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

    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.
  2. 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.
  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. Investing

    The Rise of Corporate Venture Capital

    After the success of Google Ventures, corporate venture capital is an increasingly popular diversification and hedging tool for many large corporations.
  7. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  8. Investing

    What’s Plaguing Twitter and Yelp?

    Yelp and Twitter have recently become grounded in reality and unable to justify their sky-high stock valuations.
  9. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares Morningstar Small-Cap Value

    Find out about the Shares Morningstar Small-Cap Value ETF, and learn detailed information about this exchange-traded fund that focuses on small-cap equities.
RELATED TERMS
  1. Management Fee

    A charge levied by an investment manager for managing an investment ...
  2. Equity

    The value of an asset less the value of all liabilities on that ...
  3. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  4. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  5. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  6. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
RELATED FAQS
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
  6. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!