Having owned 3M (NYSE: MMM) for more than eight years, I have to say that I'm perfectly happy with how the company has developed and how the stock has outperformed against the S&P 500. 3M often only gets grudging credit from some analysts as a good stock to own during downturns, but few companies match, let alone surpass, the company's long-term returns on capital and net assets.
I am not all that eager to dislodge a cornerstone position (albeit a small cornerstone...), but I cannot aggressively advocate readers to join me in owning 3M right now. The company's market exposures (both by end market and geography) don't look ideal for the coming year and the valuation seems to already assume that everything will go well. Instead, I would suggest that investors consider names like Honeywell (NYSE: HON), Eaton (NYSE: ETN), and Dover (NYSE: DOV) in what is an admittedly bargain-poor industrial conglomerate sector these days.
Q4 wasn't bad... but it wasn't great either
3M's growth issues popped up again in the fourth quarter, as organic growth of 3.4% marked a noticeable slowdown from the third quarter. Now, the comp was about 210 basis points harder this time around, but organic growth still came in about a point shy of analyst expectations. What's more, the miss was pretty even as every segment except consumer was light on revenue and the growth rates by geography were similarly unimpressive.
Looking at some of 3M's peers, you find better results. Danaher was ever so slightly better at 3.5%, while United Technologies and Eaton saw organic growth of 4%. Dover grew 4.7% this fourth quarter, while GE and Honeywell both grew 5%.
The right customers...
Some of the performance differences can be explained by the companies' end-market exposures.
Auto and heavy vehicle demand seems to be improving, helping both Honeywell and Eaton. Not coincidentally, 3M's industrial business (which gets about 40% of its revenue from automotive original equipment manufacturers and aftermarket sales) was the best performer this quarter at 3M, with sales up about 6%.
Likewise, printing and product ID were pretty healthy markets for Danaher and Dover, but it's only a small part of 3M's business (within safety and graphics segment). Electronics demand was a positive for Danaher's test and measurement business, and Dover's consumer electronics business, but 3M's higher exposure to display continues to weigh on its performance as products like touch sensors are not significant contributors yet.
Thinking about 2014, areas like U.S. non-residential construction, automation, oil and gas, and commercial aerospace could all be above-average opportunities. That's good very good news for Honeywell, Eaton, Dover, and General Electric, but not such good news for 3M. While 3M is looking to build up its oil and gas and aerospace businesses, that's not going to help in 2014. In the meantime, markets like infection prevention, drug delivery, traffic management, and personal safety where 3M is strong are not looking like above-average markets in 2014 in my opinion.
...in the right places
Normally 3M's above-average exposure to emerging markets (around one-third of sales) would be seen as a good thing, and for the long term I do believe it is. For 2014, though, worries about a slowdown in Latin America (particularly Brazil) and weaker consumer spending across multiple emerging markets seem to be really weighing on sentiment. With 3M's peer group having around 20% exposure to emerging markets, that could be a source of relative weakness if these fears prove valid.
I am looking for Europe to show real signs of recovery in 2014. Unfortunately, Europe makes up less than 20% of 3M's sales base. Honeywell generates about 30% of its sales from Europe and Eaton generates 25% -- not hugely different than 3M, I'll grant, but enough to still make an incremental difference.
One year versus the long term
None of this should be read as an indictment against 3M's long-term potential. I was pleased to see management talk during December's analyst day about maintaining significant investment levels in R&D and building up new business units like mining, oil, and gas. Likewise, I find management's willingness to consider larger M&A transactions, but sticking within its existing markets, to be a positive for long-term growth.
3M has also decided to pull some capital allocation levers -- upping the dividend by 35% and authorizing a $12 billion share repurchase program. In short, I see 3M doing what it has long done -- sticking to its knitting in its core markets, out-competing its rivals with R&D-driven serial innovation, and constantly refining the logistics, supply, and manufacturing processes to maximize margins and cash flow.
The bottom line
Looking at free cash flow, I expect free cash flow growth of more than 6% a year from 3M, which is in the same neighborhood as Danaher, Dover, and Honeywell. Discounted back, though, I think the shares are trading above fair value and likely to struggle to beat the market over the next couple of years. Considering other valuation approaches like EV/EBITDA and ROE/BV, Honeywell, Dover, and Eaton may have a little more to offer in terms of upside, not to mention they may well be in better shape to provide the quarter-to-quarter growth that short-sighted Wall Street craves.
As I said in the open, I'm a long-term holder of 3M. As a long-term holder, I expect periods where the shares trade below fair value and those periods where it trades above. I'm content to continue holding for the long term, but I would suggest investors looking for new holdings take a long look at Dover, Honeywell, and Eaton these days.
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