3M (NYSE:MMM) stock is by and large a defensive stock that mostly trades on the basis of strong margins. The company's repeated margin weakness in recent times is now beginning to become a major source of worry for its investors. In its defense, 3M's growth stacks up quite well against major peers (industrial conglomerates), especially bearing in mind that the stock is not rated as a top growth stock that is capable of producing huge growth spurts.
Second quarter mediocre at best
3M gets top-rate credit for its strong margins, the defensive characteristics of the stock and a respectable global footprint. All this is true on balance, but it would still be a stretch to say that performance is not eroding.
Revenue was up 3% to $7.8 billion in the second-quarter, or slightly above 2% on an organic basis. About three-quarters of this growth was driven by volume gains. Three-out-of-five of 3M's business units recorded organic growth (Health Care registered 6% growth while Industrial and Consumer unit grew 3%). Graphics/Safety as well as Electronics/Energy fell by 2% each.
3M's margins missed expectations- again. Gross margin fell by 40 basis points, and segment profits declined by 3%, thereby missing expectations by 2%. The consolidated operating income declined 2% while the operating margin fell by almost one point. Some of the firm's underperformance can be directly pinned on acquisition-related costs; however, this was the second straight quarter that saw 3M log a $0.04 miss on the operating line. If the trend continues any longer, it will at some point begin impugning 3M's solid reputation as an all-weather industrial conglomerate margin play.
Can 3M keep up with the growth?
3M's 2.3% organic growth rate in the second-quarter was in the same range as, and in some cases better than, comparables such as General Electric (NYSE: GE), Danaher, and United Technologies (NYSE: UTX)
Although 3M's relative performance compared to its peers was okay, it could worsen as the quarters roll on, given that the company's sales did not decline compared to its peers. 3M can certainly benefit from the improving global industrial demand as well the recovery in electronics. 3M's electronics business currently continues to decline in tandem with close peers' Danaher and Du Pont (NYSE:DD). This business simply isn't geared for a fast turnaround.
3M's saving grace in the quarter was Teradyne Ceramics, a firm that it bought in October Last year for $860 million. The company won a $40 million contract in the second-quarter from the Department of Defense to make 242,000 body armor plates for US soldiers serving in Afghanistan. Ceradyne ceramic is used in a wide variety of products such as military helmets, car engines, helicopter armor, and missile nose cones. More recently, Ceradyne won a $151.2 million contract from the Defense of Department to supply it with Enhanced Small Arms Protective Inserts. The future for this division looks bright.
3M is a company founded on serial innovation as well as high efficiency. This is a formula that produces a slow but steady performance. The company certainly has the financial wherewithal to buy rapidly-growing companies that fit in with its innovation culture; this strategy, however, simply isn't 3M's style. Most of 3M s deals are built around synergy and complementary business lines as opposed to growth. At this point in time, close to half of 3M's businesses can be classified as ''early cycle'' businesses. Early cycle businesses tend to grow much more rapidly than advanced stage businesses; however, I still don't expect to see 3M growing rapidly in the coming years, even taking into account that there are now strong signs of a global economic recovery.
For comparison purposes, have a look at the chart below that compares 3M and close competitors General Electric and United Technologies.
Price to sales
Return on Equity
United Technologies offers better value as far as P/E and growth are concerned while 3M performs better on margins. Meanwhile, Danaher returned a 15.7% net margin in the quarter while Du Pont returned a 10.29% net margin. On an absolute numbers basis, therefore, 3M's net margin is actually just average compared to its peers.' After all, of 3M's four peers named here, only Danaher had a better net margin of 15.7%. But that's not my point here. My main concern is that 3M is showing a worrying trend where its margins are slowly falling and this places the defensive characteristics of the stock in jeopardy.
Both General Electric and United Technologies are heavily dependent on the US economy and consequently their bottom lines have tended to recover in line with the recovery of the US economy. 3M's stock dividend yield of 2% is similar to United Technologies,' while General Electric has the highest yield at 3.10%. 3M has returned 27% Year-to-Date while United Technologies has returned 30%.
3M revenue weak compared to industrial peers
3M has the weakest revenue growth TTM compared to its peers in the Industrial Select SPDR holdings with just 2.24% revenue growth. United Technologies (NYSE:UTX) beats its peers by a mile when it comes to revenue growth. United Technologies provides high-technology products and services to the global aerospace and building systems industries.The firm has a strong 11.23% revenue growth TTM, compared to its closest rival Boeing (NYSE:BA) with 5.15%. Union Pacific (NYSE:UNP) comes in third with a 2.74% revenue growth TTM.
Considering that 3M's revenue growth TTM was a mere 2.24% by Sept. 22, 2013, the company might not register very impressive revenue growth in the third quarter either.
Margins certainly need to improve
Improved margin leverage is critical for 3M's valuation multiples. Improved factory utilization as well as M&A dilution is the major reasons for the year-on-year decline. The price/cost tailwinds that remain in place for 3M can improve the valuation of the stock but I wouldn't bank on it.
Time for a pullback?
3M shares are currently trading at $120.22. The share movement is currently on a downtrend. The shares have gained more than 7% this month alone. Although Jeffries had raised 3M s PT from $128 to $140 in early August, the current downtrend suggests that it might take much longer before the 3M's price gets to those levels. The shares have a 15% potential upside.
3M currently has a 5.7% FCF. Over the long-term, I expect 3M to generate a 4% long-term revenue growth and FCF of more than 6%. The estimate for FCF could, however, be eroded by worsening margins. 3M is, therefore, better as a long-term investment stock than a short-term one.