ASX Industrials: Broker views and a fund manager's top sector picks

Following on from my recent article about the Consumer Discretionary sector, this wire looks at Industrials. Also considered highly vulnerable to higher inflation, ASX Industrials have declined by 5% since last May.

As shown in the following chart, the sector dived in the days following the RBA’s first interest rate rise back in May. Though it has bounced a couple of points since then, Industrials ended the year at a low point.

S&P/ASX 200 Industrials share price movement over the prior 12 months

Transurban (ASX: TCL)

One of the world’s largest tollroads operators, Transurban manages motorways in Australia, Canada and the US.

The company, which occupies a monopoly position in the domestic market, was among the top 10 companies in terms of earnings quality called out in a recent survey from the insights platform MarketMeter.

It was also one of the stocks presented at the latest SOHN Hearts & Minds investment conference in November. Wavestone Capital’s Catherine Allfrey described Transurban as largely resistant to inflation, “because the prices it charges are linked to CPI,” she told the Australian Financial Review. Allfrey believes inflation will further boost the firm’s nominal revenues while devaluing its debt, in real terms.

Citi lifted its rating for Transurban to Buy from Neutral on 4 January, analyst Suraj Nebhani also increasing his price target to $15.70 from $14.52.

On the other hand, Jefferies downgraded Transurban to a Hold from Buy on 25 November, though analyst Anthony Mulder left his price target unchanged at $14.13.

When Goldman Sachs added the toll roads company to its coverage list in late November, it did so with a Sell rating and a price target of $13.50.

Transurban shares closed at $13.66 on Monday 16 January, roughly in line with their price at the same time last year.

Brambles (ASX: BXB)

A global transport and logistics firm, Brambles’ biggest business is its reusable pallets, crates and containers operation. The company operates in 60 countries, with a pool of 360 million CHEP pallets, crates and containers.

In November, Brambles sold 80% of its CHEP China pallets business to a Chinese state-owned entity and competitor, Loscam Group, after trying for years to unsuccessfully break into the market.

In February, Macquarie downgraded the stock to Neutral from Outperform, with a price target of $10.55. Key reasons for this move, according to analyst David Fabris, included rising costs increasing Brambles’ operating leverage and the potential for reduced mid-term cash flow effects.

At the same time, Morgans left its rating at Hold but reduced its price target to $10.05 from $11.04.

Trading at $11.72 at the latest ASX close, Brambles' share price gained around 12% in calendar 2022.

Qantas (ASX: QAN)

Australia’s flagship airline was downgraded to Outperform from Buy by CLSA on 25 November. But analyst Justin Barratt increased his price target for Qantas to $7.10 from $6.90.

Morgan Stanley’s latest ratings move for Qantas came last October, when management delivered a trading update and guidance for the first half of FY2022-2023. Analyst Andrew Scott maintained its Overweight rating but raised his price target to $9 form $7.50. He cited the company’s faster move toward profitability than previously predicted and the improved revenue per available seat kilometre.

Jefferies also maintained its previous Buy rating after the update but lifted its price target to $7.98 from $7.04. Key highlights mentioned by Jefferies analyst Anthony Mulder include:

• The company’s earlier recovery versus international competitors
• Returning demand for travel, despite elevated ticket prices
• Operational improvements including higher wages
• An outlook for full-year profitability to be “materially” higher with strong domestic demand, which would see any weakness offset by reduced capacity and lower costs.

Auckland Airport (ASX: AIA)

The only airport listed on the ASX – after Sydney Airport was taken out by a private equity consortium last March – Auckland Airport has a market cap of just under $11 million (as of Monday 9 January).

Auckland International Airport delivered a strong set of numbers at its AGM on 20 October, with management reporting passenger traffic was at 72% of the pre-COVID level, when averaged across the airport’s international and domestic businesses.

Previously, Citi downgraded the company to Sell from Neutral on 19 August, with analyst Suraj Nebhani also cutting his price target to $7.24 from $7.55.

Jefferies downgraded the stock to Hold from Buy on 15 June, its price target was also cut to $7.88 from $8.26.

And earlier in the year, Morgan Stanley made its most recent change when it upgraded the stock to Overweight from Equal Weight. Analyst Rob Koh has a price target of $7.47 for Auckland International Airport.

The company's share price closed at $7.65 on Monday 16 January, up a little under 5% in the last 12 months.

Atlas Arteria (ASX: ALX)

The almost $3 billion acquisition of Chicago Skyway last September is among the biggest recent events from the international motorway operator. Atlas Arteria completed the deal in September, taking a majority stake in the 12.5-kilometre US toll road. Opposed by the group’s largest shareholder, IFM Investors, the spat saw the investment group threaten a board spill and culminated in former Transurban executive Ken Daley securing a board seat.

On 22 November, broker RBC Capital Markets upgraded its rating for the stock to Outperform, from Sector Perform. Analyst Owen Birrell also lifted his price target to $7.50, up from $7.

Earlier, on 1 September, Credit Suisse downgraded its rating to Neutral from Outperform. Analyst Paul Butler also cut his price target for the company to $7.55, from $8.60.

ALX's share price closed at $6.92 on Monday 16 January, down around 10% from last year's peak of $7.70.

View from the buy-side

The Industrials sector encompasses a broad range of companies, capturing all listed firms except those in the Energy, Metals and Mining industries, as Investors Mutual’s Michael O'Neill explains. He’s the portfolio manager of the Investors Mutual All Industrials Share Fund, which invests across several sectors (including the obvious Industrials component) alongside Communication Services, Materials, Real Estate, Healthcare and others.

Referring specifically to Industrials, he says its breadth makes it particularly hard to assess on a sector-wide basis: “The impacts of the macro environment are quite industry- and company-specific.”

How do you sift the sector?

On a company level, O’Neill and his team start by assessing the outlook for profit margins on a forward three-to-five-year basis. This becomes even more important in the current environments, as margins are in many cases past their peak amid heightened inflationary concerns.

“I was recently talking to a company that had no central oversight on contract increases. The sales team was out in the market agreeing on individual contracts that didn’t factor in inflationary increases,” O’Neill says.

“This created a big shortfall in profit as input costs kept increasing and the firm wasn’t able to pass on increased input costs to customers.”

On the flip side, he points to the success companies such as Brambles (ASX: BXB) have had in passing price increases through to customers.

“The company has improved the contract terms with customers, such as quarterly input cost pass-throughs, as management rolls its long-term contracts,” says O’Neill.

Balance sheet strength is another core metric for weighing up Industrials companies that is more important now than in many other economic environments. Why is that? Because elevated interest rates makes debt more expensive, which might instead prompt firms to raise capital by issuing more shares – in turn diluting the shareholder base.

“We prefer companies with low levels of gearing, that don’t feel pressured to refinance short-term debt maturities. And in some cases, such companies also have the balance sheet flexibility to make accretive acquisitions and/or return capital,” says O’Neill, highlighting Sonic Healthcare (SHL) as one example.

What’s ahead for Industrials in 2023?

This year might see a pickup in merger and acquisition activity in the sector, after the sharp decline we saw once inflation and interest rates started rising from May last year. O’Neill describes this as a “freezing up of funding markets for private equity buy-outs.”

“The key swing factors remain inflation, interest rates and economic clarity. Bankers are hopeful of a buoyant market for M&A, driven by falling inflation towards the back half of 2023, the Fed pausing, avoidance of a recession, and confidence returning in valuations,” he says.

“But uncertainty and volatility could well persist, and it may take time for funding markets to heal and the large gap in asset price expectations between buyers and sellers to close.”

He expects to see some “opportunistic activity” among well-capitalised corporates, along with some spin-offs, and possible divestitures in cases where high-value assets are trapped in larger corporates.

“We may also see some cross-border acquisitions assisted by fluctuations in exchange rates. But we are very unlikely to go back to the races.

Steadfast Group (ASX: SDF)

One of IML’s preferred Aussie Industrial names is Steadfast, Australasia’s largest general insurance broker network. A trusted distribution partner of commercial insurance companies, it provides an essential service in advising small-to-medium size businesses on complex insurance options, as well as assisting in lodging and servicing claims.

“It has predictable earnings and cash flows, enviable customer retention of more than 95%, and low gearing,” O’Neill says.
“And although it distributes the insurance, it doesn’t take on insurance risk. Steadfast’s dominant market position and industry-leading investment in technology translate into strong organic growth prospects and opportunities to make beneficial acquisitions of brokers in its network.”

O’Neill highlights the firm’s annualised earnings growth of 13% since it first hit the boards of the ASX in 2013. He also expects Steadfast to benefit from substantial premium rate increases in the years ahead.

And in terms of valuation, he notes the company’s forward PE multiple for FY2024 is close to that of the overall market. For these reasons, IML regards the firm as a high-conviction industrial holding, ranking as the All Industrial Share Fund’s eighth-largest position as of its latest update issued in December.

Aurizon (ASX: AZJ)

Alongside Steadfast and Brambles - as mentioned earlier - Aurizon is also a top 10 holding of the fund. O'Neill believes the company, Australia's largest rail freight operator, is particularly well-placed for the current economic environment. 

"Its regulated infrastructure asset, the Central Queensland Coal Network, benefits directly as rates rise through the return determined by the regulator on its regulated asset base," he says.

"In addition, its unregulated freight business has well-structured contracts with adjustments for inflation and pass-through of essential input costs such as fuel, and most of its contracted volume, is on a take or pay basis."

The company also recently announced the sale of its East Coast Rail business for around $925 million. "This vastly improves AZJ’s balance sheet and will allow it to continue to invest in growing its bulk business and diversify away from coal, also underpinning a dividend yield of around 7%," O'Neill says.

Managed Fund

Investors Mutual All Industrials Share Fund

Australian Shares

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