Saturday, July 24, 2010

3M - Do You Believe?

3M (NYSE: MMM) has been a pretty good stock for me over the last five or so years, giving me an incremental 25%+ return relative to the S&P 500. What attracted me to the stock initially, and what remains a centerpiece of my thesis, is the nebula of doubt that seems to hover around this stock - although the stock is now a consensus "buy" by the analysts, a lot of people seem to just be waiting for 3M to slide back to its old self and be a serial underperformer again.

3M's second quarter results were pretty solid, as the company pre-announced that they would be.

Revenue was up 18% yoy and up about 6% sequentially. All of the company's operating segments grew - with Display/Graphics and Electro/Comm each growing more than 30% and Consumer/Office and Health Care both growing less than 6%. Overseas growth was robust in Lat-Am and China.

The one point of concern? Pricing was down about 0.6% as the company acknowledged cutting prices in some cases to maintain market share. I am not really sure what, if anything, to make of this - a sign of oncoming deflation? A sign of competitors getting desperate? A sign of 3M falling behind in product positioning? Or a sign that 3M's cost structure is getting better and the company can afford to cut prices?

Although I am a little nervous about whether the company can keep pricing in Display/Graphics from falling off, none of this really worries me today. That is mostly because of the company's market share in films - they are far ahead of the likes of Tyco (NYSE: TYC) and Nitto-Denko.

Profitability was pretty good as well. Gross margins were flat (not bad considering rising input costs) and operating margin ticked up a bit. Importantly, all of the company's units posted operating margins above 20%. In other words, there really are not any "problem children" in the mix right now.

The big debate on 3M is whether or not the "new 3M" is real and sustainable. Company management has put out bold targets - moving organic revenue growth from a traditional level of 3-4% to 7-8% a year. For a company of 3M's size, that is no simple feat. Management seems serious, though, and has moved to change company culture (much as I hate that term/concept) and invest in both R&D and advertisting.


If the skeptics are right, we are probably close to seeing peak margins from 3M, and the company will then start to suffer from flagging growth and sagging margins - a one-two punch that will not be pleasant. On the other hand, if the believers are right, this is just the beginning of a new, more dynamic, 3M.

Right now, I am a cautious believer. I do believe that 3M has restructured itself and has a very real chance of boosting both margins and cash flow, but top-line growth as well (in the 6% range, perhaps). The company has footholds in numerous attractive growth markets and I would frankly like to see them spend even more on R&D.

Assuming roughly 6% top-line growth for the next five years and a gradual improvement in cash flow margins, I think the shares are worth $100. A bad-case scenario, 4% revenue growth and a decline back to the 10-yr average cash flow margin, puts a down-side valuation of about $75 for the shares.

$100 is not enough, perhaps, to recommend purchase, but it is enough for me to stay on board as a shareholder.

Disclosure - I own shares of 3M.

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