The Best Blue Chip for 2007: 3M

3M (NYSE: MMM  ) is the blue chip to own in 2007. It offers thousands of products that touch your life in myriad ways -- many of which you probably don't even realize. The company's culture of scientific innovation provides a formidable competitive advantage, and innovation is accelerating. With strong leadership, copious free cash, dividends, and share repurchases, 3M quite simply delivers value to shareholders.

Leveraging the innovation engine
3M's moat is its famed culture of innovation. The company derives all of its products from 40 "technology platforms," singularly or in combination. Adhesives make up just one of those platforms. At one end of the adhesives spectrum sits the ubiquitous Post-it Note. At the opposite end are structural adhesives, with strength sufficient to replace welded joints in aircraft. The goal is to develop products to make life more efficient for 3M customers. In doing so, 3M embeds itself in its customers' operations, which leads to better results for 3M itself.

All 3M employees are trained in the ways of "Six Sigma," a quality-assurance system focused on process improvement and variation reduction. (Another successful implementer, General Electric (NYSE: GE  ) , estimated that benefits from its own use of Six Sigma reached $10 billion during its first five years.) But 3M doesn't just rely on high-concept management systems -- it's also big on kindergarten concepts such as sharing and cooperation! Knowledge and technology are shared internally, rather than hoarded by individual departments or operations. Realizing that all brilliant minds who could harness 3M's technology platforms likely don't all work for 3M, the company maintains a technology-transfer program to helps inventors find and license technologies to solve their research-and-development challenges.

Financial growth
3M employs six competitive platforms for future growth:

  1. Continuously seek to lower costs.
  2. Do things better than the competition through innovation and technology.
  3. Constantly improve the distribution system -- hey, it worked for Wal-Mart (NYSE: WMT  ) !
  4. Maintain a customer focus.
  5. Strengthen brands.
  6. Develop its people. (All are trained on Six Sigma.)

Growth has gone international, with 61% of sales from outside the United States. Management is aiming to push that number to 70% by 2011. That's a good thing, since it spreads business risk across multiple countries and economies.

3M's platforms have spurred financial improvements, too. In 2001, sales of $10 billion -- 62% of the total -- were for products earning margins above the corporate average. By 2005, this number had grown to $15 billion, representing 70% of total sales. A continued transition into higher-margin products falls to the bottom line of free cash flow generation.

Let's create value
Compare my calculations for 3M's weighted average cost of capital (WACC), encompassing both debt and equity financing, with the returns that it earns by investing this capital, otherwise known as return on invested capital (ROIC). True economic value is created when there is a positive spread between ROIC and WACC.

TTM Q3-2006

2005

2004

2003

2002

2001

ROIC

20.9%

22.0%

23.0%

20.7%

18.0%

13.5%

WACC

10.2%

10.7%

10.8%

10.0%

9.3%

10.3%

ROIC-WACC Spread

10.8%

11.3%

12.3%

10.7%

8.7%

3.2%

ROIC/WACC Ratio

2.1

2.1

2.1

2.1

1.9

1.3

Value isn't frittered away in the corporate suite. 3M returns it to shareholders through steady dividend increases and share repurchases, as well as by reinvesting in the business for future growth.

After the stock hit a high of $88 earlier this year, disappointing second-quarter results cratered it to $67. Investors got overly pessimistic about a slowdown in sales of brightness-enhancement films for high-end televisions, a flagship product. 3M management opportunistically repurchased 17.9 million shares at an average price of $71. Management knew the business wasn't broken and took full advantage of depressive Mr. Market's gift.

Why now?
Quite simply, because it's cheap. 3M has been a model of consistency, with a quarter-century of 10.4% annual gains under its belt -- and that's not even counting the reinvestment of dividends. Over the past five years, revenue has grown at a compound rate of 6.1%, operating income at 10.1%, net income at 12.6%, and owner earnings (a proxy for free cash flow) at 13.4%. Yet today, the stock sits at the lower end of its relative multiples to valuation range. My conservative discounted cash flow valuation places a fair price in the mid-$80s.

The Foolish bottom line
3M brings innovation to everyday consumer, commercial, and industrial applications. The company shepherds its most valuable resource -- its innovative culture. It champions continuous improvement, and it rewards outside shareholders. There's no sign of the company resting on its laurels any time soon.

Will 3M be the best blue chip for 2007? I think so, and I hope you agree. Let us know in our brand-new Motley Fool CAPS community-intelligence database. Rate 3M "outperform." (I have.) Or if you disagree (you must be crazy!) rate it "underperform." To get going and make your voice heard, click here. Based on your responses, we'll declare the best blue chip of 2007 early next week.

To read about the rest of our blue-chip candidates, click here.

Wal-Mart and 3M areInside Valuerecommendations. Check out our value-stock newsletter service by taking Inside Value for a free, 30-day spin.

Fool contributor Jim Gillies owns 3M $75 Jan. '09 calls and is short 3M $75 Jan. '09 puts. The Fool has a disclosure policy.


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