Determining The True Value Of 3M
3M Co (NYSE: MMM) reported mixed Q2 2015 earnings on July 23. EPS of $2.02 was 1% above consensus, while revenue of $7.7 billion fell short of analyst estimated $7.83 billion. A strong dollar reduced sales 7.3% year-over-year, wiping out the 1.8% organic local currency growth. Operating margin improved despite these difficulties.
Prudena's models indicate that MMM shares are very slightly overvalued, though the current share price falls well within a reasonable range around the most likely value. The largest problem facing 3M is the dollar charge, which is a temporary headwind even though it may continue in coming periods. Overall, the company has strong prospects for stability, though investors have no reason to expect rapid growth or above-market price appreciation.
Assuming 8% required rate of return, 3M's current market price of $151.57 implies 3.01% long term residual earnings growth. This figure is supported by relatively high ROE and dividend payout ratio. Prudena's residual earnings model takes consensus earnings estimates and 5 year growth forecasts as inputs and assumes long term dividend growth in excess of 5%. Under these conditions, long term residual earnings growth is estimated at 3.0%. The residual earnings model estimates value per share of $140.08, 7.6% below the current market price.
A Monte Carlo simulation which accounts for input uncertainty in a residual earnings model returns a distribution of possible values ranging from $135 to $164, with a most likely predicted value of $147.64. Prudena's models indicate that the current market price is reasonable, though slightly over valued.
The Bull Case
3M's scale, diverse offering and broad geographic exposure provide stability for investors. The company offers products for wide range of industries and is therefore shielded from industry specific risks. Continued investment in technology will help 3M’s maintain successful results. 3M was awarded 3342 patents in 2014, and the company is planning to increase its R&D to 6% of the revenue by 2017 compared to 5.7% in 2014. 3M's scale and R&D creates a sizeable moat for smaller competitors across the various product categories. Innovation also provides opportunity for enhanced pricing power, which helped stimulate growth in the most recent quarter despite weaker-than-expected demand.
In Q2 2015, organic local-currency growth was positive for all segments except for Electronics and Energy. Despite FX headwinds and shrinking topline, operating income was flat and net income grew 1.0% during the first half of 2015. SG&A decreased 5.8% during the same period, due to cost control initiatives and efficiency gains.
Acquisition of Capital Safety, a personal protection equipment company, will increase the company’s relevance in the growing personal protective equipment industry. The company expects to benefit further from synergies as Capital Safety is tucked into 3M's scale. The award of smart grid automation contract by a European utility will act as a tailwind for the company’s Electronics and Energy segment.
3M's dividends grew in excess of 10% in 2014 and 2015. Moreover, the company is targeting $20 billion- $22 billion in share repurchases through 2020. For a diversified, mature business, investors will be attracted to these returns of capital to shareholders.
The Bear Case
The strong dollar will continue to negatively impact 3M's sales and margins, as nearly 65% of revenue is generated abroad. Despite organic growth in several segments, 3M recorded a decline in revenue after accounting for currency fluctuations. The Electronics and Energy segment is experiencing weak demand for display material and systems. Due to these short-term headwinds, the company has cut its revenue and earnings guidance. Slow economic growth in China, Western Europe and Latin America is adding to the topline pressure.
Despite falling off YTD highs around $170, 3M's valuation metrics do not indicate a cheap entry point. Their PEG of 2.02 is above that of Honeywell's (NYSE: HON) 1.6 PEG ratio. 3M's forward P/E of 17.3 is higher than Honeywell's and GE's (NYSE: GE), which are 15.6x and 16.9x, respectively. 3M's 2.73% dividend yield is lower than GE's (3.56%) and Seimen's (3.5%).
Investors may begin to seek stable companies with attractive dividend yields as the current multi-year bull run decelerates and the Fed appears increasingly likely to raise rates. 3M offers stability through geographical diversity, competitive advantage supported by a massive research budget, end market diversification, and suitably low-risk balance sheet. A respectable 2.73% dividend yield is sufficient to attract long-term value investors looking for an income play.
The company is currently experiencing significant negative impacts from a strong dollar, a trend likely to continue in upcoming periods before abating. Controlling for this headwind, 3M looks like a very straightforward modest growth play. Any long position or bull thesis would have to hinge on value, and it appears that other options are more or similarly attractive, despite 3M's stable outlook. Investors could make an argument that MMM has a place as an element of a highly diversified defensive portfolio, but there is nothing particularly exciting about shares at this price.
The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.
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