For a company that trades largely on the basis of being a defensive stock with strong margins, 3M's (NYSE:MMM) repeated margin weakness in the second quarter is starting to become a cause for concern. Moreover, while 3M's growth doesn't look too bad compared to many of its peers, the relative comps are likely to get less favorable and 3M isn't really built to produce growth spurts. Much as I like and respect this company, the shares too look overpriced today and I'm considering selling my own shares.
 
Not A Very Good Quarter By Most Measures
3M gets a lot of credit for its strong margins, its defensive characteristics, and its strong global footprint. All of that may be true on balance, but it's hard to say that performance isn't eroding.
 
Revenue was up 3% this quarter, or a little more than 2% on an organic basis, with about three-quarters of that growth fueled by volume gains. Three of the five business units reported organic growth (with Industrial and Consumer at 3% and Health Care at 6%), while Safety/Graphics and Electronics/Energy both declined 2%. 

SEE: 5 Earnings Season Investing Tips
 
Margins once again missed expectations. Gross margin declined 40bp, and segment profits declined 3% (missing expectations by 2%). Consolidated operating income declined 2% and the operating margin fell almost one point. Although some of the underperformance can be pinned on costs related to acquisitions, this is the second straight quarter where 3M has logged a four-cent miss at the operating line. At some point, this has to start impugning 3M's reputation as an all-weather margin play among the industrial conglomerates.
 
Can 3M Keep Up With Growth?
Across the range of conglomerates that have reported so far, 3M comes off looking okay from a growth perspective. The company's 2.3% organic growth rate was in the same general range as, if not better than, comparables like Danaher (NYSE:DHR), General Electric (NYSE:GE), Honeywell (NYSE:HON), and Illinois Tool Works (NYSE: ITW).
 
The problem, though, is that 3M's relative comps are going to get more challenging as the quarters roll on, as the company's sales never declined as much as some of these peers. Although 3M can certainly benefit from improving global industrial demand and a recovery in electronics (though that business continues to decline, as do the electronics-oriented businesses at Danaher, ITW, and DuPont (NYSE:DD)), it's just not a business geared for a quick turnaround.
 
SEE: 3M, Reshine Join To Boost NMC Usage

3M is built around serial innovation and efficiency, and that is a formula for slow and steady performance. While 3M has the financial wherewithal to buy growth, and there are a lot of businesses out there that would seem to fit, that really isn't the company's style. In fact, many of 3M's deals seem built more around synergy and complementary lines of business than growth. So although about half of 3M's business could be called “early cycle”, I wouldn't expect a big bump in the growth rate when the global economy starts to improve again.
 
Margins Need To Get Better
I think improved margin leverage is very important to 3M's valuation multiples, as that's often one of the first points mentioned in any bullish thesis on these shares. While improved factory utilization and M&A dilution explain the year-on-year decline, I wouldn't necessarily bank on the price/cost tailwinds remaining in place for the company. My worry, then, is that 3M may be maxed out on what it can achieve in terms of incremental margin leverage and that's usually bad news for these stocks.
 
The Bottom Line
I'm still looking for 3M to generate long-term revenue growth around 4% and free cash flow growth of more than 6%, but the aforementioned margin issues have me feeling a little less confident about that latter estimate. In any case, those growth rates only work out to a fair value in the $102 to $110 range, and that's obviously below the current stock price.
 
Although 3M is not alone in looking overvalued on a discounted cash flow basis, and the stock's ROE-adjusted multiples don't look as expensive, I'm less enthusiastic about these shares. While I have generally expected to hold 3M shares for a very long time, I have to admit that this would be a stock I'd look to sell if I needed to raise money for a more promising new position.
 
Disclosure – At the time of writing, the author owns shares of 3M.

Related Articles
  1. Investing

    Charles Koch Biography

    Charles de Ganahl Koch is the CEO and co-owner of Koch Industries, an oil and industrial conglomerate that ranks as one of the largest privately held companies in America. While he and his company ...
  2. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  3. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  4. 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.
  5. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  8. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  9. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  10. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Conglomerate

    A company that owns controlling stake in a number of smaller ...
  3. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  4. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  5. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  6. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... 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. 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 >>
  4. 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 >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... 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!