3M Looks Fairly Valued Using Management's Own Forecasts

| About: 3M Company (MMM)

Summary

Earnings are around the corner, but we're looking longer term here.

Management's guidance indicates the stock is fairly valued.

This seems a good time to take profits.

With 3M's (NYSE:MMM) earnings around the corner (to be reported before the bell on July 26th), I decided to take a quick glance on its outlook and share some thoughts here. Rather than focusing on the quarter, I'm looking at management's long-term outlook as per its long-term financials objectives guidance for the 2016-2020 period: i) 8%-11% EPS growth; ii) 2%-5% organic growth in local currency; iii) 20% ROIC; and iv) 100% FCF conversion. If these assumptions are accurate, we can say that MMM is fairly valued.

Figure 1: MMM's Management Long-Term Guidance

MMM Guidance

Source: Company

EPS Growth Estimate Looks Fair, But Will Demand Solid Managerial Skills

The 8%-11% EPS growth guidance for the 2016-2020 period means an acceleration from the 6% average of the past 3 years. Taking into account the 2%-5% organic sales growth guidance for the same period, management implicitly expects a little margin improvement (~100 bps higher net margin according to my calculations, which is not too much). This seems reasonable enough, although representing some challenge. But for this to be achieved, an improvement in the ongoing trend of the Electronics and Energy division (which accounts for 15% of sales) looks critical. Sales in this division have fallen 10% YoY in the last 12 months, with operating profit shrinking 12%.

Figure 2: Last 12-month Revenue Breakdown

Sales Breakdown

Source: Company data

Figure 3: Electronics and Energy Revenue and Operating Income

Source: Company data

Long-Term ROIC Assumption Looks Conservative Enough

3M's current ROIC is 30% as calculated by me ([EBIT * [1 - tax rate]]/[accounts receivable + inventories + PP&E + ex-goodwill intangible assets - accounts payable]), so assuming management uses the same criteria, its long-term ROIC guidance would be significantly below the current level (diminishing returns assumption, makes sense).

ROE: A Little Trickier Here

OK, so we can safely assume that management seems reasonable in its ROIC assumption. But what can we say in terms of ROE? I used a DuPont analysis (see Figure 4 below) to assess the trends in MMM's ROE and its sustainability. There is a clear downward trend in ROE over the past few years driven by less operating efficiency (lower assets turnover). This trend was partially offset by an increasing financial leverage. Now that's a bit concerning. I've seen this trend before (management trying to offset weak operating dynamics through higher leverage, especially when cost of debt is very attractive) and it doesn't always end well. But so far, it is just a bit concerning as I said. No reason to be too worried about. Even if we assume the financial leverage coming back down to where it was in 2013 (1.85), the ROE would still be a pretty decent 30%. But in order to be even more conservative, I'll assume that ROE will converge to the 20% level expected for ROIC.

Figure 4: DuPont Analysis on MMM

MMM DuPont Analysis

Source: Company data and author's calculations

Determining MMM Target Price

So assuming a 20% ROE, a 3.5% g (long-term growth rate) as the mid-point of management's organic revenue growth and a cost of equity of 7.9% (assuming a risk free rate of 1.58% based on current 10y treasuries, equity risk premium of 6% as per Damodaran's estimates and a beta of 1.05), I have reached a fair target P/E of 18.8x for 2020 (see Figure 6 below). This is below its current 23x. Multiplying that number by the expected 12-month forward EPS in 2020 (i.e. 2021 EPS, growing at the g rate from 2020 onwards) at the mid-point of the guidance, we have a US$237/share target price at YE20, which discounted to YE16 at the 7.9% Ke would be US$175/share. At the best-case scenario (top of the guidance), MMM's fair value would be US$188/share according to my estimates.

Figure 5: Target Multiple Calculation - Part 1

Target Multiple Calculation

Source: Damodaran

Figure 6: Target Multiple Calculation - Part 2

MMM Target PE

Source: Author's estimates

Figure 7: Target Price Estimate

MMM Target Price Calculation

Source: Company data and author's estimates

Conclusion: Good Time to Take Profits

Using management's long-term outlook for MMM and my assumptions as described above for other variables such as cost of equity and fair P/E calculation, the stock looks fairly priced at the current level. Taking into account the execution risk and currently weak trend in one important division (Electronics and Energy), my opinion is that taking profits here after the nearly 20% YTD rise is a good action, despite its good ROIC and ROE. It is important to highlight though that this is a tactical trade. The stock does not look a structural short to me due to its diversified business model with apparent competitive advantages and profitable operations. Would our conclusion change significantly had we used a higher sustainable ROE? Not too much: at a 30% level our base case (mid-point of the range) upside would be 4%, and at 40% ROE it would be 7%.

Figure 8: Alternative Scenarios for Target Price

Alternative Scenarios

Source: Company data and author's estimates

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

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.

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