3M Company (MMM 0.86%) has a growth problem. The company's third-quarter earnings fell short of most expectations, and two of its most important segments -- healthcare and consumer -- continue to fall short of management's growth targets. The pressure is building on CEO Mike Roman to deliver something new during the company's investor-day meeting in November. Let's take a look at what happened and why Roman needs to take action.
3M cuts guidance
The company is known as a high-quality operation with a history of generating solid returns for investors, so when it delivers a disappointing quarter, the market takes notice. Not only did 3M miss analyst estimates for the third quarter, but management also lowered full-year growth and earnings estimates. Moreover, as you can see below, full-year free cash flow (FCF) has been cut yet again, and the midpoint now stands some $1.1 billion below that given in January:
|
Full-Year 2018 Guidance |
Current |
July |
April |
January |
|---|---|---|---|---|
|
Organic local-currency growth |
3%* |
3%-4% |
3%-4% |
3%-5% |
|
GAAP EPS |
$9.90-$10.00 |
$10.20-$10.45 |
$10.20-$10.55 |
$10.20-$10.70 |
|
Free cash flow |
$4.8 billion to $5.2 billion |
$4.9 billion to $5.7 billion |
$4.7 billion to $5.5 billion |
$5.6 billion to $6.6 billion |
Data source: 3M Company presentations. GAAP = generally accepted accounting principles; EPS = earnings per share. *Figures in italics represent changes.
What's going wrong with 3M? In a nutshell, the problem appears to be revenue growth. There are three different but related points to address from the quarter and for full-year 2018.
1. Sales pulled forward
First, there's the issue of the pull-forward of sales into the second quarter caused by the rollout of enterprise resource planning (ERP) solutions. Essentially, many customers decided to order ahead of the ERP rollout, so sales that might ordinarily have been booked in the third quarter were pulled forward into the second quarter.
The cracks are beginning to show in 3M's growth engine. Image source: Getty Images.
The pull-forward resulted in a bumper second quarter with 5.6% organic local-currency growth, and some commentators felt 3M may well have started to boost its growth rate on a sustained basis. Unfortunately, third-quarter organic local-currency growth fell back down to just 1.3%, and as noted above, management also cut its guidance for full-year revenue growth.
Moreover, management has been optimistic when giving guidance. For example, on the second-quarter earnings call, Roman estimated that pull-forward from the ERP effect was responsible for only 50 to 100 basis points (100 basis points is equal to 1%) in the second quarter. Fast-forward to the third-quarter earnings call, and Roman said "we estimate a pull-forward into Q2 was approximately 100 basis points." In other words, the pull-forward boosted second-quarter sales at the top end of Roman's estimate.
In addition, an ERP rollout in the healthcare segment boosted organic local-currency growth to 6.9% in the third quarter of 2017, and CFO Nick Gangestad promptly told investors that he saw healthcare growth "solidly in the 3% to 5% range for 2017." In fact, healthcare growth in the next three quarters came in at 3.1%, 2.7%, and 3.5%.
2. Healthcare and consumer growth below target
Second, the healthcare and consumer segments together contributed nearly 30% of the company's segment operating income in the first nine months, but the problem is they continue to underperform the company's 2016-2020 growth expectations. Healthcare has been hit by ongoing weakness in oral care, and possibly temporary weakness in drug delivery business -- management expects a recovery in drug delivery in 2019.
In order to demonstrate the overall trends in healthcare and consumer, here's a breakout of sales growth by segment for the last few years. For reference, the guidance laid in 2016 for 2016 through 2020 called for organic local-currency growth of 4% to 6% in the healthcare segment, and 3% to 5% in the consumer segment.
As you can see below, both have struggled to get anywhere near these targets. The average quarterly revenue growth for the consumer segment has been 1.7% since the start of 2016, and for healthcare 3.2% -- both notably below the low end of their targeted ranges. For reference, total company organic local-currency growth has averaged 2.7%, compared to 2016-2020 guidance of 2% to 5%.
Data source: 3M presentations. Year on year growth. Chart by author.
3. Volume growth, or price growth?
Third, 3M still hasn't provided convincing numbers that attest to the company's strength in developing differentiated products that have pricing power. This is a key facet of its business model, and earlier in the year management promised a better pricing environment in the second half.
However, a breakout of just how 3M is generating sales growth shows that the company is struggling to generate volume growth and pricing growth -- suggesting that its products might be more commoditized than management hopes.
Data source: 3M Company presentations. Year on year growth. Chart by author.
Where does 3M go from here?
The good news is that Roman and Gangestad have an opportunity to realign investor expectations and set new midterm targets during the investor-day presentation on Nov. 15. Roman may well decide to restructure oral healthcare and parts of the consumer segment, and the market is likely to applaud him if he does so. In addition, he may decide to pare back share buybacks in favor of acquisitions, in order to boost revenue growth.
The bad news is that the midpoint of FCF guidance now puts 3M at a 2018 price-to-FCF multiple of 22.6. That's expensive in itself -- and especially for a company that's been lowering guidance across the board in 2018.
Keep an eye out for the presentation in November: There's a lot of work for management to do.
