3M (NYSE:MMM) released guidance for 2011 on December 7 at an institutional investor and analyst meeting in New York. The company sees revenue of $29 - $30.5 billion, an increase of approximately 10.5%, and EPS of $5.90 to $6.10, a 7% increase. Market and analyst enthusiasm was subdued, with the stock down 2.5% to close at $84.68 on Wednesday. Now is a good time to take a historical perspective on MMM's valuation.
Ben Graham suggested a long term average EPS as a valuation metric, to compensate for the expected ups and downs of the business cycle. Five years works well. The following chart shows a history of MMM's Price/5 year average EPS, or P/E5:
Taking the long term view, the company is trading below its average low P/E5. If prices revert to the average range, we could expect the stock to trade between $98 and $135. The consensus target is $99, and the stock is trading well under that. This is difficult to reconcile with a company that is guiding both revenue and EPS higher for the coming year.
Compression and Decompression
During 2008 and 2009 investors spent a lot of time underwater. At the depths experienced during the recession, the investor's psyche becomes compressed. As the markets rise, decompression sets in, manifesting as painful attacks of anxiety and panic.
A gradual ascent to the surface will lead to the happy moment when the investor can doff his scuba gear and enjoy the sunshine and fresh air. In retrospect, the cold depths, the bizarre sea creatures, the rusted hulks, will all seem like a fine adventure. As for the sunken treasure, never to be retrieved, oh well.
Deja Vue All Over Again
The same thing happened last year. 3M tanked on its guidance for 2010. I wrote the case up favorably at the time, with shares trading at $76. They have since traded as high as $91.49.
...Market response has been unenthusiastic, with the stock trading down by 2% to as low as $76.00 in early trading. This is another case where Mr. Market is missing the point. The point is, organic sales volumes are projected to grow 5 - 7 percent. With all the complaints that companies have been growing profits at the expense of revenue, it is good to see a company that believes they can actually sell more product.
The point still is, organic sales volumes are still projected to grow, for 2011 it will be 5.5 to 7.5%. Mr. Market is still missing the point. At the time, I saw a target of $99: Today I see $105, an increase of 6%.
Priced to yield 2.5%, dividend growth or buy and hold investors can buy at today's price with a reasonable expectation of receiving the dividend and eventual long term price appreciation. Those who have opinions on market level or direction can gauge their entry points accordingly.
I'm investing on the basis that the stock will reach $105 within two years, returning 13.5% including the dividend.
MMM is optionable, to include LEAPS, and has very low implied volatility at 22.3%. That suggests buying deep in the money LEAPS for leverage and selling out of the money covered calls against the position for income. The internal rate of return for the strategy stands at 53% since September last year, and in the interest of staying with what's been working, that's how I'll play it going forward.
Disclosure: I am Long MMM.
Additional disclosure: Long MMM January 21 2012 60.0 calls, short MMM April 16 2011 90.0 and 95.0 calls