Weak industrial fundamentals hurt organic growth
The industrials sector (IYJ) has seen an environment of weaker organic sales since 2015. With these conditions expected to persist through 2016, most industrial conglomerates have been bracing for another year where the impact of reduced currency translation and low raw material prices fail to offset organic declines in sales. Therefore, companies with the willingness and capacity to finance deals have been looking for external sources of growth. As a result, 2015 saw a pick-up in mergers and acquisitions in the industrial (RGI) space with companies like 3M (MMM) and Honeywell (HON) recording billions of dollars worth of acquisitions. 3M made acquisitions to the tune of $4 billion in 2015.
MMM’s capacity to make acquisitions
3M repurchased shares worth $5 billion between 2014 and 2015, acquired $4 billion worth of companies in 2015, and plans to acquire $4 billion–$6 billion worth of shares in 2016. Despite these capital deployments, 3M currently maintains an investment-grade credit profile on its long-term debt thanks to massive cash generation in its core organic businesses. It has an AA- credit rating with a stable outlook from Standard & Poors and an Aa3 credit rating with a negative outlook from Moody’s Investor Service.
The consensus fiscal 2015 estimate is for MMM to generate adjusted net profits $5.1 billion. Assuming the mid-point of free cash flow conversion guidance of 95%–105%, free cash flows for the year are likely to be ~$5.1 billion. Adding cash holdings of $1.3 billion to $5.1 billion free cash flows, we get ~$6.4 billion. Thus, accounting for share repurchases, 3M can still make acquisitions in the $1.6 billion–$3.6 billion range without taking on additional debt or affecting its credit rating.
Investors interested in trading in the industrials sector could look into the Industrial Select Sector SPDR ETF (XLI) and the iShares US Industrials ETF (IYJ). Major holdings in IYJ include Honeywell (HON) at 3.3%, 3M (MMM) at 3.9%, and General Electric (GE) at 11.5%.