With approximately 84% of the Industrials sector having reported 4Q23 results, cash flows continue to be strong with a few subsectors contributing most of the strength. With overall spending up only modestly for the sector, fourth quarter free cash flows are indicating a continued healthy position for the sector with expectations for strong growth through 2025.
In the mosaic of company valuations, cash flow is one of the key metrics so we are checking in with FactSet’s data to see how the Industrials sector is performing. For the sector, operating cash flows continued to rise slightly in the fourth quarter. Street expectations are for a continued and solid rise of 8% in 2024 and 12% in 2025.
The construction machinery and building products industries have generated strong cash flow growth in the past few quarters. Their growth continued in the fourth quarter. Other industries with cash flows that have peaked and started to decline modestly include the transportation areas: rails, trucking, and air freight. Some of the shorter-term pressure on cash flows have been transient, which should support a recovery in 2024 in line with street expectations in the 8% range.
Free cash flow offers several investment insights and can often be a driver for performance. Companies with high free cash potentially:
Maintain higher levels of liquidity to meet financial obligations
Exhibit a higher level of return-on-equity, a quality factor
Grow their earnings, on a historical basis, at a relatively faster rate than the market given available funds for reinvestment
Free cash for the Industrials sector has been slowly growing over the past few years. Given operating cash flow growth, it is expected to continue growing through 2025 at mid-teens rates, on average. This is expected even though spending, which typically is around 50% of operating cash flows, is expected to continue rising much slower than cash flows at +3.4% in 2024 and +0.9% in 2025.
Free cash flow trends by subsector reflect higher operating cash flows and slightly higher capital spending. That is, free cash flow for the construction machinery and building products subsector has been strong, whereas the transportation area has seen a bit more weakness—though remains positive overall.
Free cash flow gives management flexibility with options of debt reduction, dividend increases, share repurchases, and business expansion. When balance sheet leverage is low or steady, debt reduction isn’t necessary, thus giving management even more flexibility. In the case of the Industrials sector, balance sheet ratios are in solid shape and are improving slightly from a traditional debt/cap standpoint. Debt-to-EBITDA, however, is strengthening noticeably, with the strength in cash flows and some sector debt reduction. Solid financial position and anticipated free cash flow mean balance sheets are less of an area of concern.
With most of the fourth quarter results in hand, and guidance and estimates being updated for 2024 (and, increasingly, 2025), we can get a good idea of embedded expectations in the sector. Cash flows and free cash flows remain healthy, led by the construction machinery and building products subsectors.
Expectations are that sector cash generation will continue to grow this year and next. Balance sheets for the sector, too, are in relatively neutral positions with free cash flow expectations helping to minimize concern about any financial tightness ahead. All these readings have positive implications for the sector and the macro environment.
Kenny Hui contributed to the analysis for this Insight.
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