In this article, we'll take a look at a stock on my permanent watch list - 3M Company (MMM). Because of recent stock price developments, the share price is tanking and certain groups of investors are sprinting for the hills. The stock has suffered rating downgrades, and this begs the question for many investors if the company remains investable long-term to the degree it has before.
In this article, I share my view on the situation, I go through some of the risks with the stock, and show you why I believe that 3M remains one of the best stocks out there that you can buy long-term, as well what sort of expectations you need to have short-term if you decide to invest.
Let's dive in.
(Source: 3M Homepage)
3M - Some basics
3M formerly stood for Minnesota Mining and Manufacturing. The company, founded in 1902, has over 60,000 products in its roster, covering needs in five different business segments. This company is active in everything from applied nanotechnology to ceramics and simple Post-its, and for the past decades, it's been thriving.
The company is currently split into the following business areas.
(Source: Investor Day 2018)
For a company as large as 3M however, let's break down these further to illustrate the scope of company operations.
(Source: Investor Day 2018)
- Healthcare handles hospital/healthcare supplies, drug delivery systems, data systems, dental and orthotic products, and food safety.
- Safety & Graphics handle personal protection equipment, fall protection, commercial cleaning, graphics equipment, and traffic safety products.
- Industrial handles sealants, adhesives, ceramics, tapes and abrasives for a variety of applications.
- Electronics & Energy handles insulation, touch screens, renewables, infrastructure protection equipment, splicing and interconnectivity devices.
- Consumer Products is by far the smallest of the segments with the eponymous Post-it notes, tapes, sponges, home improvement products and consumer adhesives.
In terms of size, Industrial and Healthcare are largest in terms of sales with about a quarter of company income each, but the segments are otherwise diversified enough where no clear segment (apart from Consumer Products) is clearly the smallest.
Unlike many American companies I try to cover on Seeking Alpha, 3M is also exceedingly diversified into other geographies, with only ~40% of sales going to the US.
While its dividend growth record stretches 60+ years, the company has actually paid an uninterrupted dividend for over 100 years. Chances are it will continue paying a dividend for another 100 years, long after everyone who reads this is gone.
Overall Business details
3M has a long history of creating value and profits for the company and company shareholders. Not only that, but also the company operates with sector-beating margins in excess of 20%+, translating into some excellent competitive advantages across the board.
The company's products often have the characteristic of being very simple in substance (adhesives, Post-its, abrasives and so forth), but at the same time being mission-critical to the customer's project application.
For instance, despite the paperless office revolution, Post-its are still a core part of most offices worldwide (including mine own!). Take something more serious, such as an automotive adhesive, or the Thinsulate Thermal insulation, for example.
The products the company produces provide such a pricing power to manufacturers/customers that it isn't, from a customer perspective, not worth risking end-product reliability for a few cents in savings. The adhesives the company makes, after all, bind materials such as plastics, metals, and ceramics, and are mission-critical to the end product.
3M produces consumables, as we know. What this means is that constant repurchasing is a necessity, adding another dimension to the company's advantage. It allows the company to continually increase its prices year by year while retaining strong customer loyalty more or less across the board.
Adaptive Strength and Ruthlessness
Many of the larger industrial conglomerates have had to adapt to the current changing world - 3M is no exception. Industrial conditions are no longer the same as they were 20-30 years ago.
(Source: 2018 Annual Report)
3M has reduced the number of operating divisions from 40 to 23 and sold 10 underperforming units entirely. The sale was cheap - $2.1B in total, but the important thing for 3M was to get the units off the books. Included in the sales were electronic monitoring, toll/license plate converting, safety glasses (prescription-based), noise monitoring, cathode batteries, and identity management. The margin for these units was below 5%. For some companies, this may have been enough, but not for 3M.
The new company CEO has embraced Lean Six Sigma and actively manages divisions based mostly on profitability and growth. 3M has shown that regardless of division tradition within the company, it'll cut underperforming areas off quick enough if no improvement is shown.
Unlike other companies that embrace their legacy businesses, 3M has no such illusions, if legacy doesn't equate profit.
Few companies run as well as 3M. The company has the following capital allocation plan going forward.
(Source: Investor Day 2018)
FY18 results were acceptable in the big picture.
(Source: 2019 Annual Shareholder Meeting)
The company is targeting an EPS/FCF growth rate of 9.5% yearly for investors, meaning the dividend should grow at a similar pace as well. Current key financials look appealing for a company the size of 3M.
While the company's earnings have lagged for two years, the overall trend is very encouraging, with ever-increasing levels of earnings growth and cash flow generation. Sales have grown from $23.1B annually to $32.4B in 10 years, marking a ~40% increase in sales.
3M's profitability indicators are ridiculously good, operating at almost twice the preferred margins of metrics given by dividend investment sites. Return on invested capital/RoE shows just how effective this company is at generating large amounts of money.
Overall, here we see some of the reasons why 3M is attributed a premium valuation - and why I, who usually am more conservative with such premiums, am willing to accept a certain degree of market premium in this stock.
Key indicators for the full year of 2018 were up. The company locked in overall organic growth and improved EPS by 12% for the year, with a RoIC of 22%, far above industrial averages. The premium margins, as we can see above, were still very much in effect at 25% margins (Source: Annual Report 2018).
A bit about M&As
A significant M&A was also done, in line with the company's focus on the portfolio. The company has acquired M*Modal's tech business, providing AI-powered healthcare solutions for the market.
One thing to note here in terms of 3M's M&As. As opposed to other large companies, 3M has a historical tendency of choosing smaller deals as opposed to market-changing mergers typical to some companies. 3M rarely does M&As to change sales as a result of the M&A directly, but rather improve existing products and businesses.
This approach and the results of it can be seen in the firm's impressive historical and current RoIC. It's hard to argue with numbers like that.
A bit about debt
Company debt is also very much under control. The company comes in at a 1.68X net debt/EBITDA ratio, giving it plenty of room to leverage its balance sheet, should the situation warrant it. The company has not, at least not for the last 10 years, ever had more of a ratio than 1.89X however.
3M has a history of using debt and leverage extremely conservatively. Despite the company's plans to increase share repurchases and invest in growth projects, the current leverage will guarantee that even with these projects realized, 3M will continue to hold a sector-beating balance sheet in terms of safety.
The S&P AA-credit rating is rare to find in companies of this size and sector, and given that management guidance provides a target of sub-2.0 leverage, there is very little risk that anything should materially change in this respect.
Risks - they exist
That isn't to say that 3M as a business isn't exposed to its fair share of risks. Let's do the rundown here.
First, macro. 3M is an industrial. While it's one of the highest-quality industrials on the market, it's still exposed to the characteristic cyclical patterns of any industrial in the sector over short periods of time.
Macro risks such as trade wars, price volatility, raw material costs, macro slowdowns, and FX effects influence 3M like any other company, and given its international profile, one could make a case for some serious FX and trade war risks here going forward.
The current pressure - Are things still golden in 3M?
Nothing of these macro risks can, however, compare to the current pressures we're seeing on the stock. As of yet, the new CEO has failed to deliver analyst expectations even a single time - and that's saying something for someone who's supposed to lead one of the world's largest industrials.
This says some things, and few of them are positive.
The company cut its guidance once more time during April 2019, and this was what started the decline of the share price we're seeing right now; shares are trading at ~$170/share.
So what's happening with the company numbers?
A few things:
- The company missed EPS and revenue growth targets; instead reporting a 1.1% decline and 11% EPS drop on a YoY basis.
- The decline wasn't limited to any one segment, but was general. Sales declines affected 4/5 segments and margin declines in 3/5. That's not good for a company that touts its margins and recession resistance.
- It adjusted revenue growth targets to -1% to 2% for the year as opposed to a 2-4% growth, and adjusted EPS growth to absolute flat as opposed to 2018 (a slash of almost 12%).
So, the company is utterly failing to meet analyst expectations. And when a company which prides itself on this is suffering from this, you may indeed expect a market reaction.
(Source: Seeking Alpha)
And a reaction is something we've gotten. On a day the S&P is up by almost a full 100bps, this company keeps dropping.
So what is happening under the hood?
Well, a few things.
- Weaker industrial sales in the U.S. and China directly resulting from management insufficiencies to the ongoing economic slowdown.
- The company's recent M&A, the largest ever, of healthcare company Acelity, which potentially will increase the debt to over 2.0X, giving this conservative company one of the highest leverages it has ever had. Important to note, however, Moody's has said the company's rating will stay the same (Source: Moody's).
- The ongoing U.S.-China trade conflict will no doubt further complicate the company's efforts to meet guidance going forward. In a word, it won't.
So, to conclude the risk segment here, the cause for the share price drop is a number of justified misses, poor performance from management, guidance cuts, M&A worries, leverage worries, macro worries, and a potential long-term trade war escalation.
Put into context, the share price drop in relation to this doesn't seem all that crazy.
How is 3M reacting?
Of course, 3M's management isn't just sitting on its hands while things are beginning to unravel.
(Source: 1Q19 Presentation)
The above restructuring is already in the process of being realized. In addition, the company is looking at reducing segments from five to four, further streamlining 3M. Management hopes that through this restructuring plan, it will be able to able to meet the ambitions of its growth plan going forward over the next five years.
Now, regardless of how 3M goes forward here, the conglomerate has lost some of its previous magical touch. In addition, Mr. Market/the Street seems to have lost confidence in the new CEO despite his 30-year history with the company.
(Source: F.A.S.T Graphs)
From a seven-year perspective, the company hasn't been valued at these levels for a long time. From a yield perspective, 3M hasn't had as high a yield as this since 1995. So far, we have some pretty good arguments for why this represents an appealing valuation, stock price premium notwithstanding.
(Source: F.A.S.T Graphs)
As I said before, I do believe that the company warrants a premium valuation given its history and growth prospects, despite the somewhat tarnished reputation over the past few quarters. At this valuation, 3M will produce annual returns of just below 14% looking at the company premium.
While this may not seem much compared to other companies we've looked at, we need to take into consideration the scope of the company we're looking at here, and where it usually trades.
When we do this, the picture becomes at the very least a bit more appealing. And that's more or less where I will conclude the valuation portion for the stock.
Because today's share price doesn't exactly scream "undervaluation" in the traditional sense. However, I don't believe that a company like 3M, barring events like the financial crisis, will ever scream "undervaluation". Companies of this caliber warrant some moderation of expectation.
I believe an investment in 3M requires a degree of trust in the premium valuation here. The company could, of course, drop lower going forward. That doesn't change the fact that we're looking at some of the lowest 3M valuations for a long time.
The Overall Thesis & Conclusion
3M bears will speak of poor managements' ability to run even great companies into the ground. They will speak of GE (NYSE:GE) in the US, and they will speak of European companies with similar histories where previously excellent companies have been ruined.
However, let's moderate a bit here.
Former 3M CEO Inge Thulin faced similar challenges during his first years of tenure at 3M, battling weak results. This later turned around. It's never easy, and I believe it is far too early to say yay or nay to this CEO or his ability to generate results. In fact, his successful track history in 3M would suggest that his ability is second to very few.
The company has a 117-year history of adapting to changing market conditions. To believe it will flounder here would, to me, require more proof than a few quarters of missing analyst expectations.
Valuation at this time shows us undervaluation relative to historical norms. For a company of this character, that is reason enough to perk up and check it out.
In my view, this drop is a gift not to be squandered, as I've long hoped for the opportunity to buy this time-tested giant. As of this week, I have. In the long term, I'm positive on 3M due to all of these reasons, and I believe headwinds to be short-term and the company will be able to adapt to these market conditions.
However, as with all investment theses touching companies like this, I do believe you need to moderate short-term expectations. I don't believe a full turnaround will be quick, and I do believe patience is key when it comes to 3M going forward (2019-2022).
With a company like 3M, however, given the company record, that patience is easily exercised.
I don't share the bear view that this is the first sign that something is seriously wrong at 3M - I believe this to be a temporary stumble, which 3M, in time, will solve.
Thank you kindly for reading.
At these valuations, I consider 3M a definite "BUY". A share price of ~$170 and a blended P/E valuation of 17.2 are very rare for this company. The yield has not been this high for over 10 years. While investors should moderate their expectations short-term, I do believe 3M represents an appealing opportunity for the long-term DGI investor.
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.