It's been a frustrating year for shareholders in 3M Company (NYSE:MMM). The company hasn't really done anything wrong, yet the stock has underperformed the S&P 500 by more than 7% this year, as of this writing. The relative weakness is somewhat surprising for such a highly regarded company. Why has the company underperformed, and what can it do about it from here on?
Global growth weakening; North America fine
As always in investing, there's no clear picture; however, there are three related reasons that 3M is underperforming. First, the diversified industrial sector has been weak in the market this year. A quick look at 3M's share price performance alongside peers Dover Corp. (NYSE: DOV), Illinois Tool Works (NYSE: ITW), and Danaher (NYSE: DHR) shows that the whole sector has found it tough going this year.
The fact is that they are all diversified industrial stocks whose growth prospects are tied to the global economy. Unfortunately, global growth hasn't been as strong as many had hoped. For example, the IMF recently lowered its projections for global growth in 2014 and 2015:
|Segment||2014 (July Projection)||2015 (July Projection)||2014 (Oct. Projection)||2015 (Oct. Projection)||Change in Projection|
|Advanced Economies||1.8%||2.4%||1.8%||2.3%||Slight Decrease|
|Emerging Market/Developing-Asia||6.4%||6.6%||6.5%||6.6%||Slight Increase|
Interestingly, the prediction for growth in advanced economies has only been slightly downgraded, with growth expectations in the U.S. upgraded for 2014. As Fools already know, there has been some strong evidence indicating that growth would strengthen in the U.S. However, IMF's forecast for overall growth in emerging-market and developing economies is that it will weaken -- with Brazil's forecasts being notably lowered.
3M is chasing growth in emerging markets
The data above is of particular concern to 3M because the company truly is a global player. Moreover, it has been making investments in emerging markets in order to chase growth. A breakout of its sales by region for the first six months of 2014 reveals just how global the company is now:
In fact, the company generated less than 36% of its sales from the U.S. in the first six months. In other words, if the global economy catches a cold, then 3M will sneeze.
Valuation, valuation, valuation
While global growth expectations have been lowered, investors shouldn't be too hard on 3M. It's already reported some weaker conditions in Latin America. In fact, its full-year EPS target of $7.30-$7.55 remains in place, as does its target for free cash flow conversion of 90%-100%. However, the issue is that 3M's stock looks fairly valued on an absolute and relative basis.
The following chart compares its enterprise value, or EV -- market cap plus debt -- to its free cash flow ratio against that of its peers. This is a useful measure, because it includes a debt consideration. Free cash flow is what companies are left with in order to reinvest in their businesses -- a metric well worth following in a sector with heavy capital expenditure requirements.
To put 3M's valuation of 21.2 times into context, the average EV/free cash flow of the other three is 17.4 times. However, 3M looks fairly valued on an absolute basis; after all, an EV/free cash flow ratio of 21.2 implies that the company is generating 4.7% of its EV in free cash flow -- a yield much better than the current 10-year Treasury note yield of 2.3%. Nevertheless, on this kind of valuation, the market will not be in any mood to tolerate any disappointments. If global growth weakens further, then 3M will be hit.
All told, 3M hasn't done much wrong from an operational perspective. However, if the outlook for emerging-market growth continues to weaken, then you can expect the market to express its opinion by putting pressure on 3M's stock price. Thinking longer-term, if you believe that global growth will pick up going forward, then any ongoing weakness in 3M's stock price is likely to create a good buying opportunity at some point.
Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends 3M 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.