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Industry Analysis: Precision Instruments
The Precision Instruments Industry is a rather fragmented, cyclical sector that serves consumers and a whole host of manufacturers and industrial businesses. Diversity is certainly this group’s hallmark, as the companies under our review run the gamut from small-cap providers of capital goods and/or services to various manufacturers to large entities that derive the bulk of their sales from consumer products. Precision instrument makers operate domestically and internationally. Many generate more than half of their annual sales overseas.
Global expansion is a key focus. Managements ensure sufficient funding of product development in hopes of gaining a greater share of the benefits of spreading affluence around the world. It’s important to note, however, that a substantial dependence on foreign business entails increased susceptibility to currency fluctuations.
Of course, a weak U.S. dollar, relative to other major currencies, lifts demand for domestic products and increases sales and net profit. A strong American dollar can be a drag on overall results.
The products and services of Precision Instrument companies are often in particular need when manufacturers boost production capacity. Such requirements usually intensify after the economy has been expanding for a few years and existing facilities become constrained. But even in challenging periods, industrial manufacturers depend on testing and measuring devices and equipment in the development of new products, cost management, quality control, and other efforts to improve operating efficiency and competitiveness.
Government regulation, imposing safety and emissions standards for example, can be another positive influence on precision instrument demand. Too, many companies in this sector serve the sizable defense market. The Pentagon’s annual budget, and those of foreign governments, can provide a good stream of business. Significant military conflicts will notably lift product demand. Year-to-year earnings are rather volatile due to business cycles and the changing health and politics of governments.
Consumer Derived Demand
Like many other sectors, industrial demand is dependent on the ebb and flow of personal consumption. On point, the number of people employed can determine demand for our group’s goods and services. When the economy is slowing down or in a recession, the level of employment is likely to come under pressure. But when times are good, unemployment typically falls and consumers feel more comfortable in opening their purse strings. Spending is affected by the degree of consumer confidence, a measure of the public’s perception of the economy’s well-being. If consumer confidence is low, people are particularly cautious with their finances, but when the mood is sanguine, spending is much freer.
Additionally, consumer debt obligations can indirectly affect demand for Precision Instrument offerings. Not surprising, heavy credit loads, as a percentage of income, suppress spending, and light burdens promote product accumulation.
When the world economy is strong, profit prospects are rosy as well, thanks to healthy demand and firm pricing. During such times, companies in this industry will use excess cash for bolt-on acquisitions and/or product development.
Conversely, in difficult economic times, especially when credit markets are tight, corporations will slash their capital budgets and try to preserve cash. Precision Instrument makers react to such a situation as many of their customers do.
They implement cost-cutting programs, which may include plant closures and consolidations, headcount reductions, and administrative and manufacturing process improvements. Work shifts might be eliminated and certain production lines transferred to low-cost locations. Managements attempt to bring supply in line with demand to protect profitability.
Because of the diverse nature of this industry, operating margins vary widely from company to company. Generally, scale is important, and larger companies often are more profitable. Those that are more labor intensive gain from a presence in economical offshore markets.
Cash flow is an important financial consideration of Precision Instrument companies. Strong cash flow enables management to adequately fund research and development, day-to-day operations, debt service, business acquisitions, stock buybacks and dividends.
Depending on the types of markets served and products and services offered, companies in the group have debt burdens ranging from none to half of total capital. When in expansion mode, managements will also issue stock to supplement cash funding. Only about one-quarter of Precision Instrument manufacturers pay a dividend, and those that do typically have very modest payouts.
We advise investors weighing a stake in these companies to focus on historical and projected sales, cash flow and earnings growth trends. Such measures are found in the Annual Rates box on the Value Line page.
Given the cyclical nature of Precision Instrument stocks, it’s probably best that only adventurous investors tread here. Although the equities in this group usually carry Safety ranks of 3 (Average), most of them have low marks for Price Stability and Earnings Predictability.