The Electrical Equipment Industry consists of companies that make a range of products for a diverse customer base. This sector is fragmented, but there are a few members that lay claim to a sizable portion of sales. Products include electrical motors, commercial and industrial lighting fixtures, heating, ventilation and air conditioning systems and components, and, among others, electrical power equipment. Operating structures involve high fixed costs. Too, copper, aluminum and steel are essential raw materials used in the manufacture of products. (Fluctuations in commodities prices can have an impact on the group's earnings performance.) The industry spans all corners of the world, and it is subject to the influence of the macroeconomic cycle.

A Global Sector

Equipment companies primarily serve the mature markets of North America and Europe, but they have found growth venues in the emerging world. Expansive global coverage helps to smooth the effects of the broader business cycle. Capable management is required to oversee long distribution networks and far flung operations.  In recent years, companies have established more overseas brick-and-mortar facilities, which has allowed them to better serve local markets economically and limit the negative impact of foreign currency exchange. Emerging nations have provided an impetus for growth and low-cost labor, production and land.

Economic Factors

Top- and bottom-line trends in the industry often track the broad economic cycle. During periods of prosperity, when they are flush with cash, customers are comfortable expanding their capital budgets and spending on electrical equipment. At times, when there is uncertainty as to the direction of the economy, those controlling the purse strings delay spending decisions, which can hurt short-term operating results. When business conditions are very challenging, customers may pull back dramatically on equipment orders. Companies try to repair and replace equipment during regular, seasonal or cyclical slack periods. Often, managers will attempt to extend the useful life of equipment as long as possible.

Key Business Indicators

There are some key indicators of the industry's prospects. The Institute of Supply Management's Purchasing Managers Index provides a near real-time view of manufacturing production, employment levels, new orders, supplier deliveries and inventory turnover. A reading above 50 indicates expansion, and one below that figure marks a manufacturing contraction. Durable Goods Orders, released by the U.S. Census Bureau, is another important statistic. Such consumer goods last three years or more and are relatively expensive. Month-to-month trends are a good indication of whether the economy is cycling up or down. Additionally, the Federal Reserve Board regularly releases capacity utilization figures. Utilization is high when demand is strong and low when demand is weak. Capacity utilization rates above 80% suggest that equipment spending will rise; such levels may also indicate that inflation will increase.

Company-Specific Measures

Electrical equipment shipments, orders, and backlog provide a fairly accurate indication of an individual company's sales prospects. Rising orders help to build backlog and lead to higher shipments and sales. Order cancellations, however, can accelerate top-line declines. Plant utilization lends insight to a company's pricing power and earnings potential. Also, product quality and ease of integration (into manufacturing systems) will influence demand, pricing and profits.

Operating efficiency is crucial for these companies to succeed. For the most part, the industry's operating margin ranges from 10% to 20%. Some leaders achieve margins in the 30s and 40s, and a few, with profitability measures in the single digits, lag behind. Popular efficiency and cost-reduction methods include Six Sigma, Lean Manufacturing, Best Practices and common production platforms. Effective hedging strategies can bring volatile commodity prices under control.

In most cases, research and development expense is less than 5% of sales. Nonetheless, R&D outlays are important to the industry. Innovation allows a company to improve its competitive position. Managements work to keep up with shrinking product life cycles and attain standardization to maintain cohesiveness and save money.

Generally, net margins hew close to 10%. For equipment makers with little or no debt, net margins about match operating margins. Those with significant debt obligations often have net margins in the single digits. Managements tap the equity and debt markets, and use cash, for expansion and acquisitions, depending on the comparative cost of capital and their tolerance for risk.

The industry has a history of substantial merger and acquisition activity. Scale is important to profitability. Only a handful of the companies included in our grouping have annual sales below $1 billion. Acquisitions offer access to new markets and products, as well as ample cost synergies. Usually, the larger the company and the more extensive the record of buyouts, the less risk there is to investors.

Final Thoughts

These stocks are best suited to those seeking relatively steady, long-term capital appreciation. Some issues offer a decent dividend component. Investors should monitor the business cycle for the best entry point, preferably taking a stake at the start of an upturn. Momentum investors will find opportunity in the midst of a firm market recovery or expansion.