The Key Number to Watch in 3M's Earnings

Industrial conglomerate 3M (MMM 0.57%) reports earnings on Oct. 27, and it promises to be an eventful affair. On the one hand, its sales guidance looks conservative, and the company may well benefit from an inventory build-up by its customers. On the other, its margin guidance is disappointing, and there's evidence to suggest it could have come under increased pressure in the quarter. Here's what to look out for, and why it matters to the investment case.

The investment case and why margin matters

Trading at 18.3 times estimated 2020 free cash flow, and with management taking concerted action to restructure the company for growth, 3M is an attractive value stock. Throw in a near-3.5% dividend yield and investors can expect to be rewarded with income while they wait for chief executive officer Mike Roman to engineer a turnaround in the company's prospects. 

A glut of respirators could lead to sales and margin challenges at 3M. Image source: Getty Images.

The key question is whether the company is on the right track or not. Obviously, the impact of the COVID-19 pandemic has obscured monitoring of 3M's progress on that front in 2020, but investors will get a key read on matters when the company reports its third-quarter earnings.

The key number to follow will be its operating margin. As a company that prides itself on investing in order to produce differentiated products -- a business model that implies pricing power -- it's very important that 3M demonstrates that it's capable of expanding its margin. Indeed, expanding margin is something that the company has had a hard time doing in recent years.

Data by YCharts

3M margin guidance

Unfortunately, it looks like 3M could have come under margin pressure in the quarter. To understand why, it's useful to go back to what chief financial officer (CFO) Monish Patolawala guided toward on the second-quarter earnings call. There are three key points to the guidance given on the call at the end of July:

• Patolawala said "We are seeing a broad-based pickup in growth across our businesses and geographies as we start the third quarter."
• He also noted that 3M's respirators were expected to be in strong demand and would "contribute approximately 300 to 350 basis points to company-wide Q3 organic growth."
• Third-quarter adjusted operating income margin would be "in the range of 20% to 21%."

The margin guidance raised some eyebrows, because it looks weak compared to the 25.3% achieved in the same period last year. However, management argued that the margin achieved in the third quarter of 2019 isn't a good comparison because the sale of a building artificially boosted margin. Instead, management argued that investors should focus on the implied sequential improvement from the second quarter of 2020. 

Data source: 3M presentations.

Margin pressure coming?

It's not a wholly convincing argument, because sales are expected to increase by low-single digits on a year-over-year basis in the third quarter (and on a mid-teens basis compared to the second quarter of 2020), so investors might have hoped for a bit more than 20%-21% on margin. And there are a couple of other concerns brewing as well.

First, 3M's latest sales guidance, given in September, implies reported sales growth of just 0% to 3.6% in September -- the midpoint of which is lower than the 2% achieved in August. 

Data source: 3M presentations.

Second, industrial supply company Fastenal has already reported third-quarter earnings, and its CFO Holden Lewis said "products like 3-Ply masks and disposable respirators are oversupplied and prices have declined."

Given that 3M's Patolawala is expecting significant revenue growth from respirator sales, it's reasonable to conclude from Fastenal's commentary that 3M's weak-looking sales guidance for the third quarter could be due to price declines in respirators. That's something likely to negatively impact margin, as a recovery in healthcare margin is seen as the key to 3M's general margin recovery. 

What it means to investors

Looking ahead, it wouldn't be a surprise to see some margin pressure, and possibly disappointing sales figures from the healthcare segment. On the other hand, there's real evidence of an improvement in the industrial economy, and management may well discuss the likelihood of customers rebuilding inventory -- and that would be good news for sales in the future. 

All of that leaves the company delicately poised ahead of earnings. An improvement in 3M's industrial-based sales might be balanced with some disappointment in healthcare, with overall margin taking a hit.

As such, if there's any earnings/margin disappointment, then long-term investors might consider this an entry point into a very interesting value opportunity. Just be mindful that there's near-term risk in the stock around its respirator sales.