The 3M Company-Misunderstood, Maligned, Cheap-Inefficiently Structured

From Value Discipline

There is a mistaken notion by some value investors that the only time that you can make serious money occurs when you can find an unknown, small-cap name that is inefficiently priced because it is off everyone’s radar screen. Yet, there have been many times in my career where a large cap name was staring me in the face that was misunderstood, maligned, and cheap. Efficiency is a function of everyone thinking the same, not necessarily that everybody is thinking! I feel this way about MMM. The release of Q4 earnings and 2007 guidance has created an interesting opportunity in my view. The inefficiency exists not only in the way the consensus views the company, but also in the way that management has structured the capital.

What can one say about 3M? With well-known products such as Scotch tape and Post-it notes, the company enjoys a broad portfolio of products that address the needs of just about every economic sector that exists in just about every geography that one can think of. From a simple P/E basis, the company is selling below an S&P 500 multiple (about 16.6 times TTM versus 21.0 times TTM for the S&P despite long term fundamentals that have generally exceeded those of the broad index. Consider that even with the supposedly difficult environment that created the earnings shortfall, the business generated 22.5% return on invested capital for the year.

Where were the shortfalls? Let’s look at the diverse segments which will give you some idea of just how broad this company’s reach is.

The largest part seemed to come from the "display and graphics" group which houses the LCD film business, 3M provides distinct products for five market segments, including products for: 1) LCD computer monitors 2) LCD televisions 3) handheld devices such as cellular phones 4) notebook PCs and 5) automotive displays. Additional optical products include touch screens, touch monitors and lens systems for projection televisions. Consumer demand for LCD television has seen double digit unit growth, but with about 40% of LCD film sales oriented to larger format LCD’s, profitability has declined. Production yields for large format films are lower than for smaller LCD’s, consequently, profitability is not as good. As well, as the technology becomes more competitive and mainstream, pricing suffers. Other aspects of the graphics business have performed very well, but the formerly very high margin LCD film business is starting to look less extraordinary. Despite the lamentations, this remains a 27.9% operating margin business though down some 400 basis points YOY.

Another interesting business which fell short of expectations was the roofing granules (for asphalt shingles) business. This is contained within the "Safety, Security, and Protection Services" business. This segment also produces "Thinsulate" Insultation and Scotchtint Window film. Apparently, there has been a sales decline of 50% YOY in roofing granules. Historically, some 70% of shingle demand has come from replacement rather than new construction. This is a 19.5% operating margin business. Ex-roofing granules, operating profit would have over 23%, slightly better than a year ago.

The transportation segments serves automotive, marine and aircraft markets with graphics, masking tapes, fasteners and tapes, interior paneling and carpeting, etc. Op margins here were 18.8%.

The healthcare segment weakened as a result of the divestiture of the pharma division in early December. 3M is a supplier of medical tapes, dressings, wound closure products, orthopedic casting materials, electrodes and stethoscopes. In infection prevention, 3M markets a variety of surgical drapes, masks andpreps, as well as sterilization assurance equipment. In health information systems, 3M develops and markets computer software for hospital coding and data classification, as well as providing related consulting services. 3M provides microbiology products that make it faster and easier for food processors to test the microbiological quality of food. Tape closures for disposable diapers, and reclosable fastening systems and other diaper components, help disposable diapers fit. Nevertheless, what remains has the highest operating margins in MMM at 29%.

The Consumer and Office segment is the home of Scotch tape and Post it notes. However, sales to construction of masking tapes and sealant products declined. Sales growth overall pre-currency effects was about 6%. Operating margins here are the lowest in the firm at 17%.

The Electro and Communications segment serves the electrical utility industry, telecommunications as well as electronics industry. Major electronic and electrical products include packaging and interconnection devices; high−performance fluids used in the
manufacture of computer chips, and for electronics cooling and lubricating of computer hard disk drives; high− temperature and display tapes; and insulating materials. Operating margins here are just under 18%.

What is unusual and what has gotten the "Street" frosted about the stock is that YOY, each of the operating segments suffered a decline in operating profitability . Some of that may be related to ongoing and incomplete restructuring efforts, some may relate to currency effects, much relates to peculiar and unique cyclical influences over certain businesses.

One other aspect of MMM that I found a little strange was management’s response to redeployment of the cash generated from the sale of the pharmaceuticals business. About $1.2 billion came in early December followed by $850 million in early January from the sale of the European pharma biz. Management indicated that it would pay down its commercial paper…this is a company with steady free cash flow generation and a debt to capital ratio of only 14% or so. Debt to toal assets is less than 5%.

Given a long tradition of innovation and growing the business (and given the ROIC of plus 20%, they should reinvest!) MMM’s capex was up 23% for 2006 and will be up another 25% for 2007 at about $1.5 billion.New plants will increase capacity geographically and improve some production facilities. Specific areas include medical tapes and drapes, optical films, and industrial tapes. Plants are being built in Korea, China, Russia, Poland, India and Turkey. Clearly streamlining efficiencies in distribution and logistics will lower costs and reduce working capital needs. I believe the capital plans make a great deal of sense.

Innovation is an inherent part of the MMM corporate culture. Researchers are encouraged to dedicate 15% of their time to projects that interest them rather than corporate mandated research.

Check out Exhibit 1 in this link which describes 3M’s quest for innovation: Innovation

What goes wrong here? MMM is sensitive to world GDP with international sales representing 63% of revenues. European growth last year was 10.5% (breathtaking for Europe!) and Latin America grew 10.2%. China and India saw 20% growth in revenues. A global slowdown naturally would affect a business of this breadth and size. The balance sheet has the formidability of a battle ship. So far, MMM has used small bolt-on acquisitions. A large acquisition would be upsetting.

The company has been a buyer of its own stock and has actually effectively reduced its share count. The company spent about $2.4 billion on share repurchases in 2006, reducing the share count by about 3%.Fully diluted shares are about 761 million versus about 813 million at the end of 1999. The company has another $750 million left in its authorization which runs out at the end of this month.

The street consensus for 2007 eps has move down to a range of $4.53-4.80 with a median $4.65.

Consensus target price is about $85 for Wall Street. Over the near term, I can’t argue with the analysis. Though analysts are agonizing over short term issues and an inordinate amount of "analysis" is dedicated to the LCD film business, most people are missing the point. This company would benefit tremendously from a more efficient capital structure. Rather than paying down debt, this company would benefit tremendously from either buying back stock at current valuations (which are generally at decade lows) or paying out a significant special dividend.

Here is a valuation for MMM with a 15% debt to cap structure. I come up with a present value of about $115 about 55% north of where we are today!

MMM DCF with a Sensible Capital Structure

What is the likelihood of the company undertaking a tender offer for its stock to achieve greater efficiency of capital? Who knows? Some investors have been pressing for this to occur. For example Lee Cooperman of Omega Advisors has recognized MMM’s conservatism:

"One thing I’d add here is that the company has a ridiculously unleveraged balance sheet – it ought to buy back $2-4 billion of common stock immediately at current prices. One reason we own it is that we expect a very significant cap shrink."

This is a great company available at a very attractive valuation. The reputation for innovation is well-deserved and operating profitability remains strong, though competition and cyclicality have shaved a bit off the edges. The yield at 2.5% is above that of the S &P at about 2.1%. Dividend growth in the last five years has been 9% compared to the S&P at about 2.9%.

The current buyback runs out later this month. The steady cash flows allow for a much more aggressive capital structure.

I think this is a terrific opportunity for someone with an investment horizon that extends beyond settlement date.

Disclaimer: A long position in MMM is currently held by either myself, my family, or my clients.

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