Boom times are coming, if only you can wait

Industrial companies are caught in the "tween" stage of the coronavirus recovery: The narrative around a post-pandemic industrial renaissance remains very much intact but there's not much to show for it yet beyond some positive early growth signs that are now old news. Meanwhile, costs are going up, expectations are high and Covid uncertainty still lingers. This year's first quarter was also just inherently noisy, with year-ago comparisons straddling the line between the comparatively normal early months of 2020 and the dire final weeks of last March as most of the world went under lockdown. It's not a great recipe for earnings-day stock rallies. 

Fastenal Co., a distributor of factory-floor odds and ends and the unofficial first mover of the industrial earnings season, exemplified that dynamic this week. The company was one of the beneficiaries of the pandemic, thanks to its ability to procure and supply personal protective gear and cleaning products. Now, demand for such goods is waning as the vaccine rollout presses ahead. In fact, there's a glut of three-ply face masks and Fastenal is having to sell its stock for less than it paid for it. The company took an $8 million writedown on its mask inventory in the first quarter, and its sales and gross profit margin fell short of analysts' estimates. This sounds bad but it's fundamentally a good thing. 

Before the pandemic, Fastenal didn't sell many three-ply masks. It got into this business because "we felt it was the right thing to do," Chief Executive Officer Dan Florness said on a call this week to discuss the results. The company would much rather see revenue growth from the higher-margin screws, rivets and other industrial fasteners that it's known for, and there are signs that's finally happening. Sales of fasteners were up 14% in March as manufacturers and non-residential construction companies recovered from last year's shutdowns. "The writedown of inventory is one of the most bullish comments we could make as an organization," Florness said. "We believe the market is going to change for masks in the months to come because we believe the economy is healing." 

At this "tween" moment, though, there's a mismatch between the pace of the snapback in fasteners and other manufacturing products and the surge-level volumes of safety-gear sales last year. Chief Financial Officer Holden Lewis warned that growth in the second quarter could be flat to slightly down, compared with a 3.7% increase in net sales in the first quarter and 10.3% growth in the June quarter last year. Elsewhere, the inflation bogeyman reared its head as Fastenal cited rising steel, fuel, plastics and transportation costs. It expects to offset this through "broad and material" price increases in the second quarter. Industrial distributors have a long, successful track record of passing on rising input costs to their customers but it may take a few quarters for things to balance out, Melius Research analyst Jake Levinson said in a note. The combination of slower growth and pressured margins isn't terribly attractive in a market that's prepared for a boom. Fastenal shares fell 1.4% on earnings day — the third straight downbeat response. 

A similar story may play out across the industrial sector this quarter. The pandemic's effects were fickle, with idiosyncratic pockets of strong growth in products such as residential air conditioners, pool equipment, power tools and gas-station pumps that may fade faster than other markets can recover. As far as cost management, results this week from Delta Air Lines Inc. show that the bar is high even for companies whose businesses can seemingly only improve from here. 

Delta started generating cash again in March — a first since the pandemic began — and domestic leisure bookings have recovered to 85% of pre-Covid levels as Americans start to plan vacations again. Positioning the airline to take advantage of that pent-up demand will require some up-front spending, though. Delta expects non-fuel costs for each seat flown a mile to rise 6% to 9% compared to 2019 levels in the second quarter, with a good portion of that tied to investments in getting pilots up to date on training and preparing idled planes to go back into service. If the recovery continues at a strong pace, the company may also need to hire more pilots and flight attendants, CEO Ed Bastian said on a call to discuss results. Delta shares fell 2.8% on the Thursday earnings release and continued their slide on Friday. 

Just like Fastenal taking a write-down on its mask inventory, airlines spending again is a good thing for both the economy more broadly and for the aerospace manufacturing industry specifically. Don't forget that when rival United Airlines Holdings Inc. announced in January that it was restarting heavy aircraft maintenance, it was considered a bullish signal. An eventual return of international long-haul travel will help Delta spread its costs around more effectively. Indeed, in a report this week, JPMorgan Chase & Co. analyst Jamie Baker argued that the coronavirus recovery may bring about a "long-term profit renaissance" for the airline sector as carriers hold on to savings from pandemic cost-cutting plans and improve the efficiency of their fleets. 

In a way, it's comforting that analysts and investors are obsessing again over relatively minor and short-term issues with quarterly margins and growth rates, rather than the possible end to life as we know it. It almost feels a bit quaint. Ideally, we'd get the growth of the recovery without the growing pains but that just isn't how the world works. 

Deals, Activists and Corporate Governance

Canadian Pacific Railway Ltd.'s plan for taking over Kansas City Southern in a $29 billion transaction has drawn pushback from the Department of Justice. The Surface Transportation Board is the rail industry's primary regulator and has the final say, but the DOJ is allowed to express its opinion and this week it asserted a "statutory right to intervene" in major railroad mergers. The DOJ takes primary issue with Canadian Pacific's plan to close the deal on a financial basis in advance of regulatory approval by putting the acquired Kansas City Southern shares in a voting trust. It rightly points out that companies in other consolidated industries frequently have to wait a year or more to close transactions and they manage just fine without a voting trust that risks compromising the target's independence and future competitiveness. The DOJ — along with rival railroads and some key shipping groups — also wants the STB to waive Kansas City Southern's exemption from tougher 2001 merger rules that require major carriers to prove a transaction is in the public interest. While Kansas City Southern remains the smallest major North American railroad, it's much bigger than it was, in part because of the 2005 acquisition of Mexico's TFM railroad. Canadian Pacific issued a response to the DOJ, arguing that the pre-2001 rules are rigorous enough for its merger and that a voting trust is essential to make the transaction work. The voting trust is useful in staving off a counterbid from the private equity firms that were circling Kansas City Southern last year, but I'm less convinced of its public interest benefits. If there are any, Canadian Pacific should have to prove that. 

Ingersoll Rand Inc. is selling the golf-cart business you maybe didn't know it had. The maker of air compressors, power tools and industrial-strength lifting equipment agreed to sell its Club Car division to private equity firm Platinum Equity for $1.7 billion. It's a smart deal that helps simplify Ingersoll Rand after last year's merger with Gardner Denver and comes at a good price that reflects the mini-boom golf has enjoyed during the pandemic. Play in the U.S. was up about 14% last year for a total of about 500 million rounds, according to Golf Datatech. While interest in the sport may fade as the economy reopens and other activities become possible again, Platinum Equity may benefit from a fleet replacement cycle tied to the shift to electrification. Increased interest in Club Car's street-legal vehicles from people migrating out of big cities to places like Florida or South Carolina may also boost demand. Club Car was one of the last oddball businesses still on an industrial company's books after Honeywell International Inc. sold a footwear business earlier this year. But golf seems to be a theme for this group because Eaton Corp. still sells Golf Pride golf grips and Textron Inc. has the E-Z-GO golf-cart business.

Raytheon Technologies Corp. got a new chief financial officer. In a press release that went out at 4:36 p.m. last Friday, the aerospace and defense giant announced that Toby O'Brien, who joined the company only last year after United Technologies Corp. acquired Raytheon, was abruptly stepping down. He will be replaced by Neil Mitchill, who was serving as corporate vice president of financial planning and investor relations. No reason was given for the change and it's unclear what happened. But it's never a great sign when companies announce news late on a Friday afternoon. It's also unusual for a company to swap CFOs just two weeks before it's scheduled to report earnings. In announcing the change, Raytheon said its first-quarter sales and earnings will be higher than previously forecast and that CEO Greg Hayes and Mitchill will be the ones leading the call to discuss the results on April 27.  

Boeing Co. is under pressure to further shake up its board in the wake of the 737 Max crisis. Proxy advisory firm Glass Lewis is recommending shareholders vote against two longstanding directors at next week's annual meeting: chairman and former Continental Airlines executive Larry Kellner and Admiral Edmund Giambastiani, who leads a safety committee set up after the accidents. Clearly, the board did not do its job properly in handling the Max debacle and didn't ask tough enough questions of management. But there's been a wave of director retirements in the past few years, so it's also not fair to say Boeing has done nothing. It's unclear if investors will be as aggressive about pushing for further change as they were last year when a significant number of them voted against the reelection of legacy directors. In the coming months, the board is separately expected to consider whether to grant an exemption to the mandatory retirement age of 65 to allow Dave Calhoun to continue to serve as CEO beyond next year, according to the Wall Street Journal. In other proxy news, Glass Lewis and Institutional Shareholder Services recommend investors vote against General Electric Co. CEO Larry Culp's compensation after the board aggressively rejiggered the terms to make it easier for him to access a one-time stock grant. 

Rolls-Royce Holdings Plc is closer to finding a buyer for its ITP Aero engine parts and development division. Private equity firms KKR & Co. and Bain Capital are among those that have advanced to the next round of bidding, while TowerBrook Capital — which owns Spanish aircraft supplier Aernnova — and partner Onex Corp. are also still interested, people familiar with the matter told Bloomberg News. Carlyle Group Inc. and CVC Capital Partners have reportedly dropped out of the sale process. The divestiture is a key part of Rolls-Royce's plans to raise 2 billion pounds ($2.77 billion) from asset sales. The engine maker burned through 4.2 billion pounds of cash last year and expects to cut that outflow roughly in half in 2021, before generating cash again in 2022. 

TuSimple Holdings Inc., a developer of self-driving trucks, went public this week at a valuation of about $8.5 billion. The shares priced above the marketed range at $40, but fell as much as 20% in their debut on Thursday before bouncing back to close flat on the day. Cathie Wood's Ark Investment Management LLC was a buyer. Like most self-driving vehicle startups, TuSimple is losing money and has little in the way of tangible revenue. But CEO Cheng Lu told Bloomberg News the company can quickly turn a profit once it starts building its autonomous trucks for partners including Navistar International Corp. and Volkswagen AG's trucking unit Traton SE in three years.

Brooke Sutherland is a Bloomberg Opinion columnist covering deals and industrial companies. 

Disclaimer: This article first appeared on bloomberg.com, and is published by special syndication arrangement.