Investors might be wary about the industrial sector after two years of unprecedented supply chain disruptions and record cost inflation, but the landscape is slowly improving. We believe some of the industry’s biggest cost pressures have already peaked and others likely will soon. Yet some issues, particularly wage inflation, may take longer to abate. In this shifting environment, investors who paint the entire sector with a single brush could miss potential growth opportunities.
The outlook for industrials varies depending on subsector and among individual companies, making it crucial to identify the manufacturers best positioned to capitalize on easing inflation and supply chain conditions. At the same time, it is important to examine longer-term secular trends that are also creating challenges and opportunities for the industrial sector.
To illustrate these dynamics, let’s look at where we were last year versus where we are in early 2022, and what these changes might mean for industrial companies.
Where inflation and supply chain challenges persist
In 2021, cost inflation in the industrials sector was largely driven by record price increases for raw materials such as copper, steel, aluminum and zinc, and plastic resins. Raw material cost inflation has now flattened, and costs could continue to decline through 2022, however, rising labor and shipping costs remain a challenge. Manufacturing wages accelerated sharply in 2021, and ongoing labor shortages could keep them elevated. Shipping costs have declined steeply from their September 2021 peak, but remain high on a year-over-year basis. We expect a slow decline, which would delay a return to “normal” until the second quarter of 2022 at the earliest.
Likewise, the supply chain disruptions brought on by the COVID-19 pandemic will not be resolved all at once. Omicron-related absenteeism, which we saw in late 2021 and early 2022, is poised to abate, while other logistical challenges such as truck driver shortages across North America that is caused largely by retirements, may persist for a long time to come.
Offsetting challenges with higher pricing
One of the keys to success in this environment is a company’s ability to raise prices above cost increases, while also being able to maintain those increases. Prices are still playing catch-up after last year’s inflation spikes, which could improve margins as costs decrease in the latter part of 2022. However, some price increases may roll back, particularly those that took the form of surcharges.
Companies that are more likely to maintain pricing in the face of easing inflation are those that provide products with tangible payback in the form of energy efficiency, increased productivity or other savings. Because of COVID, HVAC suppliers such as Carrier, for example, may have above-average pricing power due to demand for products that improve indoor air quality. Consumer-oriented companies, on the other hand, may face greater challenges. For example, Pentair, which sells swimming pool pumps, had a very strong 2020 and 2021 as locked-down consumers invested more in their homes. But it will be harder to raise prices on discretionary items like pool pumps going forward, in our view.
Industrial companies have also boosted internal capital investment to address the supply chain vulnerabilities revealed by the pandemic. This proactive approach to strengthening supply chains should promote greater resiliency, which will be crucial as industrial companies face a wave of demand.
The gap between inventories held by manufacturers and those held by their customers is the widest we have seen in decades. This has set up the industry for a replenishment cycle that well-stocked manufacturers should be prepared to fill at higher prices going forward.
Beyond the next few quarters
While lingering inflation and supply chain issues are likely to affect the industrial sector’s performance over the next few quarters, investors should also consider important growth factors that are playing out over the medium term. Chief among these trends is the worldwide push toward environmental sustainability.
Green building initiatives, demand for electrical vehicles, and electrical grid hardening efforts could provide a tailwind for companies with strong exposure to electrification growth. Eaton Corp., for example, generates substantial earnings from electrical markets. Flowserve, on the other hand, has more exposure to legacy oil and gas energy, which could be under increasing pressure from green initiatives. However, the “energy transition” opportunities are transitioning quicker than we anticipated, while the existing, massive installed base will still need to be maintained for decades to come as they assist those legacy customers with their evolving requirements.
Beyond the potential revenue and earnings impact of sustainability trends, ESG investing is likely to have a growing influence on industrial stock valuations. As retail and institutional investors increasingly seek “green” investments, industrial companies are moving to align their business models and operations with ESG criteria. This ongoing shift means that even as the sector recovers from the disruptions of 2020 and 2021, it is unlikely to revert to the status quo of 2019.