INDUSTRIALS STOCKS LIVING IN THE PAST / THE WALL STREET JOURNAL ( RECOMMENDED READING )

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AUGUST 14, 2009, 1:23 P.M. ET

Industrial Stocks Living in the Past

By LIAM DENNING

Companies' financial results are always backward-looking. None more so than the recent round of quarterly reports from America's big industrial companies.

On the face of it, the sector held its own. Of 53 S&P 500 industrial sector stocks -- there are 58 in total -- that had reported as of last Friday, three-quarters managed to beat the consensus earnings estimates. They did so by an average of 10.2%, according to Thomson Reuters.

The Street's view on second-quarter earnings growth for industrial stocks had collapsed from negative 11.3% on January 1st to negative 35.5% by July 1st. Since June 30th, the sector has rallied almost 12%, beating the wider market handily, as the average forward price/earnings multiple has expanded from around 14 times to 16 times.

In other words, that the sector largely managed to beat beaten-down earnings estimates in the quarter has fueled renewed optimism on the future.

But based on what? Results from bellwether Caterpillar illustrated the problem perfectly. It beat the consensus estimate threefold, but largely due to cost cuts, a lower tax rate, currency gains and accounting gains on shrinking inventories. Meanwhile, its revenue slumped 41% and the company was reticent on guidance for 2010. That lack of clarity, however, has not stopped investors from pushing Caterpillar's stock price up to 26 times the average 2010 earnings estimate.

Overall, industrial companies took the opportunity to trim mid-point 2009 earnings guidance by 4%, according to Nigel Coe at Deutsche Bank, suggesting caution in the c-suite, at least.

Evaporating demand is the real theme investors should be considering when pricing industrial stocks. Scott Davis, who runs Morgan Stanley's industrial research team, calculates that revenue across the sector dropped 20% year-on-year in the second quarter.

Even worse, though, was a 30% drop in the order book -- a real leading indicator. Not only did that outpace an already worrying drop in sales, it was also more than double the average rate of inventory decline in the sector, according to Mr. Davis.

This raises concerns on two fronts. First, if future demand is weak, it suggests further inventory liquidation and continuing weak industrial capacity utilization, already at an all-time low. Second, it throws doubt on industrial companies' ability to preserve pricing power. Amazingly, despite recession, they managed to eke out small price gains in the second quarter. However, if this partly reflects fulfilling orders struck some time ago, and demand remains weak, pressure on prices will increase, particularly as idle second-hand product is put on the market.

Government stimulus programs offer some hope. But U.S. efforts will take several years to ramp up, while China's more immediate program already has contractors swarming, putting pressure on margins. Pretty soon, the explosive summer rally could be a distant memory.

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