wellesenterprises
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”.
Weak Results And Guidance
Although there were a few positives in 3M’s quarter, it was overall a pretty feeble performance, even in the context of lower expectations given the company’s exposure to headwinds like China exposure and weakening personal electronics.
Revenue rose about 2% in organic terms (closer to 1% on an adjusted basis), easily one of the worst performances of the group. Looking at what I’d considered to be reasonable peers, companies like Dover (DOV), Eaton (ETN), Honeywell (HON), Illinois Tool Works (ITW), and Parker-Hannifin (PH) all performed significantly better. I’d also note that while 3M likes to brag about the value of its brands and the value it builds through serial innovation within those brands, the 4% to 5% price leverage the company saw this quarter is well below average for the multi-industrial group.
Weaker sales of respirators (down 34% year over year) on tougher pandemic comps certainly played a role, but even mainline industrial businesses like adhesives and abrasives weren’t particularly strong. Businesses tied into personal electronics (phones, TVs, et al.) were also quite weak, but this wasn’t so surprising – weak consumer electronics is a known trend at this point.
Apart from the weak pricing, what concerned me most about the third quarter was the relatively soft performance of the Health Care business. Organic revenue was up just 2% and segment profits (down 11%, with margin down 170bp to 21.8%) missed by more than 10%. I’ll grant that oral care (down 12%) was a significant headwind, but Envista (NVST) managed 4% core growth and Dentsply Sirona (XRAY) saw just 1% organic sales erosion. Moreover, 3M’s statement that procedures were at about 90% of pre-pandemic levels doesn’t match with what other med-techs reported in the quarter, with most suggesting a mid-90%s level.
Guidance, too, was nothing special, with management now looking for sales contraction of 3.5% to 5% versus contraction of 0.5% to 2.5% previously. While forex is taking a bigger bite than expected, the reality is that 3M is also getting hurt by its relatively greater exposure to autos, China, and electronics. More concerning, the company seems to be really taking a hit from an early downturn in short-cycle industrial demand, as customers seem to be slowing their purchases ahead of an expected downturn in 2023.
Not Just A Cycle Issue
I’ve written about this before with 3M, but I think it merits ongoing discussion – I think 3M management (and the board) have been far too passive about repositioning this company for the secular trends of the next quarter-century. While I respect the idea of “if it’s not broken, don’t break it” and 3M certainly has an enviable record of margins, returns, and capital returns to shareholders, I don’t believe there is an intractable “either-or” between generating strong returns and positioning a business for the future.
Look at Danaher (DHR), Dover, Emerson (EMR), Fortive (FTV), Honeywell, and Parker-Hannifin and compare these companies to what they were five or 10 years ago. As a group, these companies have repositioned themselves to leverage growth in automation, decarbonization, electrification, health care/life sciences, and industrial software, while reducing exposure to more cyclical, lower-value-added businesses.
Over that same time, 3M has basically just doubled down on what it already has, adding some business adjacencies, but often buying underwhelming businesses that had been underinvesting in their operations (like Acelity in wound care). Granted, there have been more dynamic moves of late – the food safety transaction with Neogen (NEOG), the proposed spin-off of Health Care – but I struggle to find a secular growth trend where I can confidently say 3M has a strong established or emerging leadership position.
Yes, 3M has some exposure to areas like automation, digitalization, electrification, but keep in mind that in the past 3M has tried to claim leverage to automation by virtue of the fact that it makes abrasives and adhesives that can be used by robotic systems. Likewise, there are legitimate opportunities within the electronics business to leverage growth in areas like data center and renewable energy, but I’d call those opportunities more “ride along” than dynamic.
Litigation – A Lot Of Sound And Fury
Since my last update, 3M has seen some legal setbacks, including the Bankruptcy Court for the Southern District of Indiana refusing to block earplug lawsuits and another lawsuit attempting to block the Health Care spin. The company has also seen some setbacks in its PFAS litigation, with the District Court in South Carolina arguing that the company cannot use the government contractor defense in PFAS litigation pertaining to aqueous film forming foams (or AFFFs).
Litigation is never easy to predict, and 3M’s cases are complex. I do think 3M will likely prevail in its attempts to use bankruptcy to fence in its liabilities in the ear plug litigation, as there is precedence here with other companies (including Johnson & Johnson (JNJ), Georgia-Pacific, St. Gobain, Trane (TT), and Owens-Illinois). The question, though, is what sort of settlement is ultimately reached. Given that the plaintiffs don’t get any compensation until the matter is resolved, and the plaintiff’s lawyers likewise don’t make any money until the case is settled, 3M can afford to let proceedings/negotiations drag on. Still, I think the sooner this is resolved and no longer hanging over the shares (assuming a “reasonable” settlement), the better for all concerned.
The Outlook
Given 3M’s weaker performance and my weaker short-cycle outlook, my estimates for FY’22 and FY’23 come down – my revenue estimate for FY’23 is now about 5% lower. I’m looking for long-term revenue growth of around 2%, or closer to 3% on a pre-pandemic normalized basis. I do see further scope for margin/free cash flow leverage with long-term FCF margins around 20%, driving FCF growth of closer to 4%. Using a discounted cash flow model, this gives me an anticipated total annualized long-term return of around 8%. Readers should note this also includes some attempts to estimate future legal payouts (a total NPV of around $17 billion).
Weaker near-term margins and EBITDA also lead to a lower forward EBITDA multiple and fair value based upon EV/EBITDA. With the margins/returns I now expect over the next six to 18 months, I believe 12.75x is the right multiple for the shares, driving a $156 fair value on my new EBITDA estimate.
The Bottom Line
I’m tempted to think that sentiment cannot get much worse from here. The sell-side has bailed out and these shares are now a popular “Underperform” recommendation, and expectations for FY’23 look suitably low now. Litigation remains a threat, but I think the bigger issue is that the company looks as though it has feet of clay with respect to repositioning the business for the future. Although the valuation could have some appeal given what I think are achievable (if not beatable) assumptions, and 3M is loved by many income-oriented investors, it’s harder and harder for me to make a compelling “buy” case for an increasingly undifferentiated short-cycle industrial story.
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