Fitch Outlook for Diversified Industrials: More Risks in 2007; Business Conditions Remain Sound

CHICAGO--Credit profiles of companies in the industrial sector have generally been stable, reflecting the benefits of positive economic conditions during the past three years, and little change is anticipated by Fitch during 2007. Profitability has been supported by a focus on productivity that gained importance during the previous recession and by strong incremental margins related to sales growth. As a result, primary credit concerns in the diversified sector are weighted toward companies' decisions about how to deploy cash flow rather than concerns about operating performance. The outlook for the diversified industrial sector in 2007 is also affected by the high proportion of foreign revenue that serves to mitigate the sector's exposure to domestic economic trends, as well as a more mixed outlook for a number of end markets than existed a year ago.

Financial Performance:

Results within the industrial sector have been robust for the past two to three years. Recent results have increasingly been subject to weakness in certain end markets such as homebuilding and the domestic automotive sector. In addition, the heavy-duty truck business is widely anticipated to weaken significantly in 2007 due to implementation of the EPA's new emission standards. On the other hand, most sectors of the economy, particularly oil and gas, have demonstrated strength, providing support for sales growth and positive margin performance across much of the industrial sector. In addition, cash flow has held up through the cycle despite cost pressures and higher working capital requirements related to sales growth. As a result, industrial companies have continued to maintain high levels of liquidity despite aggressive discretionary spending. In general, economic conditions remain solid, but as the current economic cycle ages, economic imbalances could become more prevalent, raising the risk of a decline in financial performance across the industrial sector.

Mixed Economic Indicators:

There is more uncertainty with respect to broad economic trends in the United States than during the early stages of the current economic cycle. For the most part, indicators related to industrial production have been solid, if slightly weaker than expected, and most indicators remain at favorable levels. By comparison, volatile raw material prices, a sharp downturn in residential construction, and a weak domestic automotive sector have tempered previous confidence about underlying economic trends. As a result, there has been a higher level of sensitivity to changes in interest rates, consumer spending and inflation and any effect they may have on demand. The negative impact of residential construction is mitigated by strength in non-residential markets where activity is generally expected to be strong through 2007. McGraw-Hill's forecast for Construction Contract Awards in 2007 includes a 13.9% increase for non-residential construction compared to an 8% decline for residential construction.

Benefits From Exposure to Foreign Markets:

The importance of the U.S. economy for diversified industrial companies is mitigated by the geographic diversification common across the sector. Industrial companies typically generate a substantial portion of sales from foreign regions (median of approximately 40% for the companies listed below) that offer higher growth rates and serve to reduce the volatility of a company's overall financial results. Whereas growth in the U.S. and Europe is primarily related to economic cycles, growth in developing markets also has a high secular component as a large amount of investment is required to raise living standards in these regions. Foreign markets are not without risk; they can be highly cyclical in the short term, but some of this risk is offset by the fact that overseas expansion by diversified manufacturers often represents the transfer of domestic supplier relationships to overseas locations with existing customers.

Potential Credit Concerns:

Aggressive cash deployment -- Most discretionary spending by diversified industrial companies has been directed toward acquisitions and share repurchases. Debt reduction has not been a significant use of cash aside from special situations where companies implemented a more conservative financial strategy (e.g. Tyco, SPX). In some cases, debt and leverage have increased due to aggressive acquisition spending, but the increases generally are expected to be temporary rather than reflective of weaker financial policies. Acquisitions have usually performed as expected, although newly acquired companies often have required additional investment to improve operating practices. The risks of an economic downturn are still considered low, but aggressive spending for acquisitions and share repurchases could exacerbate the impact on leverage if economic conditions are weaker-than-expected. In the event that operating results and cash flow were to decline, companies would have less capacity to service debt. Declining economic trends can be difficult to identify early, and any failure to reduce discretionary spending quickly could aggravate the normal challenges of adapting to weakening demand.

Raw material costs / Inflation -- Although high raw material costs for energy and metals still represent a challenge to margin improvement, most industrial companies have improved their effectiveness at passing through such costs. This trend highlights the related risk of inflation which may become more entrenched as companies incorporate expectations of rising costs into their pricing strategies. The risk of higher inflation remains uncertain and will depend on broad economic factors such as consumer spending, interest rates, and the balance between commodity production and prices.

Event risk -- The recent prevalence of leveraged buyouts has highlighted the downside risk to fixed income investors from leveraged transactions. A strong economy and ample funding have facilitated the number and size of such transactions. Furthermore, the risk to fixed income investors is compounded by the language in bond indentures that typically provides only limited protection, particularly for investment grade companies that characterize the diversified industrial sector. Partly offsetting this concern is the diversified nature of the sector that may discourage buyers interested in a "pure play" strategy.

Economic slowdown -- The consensus among companies in the industrial sector appears to be that growth is likely to slow from recent rates but will remain positive. The level of uncertainty about the strength of the U.S. economy has increased recently due to the sharper-than-expected downturn in housing and occasional hints of weakness in other sectors. However, concerns about the economy are counterbalanced by a positive outlook for the aerospace and non-residential construction markets, including the need for long term investment in the energy sector (oil production and refining, coal-fired power plants) and infrastructure (water, transportation) as well as generally favorable global economic conditions.

Following is a list of Fitch-rated issuers and their current Issuer Default Ratings (IDRs) in the U.S. diversified industrial sector.

-- AMETEK (BBB; Outlook Stable)

-- Cooper Industries (A; Outlook Stable)

-- Dover (A; Outlook Stable)

-- Eaton (A; Outlook Stable)

-- Fluor (A-; Outlook Stable)

-- Harsco (A-; Outlook Stable)

-- Honeywell (A+; Outlook Stable)

-- Hubbell (A; Outlook Stable)

-- IDEX (BBB+; Outlook Stable)

-- Ingersoll-Rand (A-; Outlook Stable)

-- ITT Corporation (A-; Outlook Stable)

-- Kennametal (BBB; Outlook Stable)

-- Parker-Hannifin (A; Outlook Stable)

-- Rockwell Automation (A; Outlook Stable)

-- SPX (BB+; Outlook Stable)

-- Thomas & Betts (BBB; Outlook Stable)

-- Tyco (BBB+; Rating Watch Evolving)

-- United Technologies (A+; Outlook Stable)

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.