For some time now, it has been very challenging to call 3M (NYSE:MMM) a bargain on the basis of its probable future cash flow streams. Investors were willing to pay up for 3M's stability and strong margins, but a somewhat lackluster second quarter seems to have market participants reconsidering if the company deserves that premium.
As I have said in the past, I'm willing to pay up for quality stories like 3M, but I'm not going to argue that you have to own this inventory when Honeywell (NYSE:HON) and General Electric (NYSE:GE) appear to offer better relative value. I still think there are arguments for owning 3M in portfolios oriented for long-term performance, but second-quarter results should serve as a reminder that even a great company like MMM isn't shielded from short-term performance and market exposure worries.
The theme for this quarter may well end up being "well ? that wasn't so bad, right?", or at least for companies that don't have outsized exposures to weak end markets like energy, power, mining, and metals. Even within that context, though, the company's performance wasn't quite the standout that it had been.
Revenue fell 6% as reported, but rose almost 2% in organic terms, with 3M one of the infrequent companies to show pricing power (up 1%) with volume growth (up 0.8%). Still, that was a weaker result than those of GE, Honeywell, or Danaher (NYSE:DHR), and it would appear that the company's electronics business has once again turned around and bitten the company.
By segment, industrial was okay with organic growth of over 1% on good auto and transportation, as well as aerospace (a relatively tiny market for 3M relative to Honeywell and GE). Safety was strong, up almost 5% on its namesake operations and good roofing granule sales. Electronics and energy were down about 3% while health and consumer were both up more than 3%.
Even in this lackluster sales growth environment, the company still came through with good margin performance. Gross margin improve 120bp as the company benefits from lower input costs, and operating income declined only 1% on a reported basis, as it kept most of the gross margin leverage. All of 3M's units saw segment-level margin improvement.
Quite a few companies have put forth plans to deploy significant amounts of capital into the M&A markets, but numerous of them have come up short in terms of actual announced deals. The stated reasons are that valuations still haven't come down to attractive levels, but I suspect that uncertainties over the health of the global economy (and the desire/need to avoid buying into trouble) have played a greater role than numerous CEOs want to admit.
Not so for 3M, though. 3M acquired Ivera Medical in February, Polypore's separations media business a few days later, and then acquired Capital Safety in late June. 3M is paying KKR $2.5 billion for this leader in fall prevention equipment and a mid-teens multiple of EBITDA, but this business has been growing beautiful well and 3M should have good synergy and cost discount opportunities after folding it into its existing safety business. In a lot of ways this is a very typical MMM deal in a very typical 3M business - nobody writes bullish paeans to the safety industry, but MSA Safety (NYSE:MSA), Honeywell, and 3M have been plugging away at it for years and have generated beautiful decent returns on capital for their troubles.
Truly, 3M's opportunities are really only limited by how much it wishes to spend and which markets management wants to target. There are billions of dollars of potential healthcare deals alone that would fit the company's "slow and steady" profile, let alone advanced materials (substrates, films, metals, etc.).
I've written about this point several times already and don't want to belabor it to death, but the attractive markets correct now for the industrial sector are aerospace, non-residential building, and auto OEM. Healthcare is an okay market, especially for procedure/volume-related segments like the ones 3M addresses as opposed to the more capex-heavy markets addressed by GE.
The company doesn't really have enough aerospace exposure to drive significant revenue growth, and the auto/truck OEM cycle is looking a little long in the tooth. On the other hand, the company neither has the oil/gas exposure that is undercutting Dover (NYSE:DOV) and Colfax (NYSE:CFX), nor the problematic mining exposure of companies like Atlas Copco (OTCPK:ATLKY). Given the weak guidance from Linear Technology (NASDAQ:LLTC), I am a little concerned that 3M could be seeing a few quarters of weaker results from electronics and that could pull down what would otherwise be an "okay" level of general industrial exposure.
So, in the short term at least, I think General Electric, Honeywell, and names like Ingersoll-Rand (NYSE:IR), Sensata (NYSE:ST), HD Supply (NASDAQ:HDS), Roper (NYSE:ROP), and Eaton (NYSE:ETN) may have an edge on 3M when it comes to stronger underlying markets (the tailwinds). Then again, 3M has a demonstrated record of using internally-driven new product introductions and pricing power to make the best of whatever it has. Said differently, I don't think the company is going to do poorly in the short-to-medium term, but other companies would seem to have an easier path ahead.
I'm still looking for 3M to generate long-term revenue growth in the neighborhood of 3% to 4%, with ample balance sheet flexibility to add growth through acquisition. I'm not looking for dramatic margin improvements from here, but I do think that over time the company can boost its FCF growth rate by a point or more relative to its revenue growth. One note of caution here, though, would be pricing power - the disappearance of pricing power is emerging as a real risk across the space and while it may not lead to the "peak margin" issue that bears have been talking about for a while, it's a threat to margin expansion.
3M still isn't cheap on a free cash flow basis, but it is not so seriously overvalued that I'm worried about my long-term stake in the company. I'd also note that the "fair" price/book value implied by the company's ROE is quite a bit higher (above $160); this metric quite consistently values companies more highly than DCF, and it is not my go-to metric, but it does at least show some of the value of 3M's superior margins and returns on capital.
Disclosure: I am/we are long MMM. (More...)I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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