Following the sharp fourth-quarter 2004 increase of the Control Engineering composite share price index, the group's valuation reversed course in the first-quarter of 2005, with an average share price decline of 3%. This negative momentum continued in April with a 4% drop. While there have been a few scattered signs of a "soft patch" in the manufacturing sector, trends are still broadly positive.
Following the sharp fourth-quarter 2004 increase of the Control Engineering composite share price index, the group's valuation reversed course in the first-quarter of 2005, with an average share price decline of 3%. This negative momentum continued in April with a 4% drop.
While there have been a few scattered signs of a "soft patch" in the manufacturing sector, trends are still broadly positive. The May ISM (Institute of Supply Management) index reported at 53.3 in May, following a 55.2 reading in April. May 2005 marks the 24th consecutive month that the index has been above 50, the level that separates a growing economy from a declining one—a longer period of 50+ readings than at any time during the 1990s.
Manufacturing capital spending is a key driver for automation and control equipment purchases. One area of capital spending risk could be the domestic auto manufacturing sector, given the market share losses and production cuts experienced by the Big Three automakers. However, it is noteworthy that in April, both GM and Ford reaffirmed plans to increase capital spending by 10-11% during 2005—an increase of $1.4 billion.
We think investor psychology has become more bearish on manufacturing/controls companies. Our bet is that this is a temporary shift, caused by slower revenue growth across the group as the business cycle moves forward. Another issue weighing on investor attitudes is the slowing momentum of increases to 2005's expected earnings growth. Over the last 90 days, there has been only a slight increase in the earnings growth outlook for this group (presently expected to be 23%). In contrast, in Q3 2004, the expectation for 2005 controls earnings was rising more rapidly—with an initial 19% growth forecast rising to a 22% growth outlook by the end of December. While we acknowledge this momentum shift, we believe the worst of the share price impact is behind us. The controls group is on pace to achieve healthy earnings growth this year.
Control Engineering Stock Index
Price ($) at close 12/31/04
($) at close 3/31/05
% chg. in 1Q05
EPS = earnings per share;
P/E = price/earnings ratio
Source: FTN Midwest Research and Control Engineering
Mark Koznarek is an industry analyst and managing director with FTN Midwest Securities,