3M Ends Up In The Same Industrial Tar Pit As Everybody Else

By Stephen D. Simpson, CFA | April 25, 2013 AAA

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.

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