3M: Buy On The Tempting Valuation And Dividend Yield

| About: 3M Company (MMM)

Shares of 3M (NYSE:MMM) have returned 13% over the past 12 moths. The stock has recently dropped by 6% from its 52-week high of $95.46 achieved in October, primarily due to lackluster Q3 results and lower guidance. I believe the pullback presents a buying opportunity for this quality dividend investment given the favorable valuations.

3M is trading at cheap valuations based on the company's solid financial performance relative to that of its peers (see comparable analysis table below). Analysts on average predict 3M's revenue, EBITDA, and EPS to grow at 2-year CAGRs of 2.8%, 5.8%, and 7.3%, respectively, over the current and next fiscal years. The growth expectations are somewhat in line with the averages of 1.6%, 7.8%, and 7.8%, respectively, for a peer group consisting of 3M's primary competitors. In addition, 3M's EBITDA margin is forecast to expand by 1.5%, very consistent with the peer average.

On the profit side, 3M has a dominant margin performance, as most of the company's profitability margins and capital return metrics are the highest in the group. In terms of leverage and liquidity, 3M carries a low level of debt, as reflected by the firm's lower debt to capitalization and debt to EBITDA ratios. The company's trailing free cash flow margin at 11.3% is markedly higher than the peer average of only 3.6%. Due to the high profitability and the low leverage, 3M was able to maintain a healthy interest coverage ratio. Both the firm's current and quick ratios are significantly above par, reflecting a liquid balance sheet.

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To summarize the financial performance comparisons, given 3M's on-average growth prospects, the company's robust profitability and free cash flow generating capability should substantiate a premium stock valuation over the peer-average level. Nevertheless, the current stock valuations at 7.8x forward EV/EBITDA, 13.6x forward P/E, and 1.30x PEG are fairly in line with the peer-average trading multiples, suggesting the stock is somewhat undervalued (see comparable analysis table above).

Moreover, both 3M's trailing EV/EBITDA and P/E multiples are currently trading at discounts of 6% and 9%, respectively, to their three-year historical averages (see chart below). The stock's forward P/E multiple has underperformed the P/E multiple of the S&P 500 Index over the past 12 months (see chart below). I believe 3M should command a premium valuation over the market given that 1) the company's estimated long-term earnings growth of 10.4% is above the average estimate of 7.9% for the S&P 500 companies (according to Capital IQ data) and 2) 3M has an industry-leading performance in profitability and cash flow generation.

On top of the attractive valuations, 3M also offers a decent dividend yield at 2.7%, which is safely backed by the company's robust free cash flow and commitment to continuously raise dividends. The dividend per share has been raised by a 10-year CAGR of 6.6% from $1.24 in FY2002 to $2.36 in FY2012E (see chart below). The dividend growth rate declined substantially between FY2005 and FY2009, but has been recovering since then. Additionally, the annual dividend payment historically only represented less than a half of the annual free cash flow, suggesting that there is still ample slack to support the current pace of the dividend growth (see chart below).

According to the one-year dividend yield chart shown below, the yield has touched the 2.5% level multiple times over the past 12 months. The pattern is partially owing to a strong demand from the income-oriented investors under the current low-interest environment. As such, assuming a target dividend yield at 2.5%, and supposing that the current annualized dividend per share of $2.36 would be raised by 6% to $2.50 in the February 2013 payment period, this scenario would imply a stock value of $100, representing a 12% upside.

Alternatively, based on a 14.0x forward P/E multiple, which represents premiums of 3% and 6% over the same multiples of the S&P 500 Index and the peer group, respectively, and on the analysts' estimated EPS of $7.34 for FY2014, one can calculate the one-year target stock price to be $102.8.

Bottom line: Given 3M's attractive valuation, sustainable dividend yield, and solid upside potential, I recommend buying shares on the tempting risk/reward profile.

The comparable analysis table is created by the author. All other charts are sourced from Capital IQ, and all financial data are sourced from Capital IQ.

Disclosure: I am long MMM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.