It's no secret that 3M Co. (NYSE:MMM) is one of the best run companies in North America, and it's also no secret that the company's stock valuation of 20 times current earnings is hardly cheap. The company is best understood as a play on global industrial growth, and in this sense it's useful to compare it to other industrial stalwarts, such as Illinois Tool Works (NYSE:ITW) and Emerson Electric (NYSE:EMR). With this in mind, investors need to ask themselves what 3M needs to do to make it a good value.
3M's relative value
The graph below offers a look at its valuation compared to Emerson Electric and Illinois Tool Works using enterprise value (market cap plus debt), or EV, over free cash flow:
3M looks relatively expensive, which is somewhat of a concern considering that the prospects for Illinois Tool Works and Emerson Electric are also tied to the global industrial economy. A quick look at a breakdown of Illinois Tool Works' operating income by segment reveals how diversified its end markets are. Similarly, Emerson Electric is known for its process control equipment in the energy industry, but it actually makes its money from a wide range of industries.
Four reasons why 3M Company can outperform, and a concern
First, its strongest profit centers (industrial, safety and graphics, and health care) continue to outperform its other segments. In order to demonstrate this point, I've broken out the organic sales growth in the first quarter (the red bars) and superimposed them on the full-year operating income figures.
The industrial division saw "strong double-digit organic growth" in 3M Purification (liquid and air filtration), according to management on the conference call. In the safety and graphics segment, personal safety is its largest business and generated double-digit organic growth in the first quarter. The health care segment is seeing strong growth in developing markets and saw sales up 10% in the quarter.
The second reason is that 3M demonstrated some impressive pricing power in the first quarter, giving the company leeway to invest for future growth. Overall constant currency sales growth was 4.6% in the first quarter, with volume growth contributing 3.4% and pricing 1.2%. The global economic recovery has been slow for some time, and pricing power has been hard to come by for many companies. It seems that it's coming back for 3M, however. Moreover, gross margins improved by 0.5% to 48.5% in the first quarter. Management was clear that they intend to invest $0.10-$0.20 of earnings into new product innovation.
The third reason is that current trends are favorable, and 3M can expect somewhat of a bounce back in the U.S. due to the severe weather conditions hampering growth in the first quarter. According to CEO Inge Thulin, the company " delivered positive organic growth in all business groups and geographic areas, we posted strong margins across the portfolio and we returned a record amount of cash to shareholders." Moreover, growth was pretty balanced, with developed markets up 4.5% and developing markets (around 35% of total sales) up 5%. EMEA organic sales growth was up 4%, but bad weather restricted U.S. sales growth (around 35% of total sales) to just 3% in the quarter. It's reasonable to expect a bounce back in the second quarter.
Fourth, Fools can expect acquisition led growth in future. During the conference call, 3M's management discussed making $5 billion-$10 billion in acquisitions by the end of 2017. Its high free cash flow conversion (management forecasts 90%-100% free cash flow conversion from net income in 2014) ensures that it has the financial firepower to do this.
On a more negative note, foreign exchange is proving a headwind in 2014. In fact, reported sales growth was just 2.6% in the quarter, with a 2% reduction caused by foreign exchange effects. It's something to keep an eye on, because 3M is expanding faster in developing markets and this is where the foreign exchange effects are being felt the greatest.
The bottom line
All told, Fools have good reason to believe that 3M can do well provided the global economy continues its upward trajectory. On the other hand, other industrial companies will also do well with a cyclical recovery, and 3M does not look cheap compared to peers like Illinois Tool Works or Emerson Electric. Moreover, if you are cautious on emerging market exposure in 2014, then you might favor other names in the sector.
Management estimates that full-year EPS will come in at $7.30-$7.55, putting the company's stock on a forward P/E ratio of 18.9 times forward earnings at the midpoint. Assuming a 100% conversion of net income into free cash flow would put the company on a forward free cash flow yield of 5.3%. Judged by these standards, 3M Co. looks to be fairly valued.
Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends 3M, Emerson Electric Co., and Illinois Tool Works. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.