Jeff Sprague on Bloomberg Radio

     JEFF SPRAGUE TALKS TO TOM KEENE ON BLOOMBERG SURVEILLANCE.

     OCTOBER 22, 2012

     SPEAKERS: JEFF SPRAGUE, CO-FOUNDER, VERTICAL RESEARCH PARTNERS

     TOM KEENE, HOST, BLOOMBERG SURVEILLANCE

     KEN PREWITT, CO-HOST, BLOOMBERG SURVEILLANCE

      TOM KEENE, HOST, BLOOMBERG SURVEILLANCE: Jeffrey Sprague. Years ago there were five, six, seven industrial analysts who quietly toiled away and provided terrific insights on as Dennis Gartman says things that fall on your foot and hurt. He is with a Vertical Research Partners, Jeff Sprague with decades of industrial American research. Jeff, good morning.

     JEFF SPRAGUE, VERTICAL RESEARCH PARTNERS: Good morning Tom. Thank you very much.

     KEENE: It's great to have you on. Isn't there a manufacturing renaissance in America?

     SPRAGUE: You know, I've kind of joked I think maybe we could use in our word. I think a renaissance might be a little too strong. Maybe it's rebound or renewal, but I think Renaissance is a little bit too robust of the word for what's going on.

     KEN PREWITT, CO-HOST, BLOOMBERG SURVEILLANCE: It seemed to be kind of the buzz back in the spring. Hey, look at manufacturing. Well, what happened?

     SPRAGUE: I think Ken what's happening is just the weight of the slowdown across the world is catching up with the United States and although I think it's fair to say that we are still the best house on a bad block it very clear that things have decelerated. That has been apparent here through earnings season so far.

     KEENE: I was mentioning your colleague in crime Nick Kamen with his enthusiasm and his uncertainty drifts away after the election. Can you be enthusiastic about industrials in the next year?

     SPRAGUE: I think you can. It's a slow grind now and I think although companies certainly have a preferred election outcome I think regardless of how it goes some of this delay defensiveness uncertainty will lift and companies will have to get up in the morning and drive their businesses and I think that should lead to a little bit of a bounce next year.

Certainly, inventories have been brought down pretty severely.

     KEENE: And man know what you learn from GE industrial and from everything else as well this distinction between reducing capital expenditures or investment versus deferring it, which is it? Are they reducing the money out the door to do things or is it just deferred?

     SPRAGUE: I think right now it's deferral. I think it could lead to outright reducing it if we get a couple of more shoes to fall. I think there's not a lot of momentum in the economy but right now the companies that I'm talking to are still talking about up CapEx for next year. They need to spend money to drive the businesses and that's still kind of in their operative agenda in the next year.

     PREWITT: Let me ask you about GE because for a few years there, there was a constant drumbeat of get rid of NBC Universal so they did.. Is there something else now that GE should get rid of?

     SPRAGUE: Well, I think you continue to see pressure to shrink the size of GE capital. Clearly GE capital is in much better shape than it was in 08 and 09 and doesn't in any way risk the future of the company so to speak like perhaps did back then but I think it will potentially be a drag on the valuation over time and not that they need to exit it entirely Ken but I think some of the consumer related businesses where you would just say there really is no synergy on the commercial and industrial side I think you can argue that they belong there.

     They know about aircraft engine leasing. They know about industrial products and some of those commercial activities I think they bring a lot to the table. On the consumer stuff I think it's still a bit of a stretch to be in those businesses longer-term.

     PREWITT: Is the problem with GE capital just reflective of that business? Or is there something specific at GE capital that needs to be fixed?

     SPRAGUE: GE capital is actually performing well this year and actually interestingly and I don't think people actually notice this is GE capital is a larger percentage of GE's earnings this year than it was last year. In a year that people are actually looking for industrial resurgence out of GE it's actually interesting to see capital take the lead in terms of earnings contribution. So capital is doing very well. I think it being over 50% of earnings through the first nine months of this year though is somewhat of a limitation on the valuation on the stock.

     KEENE: Jeffrey Sprague with us folks, Vertical Research partners. When you look at all of the different flows out there, is there a new wants for a niche within the industry that particularly strikes you?

     SPRAGUE: So as I was saying earlier, things are definitely slowed down, but we are seeing some pockets of relative strength. Nothing is immune. We are still seeing strength in global energy and petrochemical and US electrical markets particularly the utility grid in the US and also what we call energy retrofit work such as lighting upgrades air conditioning upgrades, things that actually save money and have pretty good paybacks.

     KEENE: I'm really glad that you mentioned that. I have the privilege of looking out on two skyscrapers going up here in New York City and they have all of this stuff on top of the skyscraper. All of that has to be green today to get anything done. Right?

     SPRAGUE: That is right. There is a lot of money that gets spent now on improving the efficiency of buildings and what is interesting as a growth driver though it is you look at that window and how many existing buildings you see relative to the one or two that are going up. So there's a huge installed base opportunity they're going back on that installed base improving the lighting, improving bearded conditioning.

     KEENE: Who is that? Is that Eaton?

     SPRAGUE: That's Eaton, Honeywell are really my two favorite plays into that.

     KEENE: Why Honeywell? Let's talk about Honeywell for a minute.

     SPRAGUE: Well, Honeywell had very strong results on Friday. Honeywell is just well-positioned at some of the crossroads of some important trends. They play industrial automation markets that continue to be strong. If they have this business UOP, which is positioned to capitalize on the boom in gas in the United States due to the fact that gas has become cheap and is a feedstock for petrochemicals. They play into that. So obviously cheap gas prices have hurt some people. Honeywell's business is benefiting from that bonanza and then they are very well positioned in energy efficiency type markets building controls in particular and energy retrofit work.

     TP: When we were talking about buildings, I didn't hear you mention United Technologies. There elevators, escalators,

air- conditioning.

     SPRAGUE: Yes, I like the way, Honeywell is positioned a little bit better than United Technologies currently although United Technologies will benefit from those same trends. In the very near term UTX is still dealing with some pressures in China that are more intense than what we are seeing it Honeywell but ultimately those secular trends do play that United Technologies pretty well.

     KEENE: Let's come back. Jeffrey Sprague with us. I want to come back and continue this discussion on manufacturing rebound, not a renaissance as he says. We can also talk to Jeff Sprague with us with his work on the state of security analysis. You can't make money in stocks. Honeywell at the last 10 years, do you want to make 12.5% per year?

     PREWITT: Why yes.

     KEENE: Why yes. Not bad.

     (BREAK)

     KEENE: Jeffrey Sprague with us, Vertical Research. And after a zillion years on Wall Street he retired. Ken, he went to the hall of shame for the Wall Street Journal beauty contest for cell sites people years ago. He won the award so many years. He said go away and so he's back with us. Jeff, how has it changed when you are on a conference call now.

This whole new zeitgeist of using cash, dividends, buybacks?

Is it a fad or is it a structural change among industrial management?

     SPRAGUE: No, I think there really is a structural change. There's just a lot more tension to cash deployment and importantly return on invested capital. Deploying the cash well whether it's into the company or returning it to shareholders and it used to be 10 or 20 years ago people wanted to know what they keep yes number was and that was kind of where the discussion ended and what is the PE on net EPS number. Now there's a lot more deeper analysis of what's truly going on inside his companies.

     KEENE: We talked to Greg Milano's this morning, he was doing that unlike a Stern Stewart kind of notepad thing at Fortuna Advisors and he makes clear it's almost the pendulum has gone too far. Are they giving up investment opportunities either domestic or international because they have to do a share buyback?

     SPRAGUE: I'm not seeing that in my space. As I said earlier my companies are still spending CapEx higher next year and they are active on the M&A front but there's a lot more balance. It's almost like an oxymoron in my group. I follow conglomerates so it they say focused conglomerate is kind of an oxymoron but what we see in my companies do is go from being very, very far-flung to distilling themselves down to maybe four or five businesses where they are really good.

This may be diverse businesses that at one high-level maybe don't belong in the same portfolio but they're keeping their business focused.

     KEENE: Ken, I know you want to jump in here but after beating Jack Welch to death, we ought to mention that Mr.

Welch essentially invented what Mr. Sprague just said. You don't want the number three to business.

     PREWITT: Jeff, as I look at GE here, five year net dividend growth -9.9%, does that get turned around?

     SPRAGUE: It starting to go the other way now. Obviously they cut it in the downturn will with what happened in GE capital in particular. They have kinda returned to somewhat normal level relative to the earnings of they're paying out about 40% to 45% of net income and from here you should expect the dividend to basically grow in line with net income whatever that number may be. I think next year you're looking at probably 8% to 10% net income growth and that's probably the dividend growth you get also.

     PREWITT: Soap with a current yield of 3.1%, and that's fairly high based on what we see elsewhere.

     SPRAGUE: Yes, it's a good yield. Yields like that are not uncommon in the industrial space now. You've got yields with three handles on them at the Emerson's and Eaton's and a lot of companies and this goes to the point earlier that these companies are generating a lot of cash and I think they're showing pretty balanced discipline in terms of how they deploy the cash.

     KEENE: I'm just looking at Emerson Electric. I'm not a shareholder folks but their dividend growth isn't good enough. Why does Emerson Electric five-year net growth a dividend 9% a year. That's not good enough is it?

     SPRAGUE: 9% a year is better than a sharp stick in the eye, isn't it?

     KEENE: Yes, okay. I'll go with that if you put it that way. How linked are these industrial companies to the well-being of the nation? How link are they to nominal GDP?

     SPRAGUE: I think they are pretty highly linked. These companies are showing great execution in finding a way to eke out growth in a challenging environment, but this earnings season we have heard from a lot of companies that for example September was not great either September was the weakest order month of the quarter or we didn't get our normal seasonal bounce in September or September fell off. So the something bad going off in this economy right now. We've gotten close to a stall speed. I don't think were tipping into recession but we could be dangerously close if there are one or two bad macro events here.

     PREWITT: Yes, speaking of which is all this change after the election or maybe after the first of the year? How are you factoring in other words the fiscal cliff into your assumptions here?

     SPRAGUE: It's very difficult and I'm basically assuming that we have adult responsible behavior regardless of who wins and we don't just naively go off the cliff kind of stupidly and if that's the case, then I think this massive inventory liquidation that we've seen going into the election, this sense of Crouch that companies have gotten into given the uncertainties can all lead to a little bit of a rebound next year regardless of who wins as long as we have some responsible political behavior.

     KEENE: Before I let you go, is there a shortage of available people for many of these skilled industrial jobs?

Do you buy the idea that there's a real shortage of labor?

     SPRAGUE: I'm not hearing companies say that at this point. You do here in terms of actual physical labor you to hear that around engineering talent and I think that maybe that's really. The engineering workforce has atrophied in the US over the last 10 or 20 years and hopefully it will become cool to become an engineer again at some point.

     KEENE: Had we do that just? You've been doing this for years. What is this nation need to do to make engineering, acuity, math, critical thinking required, how to we make that cool again?

     SPRAGUE: You're getting above my pay grade but I think you have to really celebrate the arts and sciences and encourage kids to pursue that and starts at a young age. I think it's a generational thing.

     KEENE: Jeff Sprague, thank you so much, Vertical Research, really appreciated. With a lead thought there I thought can in Honeywell. Honeywell seem to be the one stock he was reacting enthusiastically about.

     ***END OF TRANSCRIPT***

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