During Tuesday's Daily Rundown (see our Alert herel), we alluded to a late Monday research report published by analysts at Morgan Stanley. In the piece, they initiated coverage in several Electrical Equipment and Multi-Industry stocks. Of our four portfolio names in their coverage, Honeywell (HON) , Emerson Electric (EMR) , 3M (MMM) and Illinois Tool Works (ITW) , the analysts blessed "Overweight" ratings on HON and EMR, while MMM and ITW were given "Equal-weight".
To our delight because of its large position for the trust, their top pick of the group was Honeywell. In the initiation, the analysts called on the strong fundamental narrative led by growth in Aerospace, which has been driven by increased demand for business jets (good for Textron (TXT) as well) and defense/space spending, as well as the "strong secular themes in logistics and e-commerce" that have been an impressive tailwind to Intelligrated, a business within Safety and Productivity Solutions. But the Morgan Stanley analysts took the Honeywell thesis one step further, adding a differentiated view that increases our conviction in how well positioned the post-spin RemainCo will be in this economic environment. The business they highlighted was Honeywell's Performance Materials and Technologies segment (PMT).
The analysts are high on the future of PMT and Honeywell's Universal Oil Products business (UOP) thanks to the "catalyst demand environment ahead of IMO 2020." IMO 2020 is an upcoming requirement that calls for the reduction of sulfur content in marine fuel during the refining process. To comply with future regulations, refiners are expected to increase turnaround activity in the second half of 2018 and spring of 2019, according to Morgan Stanley's U.S. refining team, and Morgan Stanley sees the impacts related to IMO 2020 as a "unique tailwind for UPO in our coverage."
Quick side note: We do not want to get off topic, but IMO 2020 should also widen the spread between WCS and WTI crude, a tailwind that should improve profitability at BP's (BP) Whiting refinery.
Wrapping up Honeywell, in addition to the overall glowing views of the company, we are particularly fond of this research report because it discusses an upcoming theme that we feel has gotten little attention by the market, and it further strengthens the terrific investment case that can be made on the stock before and after its breakup.
Emerson Electric was also a strong pick by the analysts. They called the company a "well-rounded process franchise which appears to be cyclically well positioned during the energy and petrochem upturn, executing well on the Valves & Controls integration, and outperforming the weak market in power gen." Furthermore, they believe EMR is another beneficiary of the expected preparations and refinery upgrades related to IMO 2020.
Again, we are particularly keen of this IMO angle because we have not seen sell-side analysts give it too much attention. We are constantly on the hunt for positive themes that the market has underappreciated, and we think this one represents an upcoming catalyst that is not yet priced in.
Another important takeaway from the note is that Emerson's exposure is broad enough that the business remains insulated from specific-region issues like the takeaway capacity constraints affecting Permian operators.
All in, the analysts anticipate the company having "an outsized benefit from the productivity spending wave in process automation applications on top of cyclical momentum in oil and gas spending and a sector catalyst with IMO 2020 preparations."
On 3M, we dug through the note and thought it read slightly more positive than what the rating and price target (theirs is $212) suggests. Sure, the analysts do not expect to see "significant upside to valuation ranges from current ranges," but they do think the company will be able to manage an industrial slowdown in 2019 should one occur. And if we continue to look further on, the analysts said, "we don't find expectations for 3M through 2019 (beyond which cyclical visibility is less robust) to be overly demanding. Valuation now appears reasonable if not cheap." This adds to our belief that sticking with this great American company should yield positive results over the long-run.
Overall, they think "the recent pullback in valuation now provides an appropriate price for MMM's growth." While this does not suggest upside from current levels, one factor they may have left out is a new management team that may be willing to pursue meaningful portfolio actions to bring out value, and an under-promised, over-delivered organic sales situation that may unfold.
Illinois Tool Works
On ITW, the analysts call the stock a "defensive industrial given the high-quality nature of the company." This is a view that echoes are own as we have consistently pointed to the great American company that ITW has been. In another similar view, the analysts also pointed to the de-risked nature of the stock.
"Shares have de-rated too much and earnings don't appear to be cyclically sensitive enough to generate substantial downside from here," the analysts wrote in their research note.
Overall, the analysts are not overly bearish, but they are not expecting much from ITW due to the dim outlook in Auto (they expect the market to flatten in 2019) and belief that margins have less room to surprise to the upside. That said, we reiterate our stance that management's recently announced dividend hike and share repurchase authorization should be viewed as a vote of confidence in future operations. We find it unlikely that management would be willing to buy back an aggressive amount of stock had they lost faith in in organic sales growth trends and future successes in the 80/20 model, and its de-rated valuation supports a positive risk-reward down here.