3M's Balanced, Diversified Portfolio Maybe Not The Best Play Today

| About: 3M Company (MMM)
This article is now exclusive for PRO subscribers.

Summary

3M's fourth quarter performance stacks up pretty well next to its peer group, but the company doesn't have the best leverage to the new administration nor to an economic recovery.

Serial innovation and a near-constant focus on margin improvement remain key long-term drivers, and 3M has shown a knack for knowing how to repurpose technologies and know-how into new products.

Mid single-digit growth supports a total return in the mid-to-high single digits, which makes 3M too expensive to be an exciting new buy, but still a credible long-term core holding.

I have been favorably inclined toward 3M (NYSE:MMM) for quite some time, and I continue to think that 3M's CEO Inge Thulin is doing a great job running this global conglomerate. 3M generates very strong margins, but continues to pursue initiatives that should boost them further over the next three years, and does so while continuing to spend sizable amounts on R&D. The company is also solid from a free cash flow perspective, and has been a relatively good steward of shareholder capital with management willing to sell businesses that no longer meet management's long-term returns targets.

The bad news is that 3M is not cheap and not necessarily the best-positioned company for the current circumstances. 3M's global leverage should be a positive as emerging markets recover and the company's net exporter status does give it some leverage to potential corporate tax changes in the U.S., but it's not all that leveraged to U.S. infrastructure, its tax rate is already pretty good, it would be vulnerable to a stronger dollar and/or trade wars, and its balance between defensive and growth-oriented industries doesn't give it huge leverage to a recovering U.S. economy. While I'm in no rush to sell 3M today, it's hard to argue for this name as a must-own.

Like Usual, Some Good And Some Bad In The Quarterly Numbers

3M's fourth quarter results weren't bad, but they also weren't a hands-down win. Core revenue rose more than 1%, but it was almost all volume-driven as management backed off on pricing to gain volume. This isn't an unusual trend relative to the company's peers, but this is the weakest price performance from 3M in a long while.

The Industrial segment was the leader, with nearly 5% core revenue growth, led by double-digit growth in auto OEM sales and solid (mid single-digit) growth in advanced materials, auto aftermarket, and separation/purification. Safety and Graphics was up a little more than 2% on good safety and growth in roofing, while Healthcare was up a little more than 1% as strong growth in food safety and decent growth in drug delivery and medical consumables offset ongoing weakness in oral. Electronics and Energy was down as flat electronics revenue was offset up weaker energy, and Consumer was down almost 1% on destocking.

Although pricing is weak and commodity tailwinds are abating, gross margin was still up close to two points this quarter, while operating income rose about 11% and segment earnings rose about 8%. Segment earnings tend to be more volatile on a quarter-to-quarter basis, but Industrial earnings were up 16% and contributed the largest portion, while Healthcare and Electronics and Energy had the highest segment markets (in the high 20%'s).

Still Not Bad On A Relative Basis

Although there growing signs that many markets are starting to turn up, 3M continues to earn its reputation as a relatively better performer in tougher times. To that end, the company's core revenue growth was up more than two times the average that has been reported so far for its larger peer group. Certainly there are solid performers out there like General Electric (NYSE:GE), Rockwell (NYSE:ROK), and Danaher (NYSE:DHR), while Illinois Tool Works (NYSE:ITW) and Honeywell (NYSE:HON) bracket 3M's performance. 3M also remains very strong on a relative basis with respect to its segment margins.

Auto remains a strong market despite concerns that sales volume in North America and Western Europe has peaked, and that is helping 3M, Illinois Tool Works, and Dover. It's worth noting that the product exposures are different (ITW, for instance, is more leveraged toward fasteners in the auto space), and 3M is looking to gain content share in areas like films and electronics that could help offset weaker overall volumes.

Oil and gas is improving, but that's far more significant to companies like GE and Dover than 3M. Within energy, though, 3M is leveraged to increasing grid automation and solar adoption, with the company's films used in Tesla's (NASDAQ:TSLA) solar roofing tiles. On the healthcare side, dental remains a weak spot (for Danaher as well), and I really have no idea what the potential dismantling or restructuring of Obamacare will mean for this business - oral care has a much larger out-of-pocket component than other types of healthcare, so it is still worth watching as a barometer of consumer economic health.

The New Administration Offers Some Opportunities, But Also Some Risks

Evaluating 3M through the lens of the new administration is complicated, and not just because so few policies have actual details behind them. While 3M has long been a leader in global diversification (locating plants outside the U.S. and closer to end markets), the company is still a net exporter to the tune of about $3.5 billion and would likely have some positive leverage to lower corporate taxes, albeit not as much as many other companies with much higher effective tax rates. On the other hand, a stronger dollar would be a risk factor and revenue headwind for 3M, as would the prospect of higher barriers to trade and/or outright trade wars.

Insofar as domestic spending goes, 3M isn't much of a play on renewed infrastructure spending. There likely would be some incremental sales leverage to traffic/road signs and markings and maybe some in abrasives, but I don't see it as a major driver. Likewise, while the company does generate a meaningful percentage of revenue in the U.S. (around 40%) and would benefit from a stronger U.S. economy, the diversification of its businesses makes it a less cyclical company than many other industrials, so it isn't likely to be a leader in terms of revenue growth acceleration in a recovery scenario.

The Opportunity

3M management has given no indication that they are about to change their basic approach. That means that sales growth will be based upon R&D-driven serial product innovation, pricing for quality, and the occasional bolt-on deal. The company is in the middle of several initiatives designed to improve margins in non-US locations (including ERP rollouts and lean initiatives), but this doesn't really represent a fundamental change in how the company goes about its business.

Given all of that, I continue to see 3M as an "it is what it is" type of story - it's a company that is built to smooth out the bumps of the economic cycle and chug along with relatively consistent performance. I expect that that will translate into mid single-digit revenue and FCF growth over time, but that's not enough to support a double-digit total return from the shares at today's price.

The Bottom Line

Today's price seems more likely to deliver a mid-to-high single-digit total return, which isn't great but isn't bad given the stability and dividends it offers. 3M isn't on the top of my buy list, but I'm not in a big rush to sell, as I still think it qualifies as a long-term core holding for more conservatively-constructed portfolios.

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.