Investors were understandably nervous when 3M (MMM 0.46%) reported third-quarter earnings as the market has been particularly volatile this year, but the report was actually pretty good under the circumstances. There are some good underlying signs of improvement in the business, and the company is more investable as a consequence. The company may not be firing on all cylinders just yet, but the stock offers a compelling investment option. Here are the five key reasons why.
1. Under-promise and over-deliver
After a few years of doing precisely the opposite, it was good to see the company start to exceed its own guidance. Specifically, sales and operating margin came in better than expected. It's a development that investors should welcome, and hopefully, it will be the start of a trend.
3M looks favorable valued on a risk-reward basis. Image source: Getty Images.
Going back to the sales report in the middle of September, management had forecast third-quarter sales to be in the range of $8.2 billion to $8.3 billion, and on the second-quarter earnings call management forecast third-quarter operating margin of 20%-21%. The good news is that 3M beat both figures, with $8.35 billion in sales and adjusted operating margin of 22.9% in the quarter.
Turning to the guidance for the fourth quarter, management expects adjusted operating margin of 21% -- a figure above the 19% recorded in the fourth quarter of 2019. Moreover, given that management didn't give sales guidance for the fourth quarter, it's possible that margin could come in a bit ahead if volumes are better than management's assumptions.
2. 3M is regaining pricing power
3M prides itself on investing in innovation in order to make differentiated products with pricing power. As such, it's very important for investors to see that 3M can generate pricing improvement alongside increasing volume. Here again, 3M is showing signs of improvement.
The chart below shows that 3M appears to be back on track in 2020. A pricing improvement of 0.5% in the second quarter and 0.6% in the third quarter is quite impressive given the volume decline in the second quarter and weak conditions in the third.
If 3M can continue to demonstrate pricing power then it will help insulate the company from potential volume declines in the future due to a weakening in the economy. Similarly, pricing power is a demonstration that CEO Mike Roman's efforts to restructure the company are bearing fruit.
Data source: 3M presentations. YOY=year over year.
3. Sales could recover
3M's management did not give sales guidance on the earnings call, other than saying October sales growth will be "flat to low single digits." However, there is an argument supporting the idea that 3M is due a bounce in sales.
In response to Wolfe Research analyst Nigel Coe's question on restocking, Roman said "we haven't seen strong restocking across most of our portfolio," and "the channel has been cautious" even up until October. This is actually a positive sign, as 3M's sales may well be due for a pickup if and when its customers start replenishing inventory that's being sold off as the economy recovers.
4. Diversification should help sales growth stability
That being said, there were some worrying signs from the earnings presentations. For example, the lack of sales guidance is a concern, and one that highlights the ongoing uncertainty in the economy.
Moreover, discussing the healthcare segment during the earnings call, CFO Monish Patolawala disclosed that "while we have seen improvement in both medical and dental procedures, currently, procedures are leveling off and are forecasted to remain below pre-COVID levels through the end of 2021." He would later go on to say that healthcare margin performance was partly contingent on elective procedure volumes in the quarter.
Such commentary is obviously worrying, particularly if it's accompanied by weakness in the economy and more lockdowns. On the other hand, it's worth noting that such an environment would be favorable for 3M's COVID-19-related products such as respirators, home improvement products, biopharma filtration, and separation purification.
5. Free cash flow generation remains excellent
Adjusted free cash flow (FCF) was up 13% to $2.2 billion in the quarter, and up 19% to $4.6 billion on a year-to-date basis. Given that FCF was $1.8 billion in the fourth quarter of 2019, 3M's 12-month trailing FCF is $6.4 billion, a figure that makes Wall Street analyst forecasts for $5.4 billion in 2020 FCF look easily achievable.
Using the $6.4 billion figure means 3M trades at just 14.7 times trailing FCF, and using the analyst forecast for 2020 means it trades at 17.4 times FCF.
While some industrial companies can see a boost to FCF during recessions -- they run down inventory, curtail capital spending, and hold back on orders -- 3M's performance is still very good. Moreover, 3M's reported price to FCF multiple is attractive on an absolute basis, and when compared to those of its competitors and peers.
Data by YCharts
Looking ahead
All told, it wasn't a great report, but based on 3M's valuation it didn't need to be in order for investors to feel the stock can go higher from here. As such, 3M remains one of the most interesting value options for investors in the industrial sector. Throw in a 3.7% dividend yield and the stock should be very attractive for dividend investors.
