Industrials, after a period of outperformance, are suddenly unpopular. Specifically, 3M (NYSE:MMM) and Illinois Tool Works (NYSE:ITW) were down 5.4% and 8.0% respectively, after reporting impressive earnings. Both companies continue to expect strong organic growth, and the dip on earnings represents a buying opportunity.
As large companies with ongoing acquisition activity, MMM and ITW report organic growth statistics as a way of verifying the fundamental health of their operations, and measuring the extent to which growth can be achieved without a constant influx of acquisitions.
From MMM's 2Q 2011 earnings conference call transcript:
Netting all of these factors together, we continue to expect organic sales growth will be in the range 6% to 7.5%, including an expected 1% drag from Japan. No material change versus our prior expectations. So for 2011 in total, putting this together with the acquisitions, price and a more positive currency outlook, we're expecting strong double-digit growth with revenues easily eclipsing the $30 billion mark for the year. We now expect that per share earnings will be between $6.10 to $6.25 range versus a previous expectation of $6.05 to $6.25. So we're taking up the low end by $0.05. All in all, after a good second quarter, yet slightly tougher economic picture, we believe this is the right way to think about 2011.
From ITW's 2Q 2011 earnings conference call transcript:
Organic revenues increased 6.3% versus the year-ago period, but underperformed our original forecast to 7.5%. A combination of modest slowing in industrial production metrics in both Europe and the U.S., along with the Japanese crisis, translated into a bit slower growth in the second quarter. However, it's important to note that we firmly believe our overall end markets will continue to be in a long-term recovery mode.
When expected growth from acquisitions is factored in, growth of 7% or more is likely. John Neff observed that 7% growth adds up over time, but gets no respect from the market.
From a short-term point of view, the market looks at expressions like "slightly tougher" or "a bit slower" with distaste. There is very little tolerance for headwinds. From a long-term point of view, management's previous track record, when combined with confidence about organic growth going forward, suggests that patience will be rewarded.
"Organic" gets a lot of favorable attention when applied to agricultural methods or products. It deserves similar respect when applied to growth prospects: Organic is best.
For MMM, using three years' actual earnings, 2011 midpoint guidance of $6.19, and a 2012 projection of $7.01, I arrive at projected five-year average EPS of $5.66. Applying a historical average multiple of 19.1 to this metric, I develop a midpoint target price of $108 by year end 2012.
Applying the same line of thinking to ITW, with a historical multiple of 17.26, suggests a midpoint target price of $56, again by year end 2012. However, looking for $4.00 EPS in 2012, and observing a 10-year average P/E of 17, I think the market will eventually pay $68 for the shares. Going back to the year 2000, the shares have always traded above a P/E of 17 at some point during the year.
Strategy and Tactics
At today's prices, an investor has a realistic expectation of receiving dividend income and eventual share price appreciation. Michael Gayed recently wrote an article pointing out sudden underperformance by the industrial sector. The market as a whole is apprehensive and unpredictable, given the uncertainty around debt ceiling negotiations and the fears of contagion from Greece in the eurozone. Investors will need to develop their own opinions of future market trajectory when selecting entry points.
I've been playing these industrials by means of diagonal call spreads, long deep in-the-money LEAPS and short out-of-the-money calls with shorter durations. Starting with MMM in September 2009, this strategy has an internal rate of return of 66%. For ITW, starting September 2010, the strategy has an IRR of 24%, not bad considering yesterday's steep (and in my opinion unwarranted) decline. In the wake of the decline, I adjusted my positions in ways that increase my exposure.