"Acquisition activity and payouts to shareholders may increase, offsetting any improvement in cash flow and financial leverage and resulting in a generally stable rating environment within the context of Fitch's forecast for real GDP growth of 3.3 percent in the U.S. during 2005," the rating agency said.
Economic conditions remain favorable across much of the diversified industrial sector as was evident from financial results reported through the third quarter of 2004. According to statistics issued by the Department of Commerce, seasonally adjusted manufacturing profits in the second quarter of 2004 were $94.8 billion annualized, compared to $67 billion in 2003 and $51 billion in 2002.
Fitch said, "Strong demand has contributed to revenue growth and improving margins and appears likely to continue through 2005. The rate of revenue growth may taper off in 2005 as comparisons become more difficult, but there have been few indications that the current rebound in industrial production and services is at risk of fading any time soon."
The rating agency said in certain markets where there has been some recent weakness in order rates, for instance in electronic components, "anecdotal evidence suggests that lower orders reflect temporary inventory adjustments and that longer term growth rates remain favorable, albeit lower than the early part of 2004."
Exceptions to the positive tone for end-markets served by diversified industrial companies include automotive-related sectors as well as commercial construction, power and utility, and equipment rental markets that may have bottomed out but have yet to see significant improvement, Fitch said.
Alongside the positive news surrounding operating performance, rising raw material costs, primarily steel and energy, are affecting most segments of the industrial economy and promise to continue having a negative impact on margins in 2005.
"Despite these cost pressure, margin trends typically have increased due to strong demand and better operating efficiency, more than offsetting the effects of raw material costs. In contrast to an inability to raise prices when the economy was weak, companies have been able to pass through a portion of higher raw material costs to their customers although price sensitivity remains in certain markets," Fitch said.
"This process cuts both ways, however, as fixed price contracts for the purchase of raw materials such as steel can be repriced at higher rates as the contracts mature," the rating agency said.
Fitch said balance sheets are in relatively good shape, especially considering the difficult economy that many companies previously endured.
Actions to sell unproductive assets, rebuild margins and boost returns on capital have contributed to solid cash flow and the ability to reduce debt and build cash balances even as cash is used to fund pension contributions and healthcare costs. High cash balances serve as a cushion against potential disruptions in the capital markets and there have been few signs that industrial companies plan to reduce cash balances materially.
Fitch added, "Through the first nine months of 2004, most companies have reported stable-to-increasing expenditures, and declines have been relatively infrequent. Industrial capacity utilization reflects this trend, having risen to 77 percent from a cyclical low of 74 percent during 2003."
The current level, Fitch said, while not considered strong compared to utilization rates above 80 percent prior to 2001, indicates that modest capital spending can reasonably be expected as the economy continues to grow.
"Where companies have pursued strategies of providing customized, highly engineered products and services, as opposed to volume oriented machinery or equipment, an increasing proportion of costs, typically Research & Development, has been expensed, rather than capitalized as occurs in the more traditional manufacturing model.
"This engineering-centered approach also involves shortening product life cycles to stay current with evolving technologies that are important to customers, thus encouraging these companies to measure their competitiveness by the proportion of new products in their portfolios," Fitch said.
As a result, although future capital expenditures can be expected to increase with economic growth, they may be lower than might otherwise be expected as industrial companies invest in R&D and continually restructure their operations to keep pace with changing customer demands and competitive pressure, Fitch added.