Goldman's Pair Trade: Illinois Tool Works Upgraded, Emerson Electric Downgraded

Joe Ritchie of Goldman Sachs stated in a note on Thursday that the Multi-Industry sector ("Multis") has seen its worst underperformance relative to the S&P index in 10 years. "Negative news is rampant, fueled by broad industrial destock, softening oil capex, the strong USD driving competitive changes, and importantly, a downshift in China," Ritchie wrote. "As a result, we expect growth to be challenged and forecast 2H15/FY16 organic growth of only -1.3 percent/+1.8 percent." Ritchie continued that with so many "potholes" ahead, investors should proceed with caution. Investors who are still looking for exposure to the sector should invest in names with "self-help" runway stories, improving returns, strong free cash flow, good execution and option value from the balance sheet.

Ritchie upgraded shares of

to Buy from Neutral with a new price target of $99. According to Ritchie, Illinois Tool is a "differentiated self-help story" that will likely drive top-quartile 2014-2016 margin expansion (115 basis points annually) and nine percent compounded earnings per share growth through the same time period. The analyst noted that the company has already expanded its margins by 160 basis points since 2012 and will continue doing so through improved sourcing, product line simplification, amortization roll-off. In addition, price/cost controls could offer a "material" tailwind as polyethylene prices have fallen 25 percent year to date and 19 percent since the end of June. Finally, Ritchie stated that unlike many of its peers, Illinois Tool does not need much topline acceleration to drive top-quartile earnings per share given its "self-help" opportunities while the company can also deploy part of its "significant" overseas cash towards M&A activity to drive further upside.

Ritchie downgraded shares of

to Sell from Neutral with a new $42 price target, despite the stock already underperforming his coverage by 12 percent year to date. Ritchie continued that consensus estimates for fiscal 2015 have already been cut by 12 percent while 2016 consensus estimates have also been cut by 22 percent since the beginning of the year. The analyst suggested that further downside risk to consensus estimates are possible as current estimates are "still too high." Ritchie added three key points to further support his Sell thesis: 1) consensus estimates are "under-estimating" the impact of longer oil prices on its Process business, especially pricing, 2) further restructuring is required to drive EBIT growth given structural weaknesses across the portfolio, and 3) B/S flexibility is "limited" and potential portfolio actions are likely to be dilutive. Ritchie finally stated that in order to become more constructive, he would need to see: 1) oil prices increasing higher than expected, 2) stronger incremental margins due to better pricing/mix/cost outs, and 3) potential accretive M&A "surprises" to the upside.