Hello Fools,
I'm not so sure this a 'Falling Knive', so much as it might be a knife that's stuck in the wooden block, vibrating back and forth. Nonetheless, I'm looking at 3M Inc. (MMM) with an eye to a long-term option strategy (if that isn't an oxymoron). Below is my reasoning, and my calculation of payoffs. I apologize, but length-wise, this one's a doozy. I welcome comments and constructive criticism.
Summary
=======
MMM is trading at a low valuation relative to its discounted cash flows, its historical relative multiples, and its competitors. Uncertainty surrounding its CEO departure, as well as perhaps the perceived ease to digest its recent CUNO acquisition has punished the share price. I believe a synthetic long option strategy provides a lucrative way to profit from this situation.
The Business
============
I'm not going to go into too much description here. You all know who 3M is, and undoubtedly use more of their products than you know. There are seven major business segments (pretty much lifted verbatim from their website):
Consumer and Office - Supplying an array of products that keep homes cleaner, offices organized
and buildings well-maintained. Scotch tape, Post-it Notes, ScotchGard anyone?
Display and Graphics - World leader in films that brighten the displays on electronic products,
also touch screens and touch monitors; optical components used in projection TVs; reflective
sheeting for highway safety; and materials and systems for producing high-performance, attention-
getting graphic images.
Electro and Communications - Leading supplier of innovative solutions to the electrical,
electronics and communications industries
Health Care - innovative products and services help increase efficiency in the delivery of
patient care. Compete in multiple market segments, including medical and surgical products, pharmaceuticals,
dental and orthodontic products, health information systems, and personal care products
Industrial - strive to understand the diverse market segments – construction, food and beverage,
metal fabrication, oil and gas, woodworking and more – that make up the industrial marketplace. Use
that knowledge to provide innovative products and other solutions that make industrial customers
more competitive.
Safety, Security and Protection Services - major products include personal protection products,
laminates that help prevent counterfeiting of documents, reflective materials for personal safety,
window films, cleaning and protection products for commercial establishments, roofing
granules for asphalt shingles, and fire protection products that help
protect against the spread
of fire, smoke and toxic fumes.
Transportation - products and components for the manufacture, repair and maintenance of autos,
aircraft, boats and other vehicles. Major product categories include abrasives, tapes, films,
adhesives and specialty materials.
Beyond their product lines, I've put together, in no particular random order, a bunch of bullet points that I find interesting regarding how MMM has shaped their business:
* Consistent, long-term performer. A 25-yr CAGR of 10.5% without considering dividends, or
reinvestment of those dividends. Truly a stock that you could have bought and forgot about.
* Dow Jones Industrial Average component. First person that brings up 'Dogs of the Dow' gets slapped
with a Motley Fool Investment Guide.
* CEO has recently departed for Boeing. Uncertainty may be weighing on stock.
* Reputation for innovation. Six-Sigma a huge part of their business.
* Financially, things have looked great over the past five-and-a-half years, through the bubble
top, fall through 2002, and rise over 2003/2004. Some points:
- Continuing share buybacks: Shares O/S reduced 4% since 12/31/99
- Continuing rising dividends, although payout ratio has fallen to ~40% from 50% in 1999.
- Revenue growth compounded average of 5% since 1999
- EBITDA growth compounded average of 7.6% since 1999
- Net Income growth compounded average of 10.7% since 1999
- EPS growth compounded average of 11.5% since 1999
- FCF (as proxied by Owner Earnings) growth compounded average of 12.3% since 1999
- Given the disparity between top and bottom line growth, I likely don't need to tell you
that margins have steadily improved.
- Net debt has fallen from around $2.5 billion at the turn of the millenium, to essentially
nothing ($44 million) today (note, this is net of the effect of the CUNO acquisition, but then
again, I've not assumed any benefits in my forecasts either.
- Working capital management has steadily grown more efficient. The Flow Ratio (remember that?)
has fallen from 2.11 in 1999, to 1.47 as of Q2-2005. MMM's cash conversion cycle has fallen
from 113 days in 2000 to 82 days in the TTM ended Q2-2005.
- Cash flows have been depressed by the LARGE contributions MMM has made to fund their retirement
plans ($2.4 billion over the past three years). This repair work seems largely complete, and
so I expect their operating cash flows to increase going forward.
Other Fool Mentions
===================
I know MMM was an IV pick, but not being a subscriber I know little beyond that. However, we can make a few assumptions about the IV pick to support my thesis that MMM is undervalued. (I'll ignore the obvious - that MMM was recommended by a Value newsletter).
Since MMM is trading near it's 52-wk low, we can surmise that TMFAdmiral picked MMM when it was trading higher than today, presumably after the Q1 results knocked the stock from the $85 range to the $75 range. I'll assume the pick was made in the $72-$75 range. Given IV's focus on buying at a significant discount to intrinsic value, and assuming a 25% margin of safety, I'll guess that Philip's intrinsic value is in the $90-94 range.
Also, for those of you who subsribe to the BMW Method, MMM looks at least interesting. I admit, I'm not a proponent of the BMW Method, but that is due entirely to my lack of sitting down and digesting the material, rather than any comment on the work done by BuildMWell et al. In fact, I think Mike Klein's site is tremendous, so what better way than to shoehorn one of his excellent BMW charts into a post:
http://invest.kleinnet.com/bmw1/stats25/MMM.html
MMM currently trades at near it's -2RMS line of $69.26. As I understand it, only 2.5% of all observations will fall below the -2RMS line (a normal distribution, two standard deviations below the mean) and at the current price to return to it's long-term (25 year) CAGR, we could 'expect' a return of 21% as it returns to it's historical CAGR.
So there are at least some other proponents of a MMM value thesis.
Valuation
=========
Discounted Cash Flows
=====================
I won't bore you with all of the details, but my DCF valuations, tweaking various inputs, show a reasonable value range of $83 to $88, so we have, at least, a moderate margin of safety.
Relative Valuation - MMM Historical
===================================
Over the period Jan-00 to Aug-05, MMM is trading at near lows on a multiples relative valuation approach. Calculated on a month-end rolling TTM basis (for example, the month-end price in July 2002 calculates multiples based on the TTM financial results of June 2002). The table below shows the multiples over this time, and the current numbers (as of close, Aug 31).
P/E
P/S (diluted) EV/EBITDA EV/FCF* P/FCF EV/OE** P/OE**
--------------------------------------------------------------------------------------
Mean 2.90 25.3 12.3 23.8 22.9 24.9 23.9
Median 2.94 25.4 12.4 22.1 21.3 23.7 22.8
Max 3.78 35.0 15.3 39.0 36.9 36.8 34.8
Min 2.05 18.0 8.8 16.8 16.7 17.9 17.8
--------------------------------------------------------------------------------------
Current 2.64 18.1 9.4 16.9 16.9 17.8 17.8
--------------------------------------------------------------------------------------
* FCF defined here simply as Free Cash Flow: FCF = CFFO - CapEx
** OE defined here simply as Owner Earnings: OE = Net Income + Depr/Amort - CapEx
I'm sure some could argue that 3M going forward will not command as high multiples as in the past. So we'll try to build that in somewhat going forward. (And besides, if 3M is granted higher multiples going forward, it will improve my strategy, so there's really no downside there.)
Relative Valuation - Competitors
================================
Fairly brief here. Who are 3M's competitors? Not such an easy question with conglomerates. I'll admit, I'm pulling these competitors and data from Yahoo! and MSN. Labeled as part of the 'Conglomerates' industry group, the top 10 are: GE, Tyco, 3M, United Technologies, Honeywell, Mitsui & Co., Fortune Brands, PPG Industries, Textron, and Rockwell Automation (a disparate group, to be sure, and not a direct competitor in the bunch). Still...stacking them up:
P/E
P/S (diluted) EV/EBITDA EV/FCF* P/FCF ROE**
------------------------------------------------------------------------------
GE 2.19 19.8 22.0 32.2 16.0 17.4%
TYC 1.38 23.2 8.1 15.7 13.1 8.9%
UTX 1.31 16.9 8.6 18.7 17.0 21.9%
HON 1.23 25.4 10.8 21.9 19.6 11.3%
MITSY*** 0.51 15.8 15.9 110.9 42.0 11.7%
FO 1.74 15.7 9.9 27.4 24.3 26.3%
PPG 1.07 15.5 7.0 17.2 15.9 21.7%
TXT 0.84 20.8 10.9 25.1 15.5 11.8%
ROK 1.97 17.6 10.7 17.5 17.0 27.4%
--------------------------------------------------------------------------------------
MMM 2.64 18.1 9.4 16.9 16.9 33.2%
--------------------------------------------------------------------------------------
* FCF defined here simply as Free Cash Flow: FCF = CFFO - CapEx
** I calculate ROE as Net Income divided by the average of starting and ending equity
*** I don't trust the FCF numbers for MITSY. There are no proper filings for TTM, so I'm relying on
Yahoo! which is sketchy.
Looking at our poorly-chosen comp table, I'd say MMM is at least in the upper echelon quality-wise, with the highest ROE, and second lowest EV/FCF (and I think Tyco's past scandals might still be weighing on that price) relative to the others.
Forecasted Prices
=================
In my DCF, I forecast pro-formas based on past performance such as growth, margins, and various turnover ratios. From the pro-formas, I then apply price multiples in order to infer future prices. In the case of MMM, in recognition of the perhaps continued low price multiples granted by the market, I used multiples that are closer to the bottom of the historical range:
P/S - 2.75x
P/E - 20x
EV/EBITDA - 10x
From my pro-formas and these assumed price multiples, my forecasted price ranges (worth what you paid for them) are:
Q2-2006 TTM - $80.00 - $83.50 (Prices assumed upon release of the particular qtrly numbers)
Q2-2007 TTM - $86.00 - $89.00
FY-2007 - $90.00 - $93.50
Option Strategy - Synthetic Long
================================
Quick primer: A synthetic long uses options to recreate the profit payoff of a long position in a stock. This is done by simultaneously buying a call and selling a put with the same strike price and time to expiry.
The specific synthetic long I'm thinking of here is:
Buy the JAN08 $75 Call for $8.50
Sell the JAN08 $75 Put for $9.40 Note - prices will vary as the stock price fluctuates
Advantages
* Long time horizon (relatively speaking - this is an option strategy, not LTBH)
* Call purchase completely financed by sale of put. Small credit of $90 per contract
deposited in account.
Disadvantages
* The strategy is out-of-the money, meaning the call has no intrinsic value and is completely
comprised of time value. The delta of the call option is around 0.55, meaning a $5 fall in
the price of the stock will translate to a rough drop of $2.75 in the price of the call. However,
that $5 drop in stock price is only a 7% loss for the stock, as opposed to the $2.75 option
price drop, which translatse to a near 33% fall in option value. Those without strong stomachs
for volatility could get queasy (actually, I'd just advise avoiding looking at your option prices
on a daily, or even monthly, basis).
* You'll need significant margin collateral in your account to affect this strategy, since the
put is sold naked and uncovered.
* MMM pays a nice 2.4% dividend yield. However, the holder of a synthetic long does not profit
from dividends.
* This strategy will hopefully result in a rich payoff. However, the taxman will certainly
have his hand out. Were we to simply buy the stock, we'd avoid the loss of capital to the
taxman (although the option payoff should compensate us for that loss of capital).
Payoff Expectations
===================
I'm using the Black Scholes option pricing model to price options on dates between now and expiry. I realize this will tend to understate true value, but it's a good tool nonetheless. Payoff expectations on those interim dates are assumed as if I've closed out the respective option contracts (buy put/sell call), but I'm not including commissions.
Also important to note, I've had to make some assumptions with regards to the parameters for the option pricing. Those assumptions are:
* Increasing dividends. Assume that the remainder of 2005 will see quarterly payments of $0.42/shr,
2006 will see quarterly payments of $0.46/shr, and 2007 will see quarterly payments of $0.50/shr.
* Flat yield curve. Current risk-free rate is ~3.80%
* Constant underlying volatility, currently around 22.3%
Using our forecasted prices from above, and using the dates when the up-to-date quarterly numbers
likely will become available, the table below shows the payoff per contract:
Forecasted Payoffs/Contract
Date Stock Price Call Price Put Price Call Put Total
===============================================+=====================================
20-Jul-06 $80.00 $11.57 $5.19 | $1,157 -$519 $ 638
$83.50 $14.03 $4.14 | 1,403 - 414 989
19-Jul-07 $86.00 $12.64 $1.21 | 1,264 - 121 1,144
$90.00 $16.13 $0.70 | 1,613 - 70 1,543
18-Jan-08 $90.00 $15.00 $ -- | 1,500 -- 1,500
$93.50 $18.50 $ -- | 1,850 -- 1,850
===============================================+=====================================
Risks - Action if Things Go Poorly
==================================
The worst-case scenario is that the call expires worthless, while the put expires in-the-money. We have two-and-a-half years for that to play out, but you'd be looking at an effective buy price of $74.10 per share if this occurs (since we get the $0.90 credit due to the disparate option prices). That's $7,410 per contract folks, so don't sell 10 contracts unless you can afford to pony up for the shares at the conclusion. Sure you could sell the put fairly close to expiry, but it would essentially be for intrinsic value (strike minus then-current stock price). At the worst, you'll end up owning shares in a fairly good company (I can think of worse fates), at a higher price. You could then use a covered call strategy, or other income strategy to try to recoup some losses.
Again, using my forecasted prices come Jan-08 (and I believe I've been conservative, forecasting 7% bottom line growth, and no improvements in margins or working capital efficiency), price multiples for MMM shares would be:
Option Strategy
Price P/S P/E EV/EBITDA Gain/Loss (Held to Maturity)
================================================================
$75.00 2.31 16.0 8.3 $ --
$70.00 2.16 15.0 7.7 $ 410
$65.00 2.00 13.9 7.2 $ 910
================================================================
All (except some P/S multiples, which I put less stock in) are lower by a good margin than anything we've seen since 1999 (and likely before, I just didn't bother calculating those).
Conclusion
==========
I think this is a substantially lucrative payoff on a fairly low risk (again, if that isn't an oxymoron) option strategy. The stock's in the dumps, but it will not always be so. There is uncertainty regarding leadership and acquisition integration, but it will not always be so. The risk of loss is fairly minimal, and I believe my forecast has been made conservatively, and doesn't reflect the company's history of improvement and increased efficiency.
No money down, potentially big rewards.
Okay Fools. Have at 'er.
Cheers,
Jim
