Shares of 3M (MMM) have seen a recent correction after shares have seen significant momentum so far this year. One of the triggers was the release of a bearish research report from analysts at Morgan Stanley which are very cautious on the prospects for the industrial conglomerate.
Given the huge run-up so far this year, and the premium valuation resulting from this move, I remain very cautious in accordance with Morgan Stanley. The short to medium term appeal is limited, although 3M remains a very well-led company in the long run.
Morgan Stanley Turns Cautious
Analyst Nigel Coe from Morgan Stanley (MS) lowered his recommendation for 3M from "Equal-Weight" to "Underweight", while lowering the price target by merely a dollar to $122 per share. The new price target, in combination with the run-up in the share price recently suggests Coe sees some 9% downside potential from levels at which 3M has been trading before the downgrade.
Coe appreciates the attractive end market footprint, with the solid mix of global sales. Yet 3M shows below-average core growth in cyclical upswings according to Coe, which thereby expects that shares will underperform versus its peers in the coming two years, when the economy is set to enter the "reacceleration" phase of the mid cycle slowdown.
Coe furthermore sees limited operating leverage, with margins already at historically high levels. Therefore 3M runs the risk of multiple compression, given the outlook of below average earnings growth through the remainder of the cycle.
Little over a month ago, 3M opened its books for the third quarter. The company ended the quarter with $3.3 billion in cash and equivalents. The company operates with $5.8 billion in total debt, resulting in a net debt position of $2.5 billion.
For the first nine months of the year, 3M generated revenues of $23.3 billion, which is up 3.5% on the year before. Earnings rose by 3% to $3.6 billion. At this pace, annual revenues are seen around $31 billion as earnings could come in around $4.6 billion.
Trading around $126 per share, the market values 3M at $85 billion. This values equity of the firm at 2.7 times annual revenues and 18-19 times annual earnings.
3M currently pays a quarterly dividend of $0.63 per share, for an annual dividend yield of 2.0%.
Some Historical Perspective
Long term investors in 3M have seen solid returns, mostly driven by a decent run-up over the past year. Between 2004 and 2012, shares have traded in a $40-$90 trading range. Following strong momentum so far in 2013, with shares up 35%, shares are currently trading around $126 per share.
Between 2009 and 2012, 3M has steadily increased its revenues by some 30% to $29.9 billion. Earnings rose by nearly 40% to $4.4 billion at the same time.
Morgan Stanley's warning seems well-timed. Shares have gradually moved up this year, but have seen a big move upwards with shares trading at highs of $134 in November of this year.
The relentless focus on innovation results in a continued stream of new products hitting the market, resulting in a continued strong competitive position of the firm. These generally distinctive products and focus on R&D results in very solid margins.
And 3M has finally started to use its strong cash balances to please shareholders. In the first nine months of the year, 3M has spend $4.8 billion on dividends and share repurchases. At this pace, 3M is returning cash at a rate of over 7% per annum.
Back in October when 3M released its third quarter results, I last took a look at the company's prospects. I noted that continued R&D investments pay off in terms of solid organic sales, coupled with high margins. Note however, that this solid performance leaves little room for operating leverage, as noted by Morgan Stanley. This is particularly the case at these later stages in the recovery of the economic cycle.
I do like the very long term prospects of the business, yet the premium valuation in a reasonably solid economy, combined with little potential for further margin improvements makes me hesitant.
As such I can understand the cautiousness of Morgan Stanley. The short term appeal is hardly there given the huge run-up this year. The long term appeal remains.