Investors who prize 3M's (NYSE:MMM) ability to muddle through the tough times a little better than most had to be a little disappointed with the company's first quarter results. Not only did the company miss on the top line, but the company's reported and incremental margins were soft. Although 3M continues to look like a solid long-term core industrial holding, the company is going to need to deliver better results if there's an argument to be made for paying a premium for the shares.

Sluggish Results Across The Board For Q1
A 2% EPS miss is not a cause for panic for any stock, but when it comes from a company like 3M that is generally regarded as dependable and reliable (particularly in bad times), it tends to unsettle investors. Although there was nothing especially worrisome in the revenue numbers, the company's lack of margin leverage could be a sign that long-term margin assumptions are too aggressive.

Revenue rose about 2% as reported and 2% on an organic basis, making this a standout among the industrial conglomerates this quarter even though revenue was about 2% below expectations. I think 3M's results argue that it was just a widespread malaise in the global economy that was principally to blame this quarter, as segment results were pretty evenly weak relative to expectations. Healthcare and consumer were the growth leaders (up 4% organic, each), while electronics and energy (down 2%) continues to lag.

3M was more disappointing on the margin side. Gross margin was flat this quarter, whereas conglomerates like Honeywell (NYSE:HON) and Illinois Tool Works (NYSE:ITW) managed to deliver improvements. Likewise, the 3% decline in segment profits and just 1% growth in operating income were both disappointments relative to expectations. Lower utilization seemed to be a prime culprit, as only the safety and graphics business showed a year-on-year improvement in segment margins.

SEE: A Look At Corporate Profit Margins

Electro And Energy Still Weighing On Results
It is starting to feel like 3M's electronics and energy business never grew before and never will grow again. Obviously that's an exaggeration, but it's clear that declines in the flat panel, consumer electronics, and solar markets continue to hammer this business. Maybe there's some comfort to be found that DuPont (NYSE:DD) reported even weaker overall results in this business and that leading specialty glass company Corning (NYSE:GLW) is back near a 52-week high, but the reality is that this business is still searching for a bottom let alone a recovery.

The V May Not Be A Victory For 3M
Many of 3M's industrial peers (Honeywell, Illinois Tool Works, Dover (NYSE:DOV), Danaher (NYSE:DHR), et al) reported unimpressive growth for the first quarter, but most of the company managements reaffirmed their expectation for a significant second-half recovery this year (the so-called V-shaped recovery).

Whether that happens or not, I'm not sure that 3M is structured to go along for that ride. Businesses like safety (the traffic product component), electronics, and healthcare aren't likely to bounce that way, and I'm not sure that consumer will either. So on one hand we have the fact that 3M's overall growth rate has held up better than most industrial companies, but on the other hand 3M probably has less to gain from that potential second-half rebound.

It's also worth asking what 3M intends to do about its apparent weak incremental margin leverage. The thought on 3M has been that the company has margin improvement levers to pull above and beyond simple volume growth, but this quarter's results raise at least a yellow flag. I do have some concerns that 3M's long history of above-average profitability leaves less incremental improvement potential on the table, particularly as I think it goes very much against 3M culture to start cutting back on R&D just to pretty-up the quarterly numbers.

SEE: R&D Spending And Profitability: What’s The Link?

The Bottom Line
While this quarter has to go down as a disappointment for 3M shareholders, I don't think it's cause for panic. As I said before, 2% organic growth in this quarter is likely to go down as a very strong result, and I don't think 3M management needs to feel bad about that. Moreover, I've seen nothing change at 3M such that I doubt the company's long-term ability to continue generating very good returns on capital and copious free cash flow (FCF) streams.

The sometimes-bizarre world of Wall Street would have you believe it's better to sell 3M and buy the stock of a lesser operator on the premise that the operations will improve. I happen to believe instead that it often makes more sense to find winners and then ride them as far as you can. To that end, I do still believe that 3M will deliver long-term free cash flow growth in the high-mid single digits and that fair value on the shares lies around $105. At today's price that implies relatively average total returns, but I don't mind getting average returns from an above-average company.

At the time of writing, Stephen D. Simpson owned shares of 3M.

Related Articles
  1. Investing Basics

    A Primer On Investing In The Tech Industry

    The tech sector can provide fantastic returns for investors with a little know-how in the field.
  2. Investing Basics

    Examples Of Asset/Liability Management

    In its simplest form, asset/liability management entails managing assets and cash inflows to satisfy various obligations; however, it's rarely that simple.
  3. Personal Finance

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  4. Bonds & Fixed Income

    Equity Valuation In Good Times And Bad

    Learn how to filter out the noise of the market place in order to find a solid way of determing a company's value.
  5. Markets

    Investment Valuation Ratios

    Learn about per share data, price/book value ratio, price/cash flow ratio, price/earnings ratio, price/sales ratio, dividend yield and the enterprise multiple.
  6. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  7. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  8. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
  9. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  10. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  1. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  2. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
  3. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors insight into how efficiently a company (or more specifically, its ... Read Full Answer >>
  4. How do you calculate working capital?

    Working capital represents the difference between a firm’s current assets and current liabilities. The challenge can be determining ... Read Full Answer >>
  5. What is the formula for calculating the current ratio?

    The current ratio is a financial ratio that investors and analysts use to examine the liquidity of a company and its ability ... Read Full Answer >>
  6. What is the formula for calculating earnings per share (EPS)?

    Earnings per share (EPS) is the portion of a company’s profit that is allocated to each outstanding share of common stock, ... Read Full Answer >>
Trading Center