A Defensive Multi Industry Play

By Ashish Sharma - August 22, 2012 | Tickers: MMM, RAVN | 0 Comments

• Email
• Print

3M Company (NYSE: MMM) is renowned as an defensive investment as it tends to experience far lower core revenue attrition during times of recession, supported by exposures to Healthcare, Consumer and Safety end markets.  Last month, 3M reported 2Q12 EPS of $1.66 (vs. consensus estimates of $1.65) including a $0.03 restructuring headwind and $0.02 benefit from insurance recoveries. Operating margins were better than expected with 130 basis points YoY rise.   Management reaffirmed its EPS guidance but raised the low end of operating margin by 50 basis points. I believe that company’s rapidly shifting ability to manage profitability, strong growth prospects with expanded localized emerging market sales and new product development capabilities will provide upside to the bottom line.

Different segments and their potential in emerging markets

Following charts provides sales growth, profit margins for different segments for the second quarter as well as revenue (as a percentage of total sales).

Going forward, I believe Emerging markets (30%+ of sales) represent a significant opportunity as middle class populations increase and trade up in purchases. It is encouraging that the company is focused on further expansion and penetration in emerging markets.  The following are the key initiatives the company is undertaking in its different segments.

3M Healthcare is not particularly well positioned in Emerging Markets yet, with only 14% of segment sales into Asia Pacific and 10% into Latin America (lowest of 3M’s segments). However, Healthcare spending in China has seen accelerated trends and thus, there is a window of opportunity for 3M Healthcare to get bigger in China.

Consumer & Office has only ~35% emerging market exposure in 2012 and the company is targeting to take this number up to 50% by 2014. I expect good results in the near-term as well since 3Q is a seasonally strong quarter for this segment (typically 29% of the segment’s annual operating profit) with bump from back-to-school sales.

Electro & Communications segment (one-third of the segment’s revenues) sells specialized adhesives, tapes and films into the electronics market. This is the highest emerging market exposed segment in the company with 44% of sales to Asia Pacific.  I believe that over the next five years, this already sizable business of approximately $1 billion should experience significant growth driven by advances in battery technologies and adoption of touch-screen devices.

Industrial & Transportation segment, over the next five years is expected to grow at 7-10% CAGR. I expect 3M margins in the segment to be benefitted from falling input costs and stable pricing in near term. 

Solid core growth is supplemented by impressive balance sheet

The company has significantly improves its balance sheet as net debt of $4 billion today is lower than ever since 2008 while equity is higher. The company has paid a cash dividend to shareholders every year since 1916 and has increased its dividend payments for 54 consecutive years. No doubt, 3M has more levers to pull than ever before to use acquisition to enhance the company's underlying organic growth rate. So far this year 3M has announced three acquisitions:-

• Avery Dennison's consumer product business for $550 million
• Federal Signal traffic management business for $110 million
• Code Ryte, a healthcare language processing business for ~300 million

I like this strategy to undertake smaller acquisition as large acquisition could affect 3M's business and thus become far more complex to integrate. Moreover, I believe that these acquisitions are likely to bring excellent return on capital employed. It seems that 3M's acquisition are generated by business and not by corporate as mostly all acquisitions tend to improve the existing dynamics and productivity of the company. For example, management expects that from acquisition of Code ryte, it will be able to enhance 3M's ability to capture, digitize and codify hospital digital records and test results.

Easing material costs to offset FX headwinds

Material costs have begun to come in lower than expected and are expected to be nearly flat in 2H12. This has proved critical in the past considering FX pressures (FX reduced reported sales by 4% in 2Q12 as compared to 0.9% in 1Q12) and likely to more than offsets FX headwinds in the later half as well. Thus, company’s improving price/cost gap is expected to alleviate near term currency headwinds.

I believe with a strong balance sheet, the company is well positioned to fund growth investments, buybacks and additional bolt-on acquisitions. Given ongoing cost control, any revenue recovery should result in rapid realization of the underlying earnings power and improvement in sentiment. 3M is trading at a forward PE of 13.31 and a 1.4% premium to its large-cap industrial peer group average. The company is trading at a 31.1% discount when compared to its peer like Raven Industries Inc. (NASDAQ: RAVN). However, we believe this is not justified given vast expansion opportunity in emerging market, solid core growth, impressive acquisitions and a better dividend yield of 2.6% (as compared to Raven’s 1.2%). As 3M moves to a structurally higher earnings growth trajectory while maintaining its peer-group-leading returns and margins, I expect a gradual increase in valuation. Thus, I recommend it a buy.

Note: The article was originally published on TheAnalystHub.com. For more in-depth research articles please visit our site today.

• Email
• Print
• Feedback