Streetwise

Lauren Rudd

Sunday, March 11, 2012

Look Beyond the Immediate Past

Market volatility has increased once again and where there is volatility there is profit opportunity, despite the relatively low volume of shares changing hands. If you are reticent to act, perhaps because you are still in mourning over some previous loss, remember that 40 years of statistical data confirms an average annual compounded total rate of return for the equities markets of about 11 percent.

Yes, I am eminently familiar with the statement by famed economist John Maynard Keynes, “In the long run we are all dead.” More pertinent is the phrase that every journey begins with a first step. Unfortunately market volatility, when combined with a fear of the unknown, readily foments paranoia. Nonetheless, your task is to remain undeterred in your resolve to uncover true value.

Meanwhile, I have been accused of only revisiting companies where I have successfully projected annual performance and share price appreciation. This is not true. Although I only discuss companies where my analysis portends potential capital gain, not every idea is a winner as 3M Corporation (MMM) clearly illustrates.

So why write about 3M again? The answer is simple; I still believe 3M has excellent potential going forward and I attribute a less than exemplary share price performance to conditions beyond the company’s control.

I resisted writing about 3M for a number of years, relenting last year because as Barron’s once pointed out the world’s population continually interacts with the company’s products, from fiddling with Scotch tape, to leaving urgent messages on Post-its, to parking their posteriors on Scotchgarded furniture.

Delving into the company’s 2011 performance, 3M’s sales of $29.6 billion showed a gain of 11.1 percent. Five of the company's six business segments posted growth for the year, led by Industrial and Transportation up 19.5 percent and Safety, Security and Protection Services up 15.2 percent. Latin America/Canada was the fastest-growing geographic region in 2011 with a growth of 15.6 percent.

Full-year 2011 earnings were $5.96 per share, an increase of 5.9 percent, operating margins were 20.9 percent and return on invested capital was 19.9 percent.

Although 3M posted record sales and earnings, it had to achieve those results in the face of deteriorating demand in Western Europe. At the same time, a drop in demand for consumer electronics resulted in decreased sales for the Display and Graphics division, down 8.8 percent in the fourth quarter alone.

Nonetheless, during 2011 the company invested $1.6 billion in research and development and $1.4 billion in capital expenditures. The 2011 results vindicated the underlying strength of 3M's business model, as 3M once again generated double-digit top-line growth and a premium return on capital.

In its forward looking guidance, management indicated that it expected slower growth to persist into the first half of 2012, necessitating that close attention be paid to ensuring bottom line performance going forward.

To achieve this management has embraced preserving key investments in research and development, sales, and manufacturing, while at the same time reaffirming 2012 full-year performance expectations. Earnings are anticipated to be in the range of $6.25 to $6.50 per share with organic sales growth of 2 to 5 percent and operating income margins of between 21 and 22.5 percent.

A year ago I projected that 3M would earn $6.35 per share with a 12-month price target on the shares of $107. Given the $5.96 the company posted and a recent closing price of $85.47, I was too optimistic. Nonetheless, the intrinsic value of the shares using a discounted earnings methodology is $124, while the more conservative free cash flow to the firm model yields an intrinsic value of $215.