3M: Acelity Is Not The Solution

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About: 3M Company (MMM)
by: The Value Investor
Summary

3M has focused on (too) high margins for too long.

High margins might not just be driven by excellence and might hamper organic growth.

The market is rightfully questioning if 3M still deserves a market premium valuation.

3M (MMM) until recently was regarded as one of the best run industrial companies, but recent lacklustre performance has cast some doubts on that, pressuring the share price. As the company announced a substantial deal, with the purchase of Acelity, there are sufficient reasons to reconsider the investment thesis.

In fact, I continue to be cautious on the shares as they now trade at a market multiple based on current earnings, as I see appeal only emerging if shares were to test the $150 mark.

Recent Events - Purchase of Acelity

At the start of May, 3M has announced that it has reached a deal to acquire Acelity from a group of funds tied to Apax as well as multiple pension funds in a $6.7 billion deal.

Acelity is a medical technology company which focuses on advanced wound care and speciality surgical applications with its KCI brand. CEO Mike Roman touts the complementary nature of the acquired activities to 3M's Health Care business.

Just like 3M, Acelity is well-known for the focus on innovation as KCI branded products have been developed for growing and new segments, meeting unmet needs. Acquiring such innovation does not come cheap as Acelity will boost sales by just $1.5 billion based on the 2018 results. That being said, 10% growth looks quite solid.

The company believes that GAAP earnings will see dilution to the tune of $0.35 per share in the first year of operations, mostly relating to one-time expenses related to the deal. On an adjusted basis, accretion is seen at $0.25 per share. If unspecified synergies are included, the deal is expected to come in at just 11 times anticipated EBITDA. With a $6.7 billion deal tag that implies $610 million in EBITDA, for margins of 40%! No wonder healthcare costs are so high.

The deal presentation reveals stand-alone EBITDA of $441 million suggesting that synergies and a year of growth might add about $170 million in additional EBITDA. This seems quite steep to originate just from growth and synergies alone.

To mitigate the impact on leverage ratios, 3M is cutting back the pace of share repurchases to just $1.0-1.5 billion in 2019, down from a previous guidance of $2-4 billion. Investors are not impressed, however, as shares hardly reacted in response to the deal announcement.

Soft Quarter, Tough 2019

By the end of April, 3M announced utterly disappointing first quarter results with sales down 5% to $7.9 billion and organic sales falling by 1.1%. This marks a violent reversal from the 3.0% organic growth rate reported in the fourth quarter of 2018 and 3.2% organic growth number for all of 2018.

The company attributes softness to China, automotive, and electronics and is taking efforts to make the business more productive. The real issue in my eyes is not so much the height of these margins (with adjusted margins totalling 21.4% in the first quarter). The issue is the lack of growth and the fact that high margins might not just originate from efficiency but high prices as well, limiting growth. Furthermore, I wonder how much a realignment from 5 to 4 business groups will help the business a lot. With sales and margins down a bit, the company reports adjusted earnings equal to $2.23 per share, down from $2.50 per share reported in Q1 of 2018.

The soft start to 2019 caused management to cut back the full-year outlook in quite a big way. Organic sales were previously expected to grow between 1% and 4%, but growth is now seen at minus 1% to positive 2%. Adjusted earnings are now seen at $9.25-9.75 per share, down from the initial guidance of $10.45-10.90 per share. With the midpoint of earnings per share being cut by some 11%, it is no surprise to see a 13% fall in the share price upon the release of the earnings numbers. Shares fell to $190 per share and have drifted lower to $175 at the moment of writing, implying that shares still trade at 18-19 times anticipated adjusted earnings this year.

Ending Q1 with $3.5 billion in cash and equivalents, net debt amounts to roughly $13 billion, as this number rises to $16 billion if pension liabilities are included. With nearly $9 billion in EBITDA reported in 2018, leverage ratios remain very reasonable even if the nearly $7 billion recent deal is included. With pro-forma net debt seen around $23 billion and EBITDA at around $9 billion this year, leverage remains reasonable, although much higher than seen in recent times at around 2.5 times.

The 588 million shares trade at $175 per share currently, for a $103 billion market valuation or $119 billion enterprise value based on the net debt position (including pension liabilities) ahead of the deal. This values the company at around 3.7 times sales of $32 billion and roughly 13 times EBITDA based on a $9 billion EBITDA number reported in 2018. This means the purchase of Acelity looks a bit pricey although synergies and growth should go a long way. Pro-forma sales of 3M will grow by nearly 5% as a result of the deal as 10% organic growth of the acquired activities could boost pro-forma organic growth by 0.5% per annum, as 3M desperately needs organic growth currently.

Reiterating My Caution

I last looked at 3M in December 2018 after it bought M*Modal for $1.0 billion. In that article, I literally drew the following conclusion: ''3M is a poster child of great long-term management, recent organic growth numbers are a bit underwhelming, which combined with already fat margins make me cautious to buy the dip, even as it has been quite sizeable already.''

I noted that average earnings power, throughout the economic cycle, would run at $8.00-8.50 per share as the big cut to 2019 earnings means that projection perhaps is optimistic. Based on the conclusions drawn at the time, I noted that I would become a buyer at around $150. Given that the outlook has not changed to a positive ever since, I am willing to reiterate that entry target, provided that some stabilisation is seen in Q2.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.