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. 

Monster Monsanto & Other Risks!

This is a continuation of the previous post on Bayer / Monsanto.

In the last post, we postulated that Bayer is a buying opportunity because it is the world's largest player in crops and seeds which is growing at mid single digit and its stable cash cow businesses in pharmaceutical and consumer drugs would provide huge free cash flow to investors. At its low, Bayer traded at EUR 68 billion market cap while generating FCF of EUR 7-8bn. Salivating right?

Bayer / Monsanto's Biggest Risk

As promised, today we discuss Bayer's risks. Bayer didn't crash and burn for no reason. It lost EUR 20bn in market cap when Monsanto's cancer causing weedkiller news broke but it had also lost another EUR 20bn before that as the market caught whiff of the bad news. To summarize here, Bayer has three key risks:

1. Monsanto could face litigations amounting to USD 5bn in costs and lose more revenue in the years ahead for one of its biggest seller - Roundup.

2. Bayer's drugs going off patent would mean that the pharma business could lose EUR 10 billion in annual sales if it doesn't come up with new replacement drugs.

3. Bayer and Monsanto's matrimony is deemed a marriage made in hell. Environmentalists, farmers and some regulators hated the deal and it would face scrutiny on many fronts.

The biggest risk on most investors' mind is Monsanto's cancer causing weedkiller called Roundup. While most of us in sunny Singapore would never have heard of Roundup, this is the revolutionary weedkiller created some 40 years ago that farmers use to increase crop yield by selectively and successfully killing weeds. However, it was recently deemed as carcinogenic because some farmers died after years of handling and using Roundup on their crops. While this is sad and there might be some truth, it is also too late to turn back the clock. The world has been using Roundup for 40 years! Without Roundup, we would never produce enough food to feed 7 billion mouths. The solution is not suing Monsanto but to create better weedkillers, which is ironically also up to Monsanto.

Financially, the negatively impact has also been factored into the share price. Bayer's market cap collapse c.$20bn since the news broke. Analysts had estimated that the maximum litigation cost is c.$4bn which means that lost revenue should translate to c.$16bn. I believe this is factoring in losing close to a decade worth of sales in related products which could be the worst case scenario. In short, a $20bn drop in market cap had essentially fully factored in the bad news with regard to Roundup.

The second risk pertains to Bayer's own pharma business. It has two blockbuster drugs that will go off-patent between 2023-2025. Bayer would lose close to 30-35% of its pharma EBITDA or 30-40% of overall EBITDA. While it has 6-7 drugs in the pipeline, none of them looked promising enough to offset the decline from the two key drugs. So this means that the pharma business should see its value collapse by a similar margin i.e. 30-40%. Well, given the additional EUR 20bn drop in market cap before Monsanto's debacle, one would argue it already has. (The pharma business has 6bn EBITDA and using 10x EV/EBITDA multiple, it is worth c.60bn which means that a 20bn drop is a 33% decline.)

In short, the bad news with its pharma business is also factored in. So any incremental positive from here should be just pure upside. This brings us to the last point - Bayer and Monsanto is a marriage made in hell and global regulators would not give their blessings. The new entity would face more hurdles, litigations and what not in the future. We cannot put a number to this. Is it another 20bn market cap decline or more? Who knows? 

Bayer share price rebounding!

Investment is never about eliminating all the risks. It is about measuring the risk reward. Can Bayer fall another $20bn in market cap, bringing the stock to EUR 48bn market cap meaning it trades at a 15% FCF yield and a 6% dividend yield? At EUR 48bn it is worth less than what it paid for Monsanto and close to what ChemChina paid for Syngenta. Another Chinese SOE would just buy this up to help secure China's future food supply.

Well, the probability of Bayer dropping a lot more is not zero, but it is not high. Meanwhile, is it more likely that the market recognizes its synergies with the merger, or the market recognizes the value in its businesses and hence bidding it up back to a more reasonable historical 4-5% FCF yield. Or Roundup's litigation costs and lost revenue see better quantification which is much less than 20bn? It is hard to say, it might take some time ie 2-3 years. This is real investing, no one knows. We measure the probabilities and bet accordingly. 

The catalyst might come when the current Chairman and CEO Werner Baumann moves on which again might take 2-3 years. He was appointed two years ago and oversaw the Monsanto deal which wasn't well like. He also has a reputation of being too smart and hence not well-liked by some. So that also partly explained why it was an easy sell for investors. They don't feel good after meeting the man. So, we might need to see some changes. 

Meanwhile, we are paid to wait with the almost 4% dividend (subjected to 20+% capital gains tax though). Bayer traded as high as EUR 130 just three years ago. If it gets close, we are talking about 70% upside!

Huat Ah! This blogger just bought Bayer!

Ready Bayer One!

Bayer was a EUR 100 billion market cap industrial conglomerate that has collapsed big time from a recent high of EUR 120 per share to EUR 73.5 today. There were two reasons. Firstly, the firm is being sued in the US for selling cancer causing fertilizers. Well, actually it's Monsanto, the world's largest GMO seed seller and pesticide and herbicide manufacturer that was selling bad products but hey, Bayer is going to buy Monsanto, so Bayer and its investors are on the hook! Next, Bayer announced disastrous results warning of lower full year sales and profit blaming higher integration cost with Monsanto.

The market sent the stock down 5% last week after it dropped 12% two weeks ago as a result of the Monsanto debacle. However, I believe this is where things are getting really interesting. Value investors like to fish in perfect storms. We are prepared to get wet while catching whales! Okay, let's first state the investment thesis - our reason for buying a stock which should be clear and concise:

Bayer will become the world's powerhouse in crops and seeds after acquiring Monsanto with close to 30% global share and together with its original stable portfolio of businesses in consumer and pharma drugs, it is poised to generate at least 10% free cashflow based on today's market cap. 

The following chart shows the pro-forma breakdown of Bayer's revenue after absorbing Monsanto.

Bayer's revenue breakdown

To put it simply, Bayer's revenue split would be 50% crop and seeds, 40% pharma and 10% consumer. Essentially, we can see it as 50% Growth - coming from crops and seeds and 50% Stable Cashflow - coming from its pharma and consumer segments. All three businesses are traditionally great businesses with strong moats, which we shall discuss in greater detail in the following paragraphs.

The crops and seeds business is dominated by Monsanto. This firm is the global leader in seeds, weedkillers and crop products. It has very high global market share (40-80%) in various products including GMO (genetically modified organisms) soy bean and corn seeds. After its combination with Bayer, it would be the world's largest player in an oligopolistic market with a few other players - Du Pont, Dow Chemical, Syngenta, BASF and Agrium. But it will be the Big Brother calling the shots (actually Monsanto was already the biggest brother in the US). The agriculture industry is also in a secular growth trajectory as the global affluent population continues to increase and we need to keep up food production.

Nobody likes Big Brother. The environmentalists had been making noises about Monsanto's GMO products, labelling them as evil and causing illnesses but the truth is a lot of people would go hungry without GMO seeds. Alas, we cannot have our cake and eat it. It's gonna be GMO or no food. Your choice. What's even more interesting is that the bulk of the seeds goes into producing food to feed cows and pigs, not humans. So before labelling Monsanto evil, perhaps we should all stop eating meat first?

Regardless, Monsanto is in a huge growth industry, we need more pigs and cows to feed humans and we need faster food production. Monsanto believed that long term topline CAGR should be in the mid single digit range. With its merger, it would also be able to extract a billion Euros of synergies and it would continue to be a price and product leader, while extending its R&D prowess and distribution network to global farmers. Is it a wonder why farmers and scholars hated the deal? It was said this could be a marriage made in hell. So better hedge by owning them as minority investors right?

Bayer's pharma business

Okay, let's talk about old German Bayer. Bayer has two interesting businesses. It has a pharmaceutical arm that had produced 2-3 hit drugs with EUR 16bn in annual sales. The current largest contribution is Xarelto, a blood thinner which was very successful but its patent would expire in a couple of years. The second drug is Eylea which is used to cure certain eye conditions. Both drugs are blockbusters but investors are concerned that there might be nothing left in Bayer's pipeline which means that this business could be worth very little going into 2025. I am no pharma expert so let's assume that might be true. The key question is should this business be valued next-to-nothing? We will go through the math later.

The last business is Bayer's consumer over the counter drug business which has long standing branded drugs such as Aspirin and Claritin generating EUR 6bn in sales and 1 plus billion EBITDA annually. Bayer has tried to beef up this business with M&A but synergies were lacking. It most recently bought Merck's consumer business but with little results. This is partly another reason why investors didn't feel comfortable about another big merger with Monsanto.

Bayer's consumer business

Now putting everything together, we have two stable cash cows generating EUR 6bn in EBITDA and c.5bn of free cashflow (FCF). In the past five years, Bayer's standalone free cashflow was EUR 2.8bn, 3.2bn, 3.8bn, 5.8bn and 5.2bn. Monsanto's FCF adds another USD 2bn which brings overall FCF to EUR 7bn if not 8bn. Bayer today trades at EUR 68bn implying more than 10% FCF yield. Dividend yield is also closing in on 4% as a result of its stock price collapsing.

Recall that Bayer bought Monsanto for USD 62.5bn or EUR 53.6bn which means that market is valuing the rest of Bayer's original businesses to be less than EUR 10bn. So is it right to value two businesses generating 2.8-5.8bn FCF at 10bn? Or looking it the other way, the market is saying that Monsanto should be worth a lot less than USD 62.5bn. But this contradicts the fact that Monsanto traded at USD 50bn market cap for years before Bayer bought it. Either way, Bayer definitely doesn't look expensive.

While there are reasons why the market thinks so negatively about Bayer and Monsanto, I believe this is an over-reaction hence a golden buying opportunity. The risk reward is very skewed here. Bayer and Monsanto's free cash flow of EUR 7-8bn is very stable and more likely to grow with the promised synergies than to collapse. Hence as a Bayer buyer today, we stand to earn a c.4% dividend and the reward that it would pop 50% far outweighs the risk that it would fall 50%.  

Next post, we talk about the risks!