Editors' Note: This is a transcript of our podcast yesterday on 3M Company. We hope you find it useful.
Daniel Shvartsman: On this week's Behind The Idea, we revisit the 3M (MMM) story with Seeking Alpha author, Michael Boyd. One thing we tried to get a feel for was where things went wrong for the company. Boyd points to their market positioning over the years.
Michael Boyd: So when you think about as the company evolves, as 3M, obviously you know, $100 billion odd plus company you want to see those kind of pushes into something little bit more protective and has that kind of long-term growth trajectory, and I don't necessarily think that some of the business positioning within automotive or electronic is necessarily structured that way.
DS: We also talked about whether the recent sell off means that the market has reset expectations. But Boyd points out that the math is still optimistic.
MB: If you look at base of $9.40 a share versus 2021 expectations, it's still baking in like 8% to 9% earnings growth. And if you go towards that framework that they laid out at their Investor Day in 2018 there target was 8% to 11% earnings growth. So I don’t think they necessarily -- I don't think analysts have really moved away from those targets.
DS: 3M is a bellwether hitting on bumpy times, which could portend bad things for the market as a whole as well as its investors. Boyd does bring up the two words that might most scare investors: General Electric (GE). But are things as bad as all that or is this just a healthy reset, and how did we get here? We discuss on Behind the Idea.
Listen to or subscribe to Behind the Idea on these podcast platforms:
Welcome to Behind The Idea, I’m Daniel Shvartsman.
Mike Taylor: And I’m Mike Taylor.
DS: Today we're following up on 3M company. A couple weeks ago we talked about the company's recent struggles, its innovative history and whether that combination made this buy the dip situation or stay away story. This week we're speaking with Michael Boyd, Seeking Alpha author and the author of industrial insights in our marketplace platform.
It was his bearish take on the company's weak Q1 report that led us to talk about 3M in the first place. So excited to ask him about the story and his updated view on the company. Before we begin, Behind The Idea is the podcast that looks at what makes great investment analysis work based on ideas from Seeking Alpha ecosystem. Neither Mike nor I have any positions or any stocks we plan to discuss and Michael Boyd also does not have any positions in 3M.
Nothing on this podcast should be taken as investment advice of any sort. So Michael, welcome to Beyond The Idea.
MB: Thanks for having me.
DS: So let's just start with the basics of what is the core story here for 3M? What should investors be thinking about at this point in the game?
MB: Right, I mean for me. I think of this as a transitional story based on changing investor perceptions. I mean obviously 3M it's been industrial bellwether for a very long time on my side, looking at the industrial sector, it’s the company always look towards -- just to see how the global economy is doing for retail investors specifically. Most are attracted to that 60 year record of dividend increases, it's paid a dividend for I believe 100 year or more at this point. So that's has still a reputation you talked about this in the podcast that you did a couple weeks ago, that reputation for renovation, overall history of great returns, outpacing the S&P 500, but it's also one that’s been bid up quite a bit over the past 10 years or so, if you go back to, say 2010. I tend to look at EBITDA multiple there was little about 8x even after the -- caused of the guidance cuts and the recent share price drop.
Today we're still around 12.5 times EBITDA for 2019. So obviously there's been a lot of multiple expansion here and for most investors, I think that they view that is justified just given the execution and obviously Q1, the guidance cuts that we've seen over the past six months, maybe some of execution is being called into question.
In general I don't think there is anything wrong with investors paying little bit more for higher quality assets, especially when you think about where we are theoretically seeing where in the investment cycle and multiple expansion by itself is no reason to sell a stock and it's not a reason to short it either.
I think the problem is when investors begin to overpay for safety or at least the perception of safety and smaller shareholder in particular really trusted 3M to be great steward of their capital. That’s something I don't really think has been done very well in recent years from them. I hate to draw parallels but if you think about the General Electric, a couple of years back, it was in much the same place. They had a really sort of convoluted balance sheet. The results were there. So investors et cetera, and once things began to unravel at General Electric that’s when investors showed the true colors there and started to head for the exit.
3M doesn't really have that sort of complicated structure. Obviously there are lot of room segments here. It’s a diversified industrial, still relatively clean balance sheet doesn’t have that sort of GE Capital kind of exposure but at the same time I think investors are kind of once bitten twice shy. So any company that’s earning a premium multiple, investors expect premium execution and I don’t think that’s really been the case here.
MT: Michael could you tell us a little bit about what's driven this perception that management's execution has sort of gotten off track? What evidence do you see that leads you to that conclusion?
MB: Well, I mean, I think if you think about the results that they have reported, I mean obviously I think some of this is macro related. So it's out of our hands to some degree. I think if you go back to 2016, 2017, I think globally, I think the narrative was like a globally synchronized recovery right. So pretty much everyone internationally was doing well. And then, I think beginning in 2018 and then kind of rolling into the trade war, Europe started to have a pretty poor results on a GDP basis. The China slump narrative has been a big one trade is a big issue. Whenever you think about large international industrials, I think 3M has very large exposure to Asia Pac, very large exposure to Europe. Only maybe a third of their sales, I believe, are North American based.
So I think that’s part of the driver there, it's just you know when you are a large industrial, have exposure on an international basis, it's much more difficult and it's hard to find shelter if trends break. And also, I mean I think for 3M, when you think about like there cost structure, they always been kind of regarded as having some issues on pricing costs. It's very fixed costs in their business. If you think about like their innovation platform and everything like that. So when sales tend to slip, costs tend to not retreat in time. The business doesn’t really flex.
So when you have those issues like in Q1 -- especially when it's not adjusted on a constant currency basis, just because the dollar's been strong, issues really start to manifest themselves. I think that’s been the major driver. And I think, you know, just in end markets as well. They really kind of ramped some exposure into electronics and automotive and to a lesser degree maybe aerospace in some areas. And those tend to be highly cyclical markets. So when you had issues where sales tend to slip or global growth tends to slow, then those businesses are impacted more than, say like consumer division which has been -- I mean that’s the bread-and-butter most investors when I think about this, they think of actually sponges and posted notes and that kind of thing.
Right and that's just a small portion of their business but it's been a part of business actually done very well of late, including in Q1. So I think that’s the major issue is just the cost structure of the business and then just the nature of the end markets at their end.
MT: So but those don't sound like execution issues. Those sound like sort of larger forces and the attributes of the business model. I guess what I'm trying to…
MB: No, I think to some degree many of their problems aren’t necessarily executional in a way. They are somewhat structural to the firm. And the same thing we know, I can talk about like their balance sheet and capital allocation policy and that kind of thing. So that’s more like a financial execution, capital allocation decision that been making in the business but it is necessarily you can't really say like, they are not doing the job on manufacturing or something like that. It's mainly just the overall structure of the business and the overall design and what they're trying to achieve versus the way the global market is today.
MT: So is the aerospace or automotive -- are those examples of capital allocation decisions that you disagree with?
MB: In general, I don't necessarily dislike some of those businesses. I mean some decisions they made have been very healthy, the movement to healthcare, especially. It's definitely a less cyclical business where they are achieving a great multiple. I think maybe some of the issue within automotive aerospace is 3M isn’t really -- they really haven't pushed towards that kind of like -- you need to look at all the industrials like maybe like Honeywell (HON) or Danaher (DHR) or anyone like that, there's been the small push towards software and -- General Electric as well, right, when you think about like their push into like, GE Innovation, like the Internet of Things, that kind of thing. It's not -- they haven't really made that push towards something that might be a little bit more growing above market rate or have a little bit more protection from a competition perspective.
So when you think about as the company evolves, as 3M, obviously you know, $100 billion odd plus company, you want to see those kind of pushes into something that’s little bit more protected, and has that kind of long-term growth trajectory. And I don't necessarily think that some of the business positioning within automotive or electronic is necessarily structured that way. And I think in some ways comes down to their innovation platform. If you look at how operational cash flow or free cash flow has moved in the past five years. It hasn’t really shifted.
If you go back to 2013, 2014 versus today, really free cash flow really hasn't moved. So a lot of shifts in the share price, have been driven by increased leverage on the balance sheet, right. They bought back I think $25 billion, $30 billion worth of shares since 2013, and a lot of that is been debt funded.
So if you look at the balance sheet back in 2014, the cash was -- or net debt sorry was like $3 billion. Today its $10 billion north of that, it's more around $13 billion, right. But EBITDA really hasn’t moved, so there is lot more gearing in the balance sheet, which also makes it a lot more levered to structural changes when these kind of things happen.
DS: So Michael one question I want to -- or I actually want to put couple of things together, which is that you mentioned their innovation platform, and last time we talked about this, Mike talked about how 3M is sort of a paragon of innovation, of industrial development over the years. And what I'm curious about is two things. One more related to your work and one to 3M, is that we talked about their premium, even just the EV-EBITDA multiple going up to the teens from eight over the past decade. And when we pull up your past history you've been bullish on the company in the past I think.
And so I'm just curious what you would attribute the past multiple, that past premium to, is it just that innovation and then it hasn’t played out, or what do you think the past premium is and what sort of -- again I think you sort of pre-viewed your answer here, but I just want to see if we could pin down a little bit more what's changed in the last 18 months or two years that has led 3M into a position where it's become less of an attractive company?
MB: Right and I think if you go back -- obviously I read something on Seeking Alpha, I think early in 2017, or -- I acknowledge like the higher multiple right. I mean that’s always been, to an extent that’s always been the case here. They carry a higher premium and that does come down towards past execution. I mean if you look at like the innovation platform that I think their R&D target as a percent of sales is 5.5% to 6%, and you have like the usual CapEx, I think it's like 5.5% as well.
So they do heavily invest in this business and if you compare that to a lot of industrials that's well above the rate that they intend to do. So I think it's a decision that companies have to make right, you can either run it like 2% R&D, which is unusual in industrial space, and maybe you generate lot of free cash flow.
But maybe as a manager you have a track record of really doing a great job finding tuck in acquisitions. So you set aside a cash flow and then you add on to your business, internally free generating cash flow, as 3M is like, hey, we have this, long running culture for very long time, makes the Fortune list of most of admired companies pretty much every year. We can really attract top talent. Let's pay and develop this internally versus acquire. And I think if you go back 10 years or so, and even stretching end of 2015, 2016 some stepped into maybe like the energy business in particular. I think was really getting a lot press then from the innovation standpoint.
So I think that’s -- part of the challenge is that -- especially over the past several years, investors really haven't being seeing much in the way of growth, through actual growth, either top or bottom line, driven by the innovation. I think that -- I mean it's always been part of the story right. As you know these -- they are in so many different businesses but there is this intersegment kind of like engineers on scotch tape might be helping out someone on another side of the business, right and then also the policy, where I believe it's up to 15% of employee time can be dedicated to their own personal projects. Doesn’t even need approval from a manager, right. So it really kind of fosters that -- they really try to foster that innovative mindset but it really hasn't come through.
And at least in recent years 3M really hasn’t been a great acquirer either, and especially if you think about Acelity, recent acquisition they made, that's another $6.7 billion, that will hit the balance sheet. That’s one of the large acquisitions, that they have ever made. If you go back over the past, I think probably eight or nine years, that's about what they spend on every single acquisition. So there is lot riding on those kind of deals, and it seems like there maybe a little bit of a shift towards actually to buy there. And I think I will allow this as well on Acelity, right, as they are trying to buy a little bit growth versus internal generator, which is a little bit of a market shift for them. And I think that brings out a little bit more execution risks to their business as well.
DS: So it's interesting sort of walking through the cash flow decision tree, and what where you can allocate your cash and what you are hoping for. And one thing that has happened more discreetly since 2018 is that managements changed over. And I'm just curious how much you think the story is related to that as well as that, what's your sense, I think we're about a year into where Michael Roman has been the CEO of the company.
Do you get -- and you had raised the question of execution issues and obviously the fact they're not hitting their guidance specifically. I’m just curious what you think as far as if the -- if they are going to bigger acquisitions than ever, if the innovation lever isn't really working the way that it used to, how does -- what you think of the management team here as, how much do you think that that's involved versus just general issues at the company?
MB: Yeah, I mean obviously, some of it's going to be general. I mean I think with Michael Roman, you never want to see management come in and get off on the wrong foot, like they have. And I think maybe some of that is just unexpected on their end. But it's never good to see kind of that like overpromise under deliver kind of framework begin to develop, because I think, especially in the large cap space, your investors really want to feel safe and secure that the executive team when you are talking about companies the size, that's a lot of -- on a day-to-day basis, there's a lot of their involvement right.
It's not like a small cap rate where maybe it's a couple $100 million firm, it's very easy for a CEO to have a good grasp on every little nuance of their business. When you talk about CEOs at a large cap space they really have to be like a certain type of personality to do very well. I guess it remains to be seen if that's the case for Michael Roman. I mean I think you know for 3M in general, I don’t think he is really a change from past CEOs. I think to some extent, that comes down to that culture of innovation.
You know 3M really isn’t a company that does outside hire into major executive roles right. This is -- when you think about like fostering innovation, being like a differentiated company that way where you are kind of cultivating innovation on the inside. I think the Board is going to view that as an outsider really isn’t going to understand what makes 3M tick. But I think the full side of the coin is that there is not really anything like new fresh blood or new thought. It can be difficult.
I think for major executives at these firms, when they have been entrenched for very long, it's be very unusual for a new men to come in, that's been at 3M for 20 years or something like that. And then like come in and completely shift policy and approach. That would be very unusual to me. And once again I mean you can kind of draw that to General Electric as well, right, you have (Jeff) Immelt and everyone like knows, very similar structure where they hired insiders until recently with (Lawrence) Culp where I think the Board of Directors just had enough and they are like, we have to try some different. It's clearly the approach we're taking isn’t working.
And I’m not saying that 3M doesn’t have that type of vent. But I wouldn’t expect I think management teams or management directions to really shift from person to person. So in that way I don't think this is maybe a Michael Roman issue specifically. I think it's maybe in a large part is probably just a timing issue for him and when he became involved in the firm, just made worse. I think by the guidance that they gave. I don't really think that I would assume most likely that anyone else would have probably laid out similar guidance and had gone through the same process.
MT: So what kind of changes would you be looking for. It sounds like this is potentially a longer term issue. So maybe not something that can happen right away. But what would you be looking for from management that might flip you back or at least make you feel a little bit less, I guess you are flat out but what are you looking for from management?
MB: I think anytime you have a firm of the size with so many discrete operations. I think you can make an argument for let's pare this down. Let's try and sell a business lines, so we can kind refocus a little bit on our core competencies, or maybe you just go the spin off route as well, right, maybe you can separate your high growth businesses from your low growth, come back try and create value for shareholders while also allowing the market and the new management to things kind of few of those truly discrete operations, whereas not being a part of this giant conglomerate structure.
I think there will be a lot of value there. And you saw the same thing, with United Technologies (UTX), right, kind of spinning off the carrier business. You see the General Electric as well, with GE Healthcare. I think the argument there and I'll probably taken to the wood shed by longs, because like I said the long-term structure here is supposed to be all these segments. Everyone works together for a common goal to share technology and everything like that. So I think the argument from bulls is a separation here does make sense given that innovation platform and structure.
And like I said, your opinion there goes along whether you think past execution, over the past five years or so versus other industrial is acceptable or not. And I think if you look at the share price, at least up until you we have that run to maybe like above $220 a share. So I started getting interested on the short side in the first place. There's been a lot of multiple expansion there, investors are willing to shrug off the kind of weak execution as a short-term issue. But the longer we go without a return to some meaningful growth, that I think those -- I don't necessarily think that kind of like screw up the business conversation, I don’t think that goes away.
DS: So that sort of leads to the question, what do you think about the shares in the business right now? What do you think about the valuation? What do you think about what the market is watching for from 3M? I mean even since you - I guess you wrote about it again with relation to the Acelity deal, but the stock fell off quite a bit after your last article. So what's your -- where do you see the company right now and the shares valuation, et cetera?
MB: Right,I mean if you go to the comment section, I don’t think I gave price target in the article. I always respond if anyone to asks. I was looking for $155 to $160, that's just like a place for me to cover. That’s where I cover my short. I think we have that dip down to $159 bucks or so. I headed for the exits there. There is always going to be little bit early buying especially in a name like this, I think especially dividend investors in particular. I mean if you look at the comments right, people cite highest dividend yield on a very long time. Obviously that ignores the changes in the payout ratio.
I mean if you go back to 2013, '14 they are paying like 35% free cash flow. Today it's like 55% to 70%. So obviously the yields are going to go higher on a comparison basis like that, obviously on a free cash flow basis. I don’t think the value is necessarily there.
But no, I mean I think structurally from here. I mean, I would kind of view it as like a market perform kind of hold kind of situation. This was -- this is sold off to something like $120, $130 a share, I would probably be interested on the long side, but I think, especially with firms like this, I may never really get the opportunity on the long side, and as a deep value investor that's okay. Everything that I like or follow or I’m interested in, it's sometimes it just never gets to a price where I’m personally interested in.
That’s okay, on the long side I’m generally looking to hold 15 or 20 positions. Most of those are kind of intermediate term holds. A couple years at best unless I see something really like long-term and structural with significant upside. Given all the time I put into the market, there is going to be -- I’m going to look at hundreds of things and most companies are just never going to make it to my portfolio.
DS: What do you make about specifically, what we mentioned the sort of dividend growth investor crowd the -- you mentioned the idea of the yield being as high as it's been. We talked about a comment on one of your articles that basically they said they didn’t know anything about the 2019 to '23 framework. And we sort of came away with mixed views on that, because there is something to be said for just thinking the way, what do you make of that when you see that in the market.
You obviously read a lot on Seeking Alpha, you get a lot -- you get to see a good, as wide a swap of the commenting behaviors as we do probably. So what would you make of that sort of crowd out there in a stock like 3M? What do you think of that being either on the other side of the trade or even now as you close your position?
MB: Right I mean obviously everyone puts a different amount of time into the market. And that doesn’t necessarily mean that they are going to outperform or underperform versus indices right? Everyone has a different approach. Everyone has a different strategy, and there are plenty of investors that come to very good conclusions just based on a quick look.
With me, I think that kind of dividend yield story, like I explained, I really think that holds no water, just from a -- because of the movement of the payout ratio. But it doesn't mean that 3M might not work from here. I think most dividend investors on Seeking Alpha that maybe -- they make a couple of buys a quarter maybe. They have a core portfolio of maybe a couple dozen names that they like and they follow, maybe they keep an eye on Qs and Ks when they come out, they catch the conference calls, they read the occasional article on Seeking Alpha right, being engaged in investments, and that a good thing.
You don’t have to put 40, 50 hours a week into your portfolio to do great, and then obviously everyone has a normal 9 to 5 day job that they do, right, not everyone's in a situation where they do have the time. I think the strategy overall, and I think it could work, but in general, most investors might make a few mistakes that way, just not really following management guidance or framework and kind of how that plays into Wall Street expectations because I think it’s a little bit nebulous when you get.
I guess I think especially Seeking Alpha comments in the whole, they get a little bit confused on Wall Street upgrades, downgrades, when price targets move, when institutions tend to buy or sell. And like it or not, a lot of that is driven by what investment banks say and the research. And in many cases the first line of attack for any analysis to is the management and to see what their view is of the future and what they have over the next couple of years.
On the last podcast that you did on this topic, we talked about kind of the resetting of expectations. And how that’s impacted 3M, because obviously, you know it's still little bit of a Wall Street dealing, and even I think the consensus targets like a $190 a share at or about, so that implies a decent amount of upside for a large cap. And expectations have come down a little bit.
If you go out to 2021, I think the target is around $12 share at the moment. Consensus for 2019 is $9.40 a share, which I think is in the midpoint of their recently reduced guidance right. So whenever never management cuts guidance, the first thing that moves -- sell-side analysts are going to do is they are going to adjust their models try and fit that frame work.
In most cases it's fairly rare, probably for analyst to go outside the mold of the guidance range, unless it's something that they are really trying to make a name on, or do something different right. So if you think about like Tusa with GE, right. So if you look at that base of $9.40 a share, versus 2021 expectations, that's still baking in like 8% to 9% earnings strength. And if you go towards that framework that they laid out at their Investor Day in 2018, their target was 8% to 11% earnings growth. So I don't think they necessarily -- I think analysts have really moved away from those targets. I think they sort of reset the base a little bit lower right. So maybe they view that 8% to 9% as achievable as just coming off from lower base than what they expected in 2019.
DS: So maybe as -- and this has been great but I think as a last question that sort to sets up is just what do you -- not a prediction, obviously you don't have your position anymore, but what are you watching for -- what you think investor should pay attention to with 3M over the rest of the year or over the coming months or into 2020 and into this framework, like what should they be focused on most if they are working to understand the company and to potentially invest in the shares in either direction.
MB: I think guidance has been cut to the point now where is achievable. I think management teams, when they get to this position, they realize that they ideally, you only cut guidance once. So when you cut this many times at some point you just have to put a lowball number out there that you can readily achieve and have no worries about achieving.
So I think they can hit the number for this year. I think looking forward, I think investors really have to look at the Acelity deal. I think the execution there is going to be really important for them. Obviously this is a new management team. So they already have a pretty full plate when it comes to overall company direction.
They got a lot of moving parts, with the recent distress in the share price. So they already have a lot on their mind integrating nearly $7 million deal with a lot of moving pieces and what is a smaller division for them. It's going to bring some challenges, I think. So I think investors have to watch the numbers there. I think they should keep an eye on the restructuring that they're doing. They announced some tiny cost cuts, trying to take a little bit of cost out of the business, that I think they should be doing. So that’s good to see. I think they are moving very slow in that direction, just to make sure that they don't over cut, which I think is once again I think is the right way to approach it.
But I think investors really have to watch that kind of the usual kind of non-GAAP to GAAP reconciliations, making sure that costs aren’t going out of control on this or there are not too many adjustments. That’s something that investors like myself for playing around in small caps and mid-caps and roll up stories and that kind of thing, we're very used to kind of parsing out and making sure everything is above board. If you are in large caps usually there is not a very large spread between non-GAAP and GAAP numbers.
So that would be something I would watch. I would watch the free cash flow numbers well to see if we finally start to see a little bit of movement there in the right direction, especially for new acquisitions coming on board. They have been a net acquirer over the past couple of years, you can see a lot of improvement there and that’s even with the tax cuts in 2018.
Numbers wise, feedback has to see what leads to out-performance, free cash flow yield does much better versus price-to-earnings or something like that. That's where I focus and I think investors should focus there as well. But overall, you know, I think it's worth checking the tone and making sure that a lot of these issues are being resolved and then especially as we head into the back half of the year, some of these concerns, there is a little of growth that’s expected into Q3 and Q4 in particular. So I would make sure that they hit those numbers there.
DS: All right, okay, sounds like a pretty clear set of areas to watch for. And it's interesting with a company this big and that has -- you mentioned even Stephen Tusa for example with GE and even here he is one of the analysts who has reset and when you are just thinking about the eyes that are -- there are probably more eyes on 3M now given the selloff and so yeah, that's helpful to hear, how what they are announcing with the reset guidance translates to where the stock is now.
All right great well, thank you so much, Michael. This has been really enjoyable talking you about this and yeah, congrats on this playing out for you well and thanks for taking the time to speak with us about it.
MB: Well, anytime you know, obviously I’m out of position now. So I wish any bull good luck on this one, because at the end of the day I see people do well in market and make money.
MT: So in neutral, so it's -- we don't have too many people who aren’t talking their bucks that's kind of funded, just to hear you wish other investors well. We don’t have enough wishing other investors well on this podcast.
MB: No, definitely so. I never, even on the short side, I know I hate to be against people. I don’t try to view it as being against people. On the short side I think I’m just trying to convince longs to see the other side of the story. I never hate to see -- I hate to people lose money, especially in Seeking Alpha and you think about traditional retail base, right. I want everyone to have a good time in the market, have money for retirement and everything like that, right.
DS: A good time in the market I think that sort of -- that’s the Behind the Idea model at least. I think that's what we should put.
MT: Exactly.Something for us to take with us, Daniel and I think, little more goodwill towards other people. We will try and bring that in.
DS: All right great. All right well thanks Michael, this has been quite a fun.
MT: Thanks a lot, Michael.
DS: Thanks for taking the time appreciate it.
MB: All rightTake care.
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. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Nobody on this podcast has any positions in any stocks mentioned. Nothing on the podcast should be taken as investment advice.