3M (MMM) - Valuation Analysis

Description

3M Company (3M) is a diversified technology company with a presence in industrial and transportation; health care; display and graphics; consumer and office; safety, security and protection services, and electro and communications. 3M manages its operations in six operating business segments: industrial and transportation; health care; display and graphics; consumer and office; safety, security and protection services, and electro and communications. 3M products are sold through numerous distribution channels, including directly to users and through numerous wholesalers, retailers, jobbers, distributors and dealers in a variety of trades in many countries. In February 2011, 3M (industrial and transportation business) announced that it completed its acquisition of the tape-related assets of Alpha Beta Enterprise Co. Ltd. In February 2011, it acquired Hybrivet Systems Inc. In April 2011, it acquired Original Wraps Inc. In July 2011, it acquired Advanced Chemistry & Technology Inc.

Source: Reuters

Valuation

Key assumptions included:

                Terminal growth rate: 3.0%

                Risk-adjusted discount rate: 10.8%

                Cost of sales: 52.0%

                Selling, general, & administrative costs as % of sales: 21.0%

                Research & development as % of sales: 5.5%

                CAPEX as % of sales: 4.0%

                Depreciation as % of sales: 4.5%

                Effective tax rate: 30.0%

                Day sales in receivables: 50

                Day sales of inventory: 82

                Days payable outstanding: 44

At a 12% growth rate (bull case), I estimate the intrinsic value of MMM to be $95.00 per share.  With a risk-adjusted margin of safety of 11.1%, the target purchase price is $84.46 per share.  This is above the $81.22 per share MMM is currently trading at.  At $81.22, MMM is trading at 14.5% below the intrinsic value indicating it is a value in this scenario.

At a 6% growth rate (bear case), I estimate the intrinsic value of MMM to be $79.56 per share.  With a risk-adjusted margin of safety of 15.4%, the target purchase price is $67.30 per share.  This is below the $81.22 per share MMM is currently trading at.  At $81.22, MMM is trading at 2.1% premium to the intrinsic value.

Dividends

MMM pays a quarterly dividend.  From 2001 to 2010, MMM’s dividend has grown from $1.20 per share to $2.10 per share.  The dividend appears to grow slower than earnings and management appears to have an aggressive stock repurchase program.  The compound annual dividend growth rate is as follows:

                Ten years: 6.8%

Five years: 5.7%

                Three years: 3.0%

With the dividend appears to be growing slower earnings, the dividend appears to be sustainable.  Based on net income, the dividend payout ratio has exceeded 50% in the past five years.  A dividend payout ratio of less than 50% is a positive allowing for sustainable growth and a cushion for short-term earnings volatility.  Below is the dividend payout ratio for the past five years:

                2006: 35.7%

                2007: 33.7%

                2008: 40.4%

                2009: 44.8%

                2010: 36.7%

In the book, The Ultimate Dividend Playbook, Josh Peters discusses a model to calculate a stock’s prospective return.  The model is called the Dividend Drill Return Model (DDRM).  It is based on the premise that the dividend total return is equal to the yield plus dividend growth.  Dividend growth is then broken into core growth (the rate of growth for total profits) plus share change (reduction of shares due to share repurchase). 

Given a core growth rate of 12.0% and current dividend yield of 2.7%, MMM’s cost of growth is $2.69 per share.  After reducing this amount and dividends of $2.20 per share, the funding surplus is $0.83; this amount is forecasted to have a 1.0% impact on share price.  As a result, the DDRM forecasts the projected total return for MMM to be 15.7%.  Below is a breakdown of the total return:

                Core growth rate: 12.0%

                Dividend yield: 2.7%

                Funding surplus: 1.0%

                Total return: 15.7%

Summary

In a bull case, based on a valuation $95.00, shares are trading at a 14.5% discount to their intrinsic value.  In a bear case, base on a valuation of $79.56, shares are trading a 2.1% premium to their intrinsic value.  MMM has a history of dividend increases and the dividend appears semi-sustainable as the payout ratio is less than 50%.  Based on the DDRM, the projected total return for MMM is 15.7%.

Disclosure: I am long MMM.