3M Stock Is Still Cheap Here - Short Out-of-the-Money MMM Put Options

3M Company (MMM) stock has risen nicely since its earnings release. However, MMM stock is still cheap here based on its strong free cash flow. Existing investors can make extra income by shorting out-of-the-money puts. This article will describe this play.

MMM is at $129.75 in midday trading on Friday, Aug. 23. Since Aug. 26 when the company released its quarterly earnings, MMM has risen $26.36 or +25% since July 25 when it closed at $103.39.

I last discussed this value stock in a July 29 Barchart article, “3M Company Produces a Huge Free Cash Flow Quarter - MMM Stock Looks Cheap Here.” I argued that MMM stock was worth $166 per share based on its strong free cash flow (FCF) and high FCF margins.

MMM Stock Price Target

3M Company generated an adjusted FCF of $1.2 billion last quarter, representing over 19.9% of its non-GAAP revenue of $6.019 billion. That was also close to its operating income (OI) margin of 20.3% and an adjusted OI margin of 21.6%.

3M Company Q2 2024 operating income margins

In other words, the company's cash flows are flowing straight from its income margins, not from changes in working capital or from lower capex spending. We can trust that using this 19.9% margin going forward will be useful in valuing the stock.

For example, 15 analysts surveyed by Seeking Alpha now project $23.84 billion in revenue on average this year and $24.55 billion in 2025. That means in the next 12 months (NTM) sales will be on a run rate average of $24.2 billion.

So, if we apply an average 19.9% FCF margin against this forecast, free cash flow could reach $4.82 billion (i.e., $24.2b x 0.199). That would be $543 million more or +12.7% over the $4.2277 billion in FCF the company generated in the last 12 months (LTM).

Moreover, dividing this $4.82 billion in adj. FCF by 5.0% brings its projected market cap target to $96.4 billion (i.e., $4.82b/0.05 = $96.4b). Keep in mind that the stock has a dividend yield of just 2.14%, so this FCF yield metric is over twice that valuation parameter.

Since MMM stock has an existing market value of $71.2 billion, this is 35.4% higher than its present value. In other words, MMM stock is worth 35.4% more, or $175.68 per share.

Just to be conservative, let's apply a lower 19.0% FCF margin (instead of 19.9%). That results in an FCF forecast of $4.6 billion (i.e., 0.19x $24.2b), and a market cap estimate of $92 billion (i.e., $4.6b/0.05). This is 29.2% higher, and results in a price target of $167.64 per share.

Analysts Agree

Analysts tend to agree that MMM stock is undervalued. For example, AnaChart.com, a tracking site on sell-side analysts' price targets (as if they were stocks), shows that the average target price of 16 analysts is $154.43. That is 19% over today's price.

Moreover, many of these analysts have good track records. The table below shows that Andrew Obin of BAML recently posted a $143 target price. This was significantly higher than his prior $120 price target. He has been right 50% of the time according to the Price Targets Met Ratio. 

Other analysts who have recently written on the stock also have higher stock price targets. The table from AnaChart shows that analysts from both Deutsche Bank and Barclays have raised their price targets in the last 24 days.

In other words, analysts are now focusing on how well the company is performing and have raised their assessments of its underlying value.

Shorting OTM Puts 

As I wrote in my last article, one way for existing investors to play this is to short out-of-the-money (OTM) put options in nearby expiry periods. I suggested selling short the $120 strike price put option that expires today on Aug. 23. At the time, MMM stock was at $125.60, so this strike price was 3.9% below the stock price.

The short-put investor would have received a premium of $1.52 and an immediate yield of 1.27% (i.e., $1.52/120.00). Today, those puts are going to expire worthless, so the trade was profitable.

This can now be repeated. For example, look at the next 3-week expiry period ending Sept. 13, 2024. The $125 strike price put option, 3.7% out-of-the-money, has a 66 cents premium. That provides a short investor of these puts an immediate yield of 0.528% (i.e., $0.66/$125.00).  That is lower than the 1.27% yield earlier for a similar OTM strike price.

MMM puts expiring Sept. 13 - Barchart - As of Aug. 23

So, to keep the same yield, a less risk-averse investor can short the $127.00 strike price put for $1.40. That strike price is only 2% below today's price. But the yield is over 1.0% like before for three weeks until expiration (i.e., $1.40/$127.00 = 1.10%).

However, given how much upside there is still left in MMM's valuation this might be worth the risk. 

Just in case the investor wants to hedge their investment they could short the $127.00 put and buy the $125 strike price put. That leaves a net income of 74 cents (i.e., $1.40-$0.66 = or a net yield of 0.58%. This is slightly better than the 0.528% yield from shorting the $125 put. 

Moreover, over time, if MMM stock does not fall, the investor could sell the $125 strike price long investment put option and end up with a higher return (assuming MMM does not close at below $127.00).

The bottom line is that MMM stock looks cheap here. One profitable way to play this is to sell out-of-the-money (OTM) put options, especially for existing investors. They can gain both the income from this play plus any potential upside in the stock if it rises.

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.