Being a 3M (MMM) investor is no picnic. Sure, every sell-side analyst (and most independent writers/analysts) is quick to praise the company's long history of shareholder valuation creation and product innovation, but then the "yeah, buts" start - it's not a fast grower, it's not aggressive enough, it's not ruthless enough on costs, and so on. This is all true to a point, and 3M is probably not the best pick for a fiery second half economic rebound, but 3M remains a solid portfolio cornerstone and a stock unlikely to disappoint long-term investors.
Q4 Results - Mostly Good, With A Little Bad
For the last quarter of 2012, it posted some respectable growth relative to other large conglomerates like DuPont (DD), General Electric (GE) and Dover (DOV). Revenue rose about 4% both as reported and on an organic basis, good for about a 3% beat relative to sell-side estimates.
Profitability was a bit more mixed. Gross margin was basically flat with last year and operating income was up 6%, but the Street was looking for a little more. Combining the revenue beat and the operating income miss, 3M missed analyst targets by about a point - definitely mitigating what was otherwise a pretty solid performance.
Balanced Growth Back On The Menu
3M's consumer/office and display/graphics businesses were notably strong (each up more than 8% on an organic basis), but overall results were pretty even. Only the company's safety/security business saw revenue contraction (down 2%), and the large industrial/transport (up 4%) and healthcare (+6%) businesses saw good growth. In point of fact, it's looking like 3M had uncommonly good growth in these two segments, as the performance of others in overlapping markets like GE, DuPont, Johnson Controls (JCI), Johnson & Johnson (JNJ), and Abbott (ABT) came in weaker this quarter.
3M also saw good balance and good trends in its geographic spread. U.S. revenue definitely accelerated at year end (up 5% organically for the quarter), and Asia-Pacific revenue (up 6% organically) has come back nicely, while Latin America continues to grow strongly. Europe remains soft, and I'd be a little concerned about markets like autos and healthcare for the first half of 2013.
Reconciling Potential With Probable Performance
When CEO Thulin hosted his first major analyst day back in November, there really weren't any major surprises on offer. Now, no long-term shareholder would have expected that from 3M, but the problem with incremental improvement is that it doesn't really fire the imaginations of sell-analysts or institutional investors.
Realigning the company's operating units makes sense, and I was gratified to hear about a renewed focus on "blocking and tackling" operations like sourcing and lean manufacturing. 3M's gross margin and asset turnover have both drifted down a bit over the past decade, and just a point or two of incremental improvement would be significant to cash flow. While 3M has no reason to become a serial mass-firer or improve itself on the backs of its workforce, there are still opportunities here to just run a slightly tighter ship.
Where I would like to see more from the company is in truly fostering growth. 3M has a well-earned reputation for product innovation (about one-third of sales come from new products), but having lived in Minneapolis, and gotten to know many 3M executives, I have a slightly different take on that legacy. 3M is very good about allowing its engineers to explore experiment, but the company has a history of essentially just throwing handfuls of seeds across the fields and waiting to see what takes root, instead of identifying especially promising products/markets and carefully cultivating them. I don't believe there has to be an either/or, but I think 3M would be better served if it actually tried to pick winners a little more often.
I'm also curious to see where the company goes with M&A. I was glad to see that Thulin took down the long-term revenue growth forecast to a more reasonable range (4%-6%), as the company rarely met the prior goal. But I'd still like to hear more about how M&A plays into this strategy. 3M's acquisition strategy has often confused me, as the company has recently targeted businesses like Avery Dennison's (AVY) consumer/office products and Ceradyne, but won't go after growth businesses in areas like healthcare or performance materials [while Danaher (DHR) and DuPont certainly will]. I would also like to see 3M take a closer look at divestitures - companies like Danaher and Illinois Tool Works (ITW) have been active pruners over the years, and I see no reason why 3M should stick with low-growth/low-return businesses just for old time's sake.
What Does This All Mean For Growth?
At the risk of going a little overboard with the similes, 3M may not be the most exciting dating prospect, but it's almost always a great candidate for a happy long-term relationship. 3M isn't set up to grow significantly faster than the global economy, but it's less cyclical than many of its peers. It also produces consistent above-average returns and has always made dividend and shareholder value growth a priority.
I expect 3M to come in at the lower end of Thulin's long-term 4%-6% growth guidance, but I wouldn't rule out some upside if the company starts to actively cultivate more market-focused product development.
On the margin side, I do believe the company has upside to its operating margins - probably more upside than sell-side analysts are willing to believe. Incremental improvements in sourcing and manufacturing should add a point or two of gross margin, while some selective pruning of businesses could add a bit more to the operating margin line. All in all, I believe 3M will get back to mid-teens free cash flow margins within five years, with a couple of points of upside in the years after. All in all, that leads to me believe that free cash flow growth in the neighborhood of 7% is still attainable.
The Bottom Line
If 3M can grow free cash flow by 7%, fair value looks to be around $110. Admittedly, that's not a terribly compelling target with the stock near $100, but this isn't a stock that investors should expect to be able to buy at a major discount to fair value. Moreover, this is a long-term core holding, not a turnaround or restructuring story, and while other industrials may have better prospects for the next 12 months, it's hard not to like 3M for the next 12 years.