3M: Getting Rich Slow And Steady

3M Company (MMM) is a diversified global manufacturer, technology innovator and marketer of a wide variety of products and services with annual revenue of approximately $30 billion. The company was founded in 1902, paid dividends since 1916 and increased its dividend for 53 consecutive years. Earnings per share in the last 10 years have grown from 1.79 in 2001 to 5.63 in 2010 (a CAGR of 12%). The balance sheet is strong, has around $6.1 billion in debt and almost $5 billion in cash. Annual free cash flow is around $4 billion. 3M returns a lot of cash to shareholders. In the first 9 months of this year it generated 3.5 billion in operating cash flow. Approximately 70% is returned to shareholders through dividends ($1.17 billion) and stock repurchases ($1.34 billion).

The company has a great international presence. Only 35% of revenue comes from the United States the other 65% from Asia Pacific, Europe and Latin America. 3M manages its operations in six operating business segments:

• Industrial and Transportation serves a broad range of markets, such as appliance, paper and packaging, food and beverage, electronics, automotive original equipment manufacturer (OEM) and automotive aftermarket (auto body shops and retail).
• Health Care serves markets that include medical clinics and hospitals, pharmaceuticals, dental and orthodontic practitioners, and health information systems.
• Display and Graphics serves markets that include electronic display, traffic safety and commercial graphics.
• Consumer and Office serves markets that include consumer retail, office retail, home improvement, building maintenance and other markets.
• Safety, Security and Protection Service serves a broad range of markets that increase the safety, security and productivity of workers, facilities and systems.
• Electro and Communications serves the electrical, electronics and communications industries, including electrical utilities; electrical construction, maintenance and repair; original equipment manufacturer (OEM) electrical and electronics; computers and peripherals; consumer electronics; telecommunications central office, outside plant and enterprise; as well as aerospace, military, automotive and medical markets; with products that enable the efficient transmission of electrical power and speed the delivery of information.

Its products include items like Scotch Tape and Post-It known and used by almost everybody. The margins it is able to realize on its products and the overall return on equity (ROE) are impressive. Graph 1 shows the last 10 year margin and ROE trend.

Graph 1: 10 year EBIT margin & ROE trend

3M has almost tripled its stock holder equity and doubled its free cash flow in the same period (Graph 2). When a company grows stockholder equity with a compounded average growth rate of around 10% and has an annual return of equity of more than 25%, then you have a company with real compounding power. This is what makes 3M an excellent candidate for a buy-and-hold strategy, when bought at the right price. A slow and steady investment approach.

Graph 2: 10 year equity and free cash flow trend

3M reported disappointing third quarter results. Net income of the diversified machinery company fell to $1.09 billion ($1.52 per share) vs. $1.11 billion ($1.53 per share) a year earlier. Revenue rose 9.6% to $7.53 billion. This was short of analyst consensus estimates (EPS of $1.61 and revenue of $7.78 billion). Table 1 provides an overview of the third quarter results by business segment.

Table 1: Business Segment Revenue & Operating Income, Q3 2011

Taking a closer look at the latest SEC filing shows that five of the company's six business segments increased revenue versus Q3 2010, led by Industrial and Transportation with 18.8% and Safety, Security and Protection Services with 17.6%. Revenue growth was impacted by a slowdown in electronics-related businesses impacting the Electro and Communications and Display and Graphics business segments. Electro and Communications sales increased only 4.4% and Display and Graphics sales declined 12.2%.

Margins were negatively impacted by an increase in cost. Cost of sales increased 1.3 percentage points due to raw material inflation. SG&A increased with 13% and R&S expenses increased with 10%, both mainly due to increases from acquisitions, pension and post retirement expenses and foreign exchange effects. Compared to Q3 2010, EBIT margins have decreased almost 2 percentage points from 22.92% to 20.99%. 3M expects that the remainder of 2011 remains challenging and is putting actions in place to reduce cost.

The weaker Q3 results and overall market volatility have impacted the stock price. 3M is trading around $83, versus a 52-week high of $98. Is this the right time to start building a position?

To get to an estimate of intrinsic value the discounted cash flow method will be used. As part of the calculation, owner's earnings are calculated based on an average over the last 5 years with an EBIT of 22% and tax rate of 29%. Discount rate is 10%, 10 year growth rate of 5% and a terminal growth rate of 0%. I consider these conservative values for a company with the track record of 3M. This gives me an intrinsic value of approximately $84 a share. Very close to the current stock price of $83.

I will consider buying 3M when the stock price drops below $75.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MMM over the next 72 hours.