3M Earnings Preview: Headwinds Expected, But Valuations Remain Attractive (NYSE:MMM)

3M (NYSE:MMM) is set to report its earnings on April 26th, before the market opens. While the stock looks cheap and its medium to long term outlook remains good based on the end market recovery and the company’s growth initiatives, there are some near term headwinds that may impact Q1 results. The good news is expectations aren’t very high going into the earnings with both consensus revenues and EPS forecast below the midpoint of management guidance. So, the downside should be limited.

Revenue Headwinds

Back in February, while sharing its guidance on investor day, management talked about 2% to 5% organic revenue growth in FY2022. Embedded in revenue growth guidance was management’s expectation of a ~2% Y/Y decline in global auto builds in Q1 thanks to Chip shortages and other supply chain issues. However, the Russia Ukraine war has made chip shortages worse and global auto builds are expected to decline much more now. So, this might result in some headwinds for management guidance. Another headwind is the company’s decision to stop doing business in Russia as well as its business in Ukraine getting impacted by the war. However, Russia and Ukraine combined are less than 1% of 3M revenues. So, the impact shouldn’t be significant. However, there is a chance that management revises the upper end of its revenue growth guidance downwards due to these headwinds. The revenue performance of the company’s remaining businesses is expected to be in line with management expectations shared on its February outlook call. The current consensus estimates for revenues are building in ~2.30% topline growth and I believe analysts are already incorporating some of these headwinds in their financial models.

Incremental margin target may be tough to achieve this year

Margin outlook has also become worse since the company’s February outlook call. The Russia-Ukraine war has caused a significant increase in oil prices and the freight and raw material costs have increased for the company. Also, the war has caused worsening shortages of some components like chips and has put more pressure on already constrained supply chains. So, 3M may likely end up paying more to ensure the availability of critical components.

Management has given long term incremental margin targets of 30% to 40% but the company is unlikely to reach these levels in the current year. The company’s EPS target of between $10.15 and $10.65 may also be revised lower given the revenue headwinds and margin pressures that have emerged or become worse over the last couple of months.

Share buybacks may provide some relief

3M has been aggressively buying back shares over the last few years. In FY2021, the company purchased over 11.65 mn shares at an average price of ~$185.92 spending over $2.1 billion. With the share price much below last year’s level, I expect the company to be more aggressive in share repurchases which may provide some downside support to EPS.

Legal Issues

In addition to fundamental factors, legal issues like earplug lawsuits and PFAS cleanup costs are on the top of the list of investor concerns. The longer-term costs associated with them are really tough to forecast and any guidance from management on these issues should be closely watched by investors. Johnson & Johnson (JNJ) while facing similar kinds of liabilities from consumers spun off a separate company – LTL management – to deal with these liabilities and LTL management later filed bankruptcy shielding JNJ from significant legal costs. If there is a hint of any similar strategy being used by 3M, it could meaningfully help the stock and would matter much more to the stock price than operational performance. However, it may be too soon to speculate on it and I am not sure how much detail management will go into while discussing this issue on the earnings call.

Valuation remains attractive for long term investors

3M is trading at 14.64x FY22 and 13.67x FY23 consensus EPS estimates which is a significant discount to its five-year average adjusted FWD P/E of 19.66x. Its dividend yield is also solid at ~4%.

While there are several near term headwinds that can impact the company’s revenue growth and margins this year, I believe the company will be able to post mid-single digits annual revenue growth in the long term with 30% to 40% incremental margins. Even this year, the growth would have been much stronger if the supply chain constraints hadn’t impacted the business. Further, the company faces significant headwinds this year as the demand for its N95 respirator mask is declining as Covid recedes. The decline is expected to impact sales by 2 percentage points this year and is already incorporated in management’s 2% to 5% organic growth guidance.

In FY23, if we assume the supply chain normalizes and the headwind from less N95 respirator demand reduces, I believe the company should be able to post mid-single-digit revenue growth. Combine this with healthy incremental margins and share buybacks, we can see a healthy revenue growth rate.

So, while there are some headwinds that can impact 3M’s Q1 performance, I believe the stock offers good value and long term investors should use any decline to buy shares at attractive valuations.