Industrial giant 3M (MMM -0.27%), heating, ventilation, and air conditioning (HVAC) company Carrier Global (CARR -1.26%), and tool maker Stanley Black & Decker (SWK -0.72%) have two things in common. First, they are Dividend Aristocrats, and second, they are all companies trading on good valuations with plenty of potential to surprise investors on the upside in the coming years. Here's why they all deserve a look for your portfolio.
Valuations are favorable
The case for buying the three Dividend Aristocrats is based on the idea that they are all a good value on a price-to-free cash flow basis. Moreover, their respective management teams are positioning them for good long-term growth thanks to a combination of substantial cost cuts and restructuring.
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Let's start by looking at valuations, specifically price-to-free cash flow (FCF) based on Wall Street Analyst forecasts and management guidance. FCF is important because it represents the actual cash generated in a year by the company that can be used to pay back debt, make share buybacks, or pay dividends.
As a rough guide, a price-to-FCF of around 20 is typically a good value because it means a company is generating 5% of its market cap in FCF -- so, theoretically at least, it could be a 5% dividend yield. As you can see below, all three companies are set to grow FCF in the next couple of years, and they trade on attractive valuations. Now let's turn to why these companies are set to increase earnings and FCF and why they have upside potential.
Data source: Company presentations, marketscreener.com, author's analysis.
Investing in Stanley Black & Decker stock
This company's DIY tools sales have benefited from the stay-at-home measures imposed in 2020. There's been a surge in demand for tools, and Stanley's leadership position in e-commerce means it was uniquely positioned to benefit from it. Moreover, Stanley's investment in its Craftsman DIY tools brand -- purchased from Sears in 2017 -- is paying off ahead of expectations.
While growth rates in tools may well slow in the future, Stanley's industrial tools sales should bounce in 2021, and its security business has a long-term growth opportunity due to the renewed focus on healthy and secure buildings created by the pandemic. In addition, management sees ongoing growth in Craftsman, and from its investment in MTD (lawn and garden products).
Meanwhile, Stanley's margins are expected to expand due to cost cuts and the potential for external headwinds (from tariffs, commodity costs, and foreign exchange movements) to dissipate in the future. The headwinds cost a combined $1 billion over the last three years, so their potential disappearance could boost margin.
Moreover, there is an opportunity to cut costs by "$300 million to $500 million over the next 3-year period," according to CFO Don Allan on the recent earnings call. To put these figures into context, Stanley's earnings before interest, taxation, depreciation, and amortization (EBITDA) is set to be around $2.5 billion in 2020.
All told, a combination of mid-single-digit revenue growth, internal cost cuts, growth initiatives, and more favorable external costs means Stanley is an attractive stock to buy.
Investing in Carrier Global stock
Carrier makes the list of Dividend Aristocrats by being part of the former United Technologies. Of the three industrial companies created out of the breakup (the others are Otis and Raytheon Technologies), Carrier had the most to gain. Not only is management free to engage in long-anticipated consolidation in the HVAC industry, but it also has a plan to cut annual costs by $600 million to $700 million by 2022.
Image source: Getty Images.
Analysts expect Carrier's operating profit margin to increase from 13.1% in 2020 to 15% in 2022. However, it isn't just a story of cost-cutting, because the HVAC market is a growth story in itself. Climate change, increasing urbanization, and growing middle-class numbers in emerging markets are all acting to drive long-term demand for the industry.
Meanwhile, higher-quality HVAC providers like Carrier are better positioned to offer digital technologies and also more environmentally friendly equipment. Throw in the increased focus on clean and healthy buildings (particularly air changes in offices), and Carrier has a long runway of growth ahead of it.
Investing in 3M stock
3M's ongoing FCF will enable CEO Mike Roman to carry on restructuring it with a view to creating value for shareholders. There's no doubt that 3M lost its way in recent years, with margins facing pressure amid a succession of lower-than-forecast earnings reports.
Roman is taking action to restructure how the company is run by cutting its segments from five to four, implementing wide-scale enterprise resource planning rollouts, and running business groups on a global rather than a country basis. Meanwhile, two major acquisitions have been made in healthcare (intelligence systems and wound care), and management continues to prune less profitable business like its drug delivery business and possibly food safety as well.
All told, you can think of 3M as a decent value investment, carrying a 3.4% dividend yield, and coming with a "free bet" on Roman managing to improve revenue growth and margin. On a risk/reward basis, investing in 3M makes a lot of sense.
