Where Does 3M Company Go From Here?

It's no secret that 3M Company (NYSE: MMM  ) is a very well run company, but is it a great investment right now? Aside from some weaker conditions in Latin America, 3M Company delivered on almost every front in the quarter. Moreover, the commentary around the results made for good news for the industrial sector, and specifically, for Pall Corporation (NYSE: PLL  ) . Were the earnings good enough to suggest that 3M Company can go higher in 2014?

3M Company's quality of earnings doesn't come cheap
On an absolute and relative basis, 3M Company doesn't look like a particularly cheap stock. A quick look at its valuation versus a collection of its industrial peers indicates that the stock has a lot of good news already priced in.

ITW EV to Free Cash Flow (TTM) Chart

ITW EV to Free Cash Flow (TTM) data by YCharts

On the other hand, good news comes from well run companies, and 3M Company's latest results were very solid. A few highlights include:

  • Its full-year targets of EPS of $7.30-$7.55, organic currency growth of 3%-6%, and free-cash flow conversion of 90%-100% were confirmed.
  • All divisions delivered operating margins in excess of 20%.
  • Growth was much more balanced in the quarter.
  • The U.S. recovered -- as management had expected -- from a weather-affected first quarter.
  • Operating income margin expansion of 80 basis points to 22.8% was supported by a positive 120 basis point improvement in pricing.

The following chart helps to demonstrate the broad-based strength in the quarter. The red bars indicate organic sales growth in the quarter, while the blue bars indicate operating income for 2013.

Source: 3M Company Presentations

In addition, there were three other key takeaways that Fools should focus on.

3M Company delivers good news for Pall Corporation and the industrial sector

Source: The Motley Fool 

First, 3M Company is known for having a lot of short cycle businesses (adhesives, tapes, abrasive systems) within its industrial division, and organic growth was at an impressive 4.7%. Moreover, management outlined that these businesses led growth in the quarter -- a good sign for the industrial sector at large, because short-cycle businesses tend to respond first to a pick-up in industrial output.

Second, its water filtration business, 3M Purification, was cited for generating strong double-digit growth. Pall Corporation competes with 3M Purification in various markets (including biopharmaceuticals and food and beverage), and the strength in 3M Purification's sales growth augers well for Pall Corporation. Fools already know what the company needs to take the stock higher, and this sort of industry backdrop will certainly help. In addition, 3M Company's stronger industrial results could be an indication of an increased willingness from industrial customers to spend -- likely to also bring good news to Pall Corporation.

Third, on the results conference call CEO Inge Thulin outlined that Western Europe was at the top end of expectations, the U.S. recovered on the second quarter, but Asia was only "sideways slightly up", and Latin America was "slightly slower". All of which continues the ongoing theme of the industrial sector in 2014 of the developed world relatively outperforming the emerging world. Interestingly, the reverse is true within the health care market.

The bottom line
All told, this was a strong report for 3M Company, and arguably an even stronger one for Pall Corporation. Turning to valuation matters, 3M Company isn't cheap on a relative value basis. However, if it achieves its target of 90%-100% of free-cash flow conversion (from net income) and its EPS target of $7.30-$7.55, then the stock looks capable of outdoing its earnings' going forward.

In other words, assuming the midpoint of these two figures, 3M Company will generate around $7.05 in free-cash flow in 2014. At the current price of $145, this equates to 4.9% of its market cap -- better value than a 10-year treasury note, for example. 3M Company looks fairly valued to me, which means it could appreciate in line with its earnings growth next year. Analysts have its earnings growing at 11% and 10% for the next two years, so on this basis, 3M Company has upside potential.

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