How Diversification Helps Businesses

In this episode of Market Foolery, Chris Hill and Motley Fool analyst Ron Gross bring you the latest headlines from the markets. They chat about diversification and dividends, how social distancing is affecting the pharma and food-and-beverage sectors, and much more.

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This video was recorded on April 28, 2020.

Chris Hill: It's Tuesday, April 28. Welcome to Market Foolery. I'm Chris Hill. With me, representing the University of Michigan, it's Ron Gross. Good to see you.

Ron Gross: [laughs] Good to see you. I'm not literally with you, but in spirit, I'm with you.

Hill: Yes. And you're rocking the Michigan Wolverines hat. So any listeners, any of the dozens who, if they're in Ohio, they're not happy now. We're going to talk food and beverage, we're going to talk pharmaceuticals, but we're going to start with Minnesota Mining and Manufacturing (MMM 0.41%), better known as 3M.

Shares of 3M up just a little bit. First-quarter revenue was fueled by strong demand for personal safety products, which shouldn't be a surprise, because they make those N95 masks. And this is where the diversification of 3M pays off for investors.

Gross: Yeah. You nailed it. For sure, that healthcare segment is really strong, including the results of an acquisition they made last year. But the stock has held up relatively well just in general, down about 10% maybe for the year. So that's kind of where the market is now, maybe the market is a bit worse. But these results actually beat expectations, as you say, in large part due to personal safety, but also some home improvement strength as well as cleaning supplies, which I guess we shouldn't be surprised about. Those N95 masks being the ones that are in the news, and they are a significant manufacturer of those, and they've ramped up the manufacture of them significantly.

So healthcare up 21% for the quarter, really strong. Consumer, up almost 5% as well. And then we saw some weakness in industrial, down 1%; transportation, down 5%. Again, not that surprising to see these results. We probably could have predicted them. Operating margins narrowed a bit, so you saw earnings per share down, actually, just about 3%, 2.7%. But still, a relatively decent quarter.

They actually repurchased 365 million shares during the quarter, which we see a lot of companies now suspending that, and they will suspend it as well going forward. They're going to prioritize organic growth and the dividend, which, for dividend investors, very important to see that yield stands at 3.8% right now. It's actually a relatively recent recommendation of mine in our Total Income service, partially for that dividend. So it's nice to see that they're, kind of, signaling that, I think, that dividend is safe.

They did raise $1.75 billion recently in the debt offering to shore up the balance sheet a little bit. And as everyone is doing, they suspended guidance, not surprisingly. Just too hard to see out more than a week or two at the moment.

Hill: I don't know if you had a chance to go through the conference call, the extent to which management gave any guidance on the consumer segment, and in particular, the office segment. I think, I'm like a lot of people in that when I hear the name 3M, I immediately think of Post-it notes. And one of the conversations that we've had over the past couple of months is what is the future of office space, what is the future of business real estate? And to the extent that people start to work from home even more and that businesses plan accordingly, that's got to cut into the production of Post-it notes and all the office-related products at 3M.

Gross: Scotch tape. Yeah. I think you're right, but you also at the top said, you know, that's the power of 3M, is really in their diversification. And especially moving into healthcare in a pretty strong way with the multibillion-dollar acquisition last year. I think that makes good sense as well.

So you know, they're a conglomerate, they're diversified, they're not going to knock the cover off the ball in terms of growth in any of these segments really, especially when things normalize. But they're a steady dividend-paying company that should continue to grow, both organically and through some selective acquisitions going forward just at a nice steady rate.

Hill: Yeah, we talked about this before, the people who look to add those rock-solid dividend payers and allocate part of their portfolio to that. [laughs] It really seems like 3M is in even better shape now as a business and protecting that dividend than some of the other companies in the Dow 30 that are there with -- you know, if I were looking for dividend payers right now, I would be much more likely to add a 3M than IBM or Chevron or Caterpillar.

Gross: AT&T. Yeah, I think that's fair. We shouldn't ignore the fact that they do have $22 billion of debt, so that's a big number, and they only have about $4.5 billion in cash. So they have a significant amount of net debt, but even during weak times, they're producing enough cash flow, generating enough cash flow where they can service that dividend, especially with suspending share buybacks where it should be safe, unless things fall off a cliff further from here, which then all bets are off anyway. But I think the dividend looks pretty safe right here with the cash flow they're generating.

Hill: Let's move on to Merck (MRK -0.05%). First-quarter profits up 10% for Merck. The stock, down a little bit. I'm going to sound like a broken record; there's too much uncertainty here, Ron. In the same way that we've seen this with hospitals and we've seen it with medical device companies with elective procedures. There's enough going on in Merck's pharmaceutical portfolio that is just too dependent on physician administration.

Gross: Exactly right. Sixty-six percent of Merck's revenue comes from drugs that require a doctor visit. So in this age of social distancing, that has kind of dropped off a cliff, not so much in the first quarter, but it will be in Q2 and perhaps for the rest of the year. So this actual first quarter wasn't too bad, beat estimates, but it'll get a little bit hairy going forward.

They said $2.1 billion decrease in 2020 revenue because of these drugs that require doctor administration, drugs like Keytruda. So you know, we're just going to see a dip, it's the way it goes. For the quarter, things held up. Sales up 11.5%. Keytruda, a main drug, as I said, up 45%. So it hadn't quite hit yet, but it's coming.

They did keep their guidance, so kudos to them for being able to at least see out a bit, at least they think they can. They did lower that guidance appropriately by about 8%, but they still think they can see out through the rest of the year. Dividend, I think, is OK, 2.9%, not bad here. Stock is kind of right in line with the market, year to date down about 11% or so, a little bit weak today on the news about how the rest of the year will shape up. But overall, I don't think too bad.

Hill: Look, we're all looking for the same thing, right? We're all looking for the test to be discovered and approved, we're all looking for the vaccine to be tested and approved. Where do companies like Merck fit into your field of vision as you're looking for news? Are you looking to the medical experts like Scott Gottlieb and Dr. Fauci? Are you looking to the big pharmaceutical companies? Where do you find yourself looking for, among other things, hope?

Gross: [laughs] Personally, yes, I am a fan of Fauci. I think he's operating under tremendous stress, as is Dr. Birx. It's tough to do their job and be transparent in the current situation, but I do look to them. There are pockets of scientists, some even being led by some very successful hedge fund managers who have put together a group of, kind of, the best of the best that are, like, under the radar, who are taking immunologist here and a virus doctor there and putting them together into, like, a think-tank kind of scenario. And occasionally, they'll release some information about progress, about antivirals or potentially vaccines.

But yes, I do also listen to some of the big boys here, you know, the Abbott Labs and the Roches and the Mercks. I'm kind of, to be honest, looking for anything. I can get a little tidbits here-and-there of what may be coming, and what may be coming maybe sooner than later. And, you know, it's a waiting game, let's face it.

Hill: We'll close out with [PepsiCo] (PEP -2.97%). Pretty good first-quarter results for Pepsi. The stock up a little bit today; yet another company that pulled their guidance. I didn't see as much color from Pepsi as we saw last week from Coca-Cola with regards to the away-from-home segment, the restaurants, bars, sports venues, music venues, that sort of thing. I mean, clearly it is affecting them, but then again, Pepsi has got Frito Lay, [laughs] they've got snacks and Coca-Cola doesn't.

Gross: Correct. And that's very favorable in this situation. But I do see a lot of similarities here. The quarter itself was relatively decent. Actually, revenue up almost 8%. And pretty much across the board, results were strong in terms of geographies and businesses. Frito Lay, up 7%; Quaker, up 7%. Pepsi North America, up 7%. Pepsi Europe, up 14%. So the quarter was OK. Q2 and going forward, again, the problem, as Coke said, weak demand across the board from restaurants, theaters, stadiums. That's going to really eat in into profitability.

They did close the Rockstar Energy acquisition, they're excited about that, they agreed to be the exclusive distributor of Bang energy drinks. So we see them, kind of, moving in a bigger way into the energy drink market. As you say, suspended guidance, but I think, again, with this one, the dividend looks safe, which is a 2.8% yield right now.

Their buyback program is continuing, which is interesting. So they don't feel they necessarily need to preserve cash. They think they can get everything done, including paying this dividend and perhaps buy some stock back, take advantage of the weakness.

Hill: So we definitely saw the snacks sales help to offset the drop in the beverage businesses. I have to assume that's going to continue for the current quarter. How is that playing out in your home? Are you buying more snacks? I'm 100% helping Pepsi shareholders by buying way more Cheetos than I would normally.

Gross: We have, for sure. I mean, you got to have a little fun and treat yourself, for sure, but we're also trying to be wary of the fact that this could get messy quickly. So [laughs] we're a little of baked goods here, a little chips there. As I've mentioned many times, I have a problem with frozen pepperoni pizzas; now, that's not a Frito Lay product. But just in general, we just have to be careful: Get some exercise, don't pack on the calories too much, because that can get messy.

Hill: It's going to be interesting to see similar to what we're talking about with Merck and the healthcare industry, where I think there is this expectation of the gradual opening up that happens for retail businesses and restaurants, that's going to happen for elective procedures in healthcare. And, I think, for Pepsi and Coca-Cola, to the extent that we start to see more venues open up, I mean, it's got to be in the restaurant and bar area first, right? Because I don't think either one of us is expecting the sports venues or the music venues to be the switch that gets flipped first for Pepsi and Coke, right?

Gross: Yeah, I think that's right. Even if restaurants social distance and maybe put in half the tables than they normally would, they will open up, I think, before these huge venues that have the potential to really, kind of, devastate an area if the virus were to open up and start spreading again in that kind of a situation.

And I think that the market sees that potential. I mean, Pepsi is actually up year to date just a bit, which is pretty hard to do in this type of a market. And so not only does it have a strong business, but I think the market sees that it slowly will get better, maybe we'll have a little bit more pain in the near term and then slowly better in the quarters after that.

Hill: Ron Gross, always good talking to you. Thanks.

Gross: You too, my friend. Thank you.

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.