These three companies have a couple of things in common. First, they have rock-solid balance sheets, and according to Wall Street analysts’ forecasts, are set to generate lots of free cash flow in the coming years. Moreover, their valuations make them attractive stocks to buy. Here’s why aviation services company AAR Corp. (NYSE:AIR), industrial giant 3M (NYSE:MMM) and marine leisure company Brunswick (NYSE:BC) are good values right now.
Attractive free cash flow valuations
Free cash flow (FCF) measures how much money a company generates that management can use to do value-enhancing things for investors. It’s calculated after working capital requirements and capital expenditures are taken out of net earnings. Companies can use FCF to pay off debt (thereby reducing future interest payments), pay dividends, repurchase stock, or even fund acquisitions. In theory, at least, a company could use all its FCF to pay dividends. However, in reality, most investors would want management to invest in growing earnings, too.
For illustrative purposes, here are the estimated FCFs for these businesses over the next three years, and how they stack up relative to their market caps.
3-Year Cumulative Estimated FCF
Percentage of Current Market Cap
As you can see, all three look attractively priced. That said, the market knows these stocks are relatively cheap, and there are reasons why they are being discounted. However, I think that in each of these cases, the market is getting it wrong.
The marine leisure company has been one of the big winners from the pandemic. The social isolation measures taken to stem the spread of COVID-19 have ignited (or in some cases, reignited) an interest in boating among many people.
While that has boosted Brunswick’s sales of boats, marine propulsion systems, and aftermarket parts, the market seems worried that the sales surge might not be sustained as the pandemic eases in the U.S.
Thus far, though, those fears appear to be unfounded. For example, according to the National Marine Manufacturers Association (NMMA), new powerboat sales were up 32% on a rolling 12-month year-over-year basis through April. In fact, the real problem that manufacturers are having is that they are struggling to keep up with demand.
Moreover, Brunswick makes much more money from its propulsion and parts & accessories segments than it does from boats. For example, in 2020, the propulsion segment generated $286 million in operating earnings, and parts & accessories earned $275 million compared to just $70 million from boats. That’s important because outboard motors (propulsion) and parts & accessories tend to generate more recurring revenue over the lifetime of a boat.
As such, Brunswick can continue to generate long-term revenue growth on the back of the installed base of boats sold through 2021.
The pandemic has been challenging for this aviation services company, as the slump in commercial air travel hit it hard. Even though AAR has a substantial government and defense business, which accounted for 49% of its revenue in its fiscal 2021 third quarter (which ended Feb. 28), that wasn’t enough to offset the decline in its commercial business.
The market remains worried about the outlook for commercial aviation. However, the evidence suggests that passengers are coming back. Although flight departures are still significantly below 2019 levels (down by nearly 29% at the last weekly count), they are up 46% compared to this time last year. Meanwhile, AAR CEO John Holmes has been busy shedding the company’s non-core assets, such as its composites manufacturing business, to focus on growth.
In addition, AAR has been signing contracts to expand its aviation services business. For example, AAR expanded its relationship with United Airlines, inking a multiyear agreement to maintain the airline’s narrow-body fleet. All told, commercial aviation is coming back, and AAR is positioned to benefit from the industry’s recovery.
The multi-industry industrial looks like a good value on an FCF basis. If management’s efforts to turn around 3M’s operational performance by restructuring its healthcare business, cutting costs, and changing the way the conglomerate is managed bear fruit, then there’s significant upside potential. CEO Mike Roman certainly has the financial firepower at his disposal to accomplish those goals.
However, one reason investors might be apprehensive about buying this value stock comes from the company’s potential liabilities related to its manufacture of perfluoroalkyl and polyfluoroalkyl substances (PFAS).
While there are numerous lawsuits relating to PFAS environmental contamination, it’s far from clear what these will cost 3M, if anything. The market, though, appears to be assuming a drastic scenario. For example, Illinois Tool Works is probably its closest peer, and the two used to trade on similar multiples.
Based on Wall Street estimates, Illinois Tool Works trades at 26.6 times estimated 2021 FCF. Applying this multiple to 3M’s estimated FCF of $5.7 billion gives a target market cap of $152 billion for 3M. That’s nearly $35 billion above 3M’s current market cap. That looks like an overly steep discount to reflect the company’s potential PFAS liability. As such, 3M looks like a good value investing proposition.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.