Saturday, April 18, 2020

MMM Analysis - Part 3

This is the last post in the three part analysis of 3M.

We have discussed 3M's investment thesis and its positives. Here's a summary:

3M is an innovative industrial conglomerate that has built its brand in safety healthcare and other niche segments in infrastructure and consumer businesses. It benefits from growth in Asia and US healthcare on the back of strong pricing power. The management understands capital and resource allocation well and has delivered a stellar track record of shareholder return. It is also one of S&P's Dividend Aristocrat.

3M has close to 40% of its businesses in growth segments namely Asia and healthcare and these businesses would be its growth engines in the next few years. Coupled with its strong management capabilities and focus on shareholder returns, 3M is poised to be deliver good performance. But we also need to understand its risks and look closely at valuations. If the stock price has already factored in all the goodness, then as investors, we cannot benefit. This is an important point that even seasoned market practitioners sometimes fail to understand.

Buy when price is way below value

This is also the reason why Benjamin Graham, the grandfather of value investing said that, "The three most important words in investing is - "margin of safety". Margin of safety refers to a buffer we need to incorporate into our calculation of the intrinsic value of the company. This means that we can only buy when the stock is way cheaper than its true worth. In short, valuations matter, if we overpay, we are not going to get returns because the high price we paid has factored in the growth many years ahead.

This is like paying up for an expensive meal or an expensive wine or whisky. If we spent $1,000 on a fancy dinner, it could be a very nice experience, the food could be exceptional and the service top quality, but we didn't profit from it. We paid up. Similarly, drinking expensive wine or whisky brings little "profit" except feeling shiok*. Unless it's a hot date and even though she's wearing a mask, your heart is beating so fast that margin of safety is the last three words that would come to your mind.

Margin of safety sir?

Haha, ok jokes aside, paying up usually have very little benefits. It's just emotional high and bragging rights. As such margin of safety, i.e. don't pay up goes against dating rules. But it is paramount in investing. By not paying up, we reduces the risk of losing money, even if we got the whole investment thesis wrong and overlooked all the damned risks. Alas, in our new era of negative interest rates, disruption and bitcoins, nobody talks about margin of safety today.

However, an investment always carries risks. The only protection that investors have is to know the risks and know the valuations well so that we know we are not overpaying. Back to 3M, we know there are a few big risks overhanging. We will discuss two today. The biggest of which is PFAS litigation. PFAS is an acronym for per- and polyfluoroalkyl substances. These were found to be harmful to humans, like asbestos in the past.

PFAS are a group of man-made chemicals that includes many other acronymic chemicals which most people (including this blogger) have no idea what the non-acronym names actually meant. But importantly, PFAS have been manufactured and used in a variety of industries around the globe since the 1940s and it was discovered that PFAS are super harmful to both humans and the environment. Sadly, 3M has manufactured and used many of these chemicals.

One of the many PFAS chemicals

As things turned out, 3M is on the hook to pay off huge litigation costs related to PFAS. The company took a USD 200m pretax provision charge but analysts are saying that the true cost could be in the tune of USD 5-10bn. Meanwhile the markets had factored in even more, with 3M's market cap dropping more than USD 20bn after this risk broke out. So in an interesting twist, the PFAS risk is already factored in by the drop in share price. Is actual impact then mitigated? Well, yes and no. Yes, because it dropped more than what the analysts calculated. But no, because the future is not predictable. Is it really only USD 20bn? What we have to really worry about is that more litigations will come and the true cost is not USD 20bn but more, say USD 40bn. Then we as shareholders are on the hook.

This is why Ben Graham said margin of safety was important.

3M has another risk which is related to the economic cycle. 30% of 3M's sales is described as short cycle and capex driven. This means that when the economic cycle is going into a downturn, 3M's customers are prone to cut back on buying these short cycle products. Needless to say, capital expenditure or capex, would also be cut back. This is the reason why 3M tend to fall before economic indicators actually turn bad. Conversely, during an upcycle, 3M's share price tend to rise before the rest of the market.

3M is not doing well despite it being a COVID-19 beneficiary with its N95 masks selling like hotcakes and its healthcare business seeing strong demand. This could be due to the PFAS litigation overhanging but we could also say the overall economic situation with COVID-19 will weigh on 3M. So, 3M could go down before it goes up. This is a timing issue. It's not easy to catch stocks right at the bottom and usually we will miss the whole rally by trying to be too smart. Hence, value investors like to look at valuations.

3M's share price since 1970

At today's price, 3M trades at 6% free cash flow yield which is considered cheap for such a high quality company. This is derived by dividing 3M's market cap of USD 90bn over its free cash flow at USD 5 to 6 bn per year. Looking at other valuation metrics, 3M trades at 15x PE and 12x EV/EBITDA. Since the global negative interest rate regime started in 2016, we can hardly find quality at low to mid teens multiples, especially PE. Lastly, just to complete the picture, 3M's Price-to-book is at 8x with ROE at 50%. Ben Graham would have scoffed at anything trading at 8x book. But we are living in a different world today. Remember? Interest rates are negative! Book value is no longer as meaningful.

So rounding everything up, I would say 3M is cheap. 3M's share price peaked at c.$240 when its PE was 24x and FCF closer to 4%. I think we would see the company going back there when the PFAS issue is resolved. This might take a few years and that's the kind of trade that I have been quite successful with over the last decade (see Bayer). I think it's a good risk reward and I should buy the stock even if I couldn't get its N95 masks.

* Shiok is a Singapore slang referring to something being enjoyable. 

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