Contents
NOTE: I go to the gym daily and now see several of the television monitors tuned to business news channels which gym members are closely monitoring during their workouts. When I see this type of behavior I get visions of the dot.com bubble. In my opinion, a broad market pullback is not out of the realm of possibility, and therefore, I have refrained from deploying new money. Instead, I have begun to employ a greater use of relatively conservative option strategies.
Summary
- MMM released less than stellar Q1 2019 on April 25, 2019 and shares plunged from ~$220 to ~$191.
- Moody’s has cut MMM’s credit rating a few notches over the past decade.
- The dividend payout ratio has increased from 37.3% in 2012 to ~63.8% - ~67.5% based on current EPS guidance for FY2019.
- Management is taking aggressive action to improve results as disclosed in Q1’s Earnings Call.
- Given my outlook on a potential market pullback within the next few months I think there is a reasonable probability MMM’s share price will remain under pressure between now and the expiry dates of the options proposed.
Introduction
I have written a few 3M Company (MMM) articles with my January 31, 2019 article suggesting investors would be wise to wait for shares to pullback. Following that article MMM’s share price promptly proceeding to rise!
I thought the increase in MMM’s share price was not justified and on March 26, 2019 I wrote that I had initiated May 17, 2019 $220 covered calls. In my opinion I thought these options would expire worthless.
Once again, MMM’s share price proceeded to rise and by April 23rd, the share price had reached a high of $219.50. Then….MMM released Q1 results which were less than stellar and the share price plunged to close at $190.72 on April 25th.
Following the plunge in MMM’s share price, the May 17, 2019 $220 covered calls on which I received $1.51/share (before commission) are now virtually worthless. If MMM’s share price remains below $220 at expiry I will retain my shares and 100% of the premium I collected when I wrote the calls.
MMM has clearly fallen out of favor with many investors yet many of these same investors are gravitating to companies such as Lyft, Inc. (LYFT) and Pinterest, Inc. (PINS) which have yet to generate a profit or positive free cash flow. Now we have Uber which has announced its intent to go public where the company’s market cap could be as high as $83.5B.
In my opinion, it will likely take a few quarters of decent results before the investment community warms up to MMM. As such, I think MMM’s share price will remain under pressure for at least the next several months.
If you are of a similar opinion then you may be interested in the following option trades.
Q1 2019 Results and Guidance
MMM’s Q1 2019 results can be accessed here and its earnings presentation can be accessed here.
Q1 results were well short of plan but management has communicated that aggressive action is being taken.
At the beginning of the Q1 2019 conference call on April 25th, MMM’s CEO lays out the aggressive actions being taken to drive productivity, reduce costs and improve cash flow. In addition, an update is provided on the two 2 litigation issues which impacted results and updated guidance is provided for FY2019. The transcript of MMM’s Q1 earnings call can be accessed here.
Valuation
Guidance for F2019 EPS is $8.53 - $9.03. With MMM trading at ~$190 we get a forward PE of ~21.04 – 22.27. MMM’s PE for 2013 – 2018 was 21.54, 22.54, 19.46, 22.49, 26.27, and 25.54.
When MMM was trading just a shade under $220 a couple of days ago I viewed shares as being richly valued. Following the pullback to ~$190 I now see shares as being fairly valued relative to the valuation of recent years.
Credit Ratings
MMM’s credit rating has deteriorated over the past several years. Prior to May 2009, Moody’s rated MMM’s long-term debt Aa1 (top tier of the high grade category). This rating is now A1 which is the top tier of the upper medium grade. That is a 4 notch drop! The rating is still strong but this is a worrisome trend.
S&P Global Ratings rates MMM’s long-term unsecured debt AA- which is the lowest tier of the high grade; this is 1 notch higher than Moody’s rating.
Both ratings are satisfactory for my purposes although the trend is not.
Recent Historical Performance
There is no disputing that MMM’s performance has been abysmal relative to the S&P500 in recent years. Click on this link and enter various start dates subsequent to January 1, 2011 to see the extent to which MMM has underperformed the S&P500.
MMM’s dividend history can be found here and its stock split history can be found here.
The $5.76/year ($1.44/quarter) in dividends now provides investors with a ~3% dividend yield following the recent share price pullback
On the basis of projected FY2019 EPS guidance of $8.53 - $9.03, MMM’s dividend payout ratio range is ~63.8% - ~67.5%.
If we look at MMM’s dividend payout ratio over the 2012 – 2018 timeframe using GAAP EPS, we do not see an encouraging trend (37.3%, 37.8%, 45.7%, 54%, 54.4%, 59.3%, and 61.2%). Share count, however, has dropped from 703 million to 602 million shares during the same timeframe.
While MMM could ease up on its dividend increases and the extent to which it repurchases its shares, this would likely have a detrimental impact on its share price since such decisions would likely not be well received by the investment community.
Having said this MMM is profitable and generates strong Free Cash Flow thus providing the Board of Directors with flexibility to adjust the dividend growth and share repurchases if required.
Option Strategies
Covered Call Option Strategy
I know several readers are long MMM, and therefore, I provide details on my long MMM position.
As previously noted, the $220 May 17, 2019 covered calls I wrote will likely expire worthless.
Since I am of the opinion that MMM’s share price will remain depressed over at least the next several months, I have written covered calls on another few hundred MMM shares.
On April 26, 2019 I wrote October 18, 2019 $210 covered calls and generated $2.85/share (excluding nominal commission) giving me a $212.85 breakeven level; I am of the opinion MMM’s share price will remain below $210 between now and expiry.
As you can well appreciate, writing covered calls does not protect me from a plunge in MMM’s share price. It merely provides me with an opportunity to skim additional income from my holdings.
Bull Put Spread Option Strategy
I view shares as fairly valued following the significant pullback after the release of Q1 2019 results.
I do not expect the aggressive actions being taken by management to have an immediate positive impact to earnings. While the investment community punished MMM’s share price following the release of Q1 results I am of the opinion MMM’s share price will remain under pressure until such time as earnings improve.
On this basis I recommend a Bull Put Spread Option strategy where you profit from a neutral to bullish price action in the underlying stock.
There are various expiry dates and strike prices from which you can select; this example is for illustrative purposes only.
- Sell MMM $190 September 20, 2019 put and receive ~$9.30/share or $930/contract
- Buy MMM $180 September 20, 2019 put and pay ~$5.50/share or $550/contract
When you place these two trades you will end up with $3.80/share or $380/contract credited to your brokerage account.
NOTE: Brokerage fees are excluded in these calculations
Breakeven Level
Your breakeven level is $190 - $3.80 = $186.20/share.
Maximum Profit
You maximize your profit when MMM’s stock price is at or above $190 at expiration and both calls expire worthless.
No investor will exercise their right to sell shares to you at $190 if MMM is trading above this level and you will not exercise your right to sell shares at $180.
Your maximum profit is, therefore, the $380/contract you collected when you wrote the options.
Maximum Risk
The maximum risk is realized if the stock price is at or below $180 at expiration and is equal to the difference between the strike prices minus the net credit you received when you placed your option trades.
($180 - $190) plus ($9.30 - $5.50)
($10) + $3.80 = ($6.20)/share or ($620)/contract
Let’s assume MMM is trading at $170. Someone has purchased the right to sell shares to you at $190. While you are down $20/share ($190 - $170) or $2000/contract, you purchased an option to sell shares at $180 so you are ahead $10/share or $1000/contract. You also collected $380 in net option premium.
Your maximum potential loss is:
($20) + $10 + $3.80 net option premium received = ($6.20)/share or ($620)/contract
Benefits
This strategy can be employed if you do not want to directly own MMM shares but want to profit from your bullish opinion.
Spreads are attractive because you know ahead of time your:
- Breakeven
- Maximum profit
- Maximum risk
Risks
I would be remiss if I did not advise you of the potential risks you need to consider. This article explains Bull Put Spreads in a bit more detail and discloses the risks associated with the use of this option strategy.
Final Thoughts
MMM is certainly faced with significant challenges but management has indicated it is taking aggressive actions to improve the company’s performance.
Despite the deterioration in MMM’s credit rating and the deteriorating trend in the dividend payout ratio I am not about to ‘throw in the towel’ on MMM just yet.
While I wait for MMM to fix its issues I intend to extract additional income from my underlying shares through the use of covered calls.
If you are not a MMM shareholder and are of the opinion MMM’s share price might close at or above the current ~$190 come September 20, 2019 then you may wish to consider the Bull Put Spread Option strategy I have proposed.
As an aside, it has certainly crossed my mind that unless MMM’s performance improves in the not too distant future we could very well see activist shareholders calling for the breakup of MMM. If you look at page 5 of MMM’s Q1 2019 Earnings Presentation you will see that each of the 5 Business Groups generated in excess of $1B in Q1 revenue; each Business group is large enough to be a decent sized publicly traded company.
Thinking of breaking up MMM might be a stretch at this stage but I would not completely rule it out considering other large conglomerates have either split up in recent years or are in the process of splitting up into separately publicly traded entities (Automatic Data Processing, Inc. (ADP), Honeywell International Inc. (HON) and United Technologies Corporation (in process) (UTX)).
On a final note, it is not my intent to initiate a Bull Put Spread trade as I have just written additional covered calls so as to skim additional income from my MMM shares.
I hope you found this article helpful and wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long MMM.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
