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Investors' Options on a Wide-Moat Pick

Erik Kobayashi-Solomon

Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, co-editor of OptionInvestor from Morningstar. I am here with Adam Fleck, senior equity analyst on the industrials team at Morningstar.

Adam, as you know, back in November, I recommended to our readers to sell puts on 3M MMM, struck at $55 a share, giving them a buy price of less than $50 a share. Yesterday, on inauguration day, the price actually slipped below our strike price. So, I just wanted to talk to you a little bit about kind of sources of uncertainty at 3M.

Adam Fleck: Sure

Erik Kobayashi-Solomon: So, one of the things that I had mentioned in the original writeup was the optical films business and the electronics business. Can you give a little more color on those businesses?

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Adam Fleck: Absolutely. The optical films business certainly has been a source of uncertainty Eric. The problem is, if you look at the optical film business, it's not a large part of 3M's business.

In 2007, the display and graphics segment was about 16% of sales, optical films was about half of that, so you're talking less than 10% of their sales. However, there has been a major concern with how the dynamic has shook out for 3M's demand in that market.

The major concern has been the film that 3M produces for LCD televisions. This is a film that is quality enhancing, that is for top line LCD televisions. What 3M didn't bet on was that consumers were very quickly apt to sacrifice quality for price. You had a company like Visio, that quickly shot to the number one market share.

Erik Kobayashi-Solomon: I was just going to say, this is a Visio effect.

Adam Fleck: Absolutely, and Visio doesn't use 3M's film. 3M tried to defend its position and completely lost it to market share. However, going forward, we don't think this has a huge impact on the stock price for us. It doesn't hold a whole lot of value for us.

Erik Kobayashi-Solomon: What's happening with their optical film business right now? Do you think it has bottomed at this point? Is there any chance for them to turn it around?

Adam Fleck: There is. I think it has bottomed. I think 3M's market share although has fallen dramatically, it's a pretty stable position at this time. There is some opportunity there for power conscious consumers, energy conscious consumers who want to use 3M's film and buy televisions that use less light bulbs, because it's able to spread the light out more effectively.

Erik Kobayashi-Solomon: So, kind of the Obama green effect?

Adam Fleck: Perhaps, perhaps.

Erik Kobayashi-Solomon: To get a little pick up from there.

Adam Fleck: Absolutely. Now, you alluded to of course the electronics market as well, similar dynamic here. This is 3M's smallest segment: It's their electro and communication segment. About 40% of that is their electronics business.

What this is, is they sell to end markets such as cell phones, hard drives, printers. It's actually held out pretty well this year. Sales through the first nine months were up about 6%. Operating profits were up about 11%. So, it's doing well so far, and I think part of that is the fact that this is their segment, which has the least U.S. exposure, only about 30% of sales here at domestic.

Erik Kobayashi-Solomon: I see, so a minimal exposure to kind of U.S. problems?

Adam Fleck: Absolutely. Although, there is concern of course of the global recession, that's consumer demand driven. There is of course a problem that you could have less consumer spending on these types of electronics that are more discretionary in nature. Already, 3M is seeing a bit of weakness in for instance their inkjet market.

Erik Kobayashi-Solomon: The rest of 3M's portfolio, the reason that it really attracted me is because it's mainly throwaway stuff, and stuff that they get good margins on. How do you see the economic weakness kind of affecting that part of the business?

Adam Fleck: Absolutely. It definitely is more essential, disposable materials, especially when you look throughout their abrasives segment, when you look throughout their healthcare segment, their safety segment. These are products that people are going to use and dispose of and renew no matter what the economic condition is.

However, you did allude to the fact that of course there is opportunity specifically for a company like 3M. Already, for instance they've been doing some bolt on acquisitions throughout the year, and through late 2007 and up to 2008 they have been adding to their core competencies and safety and abrasives.

Erik Kobayashi-Solomon: They have the balance sheet to support that?

Adam Fleck: Absolutely. They have a very clean balance sheet, and they have a 1.5 billion revolving credit line outstanding, that they'll be able to continue that I think.

Erik Kobayashi-Solomon: This actually leads me to one of the questions that I had looking at the financials myself. That is, they have always prided themselves on organic growth, but lately it seems like they are having to acquire sales growth. Is that a fair complaint about their businesses? Is this helping or hurting them do you think?

Adam Fleck: I think it's definitely helping. For one, they are continuing to spend on their research and development cost. They are continuing to develop about 5% to 6% of sales and they look to do that going forward as well.

Not to mention, if you look at their return on invested capital, which is a huge metric for Morningstar, it's actually improved in the last 10 years, over 30% from about 22% as sales has increased about 50%. So, it's definitely been successful for them.

Erik Kobayashi-Solomon: I see. So, now we're looking at 3M right around our $55 strike. That means we're buying their stock. If we are assigned these options for something like $49.50, something like that. Right about there, what kind of dividend yield are we getting? How much are they paying in dividends?

Adam Fleck: They are paying about $2 a share in dividends. So, you're looking in upwards of 4% or 5%. We have an $85 fair value on this stock, so we definitely think it's a good deal for investors.

Erik Kobayashi-Solomon: Right. Well Adam, thanks a lot. I appreciate you kind of walking us through and giving us a little color.

Adam Fleck: Absolutely, anytime Erik.

Erik Kobayashi-Solomon: Thanks very much, and please continue to the OptionInvestor site. We've got lots of great investment ideas for up or down markets. I'm Erik Kobayashi-Solomon, thanks for watching.