Don't Overlook These 3 Powerhouse Stocks in 2023

The industrial sector could positively surprise investors in 2023. There's evidence to suggest that companies like 3M (MMM -0.66%), Caterpillar (CAT -7.02%), and Johnson Controls (JCI -0.25%) are set to generate significant improvements in cash flow generation this coming year.

Moreover, their current valuations are not reflecting the whole picture with regard to their underlying free-cash-flow generation. Therefore, investors should closely watch the industrial sector and all three of these stocks. 

Free cash flow matters

Free cash flow (FCF) is what's left over from net income after working capital (cash used to run the business) and capital expenditures are taken out. In other words, it's the flow of money in a year that can be used to pay down debt, make acquisitions, or return to shareholders through share buybacks or dividends. As a result, it's one of the key metrics used to value stocks. 

There's no hard and fast view as to what a price-to-FCF valuation should be, but as a rough rule of thumb, a multiple of 20 is reasonable for a mature industrial company. 

Based on Wall Street's 2022 FCF estimates for Caterpillar and 3M (and the actual number for Johnson Controls, which already finished its fiscal 2022), here are the price-to-FCF valuations for the three companies.

Data source: marketscreener.com, author's calculations. *Estimated. 

On this basis, Caterpillar and Johnson Controls look expensive. But here's the thing. All three look set to improve FCF next year significantly; if so, all three could be a good value at the end of the year. 

What happened to free cash flow in 2022?

It's been a challenging year for industrials. A combination of surging raw materials prices and ongoing supply chain issues bedeviled the sector in 2022. The supply chain issues aren't just restricted to increased transportation costs and companies paying higher prices to procure components in scarce supply. In many cases, industrial companies have endured increased costs due to disruptions caused by unavailable key components.

For example, Johnson Controls was forced to lower its full-year 2022 guidance in May as supply chain issues and inadequate semiconductor supply hit its margins. 3M started 2022 expecting $350 million to $450 million in raw materials/logistics headwinds for the full year, but it now expects a figure of $750 million to $850 million. Finally, Caterpillar's CEO, Jim Umpleby, said the company would miss its profit margin target for 2022 partly due to "supply chain constraints" and "ongoing inflationary pressures within manufacturing."

As a result, the earnings margin contracted as industrial companies were forced to pay high prices for inventory. Moreover, issues with delivering products meant they held more inventory relative to sales than they ordinarily would like. 

The second point is worth pausing on. All three of these companies have pushed through price increases in 2022, so margins should improve, and the highly priced inventory on their balance sheets (which is tying up valuable cash) should start reducing as a share of sales in 2023. As you can see below, all three turned over their inventory at a lower rate in 2022. 

Data by YCharts

Why they will grow free cash flow in 2023

Caterpillar's management expects the supply chain issues to moderate over time, Johnson Controls' management believes its supply chain will normalize in the middle of 2023, and 3M's management has already signaled that cutting costs of goods sold and improving working capital are significant opportunities for the company in 2023. 

As such, profit margins should improve, and so should inventory turnover (meaning less cash is tied up in inventory). These improvements are reflected in Wall Street analyst consensus forecasts and their implications for FCF growth and valuations. 

Data source: marketscreener.com, author's analysis.

All three are set to increase FCF significantly, and their current FCF-based valuations do not reflect their underlying FCF generation. As a result, the industrial sector could surprise investors in 2023, including these three companies.