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Hallmarks of Success in Industrial Materials
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Efficiency is what it's all about in the industrial sector. Firms that can squeeze more from their assets than their competitors can are the ones that tend to make great long-term investments. As mentioned previously, competition only increases the pressure to lower costs, so the ideal situation is for a company to produce goods at the lowest cost in its industry.

Why? In general, there are two paths to strong profitability (as measured by return on invested capital, our favorite measure): high profit margins or high asset utilization. In the industrial sector, stiff competition often results in limited pricing power and, consequently, relatively meager profit margins. Thus, the firms with the best share performance are often those that generate the most revenue from their assets:

Total asset turnover (TATO), one of the more commonly used measures of efficiency, is an easy ratio to calculate: annual sales divided by total assets (either average or year-end assets; just be consistent). To calculate average total assets, add the current year's total asset balance and the previous year's balance, and divide the sum by two. A general rule of thumb is that a TATO ratio above 1.0 is pretty good for an industrial firm. Such a ratio means that for every dollar that the company has invested in assets, it, in turn, generates at least one dollar in revenue every year.

Two wide-moat companies in this sector, United Technologies and General Dynamics, are also two of the most efficient operators. UTX managed aTATO of I.O in 2OO2, while GD's ratio was even higher at 1.2.

Another popular efficiency metric is fixed asset turnover (FATO), which corresponds to total annual sales divided by net fixed assets. Net fixed assets are listed on the balance sheet, usually as "property, plant, & equipment, net of accumulated depreciation" or "net PP&E," for short. The FATO ratio is even more telling than TATO for industrial firms because industrials are so dependent on tangible assets such as factories and equipment to produce goods and generate revenue. Importantly, the FATO ratio excludes the impact of goodwill, which often weighs on the TATO of highly acquisitive industrial concerns.

Again, our wide-moat companies, UTX and GD, are standouts. UTX's FATO in 2OO2 came in at 6.2, while GD's was 7.7. Not surprisingly, some of the no-moat commodity businesses that we cover are less successful when it comes to this metric—Dow's FATO ratio is regularly around 2.O, while DuPont's is even lower, typically below 2.0.

We mentioned that those industrials that are the most efficient tend to have the best performance. Looking at just the four companies discussed in this section, we see that UTX and GD experienced the best performance between 1992 and 2OO2, with total annualized returns (in­cluding reinvested dividends) of 17.2 percent and 31.5 percent, respectively. The total annualized returns of the less efficient firms, Dow and DuPont, are not nearly as good, 9 percent and 8.7 percent, respectively. Granted, there are numerous factors affecting long-run share performance, but "we'd argue that efficiency is one of the most important factors for industrial firms.

Besides fixed assets, an industrial company needs to manage "working capital efficiently. Looking at trends in how many days' worth of inventory are sitting in "warehouses or how many days its takes to collect customer receivables can reveal a great deal about a firm's operations. If, for example, inventories are rising rapidly, a company may be producing more than it can sell merely to keep its factories busy. This could sock the company with goods that will have to be sold at rock-bottom prices down the road. Similarly, a jump in the number of days' sales outstanding (mea­sured as accounts receivable divided by sales revenue and multiplied by 365 days per year) could indicate that the firm is pushing inventory on its customers to mask a slowdown In demand.

Most industrial firms have high operating leverage, which means that most of their costs are fixed regardless of volume and sales levels. If they can move more volume through the system by selling more of their products, profit margins should increase because sales should rise while costs stay about the same. However, operating leverage can cut both ways. For example, truck maker Navistar saw operating margins climb steadily to nearly 10 percent during the late 1990s as sales built to a cyclical peak. But in 2001, as demand for new trucks waned and Navistar's revenue dropped by about 20 percent, operating margins plunged to 2 percent. With sales weak again the following year, Navistar found itself deeply in the red. Another indicator of success is a regular and growing dividend payment to shareholders. In the industrial materials sector, dividends never really went out of style. Dividends not only represent a strong indicator of a company's financial health (its ability to make profits and pay them to investors), but also temper the volatility associated with these cyclical stocks. Regular cash payments in the form of dividends reward investors for holding stocks whose prices fluctuate depending on the pace of the overall economy.

Highly efficient operations are key to sustainable long-term profitability in the industrial sector. Look for firms that excel in getting more from their assets than competitors do, and you'll be on your way to finding the best in­dustrial firms in which to invest.

Red Flags

Because industrial companies typically operate very traditional business models, spotting trouble often requires the use of only a few basic accounting measures. That's not to say there aren't complex companies in the sector—you need look no further than GE's opaque financials to see how complex an industrial firm can become. By and large, though, industrials are pretty straight­forward, and looking at a few key measures can keep investors out of trouble. Keep an eye on three areas: too much debt, excessive pension obligations, and poorly planned acquisitions.

Debt

Because sales and profits can swing "wildly, a heavily indebted firm may not be able to meet its obligations during a downturn. A useful indicator of a firm's debt level is the debt-to-capital ratio. This ratio expresses the amount of the company's obligations to creditors as a fraction of the firm's book value. The higher the ratio, the more risky the firm's financial position. Debt to capital can be calculated simply by dividing the company's total debt (long term and short term) in the liabilities section of the balance sheet by total assets, also on the balance sheet. Some companies adjust the denominator by excluding current liabilities, which gives a better long-term measure of the company's leverage. In general, a ratio above 40 percent adds some risk to the company, and "we consider a ratio above 70 percent a bad sign.

Deere illustrates the importance of keeping debt levels reasonable. The maker of agricultural equipment survived the severe farm recession of the early 1980s, whereas financially weaker rivals, such as International Harvester (the predecessor of Navistar), weren't so lucky. Deere's debt-to-capital ratio (excluding current liabilities in the denominator) rose from 30 percent in 1979 to 53 percent at its peak in 1982, whereas International Harvester's ratio rose from 41 percent to 86 percent in the same period. International Harvester's ensuing bankruptcy and reorganization was one of the most spectac­ular business failures in history, and by 1985, Harvester had exited the farm equipment business altogether. Today, Deere enjoys a strong brand reputa­tion while most of its competitors are amalgamations of restructured firms pulled out of bankruptcy.

Pensions

Pension and other postretirement benefit obligations also bear watching because many of the companies in this sector have been around for decades and have offered defined benefits to employees for years. (For a refresher on how pension plans affect a company, see Chapter 8.)

Let's use Deere as an example again. Because of increasing health care costs and revised actuarial assumptions, at the end of 2OO2, Deere's pro­jected pension benefit obligation stood at $6.8 billion, up from $6.4 billion in 2OOI, while negative returns in its pension portfolio left the value of its plan assets at $5 billion, down from $5.9 billion at the end of 2OOI. The plan was thus underfunded by $1.8 billion. Accounting guidelines required Deere to increase the pension and postretirement benefit liability on its books at the end of 2OO2, which decreased shareholders' equity by about Si billion.

Because a company can spread out the payments it will make to prop up a pension plan, an underfunded pension plan is not necessarily a red flag in and of itself. However, investors should use their judgment when evaluating how big a drain the deficit could be on a company when its pension plan is underfunded by a large amount, as in Deere's case.

Acquisitions

Industrial firms tend to grow slowly, so some are tempted to use acquisitions as a means to expand. Acquisitions give companies a great opportunity to de­stroy shareholder value, as well as an opportunity to take big upfront integration charges that can serve to inflate future margins.

For example, in early 2OOI, Dow Chemical acquired commodity chemical producer Union Carbide, adding $2 billion to the firm's debt load and in­creasing the number of its shares outstanding by one-third to close the deal. Subsequent events proved that the increased risk from the additional debt load and the dilution of shareholders' interests was not worth the trouble of Integrating another firm's operations. Union Carbide's commodity product lines increased Dow's vulnerability to the economic cycle "while the merger distracted management during a prolonged downturn.

The U.S. and global economies remained sluggish after the merger, but instead of focusing on positioning Dow for an eventual recovery, management was distracted by merging the companies and tackling Union Carbide's massive asbestos liability, which culminated in the CEO's removal by Dow's board In late 2OO2. Three years after the merger was announced, the company's stock price languished 38 percent below Its level at the time of the announcement, about the same performance as the S&P 500 in the same time frame.

Chasing Market Share

Many firms benefit from positive operating leverage and then chase market share by cutting prices sharply, but we're wary of investing In industrial firms that are more focused on market share than profitability because they often confuse market share gains with efficiency. Many firms highlight their market share gains because the increased volume from these gains can lead to higher profit margins, but unless their TATO and FATO actually improve, market share itself is not an indicator of efficiency.

Freightllner, a unit of DalmlerChrysler, serves as a classic example. In the mid-1990s, as the maker of big-rig trucks was facing strong competition from rivals Volvo, Navistar, and Paccar, it began to guarantee the resale values of the trucks it sold. Although Freightliner's market share increased sharply in 1999, the strategy had a disastrous effect on the company's finances. At the end of 2OOI, the commercial vehicle division of DaimlerChrysler reported an operating loss in the billions, thanks in part to the guaranteed payments. At the end of the day, companies should be focused on chasing sustainable profits, not market share.

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