A Trump Manufacturing Recession Is Here. Now What?
With the U.S.-China trade war sapping demand, companies have limited options for protecting profits. Plus, more industrial insights.
By Brooke Sutherland
August 23, 2019, 3:00 PM EDT
First, manufacturing. Then, the rest of the economy?
First, manufacturing. Then, the rest of the economy? Photographer: JIM YOUNG/AFP
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The escalation of U.S.-China trade tensions has pushed the American manufacturing sector to the brink of a recession and there’s little to stop it from falling over the edge. A preliminary IHS Markit gauge of factory activity released this week came in at 49.9 for August, just below the dividing line that separates an expansion from a contraction. A regional index from the Federal Reserve Bank of Kansas City showed manufacturing order volume slumped to the weakest level since 2016, with more than half of firms surveyed expecting negative impacts from the 10% tariffs the U.S. will levy on $300 billion of Chinese goods in two stages. China retaliated on Friday with its own one-two punch of tariffs on $75 billion of American products including soybeans, automobiles and oil. President Donald Trump vowed to respond … again. So it would seem to be a better use of time to move beyond debating whether there will be a slowdown and instead think about how industrial companies are going to respond to a slowdown that’s already here and will likely get worse.
The most obvious move is to cut expenses, which will inevitably translate into layoffs. Deere & Co., Emerson Electric Co., 3M Co. and DuPont de Nemours Inc. are among those that have said they’ve stepped up cost-cutting efforts. This is tricky for several reasons. First, many big manufacturers have already aggressively cut costs after slumping oil prices brought about the so-called industrial recession in 2015 and 2016. Perhaps this prepared them to more profitably weather the next downturn; perhaps it left them with less fat to cut if margins are pressured by price cuts to spur sales. But the bigger issue is that layoffs, particularly in the manufacturing sector, are going to be political dynamite. President Donald Trump built his campaign on revitalizing hiring at U.S. factories, and manufacturing employment is up by about a half million since he took office. He’ll be wont to relinquish those gains as he seeks re-election, especially if job losses start to affect the strong consumer demand that’s kept U.S. growth afloat. It’s much harder to issue puffball press releases about firings than it is to expound on hiring commitments, exaggerated or not.
So what about share buybacks? Some companies may already be too loaded up on debt after years of low-interest-rate borrowings. Honeywell International Inc. and Eaton Corp. are among those that have alluded to the ability to unleash billions of purchasing power to prop up earnings per share in a recession. Democratic presidential candidates including Senators Elizabeth Warren, Kirsten Gillibrand and Bernie Sanders have all criticized buybacks and proposed ways to incentivize companies to share their wealth more directly with employees. Some of these proposals have clear holes and obviously not all buybacks are evil, but public opinion is negative on this issue and any manufacturer that announces a big repurchasing push should expect backlash. The Business Roundtable sees the writing on the wall, at least as far as optics are concerned. Member CEOs including 3M’s Michael Roman, Honeywell’s Darius Adamczyk and Stanley Black & Decker Inc.’s Jim Loree signed their names this week to an updated statement of purpose that said companies have a commitment to serve all stakeholders, not just shareholders. It was mostly fluff and there were no hard commitments behind the nice-sounding words. Still, it’s the latest sign that capitalism in its most unbridled, bloodthirsty form is being rethought. 1 And maybe that’s a good thing for investors, too: Bloomberg News’s Cameron Crise took a look at the GS Total Cash Return index, a collection of 50 stocks that return a well-above-average amount of cash to shareholders. He found that while those stocks have historically been winners, they’ve barely outperformed the S&P 500 in the aggregate over the past five years, with the lag over the past four months one of the most extreme since the index started in 2010. The political climate is arguably causing this industrial slowdown; it may also kneecap companies’ ability to protect their earnings from the associated damage.
Buybacks Losing Their Luster?
NO RESPITE FOR GE
General Electric Co. continued to push back this week against claims by Bernie Madoff whistleblower Harry Markopolos that the company is a fraud “bigger than Enron” and under-reserved in its long-term care insurance business to the tune of $29 billion. A statement from GE’s head of investor relations, Steve Winoker, wasn’t quite the in-depth point-by-point rebuttal some had hoped for, but it did point out legitimate holes in Markopolos’s argument and gave incremental detail as to why the company thinks it’s appropriately reserved for the specific nature of its portfolio. 2 The Kansas Insurance Department, which regulates GE’s insurance business, said this week the Markopolos report was “simplistic” and doesn’t appear to incorporate “certain technical reserve considerations.” It’s weird and disconcerting that no hedge fund has come forward as the firm that promised Markopolos a share of the profits on its bets that GE shares will slide. And yet even amid this healthy skepticism about Markopolos’s report, GE shares fell. On Friday, the stock was actually on track to close lower than the day the Markopolos’s report was released. Risk premiums, or the extra yield a bond pays compared to Treasuries, have widened. CreditSights analysts may have said it best: “Although we have lots of qualms with Markopolos’ report, it does serve as a quasi wake-up call for investors.” This week’s sell-off is at least partly a reflection of the uncertainty that naturally surrounds a long-term care insurance business whose state of duress is determined by assumptions that will play out over decades – as well as GE’s track record of poking itself in the eye. The surprise $15 billion reserve shortfall GE disclosed last year is a testament to both of those things.
Reality Check
Goldman Sachs Group Inc. analysts said GE’s reserves were on the high end relative to the number of lives covered by its policies – appropriately so, given the particularly unattractive nature of its portfolio. Fitch Ratings said GE’s reserves still may not be high enough given those same costly characteristics and criticized what it sees as overly aggressive assumptions throughout the industry on interest rates, the ability of sick people to get healthier and unapproved premium increases. 3 What’s not in doubt is that GE’s long-term care insurance business and significant underfunded pension are vulnerable to the continuing slide in interest rates. That alone could require GE to redirect billions of dollars that were previously earmarked for debt repayment, or book a hefty GAAP charge against the already thin equity levels at GE Capital. The shares fell more than 3% on Friday as investors wagered escalating trade tensions would force the Federal Reserve to further lower interest rates. Meanwhile, GE’s baseline case is to generate zero free cash flow this year, and I remain highly skeptical of its ability to boost cash flow significantly in the next few years. Bloomberg Intelligence analyst Joel Levington points out that rating firms’ leverage and cash flow targets for GE are well below the median for other companies rated in the same BBB range. He wonders at what point the firms get tired of defending rankings that can’t be supported by fundamental results. I wonder the same thing.
CLOUDS PARTING AT BOEING?
Boeing Co. shares bucked the general trading gloom at the end of the week amid signs the aerospace giant’s goal of returning its besmirched 737 Max jet to the skies by the fourth quarter remains intact and achievable. The company said it would hire a few hundred temporary employees in Moses Lake, Washington, to help get the parked Max fleet updated with necessary fixes and ready for delivery. Meanwhile, the Federal Aviation Administration said Thursday it’s inviting pilots from carriers that operate the Max to participate in simulator testing, and the Seattle Times reported that a board entrusted with determining pilot-training requirements was prepared to issue new recommendations in early September with a 30-day comment period. Taken together, this suggests Boeing is on track to submit all of the final fixes and paperwork to the FAA in September, as planned, and that the plane could be ungrounded in the U.S. as early as October. Bloomberg News reported last week that FAA regulators are increasingly convinced they don’t need to mandate new simulator training for Max pilots before lifting the plane’s flying ban. While regulators may still mandate airlines operating the Max to put pilots through the expensive training at a later date, the idea that it’s not a requirement for re-certification is another positive development. Even so, I’m still skeptical that the FAA wants the optics of a quick turnaround on the final regulatory review of the Max. A panel of experts from the National Transportation Safety Board, NASA and international regulators tasked with reviewing how the Max was certified is expected to issue its findings soon. The Joint Authorities Technical Review reportedly hasn’t found evidence that regulation protocols were breached, but rather that the protocols themselves may not have kept pace with the increasing complexity of aircraft. Either way, it seems aggressive for Boeing to be modeling a return to a production pace of 57 jets a month by June, as a Reuters report suggested this week.
DEALS, ACTIVISTS AND CORPORATE GOVERNANCE
Osram Licht AG may yet draw a higher offer from Bain Capital and Carlyle Group, people familiar with the matter told Bloomberg News. The private equity firms are reportedly contemplating an increase to their 3.4 billion-euro ($3.8 billion) offer after sensor-maker AMS AG stopped dilly-dallying and lobbed in a 3.7 billion-euro counterbid that Osram formally allowed to proceed this week. Who would have thought a struggling maker of headlights for cars would be such a hot commodity? I’m actually a bit surprised that the buyout firms would wade back into the fray given the already stretched return prospects of their initial proposal, but they also likely don’t need to surpass AMS’s offer to beat it. At AMS, it’s a toss-up as to whether this deal is more baffling strategically or financially. Osram labor representatives are also concerned about selling to AMS and you know it’s bad when workers would prefer a private equity owner.
Masco Corp. is reportedly receiving interest from the likes of Bain Capital and W.W. Grainger Inc. for the cabinetry unit it’s trying to divest. The business could reportedly fetch about $1.2 billion, which would amount to about 12 times its adjusted Ebitda in 2018, according to data compiled by Bloomberg. Jefferies analyst Philip Ng says the price is well ahead of Wall Street expectations for a forward Ebitda multiple in the 7 to 8 range, which will give Masco more firepower for deals in the plumbing and paint operations that will remain. The divestiture is part of Masco’s efforts to reduce its exposure to new construction and to focus on less volatile repair and replacement projects, a wise move given the contrast between luxury home builder Toll Brothers Inc.’s earnings disappointment this week and Home Depot Inc.’s better-than-expected sales resilience in the second quarter. You can see the appeal for private equity to come in, cut costs and run Masco’s cabinet business for cash. But what is Grainger doing on this list of potential buyers? That company has no business buying a cabinet-making operation Masco deems too cyclical at a price that analysts find surprisingly high.
Bayer AG agreed to sell its animal-health unit to Elanco Animal Health Inc. in a cash and stock deal valued at $7.6 billion. The purchase price works out to about 19 times Ebitda, compared with Citigroup’s estimate of 15 to 20 times. That said, the total value of the deal is dropping like a rock with Elanco’s stock price. The shares have fallen more than 10% since the terms were announced as investors express their displeasure over the company’s decision to load up on debt for a pricey takeover of a business with mediocre growth prospects. Still, it’s a much-needed cash infusion for Bayer as it works to reach a settlement with the more than 18,000 plaintiffs claiming its Roundup weed killer caused their cancer. The Environmental Protection Agency earlier this month said it won’t approve products with labels that claim glyphosate – the main ingredient in Roundup – causes cancer, a blow to California’s efforts to require warnings. California has said it won’t change its regulations and a court fight is in process. But the EPA’s stance could help support Bayer’s argument that Roundup’s link to cancer isn’t supported by scientific research. Plaintiffs may now be wise to accept the reported $6 billion to $8 billion settlement that Bayer is contemplating, writes Bloomberg Intelligence’s Holly Froum, with future suits at risk of largely being dismissed. |
