It's not often when you can genuinely describe three of the highest profile stocks in the industrial sector as "unloved" or "ignored," but that's the case right now. In a nutshell, there appears to have been a flight to quality in the sector and that's left some of the less-fancied names like General Electric (NYSE:GE), Raytheon Technologies (NYSE:RTX), and 3M (NYSE:MMM) looking undervalued relative to their growth prospects.
By a quirk of coincidence, the stocks for all three companies currently trade on an individual market cap of around $100 billion. Here's why they are a good value for investors.
It's the free cash flow that matters
The thing that ties all three companies together is their future free cash flow (FCF). In layman's terms, it's the flow of cash in the year that a company has left over from earnings after working capital and capital expenditures are taken out.
In a nutshell, it's the "free cash" that a business has available to do all the value-enhancing things for shareholders, like buying back stock, paying dividends, investing in acquisitions, or paying down debt. As a rough guide, a price-to-FCF multiple of around 20 is seen as a fair value for an industrial conglomerate growing revenue in line with the economy.
The case for why all three are good investments is based on their FCF valuations.
The business generates a lot of cash and currently trades at a significant valuation multiple to its peers. The chart below compares 3M to its closest peer, Illinois Tool Works (NYSE:ITW). Both are multi-industry conglomerates with significant exposure to the auto industry. To be fair, ITW is a great business and I'm the first person to argue that it deserves to trade at a premium to 3M.
Moreover, 3M has potential liabilities from litigation over PFAS, a group of chemicals the company produced that are believed to be hazardous. In addition, 3M's execution and deliverance on guidance -- particularly in the healthcare segment -- has left a lot to be desired in recent years.
However, the question is how much of a premium does ITW deserve and how much should one discount 3M's performance?
Let's put it this way. If 3M traded on a 10% discount to ITW and we use a price-to-FCF multiple of 21.9, then based on this year's adjusted FCF ($6.7 billion) 3M's market cap would be $147 billion. That's a figure nearly $46 billion above its current market cap. Alternatively, using a multiple of 20 suggests that 3M is undervalued by $34 billion.
Frankly, those are huge numbers to assume for PFAs liability and a valuation discount, particularly as CEO Mike Roman is actively restructuring the company and reshaping the healthcare segment. Throw in a well-covered dividend (current yield 3.4%) and 3M stock looks like a good value.
2. General Electric
It's no secret that the commercial aviation market took a severe hit from the COVID-19 pandemic, and most observers don't expect it to return to 2019 levels until 2023. Knowing that, there's two ways to look at this. The first is to be wary of the lost revenue/FCF and the uncertain timeline of recovery -- something largely dependent on the subduing of the pandemic. The second is to look at it as a multi-year growth opportunity for companies like GE and Raytheon Technologies, as they will start from ground zero in 2020.
The investment case for GE is based on a combination of recovery at GE Aviation, ongoing solid FCF generation at GE Health Care, and multi-year improvement in earnings margin and FCF generation at GE Renewable Energy and GE Power.
The evidence from the latest earnings report is that GE is making progress on these objectives. Consequently, management guided toward FCF of $2.5 billion to $4.5 billion in 2021.
The midpoint of the range would put GE on a price-to-FCF multiple of around 27 times 2021 FCF. While this looks expensive, readers should note that GE is set for a multi-year recovery in FCF and it won't be until 2023 at the earliest that GE Aviation can expect to get back to the kind of $4.4 billion in FCF generated in 2019 compared to zero in 2020.
3. Raytheon Technologies
A similar argument applies to GE's aviation rival Raytheon Technologies. The two compete with engines on the Airbus A320neo family of aircraft. In addition, within commercial aviation Raytheon's Collins Aerospace also makes aerostructures, avionics, mechanical systems, power systems, and even cabins.
It's going to take time for Raytheon to recover, but in the meantime it will receive solid support from its defense business (missiles, defense systems, radar, intelligence systems, and space solutions including satellites). In fact, defense now makes up around two-thirds of total company revenue.
Management predicts a strong recovery in commercial aviation profitability beginning in the second quarter and is targeting $5 billion in adjusted FCF for 2021. That's a figure that would put Raytheon on a price-to-FCF multiple of 20 times projected 2021 FCF. That's a very good value for a company headed for ongoing recovery in FCF from commercial aviation. Throw in a 2.9% dividend yield and Raytheon is an attractive stock all round.