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Baird Macro-Economic Perpsective


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Robert W Baird provides market and company analysis in core sectors served by Red Kap. Check out their thoughts on the economy, our sectors and key companies.

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Baird Macro-Economic Perpsective

  1. 1. June 21, 2011 Baird Equity Research BairdEconomically Sensitive Investing in a Slow, Mid-Cycle Growth EnvironmentWhile acknowledging recent fears of a significant macroeconomic slowdown, Baird’sIndustrial, Business Services and Consumer analysts generally agree that the globaleconomy is transitioning from early cycle to the lower-growth middle stage of thebusiness cycle. As such, we see multiple ways to invest across these economicallysensitive end-markets. In this research report, we highlight our top Industrial, Services,and Consumer stocks that possess compelling risk/rewards amid the currentslow-growth, mid-cycle environment.s Slowdown or downturn? While macroeconomic risks have been building (starting with the end of QE2 and ending with uncertainties surrounding the Greek debt crisis), our analysts largely agree that the current environment appears to be indicative of a shift to lower levels of growth observed during the middle portion of an economic cycle, with the sharp pullback in economic indicators influenced by supply chain disruptions related to the Japan earthquake.s Uncomfortably soft labor market. The BLS Employment Report showed a slowdown in Nonfarm payroll growth from +232k in April to +54k in May, confirmed by the ADP Report, which showed private sector employment growth slowing from +177k in April to +38k in May. Furthermore, the 4-week moving average of Initial Jobless Claims has risen solidly above the sub-400k level observed 1-2 months ago. Of note, while initial jobless claims rise preceding and during recessions, they have also historically risen during prior mid-cycle slowdowns.s Continued reliance on the upper-income consumer. Employment for college graduates has increased on a y/y basis for 18 of the 20 last months, while employment for non-graduates has decreased for 17 of those 20 months. The above labor dynamics coupled with higher gas prices favor companies catering to upper income consumers.s The Industrial Cycle: what’s different this time? Behavior of key industrial sub-sectors during the current recovery has differed from prior cycles, particularly as construction activity has remained disengaged. Residential construction has lagged (historically one of the earlier sectors to rebound), while traditional later-cycle areas such as mining activity and natural resource extraction related equipment, have recovered more quickly than typical. Still, the current industrial up-cycle is relatively young measured by historical standards such as months of Y/Y IP growth.Document structure: the current note presents Top Ideas (page 2), Macro commentary(pages 3-8) and Sector-Specific comments (pages 9-42). [ Please refer to Appendix - Important Disclosures and Analyst Certification ]Team Baird
  2. 2. June 21, 2011 | BairdDetails Price Current Price Target (6/20/2011) Key Investment Points Industrials - Sector Specific commentaries pg 9 - 23 Cyclical margin and end market demand recovery plus secular growth and margin JCI $63 $37.39 expansion opportunities Large Late Cycle exposure, more aggressive growth strategy, achieving all of CAT $148 $98.18 Caterpillars targets would imply $15-20 in EPS by 2015, or roughly 3-4x the prior peak Rising demand driven by investment in Oil & Gas infrastructure, backlog shows first JEC $55 $41.27 sequential improvement in two years Substantial exposure to construction markets suggests significant growth potential from cyclical volume improvement. Cyclical growth should be leveraged by realization of SWK $90 $68.83 acquisition synergies from the merger with Black & Decker Mid-cycle dynamic is supportive of several key fundamental factors, with cyclical trends increasingly positive, an improving pricing environment and acquisition activity expected to ARG $78 $66.84 accelerate Significant exposure to energy efficiency movement provides a secular theme and should drive growth in excess of core industrial peers. Concerns over HVAC demand, commodity inflation, and expiration of the high-efficiency HVAC tax credit should RBC $95 $64.27 moderate throughout 2011 Well positioned to benefit from favorable parcel industry trends, supported by both the FDX $117 $87.50 growing industrial environment and more rational industry pricing Attractive aftermarket business mix, increasing penetration in emerging markets, CLC $50 $44.72 restructured I/E segment but more margin runway available Business Services- Sector Specific commentaries pg 24 - 32 Significant progress improving positioning into higher-margin, better secular growth sub- sectors positions SFN for continued profitability growth assuming macro expansion continues. Valuation attractive, especially on FCF basis with FCF/sh. regularly materially SFN $15 $8.77 exceeding EPS. Accelerating top-line momentum is driving margin and earnings leverage as previous investments in sales staff have begun to pay off; a recent bond offering coupled with enhanced alliance agreements in CTAS# higher-growth hygiene business may provide CTAS $35 $32.29 opportunity for additional EPS upside, beyond cyclical dynamics Mid-cycle corporate focus on organic-growth-enhancing expansion programs favors Consulting and Offshore BPO. We think Genpact is well-positioned to benefit from this growth # if market growth returns to pre-recession levels of 15-20%, we think 20%+ G $19 $15.70 growth at Genpact is possible (from +13% in 2011E/2012E). Late cycle and countercyclical exposure. Roughly 55% of the business (Corporate Finance and Restructuring at 32% and Forensic and Litigation Consulting at 23% of revenues) is driven by financial distress in high yield borrowers as well as the litigation and forensic accounting engagements that often follow cases of fraud or corporate FCN $46 $36.41 malfeasance Consumer - Sector Specific commentaries pg 33 - 42 Near-term operating momentum (supported by internal drivers, higher-income customer PNRA $150 $119.85 demographic), healthy long-term growth prospects Footwear momentum, 57% of revenues non-apparel thus less exposed to commodity ZUMZ $35 $24.48 driven cost increases Internal merchandising and execution improvement in C2H11/F2H12 would be URBN $40 $28.97 exaggerated by continued improvement in trends for higher-income consumers Unique needs-based merchandise offering focused on traffic-driving C.U.E. (consumable, usable, edible) items plus strong competitive position (4x the size of its next five competitors combined) should continue to support healthy top-line trends even in a TSCO $74 $63.46 challenging environment We like OReilly for contrarian-minded investors noting: 1) an aging vehicle population, 2) industry consolidation, 3) CSK-related growth, 4) a heavier commercial mix, and 5) ORLY $70 $63.00 stronger cash flow through better inventory managementRobert W. Baird & Co. 2
  3. 3. June 21, 2011 | Baird Macro Thoughts – Industrial Perspective From a fundamental perspective, Baird’s Industrial analysts generally agree that the global economy is transitioning from early cycle to the middle stages of cyclical recovery. Aggregate general industrial indicators such as industrial production and capacity utilization generally bottomed in mid-2009 and have improved steadily since, consistent with transition to a normal cyclical expansion (albeit at lower absolute levels relative to prior recoveries), and suggesting that industrial companies are transitioning to more normal, “mid-cycle” growth rates. The PMI appears to have peaked, and is now moderating from the cycle highs, while continuing to support the prospect for additional growth. While the U.S. PMI posted a sharp sequential drop in May, the absolute reading remains at a healthy level (53.5). New orders also remained above the 50.0 level (while also reflecting a sharp sequential deceleration). Recent global shocks (Japan earthquake, Middle East unrest) coupled with an increasing inflation backdrop may have had a profound impact on this sentiment indicator. At 22 months, the current PMI up-cycle (defined as readings over >50) remains relatively short compared to the average up-cycle of 31 months (since 1960). Industrial Production continues to steadily improve on a y/y basis…but growth is decelerating. Industrial production (manufacturing ex-tech) has increased +11% (May 88.0) from the cyclical bottom in June 2009 (79.0) and now stands 13% below the prior peak (July 2007, 100.7). During the months of May, IP increased on a y/y basis for the 15th consecutive month. In the six previous cycles going back to the early 1970s, the average duration of growth has been 54 months, suggesting more growth lies ahead. That being said, growth rates are moderating, as IP grew +3.4% y/y during the month of May after increasing as rapidly as +8.3% in June 2010. Moreover, the pace of positive estimate revisions to IP have slowed, again reinforcing our belief the ‘second derivative” is leveling.Robert W. Baird & Co. 3
  4. 4. June 21, 2011 | Baird Fixed capital investment is rebounding. Global fixed investment (GFI) growth turned positive in 2Q10 and averaged +5% in 2H10. GFI growth is forecasted to be approximately +5% in 2011 and+6% in 2012. GFI growth troughed at -14.5% in 2Q09 versus -4% in 1Q02. In absolute terms, GFI peaked in 4Q07 and troughed in 4Q09. The Blue Chip Economic Indicators forecast for non-residential fixed investment is currently +7.9% and +8.2% Y/Y growth for CY11/CY12E. The Industrial Cycle: what’s different this time? While the overall industrial cycle appears to be fairly normal, the ways in which key industrial sub-sectors have behaved during the current recovery has differed from prior cycles, particularly as construction activity remains disengaged. The US residential construction market has historically been one of the earlier sectors to rebound in an economic recovery, yet housing starts fell 20% year/year in April (to near record-low SAAR), nearly two years after the official end of the recent recession. Although May starts improved Q/Q, the Y/Y rate was still negative at 3.4%.Robert W. Baird & Co. 4
  5. 5. June 21, 2011 | Baird Indeed, the current recovery has occurred almost completely without a boost from domestic housing markets – itself a function of the heights of the housing bubble in the mid-2000s and the subsequent declines in home values. As a result, sales of product consumed directly in home construction have remained weak even as areas such as construction-related-machinery have rebounded driven by pent-up replacement demand created by the depth of the downturn. On the other hand, traditional later-cycle areas such as mining activity and natural resource extraction-related equipment demand, have recovered more quickly than is typical in the early stages of an upturn, reflecting the abbreviated up-cycle during the last recovery and the tight commodity market created by years of mining underinvestment observed since the 1980s. As an example, it took three full years beyond the official end of the 2001 recession (2004) before new mining equipment orders at suppliers Joy Global and Bucyrus accelerated in earnest, whereas net orders rebounded at the same suppliers as early as the 1Q10 (and have subsequently returned to peak), just 6-9 months after the last recession’s official end (June-09). Mid- and late-cycle opportunities. While Baird’s Industrial analysts project economic growth will continue, ongoing moderation in comparisons is viewed to be consistent with mid-cycle growth and as a signal that the initial, and powerful, short-cycle recovery has largely played out. A notable exception to the above statement can be found in Automotive, where Baird’s Automotive team projects the industry is in the initial stages of a 4-5 year cyclical recovery in vehicle demand. Broadly speaking, Baird’s industrial analysts are focusing on companies likely to benefit from longer-cycle project-oriented work in later-cycle markets, such as oil & gas, mining, power and infrastructure, particularly in resource-heavy and emerging markets. Investment recommendations are also focused on the construction market, particularly companies with non-residential construction exposure, 3PLs and asset-based transportation names with secular themes, as well as companies that carry a higher aftermarket component to revenues (Filtration) that can provide defensive characteristic and still grow sales/EPS in slower growth economy. Engineering and construction companies also continue to see strong order activity for “front-end” (e.g., design-heavy) project work, which bodes well for emerging later-cycle opportunities . Macro Thoughts – Business Services Perspective Our Business Services analysts also largely agree that the US economy is experiencing a shift towards a mid-cycle slower-growth environment, evidenced in part by May’s economic data showing a deceleration in the rate of US economic and labor market growth, but also by anecdotal data points surrounding corporate budgets being directed towards the type of projects normally seen during the mid-to-late portion of the cycle. The Human Capital Services coverage team points out recent softness in the labor market. Notably, the closely followed BLS Employment Report showed a slowdown in Nonfarm payroll growth from +232k in April to +54k in May. The weakness in the BLS report was supported by the recent slowdown in the ADP-Macroeconomic Advisors Employment Report, which showed private sector employment growth slowing from +177k in April to +38k in May. Some investors may note that the BLS and ADP reports have only exhibited a sharp slowdown for one month, and the data series have historically been volatile and the recent slowdown occurred during a period that was arguably impacted by issues that may prove to be transitory (such as supply chain disruptions stemming from the fall-out from the Japanese natural disasters). However, our Human Capital Services team notes that other, more leading labor market indicators have softened in recentRobert W. Baird & Co. 5
  6. 6. June 21, 2011 | Baird months as well, the BLS and ADP reports exhibited broad-based weakness (one-month private sector diffusion index in BLS series fell from 65.0 in April to 53.6 in May), and other leading macroeconomic data points (that typically lead the lagging or co-incident labor market data) have been soft as well. For example, temporary help employment, which has typically proven to be a leading labor market indicator, has declined slightly on a seasonally adjusted sequential basis in three of the last five months (per the BLS Employment Report). Furthermore, the 4-wk. moving average of Initial Jobless Claims has risen solidly above the sub-400k level observed 1-2 months ago, most recently coming in at 425.5k. For perspective, as the chart below indicates, initial jobless claims declined materially in late 2009 and early 2010 as the US economy exited the recession, similar to the early stages of prior recoveries. Also, as illustrated by the chart below, while initial jobless claims rise preceding and during recessions, they have also historically risen during prior mid-cycle slowdowns. Our Facilities Services coverage team points out that in spite of a softening overall employment picture, employment gains in uniform-wearing industry verticals are outpacing the broader economy for the first time since late 2006/early 2007, presenting opportunities in the space. Our BPO coverage team mentions anecdotal evidence surrounding the type of spending seen from BPO’s client companies suggesting a mid-cycle shift as well. Broadly speaking, during the early stages of a recovery (2009), clients normally reduce spending significantly. When spending resumed (early 2010), it was largely focused on cost efficiencies, with a short payback focus. However, more recently client spend has shifted toward revenue-generation types of programs, including new product introductions, customer acquisition, and geographical expansion. This is indicative of companies focused on growth, consistent with the middle stage of the business cycle, a view also shared by the Professional Services coverage team, which notes additionally that Regulatory and Corporate litigation are showing early signs of growth typically seen in the mature portion of the business cycle.Robert W. Baird & Co. 6
  7. 7. June 21, 2011 | Baird Macro Thoughts – Consumer Perspective The consensus view among our Consumer analysts is that we are still in the early stages of the consumer recovery. Growth rates have moderated recently in some categories but it is unclear whether slowing trends are a result of shorter-term factors (gas prices, weather, tougher comps) or larger structural issues (depressed housing market, lingering unemployment). Given the relative uncertainty, our Consumer analysts are generally focused on companies with more durable top-line drivers (product cycle momentum, less cyclical end markets), internal profitability initiatives, and pricing power. Consumer macro indicators have been improving; however, they are still below pre-recession levels, indicating potential for further upside to the recovery. Consumer sentiment improved, but remains well below pre-recession levels. Consumer sentient (University of Michigan) in June decreased sequentially and y/y to 71.8 (vs. 76.0), remaining above the recession low of 56.3, but below the 20-year average of 88, and well below the 1997-2007 average of 96. Trends favor the higher-income consumer, as employment gains for college graduates outpace employment for non-graduates. Employment for college graduates has increased on a y/y basis for 18 of the 20 last months (+2.3% six-month average), while employment for non-graduates has decreased for 17 of those 20 months (-0.5% six-month average). Additionally, the gap between the U6 rate and U3 rate has averaged 7.0% over the past six months, reflecting high levels of forced part-time workers and discouraged job seekers. FIGURE 4: YEAR-OVER-YEAR EMPLOYMENT CHANGE 6% 4% Trailing three months 2% 0% -2% Non-College Graduates -4% College Graduates -6% May-05 May-06 May-07 May-08 May-09 May-10 May-11 Source: U.S. Bureau of Labor Statistics Gas and food prices pressuring the lower-income consumer. Gasoline prices are currently trending up +38% y/y and +21% sequentially (year-to-date), pressuring traffic and discretionary income (particularly for lower-income consumers). Looking forward, futures indicate gasoline prices will remain above year-ago levels in upcoming periods, although the recent pullback in oil/gasoline futures suggests the year-over-year pressure in the second half of 2011 could be less severe than in the first half of the year.Robert W. Baird & Co. 7
  8. 8. June 21, 2011 | Baird FIGURE 5: FOOD AND GASOLINE PRICES CPI - Food at Home $4.50 U.S. Gasoline Prices 8% (year-over-year % change) Historical Spot Prices $4.00 Future Prices 6% $3.50 4% 2% $3.00 0% $2.50 -2% $2.00 -4% $1.50 M ar-08 Jul-08 Sep-08 N ov-08 M ar-09 Jul-09 Sep-09 N ov-09 M ar-10 Jul-10 Sep-10 N ov-10 M ar-11 Jan-08 M ay-08 Jan-09 M ay-09 Jan-10 M ay-10 Jan-11 M ay-11 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Source: Bureau of Economic Analysis, U.S. Department of Commerce; U.S. Energy Information Administration (average regular retail) While the impact of higher Gas prices is an area of concern for most of the Consumer research teams, our Restaurants team points out that responses to recent surveys of private restaurant chains are suggesting that most operators still do not consider higher gasoline prices to be a meaningful issue impacting consumer spending at this stage.Robert W. Baird & Co. 8
  9. 9. June 21, 2011 | Baird Sector Commentary - Global Automotive & Truck David Leiker, CFA 414.298.7535 Joseph Vruwink 414.298.5934 Believe recovery still early in Automotive. Automotive is still in the initial stages of likely a 4-5 year cyclical recovery in vehicle demand. We believe auto supplier stocks are half way through the up cycle of outperformance, with most stocks potentially capable of doubling from current levels through 2014/2015. In the developed automotive markets (U.S. and Europe), light vehicle demand remains 15-30% below prior-cycle peak levels; modeling a return to “trend,” not peak, demand levels drives 5-6% annual production growth through 2013/2014. The potential for a strong replacement cycle, returning markets back to/above last-cycle peak levels of demand, lends further upside to our estimates. Within the group, we are most attracted to ideas with secular growth opportunities to outpace the level of end-market growth, in addition to margin expansion potential and attractive valuations. Truck still well below prior peak. We believe the commercial vehicle stocks have another 2-3 years left in an up cycle that typically doesn’t peak until incoming orders reach a cyclical peak. Both North America and Europe are in the initial stages of a strong replacement cycle, with Europe ahead of North America in terms of incoming orders translating to production by the truck manufacturers. The North America commercial vehicle market is still 45% below prior-cycle peak demand levels, with annualized production rates of 225,000 units well below the annualized order rates of 350,000 during previous months. A return to “trend” demand levels in these two markets drives 15% annual production growth through 2013/2014. Top Auto Ideas GNTX (Outperform, Price Target $42) s GNTX positioned for +15-20% annual revenue growth over next 3-4 years, in our view, driven by a combination of cyclical recovery in end-market demand (5-6% annual growth) and 10-15% organic growth above end-market growth. s 10-15% annual organic revenue growth possible (+/- production) from the combination of growing auto-dimming mirror penetration (currently around 20%) and increasing content (adding features/functionality to the mirror). - Rear Camera Display shipments, at $65-100 of content, could increase from 1,250,000 units in 2010 to over 8.0 million by 2015-2016 as the government mandates in-vehicle technology to improve the rearward field of vision in vehicles to eliminate blind spots and prevent backover accidents. - Additional technology delivering gains in content include SmartBeam (automatic control of high/low beam head lamps) and driver assistance features (e.g., lane departure warnings, driver notification, blind spot detection). s Margin expansion could be meaningful against double-digit revenue growth backdrop. Other factors supporting margin expansion include excellent cost management, a strong track record of productivity gains, and implementing value-added engineering actions.Robert W. Baird & Co. 9
  10. 10. June 21, 2011 | Baird s Price target. Our $42 price target is based on 14.6 times our estimate of 2014 EBITDA, the median of the valuation range during the "steady growth" period from 2000-2004. s Risks: 1) the pace/slope of end-market recovery; 2) adoption rates of auto-dimming mirrors and advanced features; 3) a shift in mix between large and small vehicles; and 4) raw material and component costs, primarily purchased electronics components. JCI (Outperform, PT $63) s Cyclical margin and end-market demand recovery plus secular growth and margin expansion opportunities underpin our JCI recommendation. s Multiple areas for margin expansion. JCI’s three businesses all offer attractive margin expansion opportunities over the next several years, with the potential to expand segment margin by 200-300 basis points from current levels through 2014: - Power Solutions, the sale of higher-margin AGM batteries (2x the selling price and 3x the margin dollars versus a traditional SLI battery), further vertical integration with internal recycling, and capacity expansion in China could drive segment margin to 16.0-17.0% from current 13.0% level. - Building Efficiency, an improved business mix (more product-centric offerings versus lower-margin service and building maintenance), productivity gains in the global service network, and operating leverage from residential HVAC could drive segment margin to 8.0-9.0% from current 5.0% level. - Automotive Experience, higher-margin new business launches, increased vertical integration following recent seating structure and materials acquisitions, and improvements in Europe could drive segment margin to 6.0-7.0% from current 4.0% level. s M&A could supplement organic EPS. We estimate continued deployment of free cash flow towards acquisitions, generating a 15% return on capital, could add $1.00 to our mid-cycle EPS estimates. s Price target. Our $63 price target is based on the stock trading at 10.5 times our estimate of calendar 2014 EBITDA, the median valuation of the S&P 500 Industrials, plus the present value of equity income net of minority interest expense valued at 17.2x per share, discounted at 10% to reflect a 12-month time horizon s Risks: 1) the pace/slope of end-market recovery; 2) the pace/recovery of residential and non-residential new construction markets (about 5-10% of total sales); 3) the costs associated with winning/launching automotive new business; 4) raw material prices; and 5) acquisition-integration risks. Truck Top Idea PCAR (Outperform, PT $66) s Expecting cyclical recovery in developed markets (where PCAR has good exposure through Peterbilt/Kenworth in North America and DAF in Europe), incremental initiatives to outgrow end markets, and secular margin expansion opportunities. s Rebound in operating leverage. As recovery gains steam and pricing improves, as has happened in past cycles, we expect incremental margin to return to, or even exceed, historical levels. s History of up-cycle market share gains. PCAR has historically outgrown its end markets by 5-7 percentage points over the course of a cyclical recovery, via market share gains and acquisitions/international expansion, while also growing profit margin by 100-200 basis points. We expect these trends to continue over the upcoming cycle, driven by market share gains (DAF vocational trucks, North America medium-duty), organic growth internationally (primarily in South America), an improved cost structure, engine in-sourcing in North America, higher parts revenue (a higher-margin offering), and Financial Services growth.Robert W. Baird & Co. 10
  11. 11. June 21, 2011 | Baird s Price target. Our $66 target price is based on 8.3x our estimate of 2014 EBITDA, the median valuation range of the last cycle, discounted to reflect a 12-month horizon s Risks: 1) the pace/slope of cyclical end-market recovery; 2) commodity prices; 3) credit markets and credit availability; 4) loan portfolio performance; 5) post-retirement liabilities; and 6) the maintenance of premium market position.Robert W. Baird & Co. 11
  12. 12. June 21, 2011 | Baird Sector Commentary – Diversified Industrial & Machinery Robert F. McCarthy , CFA 312.609.5434 Christopher B. Weltzer, CFA 312.609.5463 Machinery versus diversified industrials. The two halves of our coverage universe – machinery and diversified industrials – can experience the economic cycle quite differently. Machinery manufacturers deal in long-lived, capital equipment, where demand is ultimately driven by underlying activity levels (construction spending, for example), but factors like variable replacement cycles, tax incentives, the availability of financing, and business confidence can significantly influence buying patterns. Diversified industrials typically focus more on products with less cyclical amplitude and that are tied more directly to actual activity levels. Construction fasteners and locksets would be two examples. Seek leverage to late-cycle mining and nonresidential construction markets. We believe exposure to the traditionally late-cycle markets for mining machinery and nonresidential construction offer compelling opportunities from this point in the currently developing up-cycle. While mining machinery orders have rebounded quickly, we see significant growth potential from here in the context of a stunted up-cycle (through 2008), declining ore yields worldwide, and roughly 20 years of low commodity prices and associated underinvestment. Despite the relatively slow pace of the current economic expansion in the developed economies, global mine capacity is already running in the mid-90% range. The swift recovery in commodity prices signals the tightness of current supply and the need for additional investments in capacity. Global mining sector capital spending may grow 30+% in 2011 and another 20-25% in 2012; sustained high levels appear likely for three-to-five years. We also see significant growth potential in US nonresidential construction markets, where spending levels in the US remain nearly 40% below the prior peak, despite little evidence of significant overbuilding or a spending bubble during the last upturn. Dodge construction contract square footage (a measure of real activity), suggests that on a per-capita basis, the US has been meaningfully under-investing in nonresidential buildings in 2009 and 2010. While certain sectors of nonresidential building construction are intimately tied to residential construction activity (like retail stores and gas stations), a significant portion has little direct link and is already showing signs of recovery. Manufacturing construction contract square footage increased 69% year/year (L3M) in April, while hotel and motel contracts were up 49% year/year. CAT (Outperform, PT $148) s Large late-cycle exposure. Beyond machinery demand tied to nonresidential construction activity, other major later-cycle markets include oil & gas, energy infrastructure, power generation, and commercial marine. Mining is traditionally the latest-cycle machinery market, but challenged by the EMD locomotive business. Clear majority of Caterpillar’s OE sales are to later-cycle markets. s More aggressive growth strategy. CAT acquired mining machinery maker BUCY purchased EMD (locomotives) and while planning to acquire MWM (gas engines). We estimate mining could approach 30% of CAT CY12 sales. Mining is CAT’s highest-margined machinery market by far. Accretion will be modest through 2012, but CAT projects meaningful synergies by 2013, reaching $400M by 2015. Our forecasts indicate CAT could repay all acquisition debt from operating cash flow by 2013.Robert W. Baird & Co. 12
  13. 13. June 21, 2011 | Baird s Substantial financial targets. Beyond $8-10 of EPS in 2012, achieving all of Caterpillars targets would imply $15-20 by 2015, or roughly 3-4x the prior peak. Current (and new) executive management team has established a 25% incremental operating margin objective; structural improvement in Machinery margins is an explicit objective. s Price Target and valuation. Our $148 price target is based on our estimate for normalized, mid-cycle earnings and a target multiple that is consistent with valuation metrics experienced at the same point in past business cycles. We assume 2013 will be mid-cycle, when our $148 price target assumes Caterpillar can achieve a 14x P/E multiple of our $11.70 estimate for normalized EPS and/or an 8.5x EV/EBITDA multiple of our estimate for normalized EBITDA (~$13.7 billion) plus the estimated future book value of Caterpillar’s finance subsidiary. s Risks include global economic growth; residential and nonresidential construction, quarrying and mining, power generation, industrial, oil and gas, marine, road construction, forestry, commercial vehicle industry fundamentals, acquisition regulatory approval and integration, and CPS implementation. MTW (Outperform, PT $28) s Potential inflection point reached in Crane. Crane orders surged 72% sequentially in 4Q10, generating a 1.25x book/bill ratio and bringing full-year orders even with 2010 Crane revenue. 4Q orders were ~40% above 2010s quarterly average; backlog expanded further in 1Q11, as orders increased sequentially and book/bill exceeded 1.55x. s Substantial deleveraging opportunity. High financial leverage from Enodis acquisition (1Q11: $2.0B debt; 81% D/TC; 6.1x debt/EBITDA), but Manitowoc targets $200 million of debt pay-down in 2011 (supported by ~$100-million proceeds from 1Q11 divestiture of refrigerated display case operations). Cutting $200 million of debt at 5% adds ~$0.05 to annual EPS and shifts $1.50 of per-share enterprise value to equity holders. s Building construction headwind easing. The global recession, plunging real estate values, and reduced global credit availability created huge declines in new nonresidential building investment and drove significant Crane order cancellations, beginning in 4Q08. Net new Crane segment orders have strengthened since that nadir and given backlog of $800 million at 3/31/11, we estimate Manitowoc could deliver 10-13% Crane growth (=guidance) in 2011 without any growth in full-year orders. s Price Target and valuation. Our $28 price target is based on our estimate for normalized, mid-cycle earnings and a target multiple that is consistent with valuation metrics experienced at the same point in past business cycles. We assume 2014 will be mid-cycle, when our $28 price target assumes MTW can achieve a 15.0x P/E multiple of our $2.60 estimate for normalized EPS and/or an 8.0x EV/EBITDA multiple of our estimate for normalized EBITDA (~$850 million). s Risks. Global economic growth; high financial leverage; residential and non-residential building construction activity, foodservice fundamentals; input costs; acquisition integration; and foreign currency fluctuations. ETN (Outperform, PT $65) s Big and rapidly growing emerging markets exposure . Just 8% of sales in 2000, emerging markets were 24% of Eaton’s 2010 sales, and intended to hit 30% by 2014. Growth rates generally exceed 20%. Organic growth augmented by recent electrical acquisitions in South America and South Africa, and a joint venture with Shanghai Aircraft Manufacturing Co. to support the COMAC C919. s Significant leverage to NAFTA heavy-duty truck cycle . Eaton is the primary OEM supplier of heavy-duty truck transmissions, and the stock has historically outperformed while Class 8 (heavy-duty) truck production is accelerating. Industry production is expected to surge ~60% in 2011, but still remain ~30-40% below the 2006 peak. Truck segment to grow 31% in 2011, contribute ~40% of Eaton’s operating income growth.Robert W. Baird & Co. 13
  14. 14. June 21, 2011 | Baird s Significant later-cycle exposure. Eaton’s traditional electrical distribution products business is geared towards nonresidential construction (and particularly industrial, energy, and power generation investment); plus, large data centers are now a core market. Certain fluid power markets are later-cycle; the Aerospace segment is ~60% commercial. Eaton estimates 20-25% of sales are later-cycle; 15-20% non-cyclical (including airline aftermarket). s Up-cycle growth objectives appear achievable. Management believes an expanding geographic footprint and significant investments in the global Electrical market have increased Eaton’s normalized organic market growth rate from +4% to +5% across the cycle, with Eaton targeting +7% market growth during the up-cycle (2009-2014). Developing markets growth expected to outpace developed markets, driving 30% of sales by 2015 (up from 22% today) and adding 1.5% to normalized growth, while innovation efforts contribute an addition 1.5% and acquisitions add 2-4%. Resultant 12-14% growth would essentially match Eaton’s performance during the prior cyclical expansion (+13% revenue CAGR) and appears to be a conservative target. s Price target and valuation. Our $65 price target is based on our estimate for normalized, mid-cycle earnings and a target multiple that is consistent with valuation metrics experienced at the same point in past business cycles. We assume 2013 will be mid-cycle, when our $65 price target assumes ETN can achieve a 13.5x P/E multiple of our $5.40 estimate for normalized EPS and/or an 8.5x EV/EBITDA multiple of our estimate for normalized EBITDA (~$3.2 billion). s Risks: Global economic growth; automotive, commercial vehicle, mobile equipment, industrial machinery, HVAC, electrical equipment, power quality, and commercial and military aerospace fundamentals; acquisition pricing and integration; foreign exchange rates.Robert W. Baird & Co. 14
  15. 15. June 21, 2011 | Baird Sector Commentary – Industrial Services Andrew J. Wittmann, CFA 414.298.1898 Justin P. Hauke 312.609.5485 Recommend E&C positions with leverage to later-cycle construction opportunities. Despite recent volatility, we believe later-cycle opportunities are emerging for E&C companies, particularly internationally, supported by leading indicators of construction activity, capital budgets, and our proprietary industry backlog model, which we believe suggest risk/reward favors an overweight position. The graphic below illustrates that E&C industry backlog (a key driver of multiple expansion) has only recently posted positive growth, with our proprietary model suggesting further momentum ahead. As later-cycle opportunities emerge, E&C stocks should outperform earlier-cycle industrial stocks more leveraged to utilization rate gains (earlier cycle). Thus, while a developed-nation slowdown is damaging to earnings for the industrial space broadly, E&C exposure to the developing world, specifically Asia, the Middle East and in resource-driven economies like Canada and Australia, can offer a cushion versus other industrials more heavily exposed to the U.S. and Western Europe. Current valuation for the group reflects early/mid-cycle levels at roughly 7.0x EBITDA and 14.0x earnings. However, as back-end construction activity begins to turn (likely later this year and in to 2012), we believe valuations will warrant modest multiple expansion and drive share outperformance for the group. History suggests that, paradoxically, peak E&C multiples are often achieved closer to the peak of the cycle rather than at the trough. JEC (Outperform, PT $55): Top E&C Pick s Demand rising. Economic fundamentals are slowly improving and investment in Oil & Gas infrastructure (~35-40% of revenue) continues to gain steam, driven by (still) high commodity prices and returning aggregate demand.Robert W. Baird & Co. 15
  16. 16. June 21, 2011 | Baird s Tight customer relationships. We like Jacobs relationship-based business model, focused on long-term share gains from core customers, which we believe is not only lower risk, but also leaves JEC well positioned to capture share at earlier stages of the cycle as clients cautiously expand capex budgets. s Backlog inflection point. Jacobs F2Q11 backlog moved modestly higher sequentially - its first sequential gain in two years - which we view as an early indication that greater earnings content lies ahead paving the way to the next phase of the recovery – and we remain quite positive on Jacobs exposure to oil sands work (Canada) and its increasing traction in the Middle East, with the companys opportunity set potentially enhanced by last Decembers acquisition of Aker. s Price target and valuation. Our $55 price target assumes essential flat multiples of 9.5x our FTM EBITDA estimate (16.2x earnings), a modest premium to historical levels, but recognizing the cyclical bottom and more robust earnings outlook in F2012 (and F2013 in particular). The multiple is slightly above JECs historical 8.7x average and at a slight premium to the E&C group, which we believe is warranted given the companys industry-leading franchise and evidence of strengthening fundamentals. s Risks include economically sensitive markets, acquisition integration risk, a highly competitive industry, and significant exposure to national government budgets. PWR (Outperform, PT $25): Top Specialty Contractor Pick s Electric transmission capex beneficiary. While weather and regulatory delays continue to impact near-term earnings potential, we continue to view PWR as a compelling stock ahead of the emerging capex cycle in electric transmission, particularly following the stock’s recent relative underperformance. s Eye on 2012. While we see some risk to near-term estimates and execution risk remains in 2H11, our thesis has always been underpinned by 2012 more than 2011, with recent data points still supportive of that outlook. We are also encouraged by recent insider buying on the open market by the companys newly appointed CEO. s Price target and valuation. Our $25 price target assumes 8.5x FTM EBITDA, a discount to both recent and historical levels, recognizing the stocks higher risk and recent poor execution, balanced by what we see as a still-large opportunity set. s Risks. Highly competitive industry, state and federal regulatory changes, fixed-price contract exposure and acquisition integration risk.Robert W. Baird & Co. 16
  17. 17. June 21, 2011 | Baird Sector Commentary – General Industrial & Building Products Peter Lisnic, CFA, CPA 312.609.5431 Joshua K. Chan 312.609.4492 Strong cash generation, ex-cyclical growth potential drive our recommendations . Within our coverage universe, stocks with the most attractive risk/reward profiles appear to be those with primary end-market exposures closer to their respective cyclical bottoms. From a general industrial perspective, fundamentals appear to be approaching mid-cycle levels with growth expectations for 2013 (and beyond) the primary determinant of potential equity upside, in our view. Construction-related markets appear to bottoming in nonresidential verticals, while the painfully slow “recovery” in residential markets continues, albeit well off from historically normal levels of demand. While longer-term risk/reward could be favorable in certain cases where residential exposure is material, our posture remains defensive with our top ideas based on differentiated growth drivers, leveraged by eventual strong cyclical upside and strong free cash flow. SWK (Outperform, PT $90) s Underappreciated cyclical leverage . Substantial exposure to construction markets suggests significant growth potential from eventual cyclical volume improvement. Cyclical leverage to be enhanced by realization of cost and revenue synergies from the merger with Black & Decker and growth opportunities afforded by strong free cash flow generation ($1B+ annually). Earnings power exceeds $8.50 in our estimation with EPS CAGR exceeding 15%. s Cost, revenue synergies enhance leverage . Cost synergies from BDK merger on target with $460MM run-rate projected by end of 2013. Additionally, SWK estimates revenue synergies of $300-400MM from the Black & Decker acquisition by 2013, adding $0.35-$0.50 to structural EPS when fully realized. s $8.50/share in EPS power. Management is targeting sales of $15B and operating margin exceeding 15%, implying earnings power in excess of $8.50/share. Target assumes sales CAGR of 10% from 2010 to 2015 including acquisitions. Based on the company’s strong FCF profile, we believe SWK can achieve its target without extending financial leverage markedly from current levels. s Price target and valuation. Our $90 price target is based on a 9.0x EV/EBITDA multiple applied to our 2012 EBITDA estimate (15.7x P/E multiple), modestly above the blended peer multiples (8.1x EV/EBITDA, 14.2x P/E), but we believe appropriate considering the company’s cyclical earnings growth potential and strong FCF profile. s Risks include: Execution risk surrounding the BDK integration, cyclicality of end markets, rising and/or volatile commodity costs, private-label competition, adverse foreign currency movements, and ability to find and successfully integrate acquisitions. TNB (Outperform, PT $63) s Attractive mid/late cycle exposure . Shares appear attractive considering cyclical leverage to improving construction and utility markets, strong free cash flow, and exposure to longer-term secular growth in electrical infrastructure investment. s Solid execution in improving markets. TNB’s 2011 outlook assumes continued strength in industrial demand, improving utility distribution demand, and early stages of recovery in nonresidential construction markets. Operating margin in primary electrical business has already exceeded previous peak with volume still materially below previous-cycle high. Capital allocation appears toRobert W. Baird & Co. 17
  18. 18. June 21, 2011 | Baird be a key company strength with recent bolt-on acquisitions initially appearing to be solid contributors to growth and return profile of the business. s Strong FCF buttresses growth potential. Since 2005, free cash flow has averaged 130% of net income. Acquisitions are the primary targeted use of capital with TNB seeking targets that provide leading brands and can be leveraged through the company’s distribution network. We estimate acquisition dry powder could approach $500MM with TNB maintaining net D/TC below 30% and net debt-to-EBITDA below 2.0x. s Price target and valuation. Our $63 price target is based on an 8.0x EV/EBITDA multiple (14.5x cash-adjusted P/E) applied to our 2012 EBITDA estimate, slightly above the average EV/EBITDA multiple accorded TNB’s electrical equipment peer group and we believe appropriate considering TNB’s history of execution, and solid FCF. s Risks include: Cyclicality of construction and industrial end markets, protracted decline in utility spending, rising and/or volatile commodity costs, and the ability to find and successfully integrate acquisitions.Robert W. Baird & Co. 18
  19. 19. June 21, 2011 | Baird Sector Commentary – Industrial Distribution & Services David J. Manthey, CFA 414.465.8020 Luke L. Junk 414.298.5084 We remain positive on the group in a moderately expanding industrial economy. We expect continued expansion in US industrial activity and believe we are in the “big middle” of the business cycle. Historically, this is the point in the cycle when industrial supply stocks have outperformed. Periods of underperformance are infrequent due to secular positives, and are typically late in the cycle. We are also increasingly constructive on companies with exposure to non-residential construction, given our outlook for flattening trends in 2011 and a possible modest recovery in 2012. Overall this should be a good time frame for the group – watch for catalysts and valuation opportunities as cyclical factors are positive or less negative for nearly every stock on our list. ARG (Outperform, PT $78) s Thesis. We rate ARG Outperform. Mid-cycle dynamic is supportive of several key fundamental factors, with cyclical trends increasingly positive, an improving pricing environment and acquisition activity expected to accelerate. Ongoing SAP implementation also provides a meaningful catalyst. s Price target and valuation. Our $78 price is based on 9x EV/C2012E EBITDA, a slight premium to the five-year average of 8.6x NTM EV/EBITDA. s Risks. Key risks include general US economic conditions, demand/pricing, SAP implementation, opening/operating ASUs, shareholder base turnover GWW (Outperform, PT $170) s Thesis. We rate GWW Outperform. Overall, mid-cycle is an advantageous point in the cycle for industrial supply stocks. Adding to positive cyclical dynamics is the ongoing “cultural renaissance” at the company, which is driving a more aggressive, growth-oriented approach and sustainably higher margins and returns driven underscored by the implementation of LEAN and 5S techniques. As such, we believe the stock deserves a premium relative to its historical valuation. s Price target and valuation. Our $170 price target represents 9x EV/2012E EBITDA, a premium (which we believe is warranted) to the historical NTM average of 8.3x. s Risks. Fundamental risks include macroeconomic conditions, ability to expand margins, pricing power, benefits from product expansion, sales force additions, global sourcing and international operations.Robert W. Baird & Co. 19
  20. 20. June 21, 2011 | Baird Sector Commentary –Process Controls Michael Halloran, CFA 414.298.1964 Brian Meyer 414.298.7664 Favor companies benefitting from secular growth opportunities. We believe that market outperformance by pure cyclical stocks is largely over, and that prevailing market uncertainty and broadly souring of sentiment remain broad-based headwinds for industrial stocks. Consequently, our stock recommendations focus on secular drivers over cyclical drivers, and late-cycle exposure over early-cycle exposure. On this premise, our top picks remain RBC and GDI (see comments below). From a purely cyclical standpoint, we believe ABB (Outperform, PT $32) is the best way to invest in the late-cycle acceleration and sentiment shift within the Process Controls space, followed by FLS (Outperform, PT $142) and CFX (Neutral, PT $24). RBC (Outperform, PT $95) s Buyers on 2012 earnings power of $6.50+ (including AO Smith EPC acquisition) and 2015 earnings power of $7.00-$8.50+/share organically ($9.00+ inorganically). Significant exposure to energy efficiency movement provides a secular theme and should drive growth in excess of core industrial peers. Concerns over HVAC demand, commodity inflation, and expiration of the high-efficiency HVAC tax credit should moderate throughout 2011. s Price target and valuation. Our $95 price target assumes forward multiples of 8.4x EV/EBITDA and 14.3x earnings versus historical average multiples of 7.7x and 12.9x, respectively. Potential for further multiple expansion over time with crisp execution of five-year plan. s Risks. Industrial activity, highly competitive industry and integration of current and future acquisitions. GDI (Outperform $100 PT) s Corporate transformation and secular themes drive impressive earnings power . Continued structural margin improvement, improving industrial end markets, and significant leverage to shale oil and gas drilling trends should drive near-term earnings upside. Longer-term margin improvement story still not fully reflected in stock price; 2012 EPS power is well north of $6.00. Early stages of transformation from a low-margin, average-growth industrial company to a high-margin, new market/product-oriented company should drive valuation multiple expansion. s Price target and valuation. Our $100 price target assumes forward multiples of 10.6x EV/EBITDA and 16.6x earnings versus historical average multiples of 7.8x and 13.3x, respectively. s Risks. Exposure to highly cyclical markets, pricing pressure from lower cost countries.Robert W. Baird & Co. 20
  21. 21. June 21, 2011 | Baird Sector Commentary – Transportation & Logistics Jon A. Langenfeld, CFA 414.298.1965 Benjamin J. Hartford, CFA 414.765.3752 Kenton Moorhead 414.298.1864 Favor 3PLs and asset-based names with secular themes as cycle matures. We identify three key elements signifying a transition from cyclical recovery to slow-growth expansion in the Transportation and Logistics sector: s Duration of cycle. Currently in 30th consecutive month of ISM diffusion index recovery from trough, versus 40-month average duration of cycle over past 50 years. s Moderating demand. Demand growth moderating across modes in 2011 following 2009/2010 cyclical recovery, consistent with a maturing cycle. Moderation in international airfreight and ocean freight, domestic truckload, and rail car loadings a function of strengthening prior-year growth comparisons and normalizing freight demand and inventory restocking activity. s Recent underperformance among early cyclicals. Asset-based truckers underperforming the broader market (Russell 2000 Index) after early-cycle outperformance, consistent with mid- and late-cycle performance. We would position investors for rotation into mid- and late-cycle names as cycle matures; favor 3PLs and asset-based names with secular themes (pricing, margin expansion). FDX (Outperform, PT $117) s Industry trends more favorable. Well positioned to benefit from favorable parcel industry trends, supported by both the growing industrial environment and more rational industry pricing. s Catalysts: include F12 guidance, which should remove investor overhang and reflect building earnings power. s Price target and valuation. Our $117 target price equates to 14.6x F13E EPS (vs 17x average 2004-2006), slightly below its average multiple. s Risks. Economic sensitivity, constrained growth in domestic express market, operates in a highly competitive industry which could be subject to price competition and deteriorating profitability. UNP (Outperform, PT $120) s Our favorite rail idea. We see a host of beneficial factors underlying our UNP thesis: strongest commodity group, capable of mid-single-digit volume growth; largest legacy repricing opportunity, providing above-market pricing growth potential over next cycle; and management’s 65-67% operating ratio target by 2015 should prove conservative. s Price target and valuation. Our $120 price target reflects roughly 14x forward estimates, one year out, a valuation multiple more in line with the S&P 500s average (15.5x 10-year average). s Risks. Competes in mature, cyclical industry, improving ROC key to thesis, potential liability exposure for hazardous materials movement, truckload competition in Intermodal, highly regulated industry potentially subject to further regulation, unionized workforce cost inflation/service disruptions.Robert W. Baird & Co. 21
  22. 22. June 21, 2011 | Baird RRTS (Outperform, PT $19) s Unique asset-light model. LTL brokerage (65% of revenue) offering well positioned to gain market share given its low-cost model, and LTL pricing dynamics improving. Though the stock remains a “show me” story, narrowing of valuation gap to 3PL peers provides further upside opportunity. s Price target and valuation. Our $19 price target reflects 17.5x forward estimates, one year out vs. 18-20x for its 3PL peer group. s Risks. Acquisition risk, reliance on third-party capacity, unique LTL brokerage margins with potential for margin squeeze (price in LTL, buy in TL), economic sensitivity, highly competitive market, limited public company experience.Robert W. Baird & Co. 22
  23. 23. June 21, 2011 | Baird Sector Commentary – Advanced Industrial Equipment Richard C. Eastman, CFA 414.765.3647 Robert W. Mason, CFA 615.341.7111 Favor stocks possessing margin expansion ability, defensive elements . Our AIE coverage list generally enjoys strong business fundamentals in the mid- to latter part of the business cycle. R&D budgets, which are significant drivers for our Test and Measurement and Analytical Instrument companies, can experience attractive growth as end demand solidifies. Rising industrial production/capacity utilization also spurs growth in productivity projects, and new capacity for our Automation companies, while rising production and utilization in general aids our aftermarket-driven Filtration companies. Near term, as investors adjust to what we view as mid-cycle slowing (mean reversion), we believe a rotation to more defensive growth could prove most beneficial to Filtration companies (CLC, PLL). We also favor MSA, which has exposure to employment growth (personal occupational safety) as a way to capitalize on an eventual recovery in employment growth. Additionally, we find each of these stocks particularly compelling because of specific, targeted underlying margin expansion efforts that could propel EPS growth above the normal mid-cycle trend. CLC (Outperform, PT $51) s Attractive aftermarket business mix . CLC derives ~80% of sales from disposable filtration products. We expect the business will perform well in a low-growth environment. CLC has an expectation (and history) of growth +2-3pp above GPD. s Increasing penetration in emerging markets, especially China (where CLC targets +30% growth), further supports CLC overall growth objectives. s Restructured I/E segment, but more margin runway . Following a multi-year restructuring and upgrading of it Industrial/Environmental (I/E) filtration operations, CLC has already raised the margin goal for this segment from 10% to 15% (Q2: 12%). If CLC tracks toward 15% by 2014, we believe CLC would generate attractive incremental profitability in the mid- to later portion of the business cycle. s Balance sheet can create value. CLC currently possesses ~$105M of net cash, providing the ability to also create value in a slower growth environment, via M&A, share repurchases. s Price target and valuation. Our current price target of $51 is based on 10X our FY12E EV/EBITDA, versus CLCs historical 8X-11X trading range. The shares currently trade at the low end of the historic EV/EBITDA multiple range, or 8X FY12E EBITDA. s Risks for CLC include the economy, ongoing success with productivity improvement programs, periodic patent litigation between industry participants. PLL (Outperform, PT $62) s Leading industry scale. PLL is the largest filtration/separations pure play by revenues, holding an approximate 7% market share. Pall has a tradition of participation in higher-value-added niche markets, product innovation, aggressive international expansion, and strong distribution.Robert W. Baird & Co. 23
  24. 24. June 21, 2011 | Baird s Growth opportunities. PLL’s strong market position in the Life Sciences less influenced by cyclical macro-economic considerations. PLL should benefit from new medical opportunities including blood prion removal filters, bacterial detection systems for platelets, and hospital critical care products. Biopharma growth should be driven by higher volumes of produced biotherapeutics/vaccines, adoption of single-use/disposable production technologies and emerging market customer growth. PLLs Industrial business has benefited from a cyclical recovery in microelectronics markets and general economic improvement. Demand in the commercial aerospace aftermarket has returned to growth military systems/consumables positioned for strong FY12. Other secular growth markets for PLL include Asia and municipal and industrial water markets/systems. s Strategic growth plan aims for higher margins. PLL’s four-year (FY10-13) financial plan targets EBIT margin of 19.5%-22.0%. Execution to date against the plan has been noteworthy from 13.9% starting point (FY09A) to current 17.4% (F3QA). Further, margin expansion expected from a combination of regionalized HQ structure, value-based pricing and SG&A leverage. Coupled with further reduction in tax rate, PLL’s FY13 targets equate to $3.77-$4.77 EPS, or +14%-28% CAGR from FY11E $2.89. s Price target and valuation. Price target of $62 assumes shares trade at 10X our CY-12E EBITDA forecast, within PLLs normalized five- and 10-year 9X-13X EV/EBITDA range. s Risks. Global macro-economy, in particular industrial production/utilization, FX, and execution of planned margin expansion initiatives. MSA (Outperform, PT $44) s Beneficiary of eventual employment recovery. MSA manufactures/sells high-end safety equipment to protect employees (employment driven). Industrial markets (process, oil & gas, power, non-res construction, aggregates, other) now about ~70% sales. MSA aims for sales growth of 10%+ (including General Monitors acquisition) from these core markets. We remain cautious on Fire Service spending due to U.S. funding concerns; however, with help from international demand Fire Service sales appear to be bumping along a bottom, “stabilizing.” MSA Military sales will improve this year due to sales of ACH3’s against a 12-15 month backlog. s Earnings power substantial. MSA delivered ~14% operating margin in CY05 largely resulting from a rich sales mix. We believe a realistic OP% opportunity/goal is a return to 14%; however, continued progress on streamlining/realigning the cost structure , principally in Europe, will be key to offsetting a more normalized forecast sales mix. Sales volume, leverage will also contribute. Achieving 14% GAAP OP% (sales CAGR +7%, four-year goal) would equate to about $3.50 in EPS in CY14. s General Monitors (GMI) attractive strategic fit . GMI adds leadership in fixed based gas detection products, technology/sensor, sales synergy with MSA portable gas detection products, sales and earnings accretion. s Past M&A activity/multiples validate attractiveness of Safety/Personal Protection market . Several notable transactions support interest in the space: MMM’s $1.2B purchase of Aearo (‘07, 11X LTM EBITDA) and HON’s $1.2B purchase of Norcross (’08, 12X LTM EBITDA) and $1.4B purchase of Sperian (’10, 11X LTM EBITDA). s Price target and valuation. Our $44 price target assumes shares trade at 9.5X our CY12E EV/EBITDA, the midpoint of MSAs seven-year 7X-13X EV/EBITDA trading range, reflecting expectations for improved operating margin in 2012, balanced by caution over CY11 U.S. Fire Service spending and continued progress on restructuring. s Risks. Industrial business cycle, government security subsidies, variations in secular growth rate, product liability.Robert W. Baird & Co. 24