Uncertain Times Won't Derail 3M

With a diversified revenue base and mostly short-cycle businesses,  3M (MMM) tends to feel the pinch of economic weakness very rapidly. However, it proved its ability to maintain decent profitability during the last recession and was able to increase pricing as volume cratered. Given its strong returns on invested capital, solid balance sheet, and relatively conservative need for capital allocation, we believe 3M is an attractive investment.

The company's expectations for revenue and profitability in 2012 nearly mirror our own. Management expects slowing volume growth this year, but as in 2009, it believes sales can get a boost from price increases and acquisitions. In all, including currency headwinds, 3M forecasts a 3%-8% top-line increase for the year.

This rate is below the long-term goal of 7%-8% internal growth, but the firm still believes its targets are attainable based on many of the same tenets it has previously outlined: an increased New Product Vitality Index, a move toward higher-growth markets and geographies, and scale-related benefits from acquisitions. Although 2012 is likely to prove difficult for 3M's end markets, the company's general competitive position has probably not changed materially.

3M believes it can generate 21%-22.5% operating margins in 2012, even with slower revenue growth. We saw relatively stable margin performance during the 2009 downturn (still north of 20%, even as sales fell about 9%), so we think this target is attainable. We model similar profitability in our discounted cash flow model.

Still, it's possible that the global economy could prove far weaker than expected, as 3M admitted it does not include a renewed worldwide recession in its forecast. In such a case, we anticipate that the firm would see declining volume, probably still mitigated by price increases. We think factory underutilization would lead to slight margin degradation and an earnings per share decline of about 10% versus management's current 8% growth expectation. We estimate the company's fair value at about $78 per share in this case, not far below current market levels.

Investing for the Future
Regardless of the near-term economic landscape, 3M plans a similar level of capital expenditures in 2012 as 2011 (about $1.4 billion), building out its geographic manufacturing reach. The six most recent bolt-on purchases are ahead of budget, and the company plans to invest another $1 billion-$2 billion in purchases this year.

In addition, management plans to fully integrate the company on one SAP IT system--a process that could take at least seven years. This project is estimated to cost $600 million-$800 million through 2017 (probably less than 0.5% of total revenue over the period), but will save $500 million in annual operating costs while also reducing the firm's working capital needs by $500 million. The lack of full IT integration hasn't muted 3M's profitability in the past, and the company's tardiness to the process may actually reduce disruption to its business. We're also encouraged that this is CFO David Meline's fifth such implementation of his career.

We think the company's balance sheet and cash flow generation are strongly positioned to support such actions. Management estimated it would have about $4.4 billion in cash equivalents (versus roughly $6.2 billion in debt) at the end of 2011 and $6.4 billion-$6.8 billion in cash flow from operations in 2012. Net of mergers and acquisitions, capital expenditures, planned pension contributions (about $0.8 billion-$1 billion), and debt maturities ($500 million-$600 million), 3M plans to have about $2 billion-$3 billion in available cash flow for share repurchases and dividend increases.

3M estimates its optical film division will account for about 4% of 2012 revenue, down from about 7% in 2010 because of weakness in LCD television demand. Investors often point to this unit as an example of underperformance at 3M, but this TV end market will make up just 25% of the division next year, down from nearly two thirds in 2010. Results have declined as a result of shifts in customer preferences and low prices for substitute solutions, but the firm is having some success in film sales for tablets, smartphones, and other battery-powered devices (which can make better use of 3M's power-saving offering). Regardless, the business will contribute only a small portion of 3M's revenue in 2012, while likely maintaining profitability near company averages.

3M Looks Undervalued
Our fair value estimate for 3M is $100 per share, based on long-term operating profitability that we expect to be slightly above current levels as a result of the aforementioned productivity improvements and a continued push in new products as a percentage of overall sales. We forecast slowing 2012 top-line growth, but a rebound after that toward the firm's long-run goal of high-single-digit internal growth rates. Barring another global recession, we think 3M's stock looks attractive, given its price/forward earnings multiple of about 13 times and a dividend yield of 2.6%. Our fair value estimate suggests a P/E ratio of about 16 times 2012's earnings, still below the company's historical high teens average.