Litigation And Economic Cycles Dominate The 3M Discussion, But There Are Longer-Term Growth Issues To Consider

There's really not much positive to say about 3M (NYSE:MMM) since my last update on the company. Even against a backdrop of low expectations, the company has managed to come up short, with weaker-than-expected results in businesses tied to consumer electronics and healthcare. On top of that, the company has seen some adverse legal judgements, albeit these are early-stage rulings that aren't likely to fundamentally alter the picture.

My issues with 3M still run deeper than all of this. I praised the company in my last article for finally taking some value-building steps (spinning off Health Care and attempting to ring-fence some of its legal liabilities), but the fact remains that the company has been painfully reticent to reposition itself for the future and is increasingly looking like a short-cycle cyclical focused on squeezing margin and cash flow out of legacy businesses.

Down a bit since my last update, 3M has continued to underperform the industrial group, and while there are a few worse performers out there (Stanley Black & Decker (SWK) comes to mind), there aren't many. I do see some relative value here, and the dividend is good, but I'm still quite concerned that management seems to have little vision for the future beyond "that worked in the past … so let's do that again".

 

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Litigation And Economic Cycles Dominate The 3M Discussion, But There Are Longer-Term Growth Issues To Consider

For 3M, Inertia May Be The Bigger Long-Term Threat

3M (NYSE:MMM) has been hit hard by growing concerns over the company’s potentially large financial liabilities tied to PFAS (per- and polyfluoroalkyl substances) contamination and allegedly defective military earplugs. It certainly also hasn’t helped that the company’s revenue and margin leverage performances have been lackluster at best, all contributing to a nearly 25% decline in the stock price since my last update on the company – far worse than the basically flat performance of the broader multi-industrial sector.

I do still see some value in these shares, but for reasons I’ll discuss in greater detail, I don’t have as much confidence in management as I'd like, and it’s harder to argue for owning these shares given the sentiment headwinds from the legal liability issues.

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For 3M, Inertia May Be The Bigger Long-Term Threat

3M Not Getting Its Due In A Growth-Obsessed Market

 

I’ve been critical of 3M (NYSE:MMM) in the past regarding its M&A and repositioning decisions, and that criticism still applies – compared to how peers like Danaher (NYSE:DHR), Eaton (NYSE:ETN), Fortive (NYSE:FTV), Honeywell (NASDAQ:HON), and Parker Hannifin (NYSE:PH) have repositioned their businesses in recent years, I feel like 3M has missed out to the detriment of its shareholders. That said, for the here and now, I also feel that 3M isn’t really getting its due as a cyclically-sensitive multi-industrial with superior margins.

Up only about 10% since my last update, 3M shares have underperformed the broader industrial group by about 10%. Some of this can be tied to a general shift away from short-cycle names, but 3M is also a relatively unpopular name on the Street now, and it doesn’t fit the “growth over everything else” sensibility of many investors. I do believe the shares are undervalued today, though, and while 3M doesn’t offer the same story-stock leverage as names like Danaher, Eaton, or Honeywell, I do believe quality and undervaluation ought to be worth something.

 

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3M Not Getting Its Due In A Growth-Obsessed Market

3M Leveraging The Early Recovery, With Further Room For Self-Improvement

Despite its reputation as an early cyclical mover, 3M (MMM) hasn’t gotten a lot of love lately in a market that couldn’t seem to get enough of cyclical stories, as industrials continued to perform well through the end of 2020 and into 2021. While 3M has definitely perked up since its fourth quarter earnings report, it had spent most of the last three months lagging the broader industrial space, including good recovery names like Eaton (ETN), Emerson (EMR), ITT (ITT), and Parker-Hannifin (PH).

While some of the underperformance may be due to perception around 3M’s risk to PFAS legislation and litigation, I believe it’s also due at least in part to the choppy recovery we’ve seen so far across industrial and healthcare markets. Some end-markets, like autos, have definitely started to improve, but many othes have shown decidedly mixed performance.

I believe 3M will enjoy a couple years of above-trend growth as the global economy recovers, and I believe the latest restructuring effort will provide another boost to margins. I’d still like to see a more dramatic restructuring (exiting some less promising and lower return businesses and moving into more attractive markets), but if 3M can hit my long-term of just modestly above-GDP revenue growth and two or three points of FCF margin leverage, the shares look like a comparatively rare bargain in the industrial space.

 

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3M Leveraging The Early Recovery, With Further Room For Self-Improvement

3M Delivers Familiar "First In, First Out" Performance And Still Offers Some Value

I’ve written a lot in the past about how 3M’s (MMM) business mix and operational strategy leads it to being among the first to enter into downturns, but also among the first to emerge, and that would seem to be holding true again, as 3M returned to organic growth in the third quarter. Looking ahead a bit, I would expect to see further improvement in key end-markets like autos, general manufacturing, and electronics, but the resurgence of COVID-19 cases in Europe and the ongoing growth in cases in the U.S. does certainly create some risks.

3M has continued to lag industrial names I liked better a quarter ago, including Parker Hannifin (PH) and Eaton (ETN), but the relative valuation is starting to look more interesting. As I’ve said before, I think 3M management needs to take a more comprehensive look at its business mix and strategic priorities, but long-term FCF growth in the mid-single-digits can still support a total annualized return of around 8%, which I believe stacks up pretty well to likely market returns over the next few years.

 

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3M Delivers Familiar "First In, First Out" Performance And Still Offers Some Value

3M Quietly Outperforming Ahead Of A Short-Cycle Turn

I thought 3M (MMM) had some relative appeal back in January, before COVID-19 became a global pandemic, and the shares have outperformed their peer group by about 14% in that short window since. I think there are several parts to this. 3M’s leverage to N95 respirators certainly counts for some of it, but I also think 3M has outperformed on the perception that its businesses will be more likely to see an earlier recovery and that it was already underway with some restructuring activities before the downturn.

With that relative outperformance, I don’t see as much upside at this point. I don’t think COVID-19 will have a substantial long-term impact on the business, and I still expect 3M to deliver low-single-digit revenue growth, mid-single-digit FCF growth, and healthy capital returns over time. But given the relative value opportunities with names like Eaton (ETN), Emerson (EMR), Honeywell (HON), ITT (ITT), and Parker-Hannifin (PH), I can’t say that 3M is far and away the top call now, though 3M does have the advantage of relatively less exposure to problematic markets like non-residential construction, aerospace, and oil/gas.

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3M Quietly Outperforming Ahead Of A Short-Cycle Turn

3M Running Lukewarm-To-Cool, But The Turn Should Be Coming

It’s still a challenging time to be an industrial company. While the early consensus does seem to be that the second-half rebound story is still in play, it’s sounding more and more like the magnitude of that rebound is going to be less than hoped and the first half of 2020 is likewise going to be tougher than expected. In that respect, then, 3M’s (MMM) fourth quarter results and 2020 guidance don’t appear all that unusual.

I still have very mixed feelings about 3M. The company has frittered away a lot of balance sheet optionality on questionable M&A (and arguably oversized buybacks), and I think the latest restructuring effort (we seem to be averaging one a year now) falls short of the more radical change the business needs. On the other hand, 3M’s high R&D spending establishes high walls around a lot of its businesses and all but ensures healthy margins and cash flows. I’d very much like to see a deeper “re-think” of what 3M should look like 10 years from now, but the valuation today is not demanding and business conditions should improve from here.

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3M Running Lukewarm-To-Cool, But The Turn Should Be Coming

3M Grinding Through The Downturn

The Street was definitely disappointed with 3M's (MMM) results and guidance, as the company was a notable weak link in a chain of multi-industrial earnings that thus far haven't been as bad as feared. I see this as a good news/bad news situation. I believe 3M is a little further along within the downturn than many of its peers, and in that respect, I consider 3M's results something of a preview for what the multi-industrials may see in the next quarter. I also believe that 3M may be one of the earlier companies to pull out of the downturn.

3M is still a mixed investment prospect, even though I continue to own the shares. On one hand, I still like the company's broad exposure to a wide range of industrial end-markets and geographies, as well as structurally strong margins. On the other hand, I don't like the weakening margin leverage, the questionable M&A choices, and the lack of investment in growth markets. I do believe the shares have fallen to a point where they trade below long-term DCF-based fair value, and that's not a common occurrence, making this a name to consider for more patient investors.

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3M Grinding Through The Downturn

The Cycle Is Probably The Least Of 3M's Worries Now

Despite its arguably undeserved (or at least exaggerated) reputation as a “defensive growth” name, 3M (MMM) actually has a history of being one of the most sensitive names to turns in the cycle – 3M tends to see the downturn before others, and likewise tends to see the recovery. While the good news in that is that 3M may already be about halfway through the downturn (if this cycle matches past cycles), the bad news is that there are a lot of bigger challenges for 3M beyond the cycle.

Environmental liability is going to capture a lot of attention in the near-term, but I’m more bothered by the company’s troubling lack of margin leverage and recent capital allocation decisions as they pertain to M&A. 3M isn’t a bad business, and it’s not un-fixable, but it’s going to take work to fix, and the apparent returns aren’t all that exciting in that context.

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The Cycle Is Probably The Least Of 3M's Worries Now

3M's Acquisition Of Acelity Is Too Much 'Business As Usual' For Me

The more things change, the more I guess they stay the same. After a sharp drop in the wake of its worst quarterly report in years, and growing investor concern about the direction and fundamental growth capacity of the business, 3M (MMM) has chosen to spend almost $7 billion of shareholders’ money on a medical technology business that isn’t growing all that fast and doesn’t have exceptional margins. I can see how this deal for Acelity could produce above-average synergies and become a stronger deal over time, but to me, this seems all too familiar of a deal with 3M overpaying for an asset that doesn’t really add much of what the company really needs.

Worse still, 3M announced that they’ll be pulling back on share buybacks. Coupled with concerns about possible long-tail pollution-related payouts, this is not what 3M’s generally more conservative investor base wants to hear, and I’m concerned that future divestitures could further compromise short-term FCF generation capacity. I don’t believe this fundamentally alters the 3M investment argument (yet…), but it’s another thumb on the wrong side of the balance scale.

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3M's Acquisition Of Acelity Is Too Much 'Business As Usual' For Me

3M Decimated On Autos, Electronics, And Execution

Thursday’s first quarter earnings report was the worst day for 3M (MMM) shareholders in a long, long time, as a huge double-digit miss at the segment profit line drove a double-digit decline in the share price. While 3M is not going to burn down, fall over, and sink into the swamp, the shares are going to be in the penalty box for a while, and management needs to prove convincingly that they can not only improve margin execution, but restructure the business in the direction of both great margins/returns and at least decent growth.

3M’s valuation is much more reasonable than it has been in some time, but it’s fair to ask and wonder if turning around this supertanker is going to be a longer process. If the problems really are confined primarily to auto and electronics, this is a name to investigate further, but I don’t think investors need to make a snap decision for fear of missing out, as the concerns about 3M’s growth and execution capabilities have been building for a while and won’t go away in quarter.

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3M Decimated On Autos, Electronics, And Execution

Eaton Hitting Its Marks, But Still A Controversial Name

This fourth quarter earnings and guidance season has gone a little better than expected, with many companies having fine-tuned their guidance before the end of 2018 and defanging some of the potential disappointment here in January and February. Even so, there is still a lot of uncertainty regarding the health of the U.S. and global economies, with multiple multi-industrials (including Honeywell (HON), Illinois Tool Works (ITW), and 3M (MMM) ) establishing some rather low numbers for the low end of their 2019 growth outlooks.

I continue to like Eaton (ETN), even if more on a relative, “it’s not that bad” basis. I am definitely concerned about the risk of slowing demand in “general industrial”, trucks, off-road machinery, and non-residential construction, but management’s guidance for the year was fairly encouraging and markets like aerospace and data center are still looking healthy. With skepticism already seemingly built into the valuation, Eaton is a name that could surprise if 2019 proves to be better than expected for the U.S. and global economies.

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Eaton Hitting Its Marks, But Still A Controversial Name

Weak Growth And Robust Expectations Create Headwinds For Illinois Tool Works

Quality is all well and good, and Illinois Tool Works (ITW) certainly has that, but growth and margin leverage tends to drive share price performance and ITW looks to be in shorter supply where those are concerned. Meaningful exposure to softer end-markets like auto, “general industrial”, non-residential construction, and electronics are headwinds to me, and I’m not sure there’s a lot that ITW management can do to repeat the meaningful past improvements in operating margins. On top of all that, the valuation is not all that cheap at this point.

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Weak Growth And Robust Expectations Create Headwinds For Illinois Tool Works

Reputation Alone Won't Do It For 3M

As a long-term owner of 3M (MMM), there’s certainly a lot I like about this company, but the fact remains that 3M’s exposure to autos, electronics, China, and non-residential construction are not assets right now, and the company lacks the exposure of peers like Honeywell (HON), Danaher (DHR), and Emerson (EMR) to more attractive end-markets like aerospace, process automation, life sciences, and diagnostics. What’s more, I have some long-term concerns about the corporate strategy that I want to address later.

Weaker short-term growth performance and prospects have done their damage, with 3M lagging many/most of its industrial peers in 2018. Even so, the shares aren’t all that cheap on either a DCF or EV/EBITDA basis and there are other names with more interesting near-term stories in the industrial space.

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Reputation Alone Won't Do It For 3M

Stanley Black & Decker's Guidance Doesn't Bode Well For Industrials

Seen by many investors and analysts as a relatively safer play in industrials for 2019, Stanley Black & Decker (SWK) was hammered (down 15%) after reporting earnings, as investors saw more than a few alarming items in the company’s guidance pertaining to some major industrial end-markets. Given the acknowledgement of weakening conditions in key markets like autos and residential housing, not to mention some limits on pricing amid ongoing cost pressure, I expect investors are going to be paying much closer attention to names like Illinois Tool Works (ITW), Ingersoll-Rand (IR), and 3M (MMM) in this earnings/guidance cycle.

As for Stanley Black & Decker itself, the shares do look undervalued, but the back-end loaded guidance for the year and the margin challenges make it a tough call right now, as there could be at least one more cut to guidance before this is over. I’d also note that Stanley Black & Decker hasn’t exactly been a standout either when it comes to metrics like free cash flow growth, despite ongoing cost reduction efforts.

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Stanley Black & Decker's Guidance Doesn't Bode Well For Industrials

As Expected, Evolution, Not Revolution, From 3M

When I previewed 3M’s (MMM) capital markets day in my last article on the company, I said that I expected a presentation that was more or less “more of the same”. It’s not really in 3M’s corporate DNA to make major course corrections, and besides, I think there is a lot of wisdom in following an approach of “if it’s not broken … don’t break it”. 3M more or less fulfilled those expectations, laying out a five-year plan that looks a lot like the company’s recent history, albeit with what I believe is a more growth-conscious focus.

Between a “steady as she goes” investor day and a disappointing third quarter hurt by what I’d call non-structural issues, there’s not a particularly strong case for liking 3M if you didn’t already like it. The valuation is not really in bargain territory and next year looks challenging given slowdowns in a lot of significant markets (including autos, electronics, and “general industrial”). Still, as a high-quality name and one of the most R&D-focused multi-industrials, I have no problem with holding on to 3M today as part of a long-term core portfolio.

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As Expected, Evolution, Not Revolution, From 3M

More Clarity On Honeywell's Spinoffs And A Boost To Guidance

There's an ongoing tug of war in the industrial sector between analysts and investors who believe the end is nigh and that the cycle is going to start showing real signs of slowing next year, and the people who actually run those companies who believe business conditions remain strong. While many short-cycle industrials have picked up a little momentum lately, longer-cycle Honeywell (HON) has remained a strong performer throughout, with the shares arguably replacing 3M (MMM) as the must-own in the space.

In relatively short order, Honeywell will become a smaller, more profitable, and faster growing company as it completes the spinoffs of Garrett Motion (GTX) and Resideo Technologies. Spinning these two businesses should, in turn, lead to higher multiples for Honeywell as it will improve the company's margins, returns, and growth prospects. As all of that is going on, Honeywell continues to enjoy healthy demand across many of its businesses, with certain categories (aerospace, UOP, and automation in particular) looking like they have more to give. I've been a steady fan of Honeywell for a while, but given where the shares now sit in terms of valuation, I can't be quite as enthusiastic as before.

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More Clarity On Honeywell's Spinoffs And A Boost To Guidance

The Cycle Weighing A Bit On 3M

Shorter-cycle names have done a little better in recent months, but overall it’s been a challenging year for the stocks of companies like 3M (MMM), Illinois Tool Works (ITW), and Colfax (CFX) compared to Emerson (EMR), Honeywell (HON), and Eaton (ETN). The late summer/early fall is a popular time for sell-side conferences and investor days, and with that another chance to look at these names heading into the last three months of the year. In the case of 3M, it looks like the company’s shorter-cycle exposure is weighing a bit more on results, with management nudging down growth expectations while also experiencing higher cost inflation.

All told, 3M remains a well-run company at a somewhat challenging point in the cycle and with a tough valuation. 3M has a lot to offer as a flight-to-quality name and the company’s strong tradition of innovation and reinvestment supports a longer-term investment case, but unless management offers an uncommonly bullish outlook at its November investor meeting, investors are likely looking at middling near-term performance prospects.

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The Cycle Weighing A Bit On 3M

3M Beats Lowered Expectations, But The Second Half Has Challenges

The wilder the party, the worse the hangover, and 3M (MMM) shares were definitely a major beneficiary of the Street’s overheated enthusiasm with industrials going into the start of this year. Still down a quarter from its peak, 3M is looking at a slow process of rebuilding expectations and investor trust, even though the company’s “disappointments” were really not all that egregious.

3M posted decent second-quarter results, with surprisingly strong pricing, but margin concerns will persist and the company is looking at some challenging growth comps in the second half of the year. Valuation is more reasonable now, but stocks like Honeywell (HON) and Eaton (ETN) appear to offer more value among the U.S.-centric multi-industrials.

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3M Beats Lowered Expectations, But The Second Half Has Challenges

Illinois Tool Works Loses A Little Luster

A quarter ago I said I preferred Honeywell (HON) and Eaton (ETN) to Illinois Tool Works (ITW), and in the three months since Honeywell and Eaton have outperformed Illinois Tool Works by about 10%. Now, Illinois Tool Works shareholders are left to digest a second straight disappointing quarter - while ITW hit the organic revenue growth target this time, segment EBIT missed expectations by a few percentage points and management lowered guidance.

I'm not too surprised that Illinois Tool Works is seeing higher than expected cost pressures; if anything, that's a theme this quarter in the industrials. I'm more surprised, though, by what looks like weaker results in areas like auto and electronics relative to peers like 3M (MMM), Danaher (DHR), and Stanley Black & Decker (SWK). With weaker prospects for beat-and-raise quarters across the industrial/multi-industrial landscape, I'm more worried about the risk of re-rating in the second half of 2018 (multiples shrinking back toward historical norms).

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Illinois Tool Works Loses A Little Luster