Infrastructure Stocks Could Rally

Infrastructure Stocks Could Rally

Infrastructure Stocks Could Rally on Higher Spending

Clinton and Trump both want to boost infrastructure spending. Jamie Cook, of CSFB, picks industry winners.

Updated Sept. 24, 2016 1:24 a.m. ET

“Now that oil prices are higher, I’m getting more optimistic about the end of 2017 and going into 2018.“ Jamie Cook, CSFB Photo: Brad Trent for Barron’s

Even before bridges collapsed in Cincinnati and Coachella, Calif., infrastructure became a talking point in the presidential campaign. This is one issue not up for debate: Both Hillary Clinton and Donald Trump agree that U.S. infrastructure spending must be increased dramatically. We checked in with Jamie Cook, 43, a top-ranked CSFB analyst, to find out exactly where that money should be spent and which companies will benefit.

The volatile infrastructure sector has sprung higher this year, but just as investors failed to anticipate the major losses that came in 2014 as concern grew over slowing growth in emerging markets, they may be ignoring potential gains. Cook, a Kingston, N.Y., native trained in math and statistics, has covered machinery, engineering, and construction at CSFB for 16 years. Her 2018 earnings forecasts are all higher than the consensus, and we were curious to know why. The good news is that her reasons are compelling. The bad news is that our nation needs a lot of work.

Barron’s: How bad is our infrastructure problem?

Cook: As a country, we get a D on the American Society of Civil Engineers’ broad score card for infrastructure, across roads, bridges, airports, waste water, parks. We would have to spend well north of a trillion dollars just to get us to a B. U.S. infrastructure was installed between the 1950s and the 1970s; we’ve underinvested as a country since then. Public investment is 20% below its 60-year trend.

Hillary Clinton has a $275 billion infrastructure spending proposal; Donald Trump has vowed to “build the greatest infrastructure on the planet Earth.” What can we realistically expect?

Clinton wants to get her plan to Congress in the first 100 days. She is focused on highways, public transit, and airports, and has also talked about green energy—spending on gas, or the power grid, or renewable energy. She has also talked about ensuring all households have affordable broadband by 2020. She provided a lot of detail. The details behind Trump’s commitment to infrastructure are less clear. He said he will double Clinton’s proposed spend. The dollars they’re talking about are a step in the right direction.

Investors seem optimistic some spending will actually happen. The iShares Global Infrastructure ETF [ticker: IGF] has trounced the Standard & Poor’s 500 index this year, returning 18.8% to the S&P’s 8.3%.

The group caught a lot of investors by surprise. Part of the optimism is from commodity prices improving throughout the year, which implies that, over time, capital expenditure [corporate spending on improving physical assets] should improve. We are still broadly overweight the group for 2017, which will be a transition year. Earnings could be up modestly for the group because of the restructuring companies have undergone, and as excess heavy equipment inventory leaves the channel. Most investors believe earnings are at or near a trough, but worry that we might be stuck here for a considerable amount of time. That’s the biggest debate. My estimates suggest a material recovery in 2018. Our estimates for 2018, broadly, are much higher than Wall Street’s.

The $305 billion highway bill passed in December helped. What is your outlook longer term?

The highway bill provides certainty over the next five years in terms of spend. Assuming whoever becomes president executes what they are saying regarding infrastructure, and Congress is on board, you could see some tail winds in 2018.

Based on our proprietary channel checks, mining service and parts should pick up in 2017, generally a precursor to equipment demand picking up later in 2018. The energy slowdown hurt demand for new equipment. Original equipment manufacturers have been underproducing to help absorb the used-equipment market. Now that oil prices are higher, I’m getting more optimistic about the end of 2017 and going into 2018. It’s a big positive that TCO, the $37 billion Tengiz Chevron Oil project in Kazakhstan, is moving forward. The majors are still investing. Energy is still likely to be a head wind in 2017, but should be a tail wind in 2018. China truck and construction firms have surprised on the upside in 2017 [earnings forecasts] along with Brazilian farm-equipment companies more recently.

How do you segment the infrastructure sector?

When most people, including the candidates, talk about infrastructure, they’re talking about highways, bridges, public transportation, airports. My group is much broader. It also includes energy infrastructure—think about the exploration of gas shale and what that means for the build-out of LNG [liquefied natural gas] and petrochemical facilities. It includes power—fixing the grid, or new-generation capacity. It includes mining. The impact on the economy and the earnings implications are much broader.

As an analyst, you focus primarily on machinery and engineering companies within those categories. What companies will benefit from increased infrastructure spending?

One beneficiary is Caterpillar [CAT], the largest construction-equipment player in the U.S. and one of the best plays on infrastructure globally. Deere [DE] is the second-largest. If you are building roads, bridges, highways, whatever, you need construction equipment.

Another reason to like Caterpillar is the mining-equipment recovery. Caterpillar andKomatsu [6301.Japan] are the two largest mining-equipment companies. At the peak, mining was north of 50% of Cat’s earnings. Today [that segment] is losing money, depressing total earnings. Through our proprietary checks with Caterpillar dealers, we believe mining is at or near trough. Finally, the mining companies’ balance sheets are in a better place and spending is halted. Bottom line, over two-thirds of Caterpillar’s earnings are near trough. Currently, our price target is $90, or 16 times our 2018 earnings, discounted back. That’s much higher than the Street’s target.

Most people think of Deere as an agricultural company. Why do you like it?

Deere has dramatically increased its product line, so it is well positioned for any infrastructure renaissance. U.S. agriculture will be challenged in 2017, but there are green shoots in Brazil. Deere has dramatically improved its earnings power. It said on its last earnings call that it can improve income by $500 million by 2018, assuming agriculture stays at these depressed levels. So it can grow earnings assuming no improvement in demand. Agriculture will improve. Deere also executes. Its internal forecast is much higher than $500 million. The Street doesn’t appreciate this. My price target for Deere is $100. I see Deere earning $4.30 a share next year, flat with 2016, and $6.20 in 2018.

Which other companies benefit from a construction boom? How about the component makers?

Cummins [CMI] makes engines and components that go into construction equipment. It is also a way to play the U.S. heavy-duty truck recovery. I have high conviction that 2017 is the trough and multiyear growth follows. The U.S. truck cycle averages six years; it had a very muted peak in 2015 and now a downturn in 2016 and 2017.

Secondly, Cummins is a call option on a recovery in emerging markets, where it is involved in mining, oil, and gas-power generation. We also like that their market share in Chinese trucks has grown from 10% to 18% in this downturn. This is key, because the Chinese truck market is three times the size of the U.S., and has surprised on the upside this year. Cummins also has a dividend yield north of 3%. Net debt is around 9.7% of capital, versus 25% to 30% for the industry. Cummins has $1.3 billion in cash, which it will use to buy back stock and make acquisitions to diversify earnings. It trades at 15 times consensus 2017 earnings forecasts, four or five multiple points lower than the group. The inflection point for earnings is 2018, when I expect Cummins to earn $9.70 a share, up from $7.30 this year. My price target is $132, or 15 times my 2018 earnings estimate.

Do any other component suppliers interest you?

Parker-Hannifin [PH] is the biggest player in motion control. They make valves, pumps, filtration, automation, components that are sold to Caterpillar, Deere, Cummins. They’re a proxy for global industrial demand and a derivative way to play global infrastructure. When demand improves they are the first guys to benefit. They are set up well for 2017, because the excess inventory is out of the channel. They have a new CEO, Thomas Williams, who has implemented a sizable restructuring to streamline the organization. That’s why their earnings are holding up better in this trough. Margin growth will accelerate, and earnings power will be higher than people think.

Lastly, they have over $2 billion of cash on the balance sheet. They will be more aggressive in this downturn in M&A [mergers and acquisitions] and buying back stock, which would further diversify their earnings stream and drive higher peak earnings. I see Parker-Hannifin earning $6.65 in 2017, $7.60 in 2018. My price target is $131.

How about the engineers?

We like Aecom [ACM]. It offers professional services—design, construction, management of large infrastructure projects globally—and is a good cash generator. Historically, it focused more on design engineering, but through M&A, it now has construction capabilities. Relative to its peers it has minimal energy exposure, so that won’t be a head wind in 2017. It is also a deleveraging opportunity. It has a net debt to capital ratio of about 50%. It wants to pay down debt and lower interest expense, which means accelerating earnings growth. Lastly, Aecom is a self-help story. Through its 2014 acquisition of URS [a rival professional-services company] there’s significant opportunity to streamline corporate, real estate, and overhead costs. I see Aecom earning $3.50 a share next year, and $3.70 in 2018. My price target is $36, or seven times 2018 earnings before interest, taxes, depreciation, and amortization.

Aecom was recently in the news when short seller Spruce Point Capital suggested it lacked effective controls over its financial reporting and overstated results.

Aecom has been very transparent with regard to changes it has made to adjusted earnings per share and free cash flow. Aecom’s EPS guidance for the year reflects one-time benefits and gains that weren’t in the original outlook, as well as a deterioration in underlying demand. Earnings quality isn’t great, but that’s reflected in the multiple. Furthermore, its underlying business is holding up better than its group.

Thanks, Jamie.

About Timeless Investor

My name is Samual Lau. I am a long-term value investor and a zealous disciple of Ben Graham. And I am a MBA graduated in May 2010 from Carnegie Mellon University. My concentrations are Finance, Strategy and Marketing.
This entry was posted in Investment Planning, Macroeconomics. Bookmark the permalink.

Leave a Reply

Your email address will not be published. Required fields are marked *