3M Stuck In The Same Macro Mire

By Stephen D. Simpson, CFA | October 25, 2012 AAA

Industrial conglomerate 3M (NYSE:MMM) may be well-balanced in terms of market and regional exposure, and the company scores well on comparative margins and returns on capital, but it is not immune to the sluggishness that we're seeing across the board today amongst international industrial conglomerates. Although the company's organic growth and margins actually compare pretty well on balance, management's lower guidance and caution on 2013 may result in investors hitting the pause button on what has been one of the few big industrials to outperform the S&P this year.

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"It Could Have Been Worse" Is Only Worth So Much
Add 3M to the list of companies with unimpressive revenue growth in the third quarter. The fact that results were solid relative to others such as Dover (NYSE:DOV), Danaher (NYSE:DHR), Illinois Tool Works (NYSE:ITW), Honeywell (NYSE:HON) and DuPont (NYSE:DD) is only worth so much in the bigger picture. Reported revenue was down slightly, with organic revenue up just over 2%. 3M was actually unusual in that its organic growth improved from the second quarter, but that doesn't really matter much in the context of a slight (2%) but real miss relative to sell-side guesses. Interestingly, Europe was not a disaster (organic revenue up almost 1%), and Asia-Pacific sales were just barely down.

On the margin side, I suppose it's all a matter of perspective. Gross margin did improve a full point from last year, but still missed most sell-side expectations. Likewise, segment and reported operating income both rose 6%, and the company did see over 100 basis points (BPs) of improvement from last year, but margins missed analyst targets and declined about a half-point from the second quarter. While 3M did post reported earnings in line with estimates, the company got a below-the-line boost and actually missed by about four cents at the operating line.

SEE: How To Decode A Company's Earnings Report

Everything Sort of Muddled Together
Unlike Illinois Tool Works, 3M didn't really have any standout areas of outperformance. Then again, unlike DuPont, it didn't have any smoking craters either. Revenue in Industrial/Transportation rose about 3% organically and, like Illinois Tool Works, 3M saw surprising strength from its OEM auto business. Growth here came in at 11% (better than double production rates). Healthcare was also quite strong (up more than 4% organically) on the back of good performance in food safety and wound/skin care, especially in emerging markets.

The news was a little more mixed in Display/Graphics and Electro/Comm. Although Display was actually positive (up about 1% organically), it's been weak for a long time now and neither DuPont nor Corning (NYSE:GLW) are pointing to major end market improvements. On the Electro side, no investor in semiconductor or hard drive stocks will be surprised to hear that the recovery hasn't arrived; while this business seemed to bottom, management's guidance wasn't too positive (nor was that of Danaher).

SEE: Can Earnings Guidance Accurately Predict The Future?

Time to Hear About the Future
3M's upcoming analyst meeting in early November will be CEO Thulin's first real opportunity to lay out his vision for 3M, particularly as it pertains to cash management and the company's acquisition strategy. If the recent offer for Ceradyne (Nasdaq:CRDN) is indicative, I would expect that he will be more aggressive than former CEO Buckley and more willing to push 3M into new markets.

As I have said previously in relation to Illinois Tool Works, there's always a balancing act when it comes to strategic shifts - what 3M has done for a while has worked, so there is a trade-off between seeking growth and inviting risk and volatility. In any case, there's ample opportunity for expansion in areas such as healthcare and specialty materials, but I would be surprised if the company made a big plunge into large-scale OEM equipment.

The Bottom Line
That 3M is seeing slower growth is hardly news; many business segments have been seeing declining growth rates for a year or more. At the same time, I think the company remains leveraged to improvements in areas such as consumer spending, construction, electronics and renewable energy.

I've owned 3M for a while and though I have been frustrated by the company's conservatism towards R&D and growth-oriented acquisitions, I have resisted the urge to swap it out for other industrial conglomerates such as Honeywell, Danaher, ITW or GE. After all, there really aren't many names out there with better free cash flow (FCF) conversion or better market exposures. At this point, I'm still comfortable with a free cash flow growth estimate in the mid-single digits. That points to a fair value in the $100 to $110 range - making it one of the more attractively priced conglomerates today.

At the time of writing, Stephen D. Simpson owned 3M (MMM) for over five years.

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