3M (MMM) is one of my longest-held positions and one of the most confounding. I love the company's strong brands and excellent tradition of innovative R&D, but I have often found the company's M&A priorities to be both exasperating and confusing. And while the company has a remarkable record of steady performance, it seems to always be a relatively unloved name for Wall Street analysts. Nevertheless, with the company's sizable exposure to early-cycle markets and China in particular, I believe this company should be a leader if global growth resumes and a steady survivor if the malaise continues.
A Familiar Theme To Q2 - Weak Growth, But Good Margins
3M once again had a disappointing top-line performance, with revenue falling 2% on a reported basis and rising just 2% on an organic basis. That puts the company pretty low on the list of conglomerate growth this quarter, weaker even than Dover (DOV), Danaher (DHR), and Ingersoll Rand (IR).
On the flip side, management did a laudable job of squeezing more profits out of the revenue they had. Gross margin improved more than a point from last year, while operating income rose about 4% and the operating margin expansion exceeded the gross margin improvement. Notably, every unit but Display/Graphics saw an improved segment margin.
Growth May Have Been Disappointing, But It Wasn't All Bad
3M delivered better than 5% organic growth in its healthcare business, putting it in good company relative to healthcare stalwarts like Johnson & Johnson (JNJ) and Covidien (COV). Industrial/Transport also looked solid (up 4% organic) and held its own with Illinois Tool Works (ITW) and Honeywell (HON) with strong performance in autos and aerospace.
Electro/Communications and Display/Graphics were weak once again (down 2% and more than 6%, respectively), but this is perhaps not as bad as it may seem. Chemicals and commercial graphics are two segments that 3M management follows closely as harbingers of economic downturns, and both held up okay - in fact, commercial graphics showed a double-digit increase.
There's also reason for some cautious optimism here. In the display business, a long stretch of bad performance in TVs has significantly reduced the impact of that part of the business, while the company is levered to the same sort of small-screen (mobile devices) growth that bulls like about Corning (GLW). As for Electro/Comm, the company has delivered a lot of new products out of R&D recently and there seems to be nothing wrong with this business that a general turnaround in the electronics industry wouldn't fix.
Deals Versus Internal Delivery
As much as I disliked the deal for Avery Dennison's (AVY) office and consumer products business, I do like the deal for Federal Signal's (FSS) Federal Signals Technologies. Not only was the price low ($100M), but products and technology built around the road tolling, parking meter, and license plate ID markets seems like a natural fit for a growth business. That makes up a little bit for what I think has been an M&A policy more focused on margins and incremental cash flow than growth.
That said, I don't think there will be a lot of big deals in the near future. New CEO Thulin seems quite confident about the organic growth potential that the company can realize from its internal R&D. So, while I'd like to see more deals in spaces like industrial and resources (getting back to 3M's roots in "mining" and "manufacturing"), it looks like 3M is more interested in keeping the hand it has and playing it better.
And that's not the worst thing. First of all, this is a conservative company from top to bottom and all the way through to its pension accounting. Second, the company is structured such that it will likely hold up better than its peers if this economic malaise worsens, but will also be one of the first to recover when growth resumes (large exposure to Asia and emerging markets certainly helps there). I like those "heads I win, tails I tie" opportunities.
The Bottom Line
As I said in the open, 3M has been an exasperating holding for me at times - I'm solidly in the black with it and I think it's a top-notch conservative dividend growth stock, but it can be a frustrating stock due both to internal decisions and external analyst/investor sentiment. While I have to admit being tempted to trade it out for a name like Honeywell from time to time, I think this is a stock that I will be glad I hung on to in the years to come.
Concerning value, I don't agree with the general sell-side opinion that margins have peaked and have nowhere to go; simply seeing some recovery in electro/comm and display/graphics should help somewhat. Accordingly, I incorporate mid single-digit revenue growth and a slight improvement in free cash flow conversion into my model, resulting in a projected 6-7% forward free cash flow growth rate. That, in turn, supports a fair value above $110 - a bold projection for a company like 3M, but one that I'm nevertheless comfortable making.