The Long Case for 3M

Dec.21.06 | About: 3M Company (MMM)

Leon Cooperman Omega AdvisorsNewsletter Value Investor Insight carried an interview November 29th with Leon Cooperman, who runs Omega Advisors, along with Steven Einhorn, Mark Cooper, Michael Freedman and David Mandelbaum. Omega manages $5 billion, and its flagship fund has earned net returns of 16.3% per year, versus 10.6% for the S&P 500, according to Value Investor Insight. Here's the excerpt from the interview in which they discuss 3M (NYSE:MMM), which was trading at $80.98 at the time of the interview:

Another blue-chip attracting your attention is 3M [MMM]. Why?

Mark Cooper: 3M is a large industrial conglomerate whose specialty is utilizing chemistry and materials science for a wide variety of purposes, often involving applying coatings to some kind of surface. Their best-known products are Post-it notes and Scotch tape, but that division makes up only about 15% of revenues. They have six different business units, serving a wide variety of consumer, commercial and industrial markets. For example, the display and graphics business applies film over any type of screen to enhance brightness or improve the viewing angle.

It’s very much a company driven by intellectual property. It generates among the highest number of patents annually and BusinessWeek earlier this year ranked it #3, behind Apple and Google, on their list of the world’s most innovative companies. The fact that its researchers can spend approximately 15% of their time doing what interests them is an important part of the company culture and a source of its competitive advantage.

You’ve said the company is currently misunderstood. What do you mean?

MC: With all the different business units and industries, it’s very hard to analyze 3M at a micro level. Perhaps that’s why the market seems so unenthusiastic about the company. I was at an investment conference in New York a few weeks ago and George Buckley, 3M’s CEO, made a presentation. It was supposed to be mostly a Q&A session, but only two people asked a question and I was one of them. Afterwards, only one other investor joined me on the stage to speak with Mr. Buckley. This is a $60 billion market-cap company and I could spend a month with them and not know half the detail I’d want to learn about their businesses, but no one had any questions.

The opinions that seem to be driving the market price don’t match reality. For example, there seems to be an increasing fear that the company’s growth prospects have diminished, but if we look at the last three years of sales growth, it’s close to the long-term average. The most recent year sales growth wasn’t great, but I don’t at all consider that a permanent trend, primarily due to growth potential overseas, particularly in Asia. The company currently gets just over 60% of revenues from outside the U.S. – that should be 70% within the next five years. I’m confident they can at least hit their overall target of 8% annual organic sales growth.

There’s also concern that the company will overemphasize growth at the expense of margins. I think that concern is exaggerated for a few reasons. One, they’re growing incrementally faster overseas, where they’ve historically earned higher margins. I also believe there’s considerable inefficiency in their manufacturing and logistics operations. Over 50% of the products 3M sells go through at least three of their factories, which is shocking. Attacking those inefficiencies and taking costs out will obviously benefit margins.

Despite these issues, margins are currently at all-time highs – gross margins are over 50% and EBITDA margins are close to 30%. Even if the company did sacrifice some margin to grow faster in certain areas or devote even more than the current 5-6% of revenues to R&D, that would likely be a positive from a netpresent- value perspective.

How is the market’s seeming lack of enthusiasm showing up in the share price, which is currently around $81?

MC: Almost every valuation metric today is at a multi-year or all-time low, which contrasts with the growth potential and the returns on tangible capital this company earns, which are consistently over 50%. The P/E is close to a 15-year low, price-to-book a 10-year low, price-to sales a six-year low and the dividend yield, at 2.3%, is the highest it’s been in eight years. If the company does just what the market expects, which is to earn $5 per share next year, I believe they deserve a 20x P/E multiple, which is appropriate for a business that should produce consistent 15% annual growth in earnings per share while generating extraordinary returns on capital.

That puts our target price next year at around $100. If 3M does what we believe it can do over time on the growth side, the upside is much more than that.

LC: One thing I’d add here is that the company has a ridiculously unleveraged balance sheet – it ought to buy back $2-4 billion of common stock immediately at current prices. One reason we own it is that we expect a very significant cap shrink.

MMM 3-yr chart:

mmm chart