- 3M reported record sales in the second quarter of $8.1 billion.
- The operating margins should attract attention.
- Leverage is impacting the Weighted Average Cost of Capital.
3M (NYSE:MMM) is a huge company with many segment lines and huge investments in research and development. For some investors, it may be difficult to tackle such a company. How should an investor examine such a company? Do it the same way you would eat a whale, one bite at a time. One great method for getting those pieces sectioned out is to use a DuPont Analysis. Using that analysis enables investors to see the trends in the company by breaking down several important metrics.
The effective tax rate was lower in first quarter than second quarter, but for the first half overall it is in line with previous years. No major concerns here. For investors that are new to DuPont, the "Tax Burden" and "Interest Burden" are the inverse of the intuitive meaning. The percentage showing up in "Tax Burden" Is the amount of "Earnings before taxes" that reaches "Net income attributable to common shareholders".
Net interest expense has been a fairly small cost for 3M relative to their operations. Q2 costs were in line with the average over the previous few years. The very low interest burden for 3M could be considered an issue. It appears the company is using very low levels of leverage which may put them below their optimal weights for capital structure. We're expecting interest costs (and leverage) to increase slightly through the remainder of the year.
Operating Margins were solid; they have also been trending better for years. A large part of what makes 3M desirable is their improving operating margins. This is the major factor driving the return on equity up. While calculating operating margins, research and development is expensed as incurred and included as an operating cost. 3M has been aggressively investing in research and development, so I wanted to see how that is working for them. The next table focuses on operating margins and removes the expenses for R&D.
From this table it is clear that the research and development has been paying off. Margins excluding R&D have been improving significantly each period. In addition to the improving margins, the investments in R&D have been growing. The increase in R&D matches the plans laid out by management. According to Forbes, "It has decided to gradually increase its annual investment in R&D from 5.0-5.5% to 6% of total sales by 2017".
The levels of asset turnover are driven by an increase in sales, not a reduction in assets. Given the historical figures here, part of the increase may not be sustainable. I'd expect the figures to drop back a tiny bit closer towards their long run averages. I only expect the decrease to be in the realm of 1 to 2% though.
Based on the DuPont Analysis it appears that leverage has been decreased, though only slightly. As investors familiar with DuPont will be aware, one of the weaknesses in using DuPont is the reliance on book value of equity. At times it can be very useful, but leverage can appear distorted from this picture. To handle that weakness, there are more tables. The next table will look at shares outstanding combined with cash and book value of equity.
From the above table we can discern a few things. The company's repurchasing of shares has increased recently. Given that cash values are not trending upwards, an enormous repurchase of shares would require debt financing. It seems more likely that the company will continue in about the same pace of repurchases they have been doing over the last six quarters. Based on the decrease in shares outstanding, it would appear the company is becoming more leveraged. To get a deeper picture of the leverage will require another table:
Without access to the market value of debt, the book value of liabilities will be used as a proxy. When looking at a company's WACC (Weighted Average Cost of Capital), it helps to be as close to market weights as possible. It appears using market weights (for equity) that the company has actually become significantly less leveraged as the value of their equity has been expanding. The company can't respond to every movement in their leverage, but the trend shows that their leverage has clearly decreased. I don't like this development, because I think the company should use more debt in their capital structure.
Expected changes in leverage
It was time to dig. I found the answer on page 65 of the 2014 Q2 10-Q. For simplicity sake, I'll quote the relevant part: "3M continues to manage towards a more optimized capital structure, financed with additional low-cost debt. The strength and stability of 3M's business model and strong free cash flow capability, together with proven capital markets access, enables 3M to implement this strategy while continuing to invest in its businesses. Organic growth remains the first priority, thus 3M will continue to invest in research and development, capital expenditures, and commercialization capability. In 2013, as a first step towards increasing capital deployment, 3M drew down its U.S. cash position to a minimum level and also reactivated its $3 billion commercial paper program. In 2014, 3M filed a new 'well-known seasoned issuer' shelf registration statement, and recommenced the Series F medium term notes program for future debt issuances."
Based on values from the end of Quarter 2, even if the company issued 4 billion in debt (rather than 3 billion) and used it all in share repurchases (without impacting the stock price), the Debt / (Debt + Equity) ratio would only be 16.18%. Since 3M is planning on less new debt than that, it appears that leverage will remain fairly low throughout the year, though it may be bumped up slightly from current levels. It is my opinion that the lowest WACC available to 3M includes a capital structure that uses more debt than the current structure. Therefore, I would support 3M issuing more debt to buy up shares of common stock. However, given the operating margins and the success of 3M's R&D, their priorities are correct. There is no reason, in my opinion, to believe that 3M's primary goals would be significantly impacted by improving their capital structure, which they have admitted is not optimal.
3M has done an admirable job of balancing conflicting desires. They have established a solid dividend, an aggressive share buyback program, and continued to increase their investments in R&D without sacrificing their operating margins. The company's suboptimal capital structure provides opportunities for significant increases in share buybacks (financed with debt) which creates an upside for current shareholders. I expect within the next year or two that management will announce an increase in their share repurchase program and fund the increase with debt. If that happens, I expect the announcement to be treated as positive news by the market.
It is rare to see companies erring on the side of caution. It feels like every other day I find companies that are over leveraged and poorly managed. That isn't the case here. 3M looks like a solid investment with reliable returns. By no means is that an excuse to ignore the need for diversification. When considering 3M as a part of a diversified long term portfolio, I am bullish on the stock.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. The analyst holds a diversified portfolio including mutual funds or index funds with long exposure to the stock.