Eye On Conglomerates: GE Is A Buy, 3M Is A Hold

 |  Includes: GE, MMM
by: Takeover Analyst

In an earlier article, I argued that 3M has significant upside and could benefit from a strategic restructuring. Since the piece was published, the stock has appreciated by 11.1% and, at this point, I feel the risk/reward is no longer so favorable for the firm. On the other hand, I believe that GE represents an attractive value play with strong growth in tech and energy infrastructure. This overall sentiment is shared by the Street where shares of 3M are rated a "hold" and those of GE a "strong buy".

From a multiples perspective, GE is the cheaper of the two companies. It trades at a respective 13.8x and 10.7x past and forward earnings while offering an impressive dividend yield of 3.6%. 3M, on the other hand, trades at a respective 14x and 13.1x past and forward earnings while offering a dividend yield of 2.7%. With an overly aggressive sales goal and poor demand for Display and Graphic, 3M has, in my view, set the bar too high and has thus added considerable risk to an investment that will limit buying and inspire selling. It is a stellar company with strong fundamentals, but I see a lack of catalysts for now.

At the third quarter earnings call, 3M's CEO, George Buckley, began his speech by highlighting significant business challenges:

"The quarter turned out to be very different one than what we expected. The challenges that we faced were primarily 2 causes and 2 effects focus. Cause #1 was words about European sovereign debt and the European economy. Cause #2, was the rapid contraction of the electronics end markets. It began with TV, extended to all the consumer devices and has now crept a bit into factory automation. Effect #1 was a flip in exchange rates as confidence in Europe's ability or willingness to deal with the crisis fell and its economy responded negatively. Foreign-exchange alone will reduce our earnings by up to $0.07 over the balance of Q4. This is the reverse side of having almost 70% U.S. sales outside of the United States. On the second effect, this was simply volume and the under absorption that comes along with it.

In the last few months, worldwide IPI forecast for 2011 have fallen by 4,200 basis points".

Third quarter results were slightly disappointing and underscored greater vulnerability to the macroeconomy than what some investors previously thought. Tablet demand is thus far lower than what many expected and Display and Graphic could possibly decline y-o-y in the double digits for the fourth quarter. Management has also essentially set a sales target of 11% CARGR until 2016 - excessively high, in my belief. With that said, the company is notably improving productivity and indicating greater interest in returning free cash flow to shareholder through buy backs. Organic volume growth is anticipated to be stronger in the second half of 2012 and total upwards of 5%.

Consensus estimates for 3M's EPS are that it will grow by 2.8% to $5.91 and then by 6.3% and 7.8% more in the following two years. Assuming a multiple of 15x and a conservative 2012 EPS estimate of $6.15, the rough intrinsic value of the stock is $92.25. This implies only 12.2% upside and does not, in my view, make the company a value play. If the multiple were to decline slightly to 12x and the 2012 EPS turns out to be just 3.7% below the consensus at $6.05, the price of the stock would be $72.50 for 11.75 downside. Accordingly, I recommend holding out on an investment.

GE, on the hand, will benefit from a business mix shift towards infrastructure over financials. While GE Capital will struggle from weakness in real estate and consumer products, the fundamentals are strong in energy and technology. Overall, consensus estimates for GE's EPS are that it will grow by 19.1% to $1.37 and then by 13.9% and 16.7% more in the following two years. Assuming a multiple of 12x and a conservative 2012 EPS estimate of $1.45, the stock has 20.5% upside. Even if the multiple falls to 12x and 2012 EPS turns out to be a substantial 10.3% below the consensus, the company has no downside implied by these assumptions. An attractive risk/reward coupled with strong operating projections (see here) makes GE, in my opinion, a "buy".

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.