upside
play on an economic recovery. However, given the lack of earnings
visibility, especially abroad, and a relatively full valuation (~20X our
calendar '02 estimate), we prefer to remain on the sidelines. At 15X, the
stock looks reasonably valued on our '03 estimate, but at this juncture there
is very little visibility to improvement in '03. Our $20 target assumes a
~17X P/E on our '03 estimate or roughly in-line with the S&P 500 multiple.
Risks
Until a sustained recovery in industrial capital spending and capacity
utilization rates returns, we believe ROK's earnings could remain below
historical levels. Although we are encouraged by recent trends signaling a
sequential increase in demand at certain end markets, we remain hesitant
until further clarity emerges. While it appears declining demand trends have
generally bottomed, continued weak demand in automotive and consumer products
in 2H02 could signal a slower and/or delayed recovery. The company currently
derives 55% of consolidated sales from consumer and automotive related end
markets. Economic conditions abroad could also pose a risk to future
earnings in the form of foreign currency exposure.
Textron (TXT--$38.85; 3H)
Valuation
Textron's massive restructuring effort and integration of Six Sigma
initiatives appear to be gaining traction, but it is too early to declare
victory. With the company's operations at such depressed levels, the
potential for upside is tremendous. However, the company has struggled with
execution in the past and fundamentals in the company's industrial businesses
are very difficult. Additionally, weakness in the business jet market could
limit upside leverage to a recovery, whether it occurs in late 2002 or
sometime in 2003. Nevertheless, we are encouraged by Cessna's share gains in
such a competitive environment and will be watching orders closely. While
downside may be limited with the stock at less than 11X our '03 estimate,
execution risk, sub-par cash flow and Cessna uncertainty keeps us on the
sidelines. We reiterate our 3H rating and $45 price target. At $45, the
stock would be trading at the low end of its historical forward valuation
average (~12X) but at a premium relative to price/free cash flow (24X versus
group average of ~18X).
Risks
Textron has considerable exposure to the business jet sector through its
Cessna subsidiary, which accounts for ~ 30% of total Textron revenues and
~40% of operating profit. The health of the business jet market remains
uncertain, following the economic downturn and tragedy of 9/11. Orders have
been depressed for over a year, but the company still has more than a year of
production left in its backlog, assuming no further cancellations. Another
risk is the industrial economy. Low capacity utilization, tight capital
spending budgets and continued global weakness could continue to pressure our
estimates beyond our current assumptions. Finally, Textron's massive
restructuring effort carries execution risk. The restructuring and
integration of Six Sigma initiatives appear to gaining traction, but it is
too early to declare victory. The company has struggled with the execution
in the past and it is hard to overlook the company's serial restructuring
charges and several disappointing or ill-timed acquisitions although we
believe the company has strengthened its acquisition discipline plan.
ANALYST CERTIFICATION
I, Jeffrey Sprague, hereby certify that the views expressed in this research
report accurately reflect my personal views about the subject companies and
their securities. I also certify that I have not been, am not, and will not
be receiving direct or indirect compensation in exchange for expressing the
specific recommendations in this report.
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Guide To Investment Ratings: Stock ratings are based upon expected
performance over the next 12 to 18 months relative to the analyst's industry
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Prior to September 9, 2002, the Firm's stock rating system was based upon the
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higher the risk, the higher the required return). A Buy (1) rating indicated
an expected total return ranging from +15% or greater for a low-risk stock to
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