"While competitors have cut their budgets in response to weak global demand, 3M has maintained its spending levels. […] The logic is that it puts 3M in a better position relative to competitors for when demand recovers. The problem is that things aren't getting better, and in order to return more cash to shareholders 3M has had to increase leverage."
The company is undeniably restructuring its capital, shifting from a highly conservative 0.25 Debt/Equity ratio in 2013 to a more typical 0.76 Debt/Equity ratio in the latest quarter (source Morningstar). In my opinion this is sound policy given the exceptionally low cost of capital in the current market. Morningstar lists $11B of bond issues, of which just three issues representing 12% of the total carry a coupon greater than 3%. (The two most expensive were issued in 2007 and 1998.) It is almost certain that 3M will save more in dividends than it pays in interest on these bonds, even before taking the tax deductibility of interest expense into account.
But cash is perfectly fungible! Dollar bills don't come with printed labels declaring, "This dollar was earned from operations." or "This dollar was borrowed." No matter the source, they all spend the same. The author argues that 3M could better afford the dividend and share repurchase program if it responded to declining revenues by cutting back on R&D. I may personally view the debt issuance as contributing to the share repurchase program (they have actually been retiring stock much faster than they have been issuing debt), but the author's suggestion is also reasonable.
Cutting Costs to Support Margins
Keeping costs in line with revenues is certainly common practice among the Industrials. For example, Emerson Electric (NYSE:EMR) reduced R&D by 13% from 2013 to 2015, exceeding the 10% decline in sales and thus helping to support margins. United Technologies (NYSE:UTX) has cut R&D by 10%, matching their revenue declines. The author cites Du Pont (NYSE:DD) as perhaps the most striking example, slashing R&D by 13% year-over-year vs. just a 1% decline in sales. In contrast, 3M has increased its spending by 3%, despite a 2% drop in sales. (All figures sourced from Fidelity's Financial Statements.) The 3M Company has demonstrated a willingness to cut SG&A in other areas, but has sustained its investment in research.
While cutting back on R&D has an immediate impact on the bottom line (these expenses are marked against net income), I believe this is a short-sighted way to operate a company. Research funds growth, and the alternative is… Shrinkage? (Tip of the hat to Seinfeld.) Perhaps the best caution here would be International Business Machines (NYSE:IBM) where R&D spending peaked at $6.3B in 2008 (source Morningstar) with revenues peaking just three years later. Under CEO Palmisano's leadership they cut back on investment in the 2009 recession, perhaps understandably choosing instead to pay down debt, but as the markets rebounded they chose to direct their cash to an aggressive share repurchase program. From 2010 to 2014 they averaged $14B of share repurchases per year vs. just $6B of R&D! This may have seemed to be a shareholder-friendly approach at first, and the shares initially responded as seen in the first chart below.
Yet the impact of these short-sighted policies began to be felt by 2013. IBM is now forced to purchase R&D through premium-priced acquisitions, with (in theory) less bang for the buck than if they had developed these businesses in-house. Shareholders are surely less than happy with the way this has played out over the longer term!
What We Look For In R&D
A sound R&D program should be purposeful, adding new products to a company's lineup and supporting long-term revenue growth. There is certainly reason to question the efficiency and discipline with which some companies pursue research, chasing pie-in-the-sky ideas that cannot be monetized in any reasonable time frame. However, 3M has a long history of effective innovation. There is every reason to trust that their continued investment will produce results over time. Nor do I take caution from cutbacks elsewhere. Rather, the best time to invest is when others are not. Their new offerings will face less competition in the marketplace, owning a greater share of the growth while commanding higher margins.
The 3M Company may seem like it is in a "boring" manufacturing business, yet it is in reality an innovation powerhouse. This focus supports exceptional margins, with a 15% ROA, 23% ROIC, and 38% ROE over the past year. As cited in the Harvard Business Review, they aim for 30% of each division's revenues to come from products introduced in the last four years. R&D is the engine that drives this business, a core piece of 3M's operations in the same way that advertising is essential to the Coca-Cola (NYSE:KO) brand.
It would be a mistake for 3M to listen to Wall Street analysts pushing a short-sighted focus on quarterly results. While some "financial engineering" makes sense, leveraging cheap debt to recapitalize more expensive equity (without risking their pristine credit rating), this cannot be allowed to impact investment in their operations. Cutting back on R&D might drive shares higher in the short-term but (as with George Costanza) would leave them exposed to shrinkage down the road. Surely we don't want to see that?
Disclosure: I am/we are long EMR, KO, MMM, UTX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.