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. 

MMM Analysis - Part 2

This is a continuation of 3M's analysis.

In the last post, we gave the background on 3M and why it's a good stock. Today, we shall formally write down its investment thesis, analyze the other positive factors, look at its risks and finally determine whether valuations are reasonable. I find that documentation is really a good practice for all investors. It makes the whole process transparent and we can look at to learn what worked and what did not. So, do write down our thoughts before buying or selling, even if it's just one line.

Okay, here's 3M's investment thesis:

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 Dividend Aristocrat.

The Dividend Aristocrat is a list of stocks in the S&P500 index that has increased its dividend payout for at least 25 freaking years. As of 2020, there are 64 stocks according to the wikipedia page. The table below shows an old list with the annual returns and absolute price change. It seemed that one can get a high single digit return by any dividend aristocrat stock.  

Dividend Aristocrat - Old List

Let's return to 3M, so we have got the investment thesis. We would want to support it with a few strong points. In investment lingo, we usually call these positives. As alluded above, 3M has a few positives going for it. Its growth sectors are Asia, which makes up c.30% of sales and healthcare, which makes up c.25%. There could be some overlaps so growth in total might be 35-40% of sales. As these portions grow, earnings improvement could accelerate from the current low single digit levels to something closer to its historical performance (13% according to the table above).

How did we get these numbers? Can we be sure Asia and Healthcare makes up 35-40%? Well, we can never be 100% sure. It is just a ballpark. In the past, Warren Buffett spent all his time scouring through annual reports/10K year after year to figure all these out. We can still do that today, but analysts, Bloomberg and reports usually do a good job putting all these together. The following are the segment and regional splits we can get from its 10K. The parts in red are of our interest.

3M EBIT split, margins and short descriptions:

Healthcare 24%, OPM 25%, skin and wound care, infection prevention, patient warming and oral care, food safety indicators, coding and reimbursement software etc.

Transportation and Electronics 28%, OPM 23%, display materials and systems, automotive and aerospace, advanced materials and transportation safety etc

Safety and Industrial 34%, OPM 23%, personal safety, adhesive and tapes, abrasives, automotive aftermarket, roofing granules, electrical markets etc.

Consumer 14%, OPM 22%, consumer tapes, Post-It notes, home air filtration, cleaning products, bandages, braces and supports, retail abrasives etc.

Geography split:

US 39%

APAC 31%

EMEA 21%

Latam/Canada 9%

As we can see, 3M enjoys good margins across its business segments. None of the its businesses are below 20% margins. Its geography split is also well-balanced with growth regions making up half or more of its overall revenue. Its ROE is even more spectacular at 40-50% annually over the last few years. Besides its high ROE, we also know from the slide below that 3M is laser focused on good capital allocation and shareholder return.

As such, 3M's exposure to growth sectors (healthcare and Asia), its stellar track record of capital management built on the back of its strong brand rounds up the investment thesis for 3M. Needless to say, it benefits from idiosyncratic events such as the coronavirus outbreak precisely because of its strong brand as a safety and healthcare pioneer.The stock is also a leading barometer for the industrial cycle. It is usually the first stock to recover at the bottom of the cycle. Hence by having the stock in the portfolio, we then tend to be able to monitor the cycle better which helps with our assessment on the other stocks in our portfolios.

In the next post, we shall look at 3M's risks and valuations.

Huat ah!

MMM Analysis - Part 1

3M (ticker MMM) is a stock that I have looked at ten years ago right after the financial crisis but never gotten to buy. This is one of the biggest opportunities missed. The share price at that time hovered around $80 to $90 but collapsed below $60 after Lehman Brothers went down. It was trading at 10x PER and looked really interesting. However, with the state of the global financial system at its brink and this blogger could not muster the courage to buy the stock.

Since then 3M went on to quadruple its share price hitting $240 at its peak back in 2017. It has since fallen to $170 on the back of the trade war in 2019. At the start of the year, Trump and Xi secured an initial deal to reverse the trade war which helped global markets but little did we expect the Wuhan virus outbreak to hit us. The stock fell further to $158 last week. When the dust settles, it might be a good opportunity to finally own a piece of this spectacular company. The chart below tells its history nicely.

3M was founded in 1902 as Minnesota Mining and Manufacturing company but has since evolved into a diversified industrial conglomerate with unique businesses. The chart above showed how it started as a maker of infrastructure supplies and subsequently branched into industrial, manufacturing and safety products. Some of these early businesses are still supporting its earnings today. It has built strong branding in specific industries, allowing the firm to charge higher pricing vs its competitors.

Today, the firm is focusing on retail and healthcare where its innovative prowess has helped created differentiated products from Post-It Notes to 3M N95 masks to waterproof band-aids for intensive wound care. 3M takes pride in its culture of creativity and has created one of the most conducive corporate environment to nurture innovation. Numerous case studies had been done to figure out how 3M continued to be an innovative company for 100 years.

3M's secret to unleash people's creativity was deceptively simple. It was to empower its employees and giving them freedom to create products as they wished. 3M was also a master at organizing people. Human organizations eventually get too complexed over time and 3M consciously keep its working groups small, making sure that politics and people issues are kept minimal. It is said that humans cannot have deep relationships with more than 150 people in their lifetimes and 3M had adhered to this logic. Without politics and empowering people to do what they want, creativity flourishes. In my view, this is 3M's secret sauce.

Today 3M is investing in new priorities and growth platforms as shown above. Some of these are really top global concerns: air quality, food safety, grid modernization. Business opportunities are abundant and 3M is ideally positioned to capture them. Together with its anchors in its core businesses today, 3M's foray into these areas would bring about the next phase of growth.

3M's ability to harness innovation is further strengthened because of its financial savviness. The company intrinsically understands the importance of growth, free cash flow, return on invested capital and margins. 3M's focus on ROIC and FCF are the tenets of good companies. This is evidenced by its consistently high ROIC (above 20%) and strong FCF (c.USD 5bn per year) over the last five years.

3M organizes itself into four segments: Health Care, Safety & Industrial, Transportation & Electronics and Consumer. All four segments boasts margins above 20% with Health Care leading the pack at 28% for 2018. These high margins are very sustainable on the back of its strong branding, innovation and economies of scale in some of the niches that the firm competes in. In the next post, we shall delve into some of its strengths here and discuss both valuations and risks.

Stay safe, wear masks and sanitize!

Trees, Mass Destructed, Masks and Madness - 3M

Last week was hell week in Singapore.

For the global folks who are uninformed, Indonesia burned down Sumatra's virgin forests to make way for crop plantation and resulted in drastic air pollution as the haze from the smoke invaded half of South East Asia, with Singapore and West Malaysia most adversely affected.

For those of us in Singapore, it really felt like living in hell, right? We were breathing smoke, our clothes and food smelled like ashes and we were queuing to reincarnate. Well, fortunately (or maybe unfortunately) no, we were queuing to get 3M’s N95 masks that were supposed to help us breathe better in bad air.

But there weren’t enough to go around. We hear stories of how poor aunties queue for an hour at Guardian pharmacy only to find out that the inventory ran out. We then activated our friends overseas to bring masks back from all over the world. Masks were running out in Hong Kong, Taiwan and Australia. Air purifiers ran out too. Sharp’s ionizer sold so well that the stock actually bounced a bit. This Japanese firm did went to hell and came back.

So turning a threat into opportunity, I decided to revisit an old stock that I looked. I always liked to co. but somehow, never got a chance to own it. Yes, it’s 3M, the manufacturer of the all important N95 masks.

Since it has been years since I looked at 3M. I just want to share my process how I approach a stock analysis for the first time. As mentioned before, I ask 10 questions and try to answer them. Also, this would be a really prelim analysis. A deep dive analysis (like the one I did on Swatch which is still incomplete) should follow if you are really serious.

So here goes:

1. What is the Investment Thesis?

3M is a global industrial conglomerate founded on principles of science, imagination and innovation. It is a global niche leader in fields that it conducts its businesses and its products resonate quality assurance. 3M is a story about branding, innovation and shareholder return.

2. It is Cheap?

Sadly no.

3M trades at 16-18x PE (1 to 2 year forward) for an industrial company
9x EV/EBITDA
4x Price to Book on ROE of 20+%
FCF yield 5% and Dividend of 2+%

Buy at $80, when it is 20% cheaper vs now at $108.

3. It is a Good Business, Good Franchise?

Hell, YES!

3M began operations as the Minnesota Mining and Manufacturing Company in 1902. The company started as a sandpaper manufacturer and later manufactured masking tape in 1925. Today 3M has over 55,000 products in six business segments. 3M is headquartered in St. Paul, Minnesota and has operations in more than 60 countries.

Some of its best well-known products include Post-It Notes, Scotch Tape (yes the brand became the product!), 3M Solar Film and Car Floor Mats and not forgetting N95 masks! It also has a huge array of products used in almost all aspects of our lives, just that we are not aware. This includes film used in our mobile phones, safety goggles, tapes, etc. You name it.

30% of 3M sales comes from new products which allow it to reset price points and capture customers’ time and mindshare.

3M also focuses only at the top of the pyramid high performance products to differentiate itself from the competition. Top tier products account for 50% of its sales.

15% Time: In 1948, 3M’s management introduced this concept that allows its staff to spend 15% of their time to do non-core related idea generation. Post-it notes and some products we see today were born from 15% Time. Today many innovating firms use the same concept to help foster innovation. For example: Google’s 60:30:10 concept.

4. How’s the Management?

3M’s management is very focused on shareholder return. It has been paying dividends and it regularly conducts share buybacks.

5. Does it have Strong Financials?

Here's a cheatsheet that I would often use as a first cut to look at the co. In short everything is in order.

6. Geographical and Industry Exposure?

30+% Sales to EM markets.

Quick Regional Operating Profit (OP) breakdown
Asia Pacific 41%
Europe, Middle East, Africa 19%
Latam, Canada 14%
US 26%

Segment OP breakdown and OP margin (2012 USD) Industrial 2.2bn 23%
Safety and Graphics 1.2bn 22%
Electronics and Energy 1.0bn 19%
Healthcare 1.6bn 32%
Consumer 0.9bn 22%
Others -0.6bn
Total 6.5bn 22%

7. Dividends?

3M is a Dividend Aristocrat ie it has been giving and increasing dividend for the past 40 years. This company has been giving dividend since Singapore was born. It’s current dividend yield is 2.4%.

8. Risks and Mitigators?

3M is very geared to the global economy. Weakness and slowdown has an amplified impact on 3M. During the Lehman GFC (Global Financial Crisis), 3M fell to a 10 year low of $40.

9. 2nd Level Thinking Angle?

In this kind of weak stock market and macro environment 3M is not on investors’ mind. But the stock has not corrected as much. This could be a reflection that the 3M brand is also growing stronger.

10. Can I Sleep Well at night holding this?

With the N95 mask on, maybe not. But no haze, Three Yes's!

Well that's that for 3M. Hope to do a really deep dive analysis in time. But this is a great stock and I do hope to have a chance to own it soon!