Rising Costs Could Keep a Lid on 3M Stock

3M's rising costs make the valuation of 3M stock seem excessive

Big-Moat, Low-Growth 3M Stock Is Stuck in Neutral

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Although global economic activity has improved throughout 2018, shares of industrial giant 3M (NYSE:MMM) have actually struggled. So far this year, 3M stock is down about 12%, versus an 8% gain for the S&P 500, with the weakness due largely to valuation worries and concerns regarding a forthcoming global economic slowdown.

3M stock took another leg lower recently after management warned of yet another headwind investors should watch out for: rising costs. Speaking at a conference, 3M’s management warned that raw materials prices were rising faster than expected. As a result, rising materials costs are expected to lower its 2018 earnings per share by about ten cents. The company had previously provided 2018 EPS guidance of 5 cents to 10 cents.

3M stock dropped on the news. But my calculations indicate that it should be down a lot more than it is. Under the assumption that margins would rise over the next several years, I previously pegged 3M’s year-end price target at around $210. But, with rising costs now becoming a bigger problem than before, it is increasingly clear that the multi-year margin expansion narrative has some serious headwinds. After factoring in those headwinds, I think 3M stock is worth about $200 today.

All in all, I think 3M stock could fall even further as rising costs combine with a pretty steep valuation.

The 3M Growth Narrative Is Low Growth, Big Moat

3M is a great company with its fingers touching everything that matters.

From safety to healthcare to electronics to energy, 3M is providing original equipment manufacturer platforms and components for many industries. Most of those industries have stable growth prospects. Some of them – like automated driving, connected roadways, biomedical technology, and data centers – have secular growth prospects. But all of them are largely tied to the global economy. As global economic activity and strength picks up, global spending on 3M’s products picks up, too, and 3M stock heads higher.

This is a tried and true formula for MMM stock. Considering the complexity inherent in manufacturing industrial components, 3M also has massive moats in its multiple end markets. Thus, 3M has essentially guaranteed itself steady revenue growth potential as long as the global economy remains healthy.

We saw this last quarter. Organic local-currency sales growth came in at 5.6%, versus 2.2% last quarter and 5.2% last year. Growth was broad-based across all geographies and operating segments, with growth in each segment ranging from 4%-9%.

These growth rates probably won’t accelerate. Global economic growth prospects remain strong, but  global real GDP growth is set to decelerate to a run-rate of roughly 3% over the next several years, versus 3.1% in 2017. Thus, global growth prospects aren’t improving. Instead, they are stabilizing.

Going forward, then, 3M is a company with 5% revenue growth potential over the next five years. That revenue growth is protected by a wide moat, but the company doesn’t have many catalysts on the horizon which could spark 10%-plus growth. Thus, 3M is a big-moat, low-growth company.

Rising Costs Challenge the Current Valuation of MMM Stock

Up to this point, 3M has been able to increase its margins as its revenue grew significantly. While that trend will continue, the pace of margin expansion could slow thanks to inflation.

Inflation is picking up globally, and that means raw materials prices are rising globally, too. 3M has a ton of exposure to those rising materials prices, so its costs will inevitably rise going forward. Granted, a lot of those cost increases will be passed on to consumers, but in a competitive marketplace, 3M has to absorb some of those costs itself. That is why the rising materials costs are expected to lower its EPS by 10 cents this year.

This headwind won’t fade. As long as global economic strength remains vigorous, inflation will roar higher and costs will go up. Thus, over the next several years, the pace of 3M’s margin expansion will likely be pedestrian as higher prices are partially offset by higher costs.

Assuming 3M’s current 5% revenue growth rate persists and its margins expand slightly from here, I think 3M can generate EPS of about $14 in five years, versus a previous target of $14.80.  Placing 3M’s average forward historical multiple of 19 on that EPS implies a four-year forward price target of $266. Discounted back by 10% per year, that equates to a year-end price target of roughly $200 for 3M stock.

Bottom Line on 3M Stock

In today’s market, the time to buy 3M stock is on dips below $200. The shares should be sold on rallies above $200. Right now, 3M stock is sitting around $210. That means it’s time to sell MMM stock, especially in light of recent warnings about rising raw materials costs.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities. 

Article printed from InvestorPlace Media, https://investorplace.com/2018/09/rising-costs-could-keep-a-lid-on-3m-stock/.

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