What should we expect for manufacturers in 2022?

It has been 21 months since the World Health Organization declared the Covid-19 outbreak a pandemic, but it has felt like eons longer. That's in large part because we keep reliving the same story lines again and again. Business operations and air travel are getting disrupted yet again by a spike in Covid cases and the emergence of the omicron variant. Americans just keep buying boatloads of physical stuff, overloading logistics infrastructure. I recently looked back at some of my early pandemic columns: The virus has solidified overly globalized supply chains "as a liability" and should "accelerate the unwinding of far-flung parts networks" and boost the adoption of industrial software to guard against unplanned downtime, I wrote in February 2020. The observation would be just as pertinent today. 

So as this year finally draws to a close, what should we expect for manufacturers in 2022? Much like Covid itself, the key themes of 2021 aren't going away, from supply chains to increased automation and a bevy of breakups. The industrial economy is entering a new stage of the recovery, though, and that has implications for everything from capital spending to equity valuations. Here's what I'm watching: 

Logistics Logjams Are Here to Stay, But So Is Demand

There are some encouraging signs that the supply-chain congestion in the U.S. may be easing as freight rates moderate from record highs and ports chip away at container pileups. Nothing is fixed, though: "The problem is really severe, and it will remain severe for at least another year," Sanne Manders, chief operating officer of Flexport Inc., said in an interview last week. But barring a shutdown of the West Coast ports because of coming labor negotiations, manufacturers have most likely already seen the worst of the supply-chain crunch — and the larger companies have generally managed just fine. While disruptions and rising costs have pinched margins and near-term sales at the edges, pricing power is off the charts and orders just keep climbing. There's no guarantee that the sales manufacturers couldn't complete in 2021 because of supply-chain challenges will still be there for the taking in the future, but bloated backlogs help support the narrative that the challenging operating environment isn't eating into demand — at least not yet. Even businesses with shorter production cycles such as Fortive Corp.'s Fluke test and measurement unit have backlogs. Concerns about over-ordering and an eventual glut of inventory linger, but manufacturers including Dover Corp. say they're selling everything they can supply right now. 

No Place Like Home

Outside of the still-beaten down aerospace sector, sales at many industrial companies are already running ahead of pre-pandemic levels. But there's reason to think the sector is due for more than just a run-of-the-mill recovery. The globalized supply chain isn't vanishing entirely; it still makes perfect sense for certain business models. But the pressures of Covid have forced companies big and small to reevaluate how resilient their manufacturing operations truly are, and many have concluded they need to have factories closer to home. For the most part, the blockbuster North American factory announcements remain heavily concentrated in the semiconductor and electric-vehicle industries as the U.S. government scrambles to rectify its over-dependence on Asia for these crucial next-generation technologies. But the chip factory announcements amount to at least $50 billion so far. Remember that semiconductor plants also need lights, air conditioning and roads. Bank of America Corp. analyst Andrew Obin estimates the new chip factories alone will add 1.8 percentage points of growth to the pace of capital expenditure expansion in the U.S. over five years. There are also signs the spending is spreading. Danish medical-device maker Ambu A/S, Chinese furniture maker Keeson Technology Corp., industrial conglomerate Boyd Corp. and toymaker MGA Entertainment are among those setting up factories just across the border in Mexico to shrink their supply chains, as detailed by my Bloomberg News colleague Thomas Black.

Spending Boom

One reason there haven't been more announcements like this at the mega-cap level is that most large industrial companies have long oriented their supply chains to put the final assembly process near the end customer. But if growth is going to be as robust as some of these companies are saying, they're going to need more capacity. Schneider Electric SE, for example, is adding three new North American plants to boost production of circuit breakers, switchboards and other electrical equipment. Big capital spending increases were limited among large industrial manufacturers in 2021, in part because of challenges getting the materials and people necessary to build new factory lines. But plans for 2022 have started to take shape, and the early read from companies such as Rockwell Automation Inc. and Deere & Co. that have already given guidance indicates a big step up in spending, according to an analysis by Melius Research analyst Scott Davis.

It's also not free to go green. Reaching carbon neutrality as a manufacturer means investments in more efficient equipment, development of more environmentally friendly technologies, analytics to measure progress and perhaps an electric vehicle fleet. Plastic-container maker Berry Global Group Inc. aims to spend $800 million on capital expenditures in fiscal 2022, double pre-pandemic levels. 1 The outlay is meant to help the company keep up with robust demand and prioritize faster-growing markets — one of which is recycled plastic, CEO Tom Salmon said in an interview last month. Meanwhile, rising wages and difficulties filling jobs in a tight labor market will likely accelerate adoption of industrial automation, fueling yet more spending on equipment. Robots are the great equalizer when it comes to geographic assessments of supply chains; they cost about the same no matter where they are in the world. The International Federation of Robotics projects that North American robot installations will grow 17% in 2021 and that a "post-crisis boom" will continue to fuel low double-digit growth rates in 2022 and beyond.

And this is all before factoring in the knock-on effects from the $550 billion in fresh infrastructure spending planned in the U.S. and the tens of billions of dollars of Covid aid that could find their way to air-conditioning upgrades or water system overhauls. These trends add up: "Perhaps somewhat astoundingly, the outlook for robust growth in demand for most industrial end-markets has not appeared as bright since the 1980s," William Blair industrial analysts led by Nicholas Heymann wrote in a report this month. 

Room to Run or Old News?

The question is whether all this good news has already been priced into industrial stock valuations. Manufacturers tend to outperform in periods of inflation, and the various engines of potential over-the-top growth should theoretically make many of these stocks even more attractive. That hasn't really happened: Backing out aerospace-related stocks, the S&P 500 Industrial Index has outperformed since stocks bottomed in March of 2020 but has tracked only slightly ahead of the broader benchmark in 2021, according to data compiled by Bloomberg. This was due in part to a sell-off in November on concerns about the omicron variant and further supply-chain disruptions. And yet industrial stocks broadly are still expensive: Those tracked by RBC analyst Deane Dray are trading at more than 25 times their earnings, well above the historical 10-year average of about 19.5 times. The multi-industrial sector's price-earnings multiple is about 21% higher than that of the S&P 500, a level that typically kicks off a period of valuation compression, Dray wrote in a report this week. 

Capital spending is typically a rising tide that lifts all boats in the industrial sector; these companies buy and sell to one another. But in this environment, investors may have to be choosier. Obin of BofA recommends focusing on companies with less elevated valuations that have the management chops to navigate the supply-chain challenges and the pricing power to offset inflation; Emerson Electric Co., Carrier Global Corp., General Electric Co. and Fortive are among his top picks. Barclays Plc analyst Julian Mitchell is more skeptical that a capital expenditure boom will materialize, citing the pressures from rising interest rates and a slowdown in Chinese markets. He recommends focusing on companies with significant valuation disconnects to peers such as nVent Electric Plc and Parker-Hannifin Corp., aerospace companies including Honeywell International Inc. that have more room for a rebound, and those with opportunities for value-enhancing breakups and acquisitions such as Dover, Ingersoll Rand Inc. and Roper Technologies Inc.

Quote of the Week

"Scapegoat" — Federal Aviation Administration officials.

The unidentified officials made the comment in defense of Boeing Co.'s former chief technical pilot Mark Forkner, the only individual to be charged criminally in connection with the twin 737 Max crashes, Bloomberg's Alan Levin reported this week. The focus on Forkner's interactions with regulators over the crafting of pilot training manuals — rather than the company's engineering decisions — is "incorrect and misguided," according to an email and a presentation given to prosecutors by the FAA employees and cited in a court filing this week. The Department of Justice's $2.5 billion deferred prosecution settlement with Boeing earlier this year placed much of the blame for the crisis on Forkner and another company pilot, concluding that "the misconduct was neither pervasive across the organization, nor undertaken by a large number of employees, nor facilitated by senior management." It was an outcome that served both Boeing and the government. A full-scale criminal prosecution at the corporate level may have complicated the company's ability to continue receiving federal contracts, and Boeing is the only American producer of large jets and is a key defense supplier. But the idea that Forkner was operating as some kind of rogue mastermind — rather than a cog in larger, rotten system — has always defied common sense.

Separately, more than a dozen families of those killed in the crashes are asking a judge to revoke the protections against criminal charges granted to Boeing under the Justice Department settlement, arguing they weren't consulted on the terms in violation of a 2004 law meant to protect victims. And just to pile on the Max woes, Boeing lost out on blockbuster orders for the jet from Qantas Airways Ltd. and Air France-KLM, both of which chose planes from rival Airbus SE instead. 

Deals, Activists and Corporate Governance

3M Co. agreed to merge its food safety unit with Neogen Corp. through a reverse Morris trust transaction that values the business at $5.3 billion, including $1 billion in new debt. Neogen's existing management team will run the combined entity. It's the largest ever divestiture for 3M, surpassing the $1 billion sale of its billboard advertising operations in 1997 and the 1996 spinoff of its floppy disk unit. The food safety unit — which sells allergen testing tools and hygiene monitoring systems, among other things — has no overlap with the rest of the health-care division in which it sits. This is somewhat unique for 3M; while most industrial giants have done large breakups at this point, 3M has resisted the trend, arguing that its disparate businesses are bound together by material science innovations. 3M executives appear to be signaling a more active approach when it comes to managing the company's sprawl. This is the closest 3M has come to an actual strategy to wrest its stock price out of its current state of malaise, but its problems run much deeper than some underappreciated assets. More on that here. 

Harley-Davidson Inc. will create a public listing for its LiveWire electric motorcycle division by merging the business with special purpose acquisition company AEA-Bridges Impact Corp. It's the latest manufacturer to conclude that the company's most promising source of future growth may be worth more if it's uncoupled from the parent's legacy and the baggage of more mature industries. In Harley's case, demand for motorcycles has waned, in part because of challenges appealing to younger demographics. A reboot plan laid out in February (one of many that Harley has pitched to investors over the past few years) calls for mid-single-digit revenue growth in the motorcycle segment over the next five years, but that isn't particularly exciting when sales are trending about 30% below the 2014 peak. Harley will retain a 74% stake in the electric motorcycle business and will provide engineering and supply-chain support. 

SPX Flow Inc. agreed to sell itself to an affiliate of private equity firm Lone Star Funds for $3.8 billion, including the assumption of debt. SPX Flow rejected an $85-a-share offer from Ingersoll Rand earlier this year, contending that the proposal "significantly undervalues" the company. It was an interesting argument; before the Ingersoll bid put the company in play, SPX Flow shares had never traded in that range in the six years since the company was spun off from SPX Corp. The Lonestar offer of $86.50-a-share is higher but only by about 2%. Ingersoll Rand shareholders weren't particularly enthusiastic about SPX Flow's lackluster growth, so Barclays Plc analyst Julian Mitchell says it's unlikely the company revisits the deal. SPX Flow makes air filters, heat exchangers and other industrial valves and pumps. 

Brooke Sutherland is a Bloomberg Opinion columnist covering deals and industrial companies. She previously wrote an M&A column for Bloomberg News.

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