3M Company (MMM) reported on Friday, July 26, that it generated huge adjusted free cash flow and a high FCF margin in Q2. That implies that MMM stock could be undervalued here. Moreover, shorting out-of-the-money puts can create extra income.
MMMM stock is trading for $124.93 in midday trading on Monday, July 29. However, the stock is up significantly from July 25 at $103.39. The market is now excited that the company could generate significant amounts of FCF going forward.
Based on management's discussion, it looks like that could happen. MMM stock could potentially be worth as much as 33% more at $166 if 3M keeps delivering high FCF margins. This article will show why.
Strong Free Cash Flow and FCF Margins
3M reported that sales were flat but its adjusted earnings per share was up 39%. Moreover, the company had a strong adjusted operating margin of 21.6%.
But more importantly, during Q2 the company said its adjusted free cash flow was $1.2 billion. That was significantly higher than Q1 when it generated $0.8 billion. It also represents 19% of the company's sales in Q2 and 19.9% of adjusted non-GAAP revenue of $6.019 billion.
This is useful in projecting FCF and the company's true value going forward.
FCF Projections
For example, analysts now project sales will range between $23.86 billion this year and $24.46 billion in 2025. That means that its run rate next 12 months (NTM) average sales could be $24.2 billion.
As a result, if 3M can generate at least 19% adj. FCF margins in the NTM period, free cash flow could reach $4.59 billion (i.e., $0.19 x $24.16 billion). That is almost 90% greater than the costs of the company's dividends (i.e., $2.442 billion). In other words, the company has huge amounts of extra FCF to buy back stock.
Setting a Price Target for MMM Stock
Keep in mind that the dividend yield for MMM stock is 2.20%. So, if the market were to assume that 100% of its FCF was used to pay out dividends, and the yield stays at 2.20%, the market cap would rise to $209 billion (i.e., $4.59b/0.022 = $208.6 billion).
That is 200% higher than 3M's present $69 billion market cap.
But, just to be conservative, let's assume the market values its forecast FCF at 5.0%, over twice its present dividend yield. That implies the market cap will rise to $91.8 billion (i.e., $4.59b/0.05 = $91.8b).
That is still 33% higher than its present $69 billion market cap (i.e., $91.8b/$69.09b-1 = +32.9%). This implies the stock could be worth one-third more at $166 per share (i.e., 1.329 x $124.93 = $166.03 per share).
One way to play this is to sell short out-of-the-money (OTM) put options for extra income.
Shorting OTM Puts
For example, the August 23 expiration period, 25 days until expiry, shows that the $120 strike price put options are trading for $1.52 on the bid side. This implies that the short seller can make an immediate yield of 1.27% (i.e., $1.52/120).
That provides extra income for existing shareholders at a strike price that is almost 4% below today's price. This can be seen in the table below from Barchart.
Here is how that works. The investor secures $12,000 with their brokerage firm. Then they can enter an order to “Sell to Open” 1 put contract at $120 for Aug. 23 expiration. The account will then immediately receive $152. That works out to a yield of 1.227% on the $12k investment.
For less risk-willing investors, the $118 put option has a $1.11 bid side premium. The investor only has to secure $11,800 in their account. It will then receive $111, or 0.95% of the investment.
Either way, this looks like an attractive way to play the potential upside in the stock, especially for existing investors. If the stock rises, they get to keep both the upside and the short-put income.
If MMM stock falls, they can buy more shares at the strike price. They can then hold the shares until they rise again, or even sell short covered calls at higher strike prices. The bottom line is that MMM stock looks cheap here and shorting OTM puts is one way to play this.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
