Equipment shares shine

Early December saw ACT's Heavy Equipment Index hit a new high of 115.72 points. This high coincided with peaks for the year for the Dow, NASDAQ and S&P 500, but as the graph shows, these highs were much less pronounced.

The mini peak was largely attributable to oil prices, which managed to stay below $60 per barrel. Not exactly a fall, but the fact that it did not rise as winter set in and demand for fuel increased clearly cheered Wall Street.

If the situation continues for the final weeks of the year, there seems a good chance of the major indexes recording some net gains for 2005. While these will not be massive - probably 1% to 2% for the Dow and about 5% for the NASDAQ and S&P, a gain is still a gain.

But the fortunes of the US markets are poor compared with other parts of the world. The Japanese stock markets have had a magnificent year, particularly the second half, and net gains for 2005 are likely to be in excess of 30%.

The European bourses have also had a good 2005, with the FTSE 100, for example, up about 14% for the year.

Although the wider US markets have had a nondescript year, the nation's heavy equipment manufacturers have faired well. Profitability in the sector grew with sales throughout 2005. Operating profits are running at about 8% to 9% of sales, a marked improvement from the 4% to 6% levels seen in 2004.

Key has been the manufacturers' ability to pass on higher costs to customers, particularly those relating to rising steel prices. There is also some evidence that production capacities have increased, allowing more orders to be fulfilled quicker. This has the double benefit that the sooner manufacturers can work through their backlogs, the sooner they can start delivering higher priced machines ordered after list price increases.

Whether profitability continues to improve in 2006 remains to be seen. Based on third quarter results, profits are still growing, but that growth is clearly tailing off from the peak in the middle of 2004. At the current rate of decline, revenue and profit growth will be flat by the end of 2006 or early in 2007, but by that point, average operating profits in the industry could be as high as 10%, and the net margin will likely be above 7%.

Outlook

With that background, equipment share prices can be expected to continue to rise for the early part of 2006 at least. It is clear, however, that a downturn is on the way, and that will make the markets nervous, and perhaps over-sensitive to poor profits. The annual results season in late January and February is the next crucial hurdle but, judging by results for the first three quarters of the year, there should not be any nasty surprises here. More important will be quarterly results throughout 2006.