The recent disappointing earnings report from 3M (MMM -0.66%) sent shock waves through the marketplace. Given the industrial giant's size, its wide range of end markets, and its short-cycle market exposure -- the first thing that gets hit in a slowdown -- the company's earnings could be seen as indicative of a sign of a greater-than-previously expected economic slowdown to come. In short, is it more of a 3M issue or a general market issue, and what should investors make of it?
This is about you, not me
I'll cut to the chase. It's more of a 3M issue. There are certainly signs of slowing in many of the company's end markets, but the disappointment in the quarter looks to be more of a factor of management being too optimistic with previous guidance and a reflection of ongoing company-specific challenges that could take time to deal with.
Image source: Getty Images.
To understand what's going on, here's a chart of 3M's organic sales growth by segment. As you can see below, the most recent quarter saw all the segments reporting organic sales declines aside from anemic growth in consumer (up 0.9%) and healthcare (up 0.7%).
But here's the thing. The weakness in the declining segments -- industrial, safety and graphics, and electronics and energy -- has also been reported by others and should be well known by now. For example, the only area of weakness in Honeywell International's(HON -0.91%) recent earnings was its safety products, and it's no secret that consumer electronics spending has slowed. Meanwhile, there's no shortage of companies reporting disappointing automotive end markets (3M's industrial segment has heavy exposure) in the first quarter.
So what's actually going wrong with 3M? There are three points, and none of them reflect well on the investment proposition for the company.
Data source: 3M presentations. Chart by author.
Three questions for 3M
First, in recent years, 3M has relied on strength in its cyclical segments while its two less-cyclically exposed segments (healthcare and consumer) have been serial underperformers. The fear was that when a slowing of economic growth occurred, the healthcare and consumer segments wouldn't be able to pick up the slack -- and that's arguably exactly what happened.
To put this into context, you have to go back to the growth targets outlined on the investor-day presentation in March 2016.
Here's a table of how the segments compared with the targets given by CFO Nick Gangestad in 2016. As you can see in the table, growth in the more-cyclical businesses has varied with the industrial economy, but healthcare and consumer have been consistent underperformers -- not something you would expect given their end-market conditions over the period.
|
Organic Sales Growth Year Over Year |
2018 |
2017 |
2016 |
2016-2020 Targets |
|---|---|---|---|---|
|
Industrial |
3.20% |
4.90% |
0% |
2%-4% |
|
Safety & Graphics |
5.10% |
6.10% |
2.20% |
2%-5% |
|
Health Care |
2.60% |
3.90% |
3.50% |
4%-6% |
|
Electronics and Energy |
3.30% |
11% |
(7%) |
0%-4% |
|
Consumer |
1.50% |
1.70% |
1.90% |
3%-5% |
|
Total Company |
3.20% |
5.20% |
(0.1%) |
2%-5% |
Data source: 3M presentations. Figures in bold represent numbers below the low end of target.
Second, 3M's guidance has been consistently optimistic in recent years. Management spent much of 2018 lowering guidance and then promptly opened up 2019 by lowering sales and earnings guidance.
Management had an opportunity to adjust its medium-term targets to better reflect current conditions, but as you can see below, healthcare guidance was kept consistent at 4% to 6% annual growth, with consumer reduced only to 2% to 4% from 3% to 5%. Frankly, it looked optimistic at the time, and still does so now.
| 3M Targets |
2019-2023 Targets |
2016-2020 Targets |
|---|---|---|
|
Industrial |
3%-5% |
2%-4% |
|
Safety & Graphics |
3%-6% |
2%-5% |
|
Health Care |
4%-6% |
4%-6% |
|
Electronics and Energy |
2%-6% |
0%-4% |
|
Consumer |
2%-4% |
3%-5% |
|
Total Company Organic Sales Growth |
3%-5% |
2%-5% |
Data source: 3M presentations.
Third, 3M's stock has long commanded a premium in the industrial sector because investors have admired its business model. In a nutshell, 3M typically invests around 6% of sales into research and development and 5% to 5.5% in capital spending in order to create differentiated products with pricing power and good margin.
Unfortunately, as you can see below, its sales growth has largely come from volume growth rather than pricing -- and when volumes declined 2% in the first quarter, the 0.9% increase in pricing simply wasn't enough to offset it. Simply put, 3M's products might not have the pricing power many investors think they have.
Data source: 3M presentations. Chart by author.
What it means for investors
The earnings report highlights areas of weakness in the economy, but the real takeaway is that it's more of a 3M-specific issue. On the positive front, CEO Mike Roman has initiated significant restructuring , and the lowering of full-year organic sales growth guidance from 1% to 4% to a range of negative 1% to positive 2% is a better reflection of reality. However, until progress is reported on the issues discussed above, then 3M is a stock probably best worth avoiding right now.
