What Would Benjamin Graham Have Thought Of 3M Company?

| About: 3M Company (MMM)

Founded in 1902 as Minnesota Mining and Manufacturing Company, 3M Company (NYSE:MMM) is an industrial conglomerate that employs 84,000 people world-wide. Overall, 3M defines itself in 6 segments: Industrial and Transportation (34% of sales), Health Care (17% of sales), Consumer and Office (14% of sales), Safety, Security, and Protection Services (13% of sales), Display and Graphics (12% of sales), and Electro and Communications (11% of sales). Operating margins are excellent as compared to segments of other industrials.

Last year, 3M Company sold thirty billion dollars of product, on which it earned $4.3 billion. Free cash flow generated was $4 billion. The market capitalization is $61 billion, four times equity on the books, and enterprise value is $72.5 billion, over two-and-a-half times assets on the books.

Analyzing 3M Company

An observation I've made about 3M is its deep roots in Minnesota, the American state with the largest proportion of ethnic Scandinavian descendants (20%+), and its Swedish CEO, Mr. Inge Thulin. 3M Company's financial statements for its multitudes of business lines are very finely detailed, like a van Eyck. As a result, I am not able to generalize about the company's business prospects. Instead, I'll emphasize 3M's culture and apply Benjamin Graham's universalistic criterion, Margin of Safety (from The Intelligent Investor), to the firm.

All figures are from 6/20/2012, using 2011 figures as most recent, not trailing twelve months.

1. Choose a time when Stock-earnings yield / Bond yield ratio is high (2x-4x) rather than low (1x or lower).

The S&P500 yields 6.40%. The AAA corporate bond yield is 3.80%. The ratio is 1.68X, calling for a bond-heavy, stock-light portfolio overall. However, the corporate bond rate is relative to Treasury bond rate and this rate is not based on Treasury bond credit risk vis-a-vis other securities (intrinsic) anymore but is now based on keeping inflation low (extrinsic).

2. Find a consistent grower by calculating the past growth rate. ("We suggest that the growth rate itself be calculated by comparing the average of the last three years with the corresponding figures ten years earlier.")

Based off the last three years and the corresponding years ten years earlier (1999, 2000, 2001), the growth rate in sales has been 5% annually. Earnings have grown 8.6% annually, and free cash flow has grown 8% annually.

3. Calculate Price / Earnings ratio.

The P/E of this $61 billion company is between 14 and 15.

4. Estimate Expected Annual Growth Rate from steps #2, #3.

On the above P/E basis, I'd drop the growth rate to 6% because 3M has made $3 billion of acquisitions in the last two years, driving the organic-growth figure up two percentage points or so. Second, operational improvements can suffer from diminishing returns (but only so far, because the company is big and management is still improving the bottom-line vis-a-vis the top line at 3% a year). Third, it's harder to make the needle budge on such a big firm.

5. Apply Projected Annual Growth Rate to Benjamin Graham's formula:

Value = Current (Normal) Earnings X (8.5 + twice the expected annual growth rate) X 4.4/the current yield on corporate bonds

(I use free cash flow in place of earnings.)

Value = $4.0 billion X (8.5 + (2 X 6)) X 4.4/3.8 = $95B

With lots of uncertainty, a $70B valuation is still higher than the market's. The current market capitalization of $62B implies organic growth of just 2.3%. For comparison, America's real GDP growth since 3M's early 20th century founding is 3.5%.

6. How is balance sheet performance?

Assets are $31.6 billion, split about evenly between debt and equity. Goodwill and intangibles are about $9 billion.

Management writes on page 32,

Based on fourth-quarter 2011 [goodwill] testing, 3M's estimated fair value when valuing each reporting unit individually would aggregate to approximately $68 billion...compared to 3M's total Company estimated fair value, with the sum of the individual values typically being larger than the value for the total Company.

This means that the sum-of-parts value of the company, including intangibles developed internally which the balance sheet does not include, is $68 billion. Management estimates that book values reflect a conglomerate discount of 53.5% against the sum-of-all-assets. This conglomerate discount was not perceived nor subtracted in 2001, 2000, and 1999. Because I am not getting paid to do this, I won't speculate about a conglomerate discount during that period. Management may have adjusted book values to reflect perceived cumulative worth rather than the opaque idea of "overlapping" intangibles nowadays.

How are debt levels? The debt ratio is 50%. In 2001, it was 58%. Excluding the conglomerate discount, shareholder equity (via assets) is 2.15 times what they are stated as, so the debt ratio is 23%.

Is the company viable? The quick ratio is 1.62. Yes. (No direct conglomerate discount impact because current assets are the same whether they are sum-of-parts or total.)

Is management doing a good job against book values?

Graham recommends a high "return on invested capital", which is NOPAT / (BV of Equity + BV of Debt - Cash). In the past 3 years, it has been 15.3%, 16.15%, 14.15%. In the corresponding 3 years a decade earlier, it was 11.2%, 14.3%, and 14.24%. Averaged, ROIC has grown from 13.2% to 15.2%. But excorporating the conglomerate discount, ROIC has fallen from 13.2% to 7.1%.

Excluding cash, intangibles, and goodwill, return on capital employed is NOPAT / Capital Employed. In the past 3 years, ROCE has been 19.9%, 20.1%, 17.1%. A decade earlier, it was 12.9%, 16.25%, 15.6%. Averaged, ROCE has grown from 14.9% to 19.0%. But excorporating the conglomerate discount, ROCE has fallen from 14.9% to 8.8%.

Has return on equity gone up?

Nominally, yes. In real terms, maybe. Return on assets has gone down and debt-to-assets has gone down, meaning that there is more equity for every part debt. 2001 real return-on-equity was 23.5% ($1,430M/$6,086M) which has fallen to 8.2% ($4,283M/($15,862M stated + $36,384 unstated)).

Because hard assets are the same whether sum-of-parts or total, intangible assets could be understated many times over. Ten years ago, amortization of indefinite-lived intangibles forced management to mark up intangible assets faithfully to fair value estimates. This understatement creates a great deal of goodwill when other companies are acquired, which really reflects their intangibles.

It is evident that management appropriates book values by considering some intangibles overlapping and others, not. Goodwill and intangibles to shareholders' equity is nominally 56.5% but really 86.8%. Minor manipulations affect billions of dollars in book value. Also, the non-inclusion of shareholders' equity that this involves could be appropriated to boost balance sheet ratios, as if writing one's own performance review.

7. Weight the following factors in your overall assessment of the company:

  • General long-term prospects

In his article Why 3M is Unique, Mark Gunther wrote that 3M "is a set of businesses organized around a big, busy and intellectually productive R&D lab which researches new technologies and processes and then develops them into products." Gunther quotes the "revered" man credited with fostering modern 3M's culture of innovation, William L. McKnight (all emphasis mine):

As our business grows, it becomes increasingly necessary to delegate responsibility and to encourage men and women to exercise their initiative. This requires considerable tolerance. Those men and women, to whom we delegate authority and responsibility, if they are good people, are going to want to do their jobs in their own way.

Mistakes will be made. But if a person is essentially right, the mistakes he or she makes are not as serious in the long run as the mistakes management will make if it undertakes to tell those in authority exactly how they must do their jobs.

Management that is destructively critical when mistakes are made kills initiative. And it's essential that we have many people with initiative if we are to continue to grow.

Today, the 3M Company corps is inculcated with the Seven Pillars of Innovation (see here). In a way, the firm resembles a pharmaceutical company: products take a few years to come to market. Once released, the company centralizes and tallies its revenues from recent products to focus future R&D spending (source). This approach rewards good labs while accommodating inevitable mistakes.

3M Company spent over 5% of its sales on research & development last year. This rate of R&D spending continued through the recession. The company makes products at a faster rate than it makes dollars, reflecting its ability to get to the bottom of customers' specific needs. This focus on existing customers may blind the company to emergent opportunities in the market if the company does not produce enough failures.

  • Management

Mr. Thulin has been at 3M Company for his whole career (unlike recent Chief Executives). He was appointed CEO just a month ago and was previously the Chief Operating Officer, Vice President of International Operations, and influential in the Health Care segment. He is tapped to enlarge 3M Company's international presence and competitiveness. In 2011, half of capital spending and two-thirds of sales were done internationally. 60% of employees are not in the U.S.

Mr. Thulin has pledged $1 billion to $2 billion of acquisitions in 2012, on cash flows that might be around $4 billion. Management's pattern of spending up to a half of the firm's power is excessive considering that goodwill and intangibles are now 86.8% of shareholder equity (see above). (Note that goodwill is the price paid for soft assets in excess of the soft assets already on acquiree's books.) Not only is it risky, its insulting: shareholders get leftovers after capital expenditures are taken out of a 3%-of-market-value retained and unspent earnings pot, plus another percentage point yield from acquisitions.

Because he was COO for a short time and was recognized for having opened (but not operated) 3M's international research labs prior, he may believe that 3M's labs and those of acquiree's can be equated on a cost basis. Mr. Thulin is himself not a researcher.

Finally, Mr. Thulin may also focus on the firm too much and on the marketplace too little. For example, he emphasizes 3M's "technology platforms" rather than any new platform possibilities. (See interview for more.)

  • Financial Strength and Capital Structure

The company holds almost $8 billion worth of cash, marketable securities, and inventory. The interest coverage ratio is in the 30s (over ten times straining the balance sheet) and historical interest rates do not justify this wasted opportunity. Management is addressing themselves towards a downgrade by credit rating agencies for higher debt/EBITDA (which ought not prejudice management in such a low interest rate environment).

Also, the company buys back shares according to market conditions, adding an additional buffer between cash and capital markets.

3M paid out $500 million more cash than operations threw off in 2007, and $850 million more in 2008, returning to a net positive on this payout-ratio metric in 2009. (The dividend pattern disciplines management, but if management senses that they cannot make opportunistic acquisitions in down markets, they may preemptively stockpile cash in up markets, as Mr. Thulin indicates.)

Pension obligation wipe-out:

Among $15.8 billion of total liabilities, around $5 billion involve pension and post-retirement benefits that are contained on that line item and on "Other current liabilities". These obligations exploded $4 billion last year, which happens to be the total annual profit figure. It was not recorded on the income statement because it was due to an adjustment to the discount rate. Liabilities went up by $2.4 billion and 3M reduced shareholders' equity by $1.6 billion, with the $800 million differential attributed to other assets (current or not, they don't say). $1.3 billion of new shares were issued against shareholders' equity, which is only indicated on the Statement of Changes to Shareholders' Equity.

Could management have averted this outcome? They could have balanced pension obligations (outflows on a discount rate that is based on low-yield fixed income products) against debt (inflows from low-yield fixed income products). This simplification would have left cash balanced against share repurchases rather than allowing management to finance pension obligations with shares. This episode demonstrates that management is not keeping cash on hand to protect shareholders from catastrophes but to spend.

  • Dividend Record

From the investor relations website: "3M has paid 382 consecutive quarterly cash dividend and increased the annual dividend for 54 consecutive years." In the past five years, this dividend has gone up at about 4.2% a year while earnings and free cash flow have gone up about 3% and about 6%, respectively.

  • Current Dividend Rate

The current dividend rate of $2.36 a year is about 40% of free cash flow and of earnings. It yields 2.7%. Added to this, the company buys back shares (but inconsistently). Expect another 1-2% in the form of share buybacks.

Finally, "seven statistical requirements for inclusion in a defensive investor's portfolio"

  1. Adequate size (for the purpose of safety)
  2. A sufficiently strong financial condition (for the purpose of safety)
  3. Continued dividends for at least the past 20 years.
  4. No earnings deficit in the past ten years.
  5. Ten-year growth of at least one-third in per-share earnings.
  6. Price of stock no more than 1.5 times "net current asset value" (current assets - total liabilities).
  7. Price no more than 15 times average earnings of the past three years.

3M passes muster on all except #6 and #7. Today's companies have much greater intangible assets, which creates goodwill on the balance sheet of conglomerates like 3M. Debt is written against liabilities and it would be extremely rare to find a company passing #6. As for the underlying intent to defend against bankruptcy at all costs, this requirement may forgive 3M's long cash position (but not management's intention to spend this protection). P/E is 15.76 times average earnings of the past three years (#7).

Recommendation

3M Company sells relationships with suppliers and customers in order to anticipate and serve needs in new niches. Internally, the company's culture of innovation attracts talent and prejudices management against acquisitions, creating less headaches for shareholders. Because all industries tend towards concentration until they are made obsolete, 3M Company is universally advantaged in the opinion of this author.

The book value of a share excluding the conglomerate discount that management has awarded themselves is $98, so at $86.83, the stock market is valuing this company intelligently, if management can be presumed to be intelligent howsoever corrupt. If you can swallow that, the stock market is discounting MMM for its low yield and large size, which makes a share an attractive investment for patient, growth-focused Grahamophiles who crave safety.

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