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%.
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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.
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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.