The 3M Company (MMM) is a $30 billion diversified industrial manufacturing and technology company with a dominant presence in consumer, office, health care and other key industrial markets.
The company has established a productive capacity in over 70 countries and sells its products in about 200 countries. 3M is an industry leader in innovation — frequently launching over 1,000 new products per year — and operates a few dozen research laboratories worldwide. In total, 3M spends about 6% of revenue on R&D activities and generates about two-thirds of its revenue from international sales.
Due to its diversified product lines and enormous global distribution network, the company’s operations are commonly viewed as being predictive of the overall health of the global economy.
3M’s operations can be divided into five business segments: The Industrial segment, which accounts for about 35% of company revenues, sells a selection of automotive, electronics, paper and packaging, appliance, food and beverage and construction products. The Safety and Healthcare segment, which accounts for about 34% of revenues, sells a range of predominantly safety and security products to medical clinics, hospitals, pharmacies and dental clinics. The Electronics and Energy segment sells electrical, electronic and communications products to a variety of industries. Electronic and energy product sales account for about 17% of revenues. The Consumer segment, which is what the company is most well-known for to the general public, generates about 14% of revenues from sales of office supply products such as Scotch tapes, Post-it notes, Scotch-Brite cleaning abrasives, stationery products and construction and home improvement products.
Financial highlights
3M delivered solid financial results in 2015. Revenues held fairly steady at about $30.1 billion compared to $30.3 billion in 2014 while net earnings slipped a modest 2.5%. Per-share earnings, helped along by a 24.8 million share repurchase plan, rose a bit more than 1%. The outlook for 2016 is slightly better: management expects earnings per share in the range of $8.15 to $8.30, representing growth of 7.5% to 9.5%. This result will, however, depend largely on global currency changes. The dividend was raised to $3.42 in 2015, representing 20.2% growth and a payout rate of 54% of earnings. Assuming the dividend remains intact, this implies a current yield of about 2.5%.
Purchase considerations
3M is one of the best and most stable companies you can find anywhere, period! The company turns out solid operating performance and stock price gains almost every year. It has been able to fend off competitive threats time and time again and has never failed to generate positive “economic” profits. It is not easy to find a company with this type of record. While many of the company’s products are commodity-based products with little perceived differentiability, sales remain steady with production and cost advantages protecting margins. These production and cost advantages also seem to help the company outperform the competition during both economic expansions and contractions.
Management has an obsessive compulsion with innovation, both in regards to product development and production efficiencies — and we like it! Cash flows, cash flow yields and cash returns are fantastic and shared appropriately with shareholders.
That said, 3M is without question still sensitive to economic fluctuations. While generally holding up better during downturns, revenues and earnings will nonetheless be squeezed, and its stock price will generally follow. Being the prudent investor you are, prepare yourself. Also, revenue growth does appear to be slowing, and you can’t ignore this. Expecting rates of growth right now above nominal gross domestic product growth might be a little too optimistic. There is also the risk that 3M could go on a buying spree to do anything it can to boost the top line. While it has a fairly good record so far with acquisitions, hopefully, this doesn’t change as the firm gets more and more desperate. Also, note that 3M is no hidden gem. That is, the market knows very well how strong and successful this company is and how strong and successful it will likely continue to be. As such, its stock doesn’t come cheap — but no stock with this much value ever will.
Fundamentals-based technical valuation
Overview
Technical valuation provides a basis for evaluating stocks by analyzing the statistics generated by market activity, such as past prices. Most technical indicators do not measure a stock’s fair value but instead use charts and other tools to predict directional patterns and ranges in stock prices in an attempt to predict the future. In this section, we do precisely that; however, we use different types of technical indicators, what we call “Fundamentals-Based Technical Indicators.” That is, while each of the indicators relies on price patterns, price patterns are always viewed in combination with drivers of company fundamentals, such as business sales, earnings, cash flows or book value. Our combined use of historical price and fundamentals data is what separates them from their traditional technical counterparts in which the only thing that really matters is the stock’s past price and/or volume pattern.
Technical indicators
A brief description of each indicator is presented below, with results to follow.
Earnings calibration model: A forecasting method that calibrates the company's forward price trend with the company’s EPS trend using 15 years of quarterly price data. This method assumes that there will be no multiplier expansion or compression. Price is projected forward based on a moving weighted average of the firm's trailing 12-month earnings line calibrated to the last three-year, five-year, 10-year and 15-year periods. The stock's average annual trading range is used to establish upper and lower price bounds. If an investor believes that the firm's earnings multiplier will expand (compress), then they might want to adjust our price estimate upward (downward).
Least squares regression model: A forecasting method built using linear econometrics processes. Price is projected forward based on a linear econometric model built using 15 years of quarterly data. Explanatory variables include sales per share, earnings per share, free cash-flow per share and book value per share. Results are tested for statistical significance and projected forward based on estimates of sales, earnings, free cash-flows and book value.
Correlated time series model: A forecasting method built using various time-series processes, including MA, AR, ARMA, GARCH, GBM and BMMR processes, that model the 15 year quarterly historical correlations between the company's stock price patterns and the company's sales per share, earnings per share, free cash-flow per share and book value per share and then uses these correlations to forecast the company's future stock price pattern. The stock's annual trading range is used to establish upper and lower price bounds.
Neural network model: Price is projected forward based on the results of a proprietary neural network forecasting model. The neural net was developed, trained, and tested on the company's financial statements over the last 10 years. Pro forma financial statements are then incorporated into the neural net to generate estimates of the company's stock price two years forward.
1-standard deviation valuation bands: Valuations bands based on 1 standard deviation P/E (TTM) multiple (outliers removed) over the past 10 years applied to (1) trailing 12-months' earnings and (2) the market's earnings estimates for the next two years. A price line that trends within the upper and lower price bounds signals that the stock is approximately fairly valued.
Proprietary valuation bands: A forecasting method that helps identify the market direction of the company's stock giving investors a heads-up as to whether the stock is likely under or overvalued. This method involves the development of three price lines. A market price trend that exceeds the upper price bound is likely to fall in value or trend sideways until it is back within the upper and lower price bounds. At these times, do not expect much from your position. A price line that falls below the lower price bound might be a strong buy. At these times, expect the price line to trend upward until it is back within the upper and lower price bounds. The upper and lower price bounds and target price line are built using a closely held proprietary market based valuation model that simultaneously quantifies the simplicity/complexity of the business' operations, the extent to which the business' future is predictable, the strength of the firm's competitive advantage, the sustainability of the firm's competitive advantage, and the financial strength of the firm.
Results
Figure 1 below presents model results with prices forecasted forward two years for our first three models; Figure 2 presents results for our last three models.
Figure 1: Earnings calibration, least squares regression and correlated time series Models
Figure 2: Neural network model, 1-standard deviation valuation bands and proprietary valuation bands
Conclusion
The price estimates derived using each of these indicators with upper and lower price bounds are summarized in Figure 3. Average price estimates are compared to the market's estimates in the last three columns.
Figure 3: Estimation results and market estimates
Our earnings calibration model indicates a value of $190.76. 3M's current price trends below the lower price bound of $179.26 and is a bullish signal. Our least squares regression model and correlated time series models point to undervaluation, with 3M's stock trending below the lower price bounds of $180.12 to $180.92. The neural network model points to fair valuation, with 3M's stock price trending within the lower and upper price bounds of $160.25 and $183.26. Taking an average of all model results, we carry a NEUTRAL rating on 3M, setting a 12- Ă‚ to 24-month price target of $177.44 and a price range of $158.33 to $197.80. We recommend waiting for a bit of a price dip before taking a position (which hopefully will one day come!). But note that, while close, our estimates are slighlty lower than the market's consensus estimates. Perhaps there will be more reward in a postion than our analysis suggests.
Disclosure: We do not currently hold any positions in 3M.
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