3M (NYSE:MMM) reminds me of a steady old draft horse. On a normal day, it'll plow your field at around 2.5 mph. On a great day, it'll plow your field at around 2.5 mph. On a terrible day, it'll plow your field at around 2.5 mph. In other words, 3M is probably not the name to go to when conditions in the broader global economy are screaming "growth!", but you'll appreciate what it can do when the global growth outlook bumps along a flat line.
I believe there are ways that 3M can, and should, improve its long-term performance. There's more margin leverage to be gained from efficiency/productivity improvements, and I would like to see the company shift more R&D spending toward disruptive innovation. As things sit today, the shares are not cheap on a discounted cash flow basis, but they don't look unreasonably priced on the basis of a relative valuation model that takes into account ROE, stability of performance, and interest rates. What's more, there aren't a surplus of great industrial names that are remarkably cheap.
More Muddle-Through In Q2
3M reported core revenue contraction of 0.2% in the second quarter, with a volume decline almost offset by price realization improvements. Healthcare (up 5% organic) was the growth leader while Consumer (up 3%) and Safety and Graphics (up 2%) were also positive contributors. Industrial was down about 1% while Electronics and Energy were down 9%.
Healthcare saw positive performance across the board, as spending on medical devices, drug delivery, and healthcare IT continues to grow. Consumer was largely driven by home improvement and OTC healthcare while Safety and Graphics was driven by roofing granules and commercial solutions. Within Industrial, the auto market (OEM and aftermarket) remains surprisingly strong, and abrasives grew, but everything else was down. Electronics and Energy is a mess, with Energy down 2% and Electronics down 14% with weakness across the board.
Gross margin improved about a half-point while operating income rose about 1% as the company held SG&A and R&D basically flat and operating margin improved about a half-point. Segment-level margins were a little stronger, with every segment improving except for Electronics and Energy. I think it's worth noting that 3M's best-growing businesses are also its highest-margin businesses.
Looking Around The Neighborhood
Once again, 3M showed that when the going gets tough, it keeps going. Looking around the large industrial sector, core revenue growth has settled out at around -1% to -2%, with modest (around a quarter-point) core margin erosion. So, relatively speaking, 3M is doing pretty well. I attribute at least some of this outperformance to its low exposure to oil/gas and metals/minerals, as well as strong exposure to healthcare and a surprisingly resilient consumer segment.
To look at some of the others, Danaher (NYSE:DHR) was one of the strongest in the peer group, as revenue rose 2% (although margins were down almost a point), and I'd note that healthcare is a major portion of Danaher's business. Honeywell (NYSE:HON) saw revenue contract 2% on squishy aerospace demand (not much of business for 3M) and weaker specialty chemicals (also not much of a direct business for 3M). GE (NYSE:GE) was down 1% on softness, but Illinois Tool Works (NYSE:ITW) was up about 1% on slight growth in autos, food and beverage, and test and measurement.
What Can Drive 3M Ahead?
I do believe that 3M still has opportunities to grow in the coming years.
The company's Consumer business still gets more than 50% of its revenue (around 55%) from the U.S., and growing this business in emerging markets is a potential future growth driver. Likewise with the Healthcare segment; dental care is an under-appreciated growth opportunity in emerging markets like China, and although that's not a particularly healthy market today, I don't believe the weak results will last forever. I likewise believe that worker safety and traffic safety are seriously under-penetrated opportunities in emerging markets and that those markets will deliver above-average growth in the coming years.
I believe 3M can also transform itself further. There are few industrial conglomerates with better margins than 3M - Illinois Tool Works is close and Roper (NYSE:ROP) is better - but 3M still has a relatively decentralized structure and may still have more employees than it needs. I am not a fan of boosting profits on the backs on workers through layoffs, but the company's productivity initiatives could make some meaningful contributions in the coming years.
I'm also hoping that 3M will shift its R&D philosophy a bit. 3M is extremely good at maintaining constant innovation within its existing product lineup to support market share and pricing, but I would like to see the company spend more than the 10% or 20% it spends on disruptive innovation (as it has indicated in conference presentations). Healthcare, autos, consumer, and electronics are all industries that have shown in the past that they will pay for innovation, and so I would like to see the company stretch a bit more here - not so much in terms of a major overall increase in spending, but a shift in spending priorities.
Slow And Steady Can Win
I don't expect major changes at 3M, but I wouldn't be shocked if the company considered selling the Electronics business. This business is heavily dependent on demand for consumer products like phones, laptops, TVs, and so on, but the business also supports a lot of 3M's other businesses "below the surface". Management has already said that it isn't looking to expand this business through acquisitions, so perhaps it would welcome an offer it couldn't refuse.
On the subject of M&A, management has made it clear that it's not looking for splashy deals. Deals on the scale of Capital Safety (around $2.5 billion) or smaller are probably going to be the norm, but it's interesting to me that 3M now bases its M&A more along the lines of long-term strategic needs than immediate valuation. The availability of basically free money is definitely an opportunity for a company like Danaher where serial M&A is part of the corporate DNA, but I don't think 3M will make a big shift in its plan.
Management used its March analyst day to pull in its revenue growth expectations, and I think the company is taking a pretty realistic view of the growth opportunities in auto, general manufacturing, medical devices, and so on. As I said, though, I do believe there are some opportunities to generate better growth with further positive operating leverage.
I'm still looking for long-term revenue growth in the neighborhood of 4%, with free cash flow growth about a point to a point and a half above that. Those assumptions don't support the idea that 3M is undervalued on a cash flow basis. There are other ways to evaluate stocks, though, and there is a historical relationship between the valuation of companies like 3M with the company's growth, margins/ROE, global growth, and global interest rates. Historically, the market has always been willing to pay premiums for growth stability and high margins, and 3M certainly offers that. Within that framework, a fair value around $180 to $185 is not absurd.
The Bottom Line
Positive calls on 3M, Illinois Tool Works, Danaher, Honeywell and other industrials earlier this year worked out well, but a lot of that was exploiting what looked like sheer panic in the market. Since then, Honeywell and 3M have done well, Danaher has been strong, and Illinois Tool Works has been absurdly strong. That doesn't leave many bargains, and those bargains that do remain have some real doubts around them.
I continue to believe that 3M is a strong option for an environment where industrial growth prospects are "meh" at best and where many of these conglomerates have to look to non-industrial markets like healthcare to drive their growth. There's little-to-no additional fundamental value here, though, so I can certainly understand investors looking to take, or at least lock in, profits on this name.
Disclosure: I am/we are long MMM.
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.