3M (MMM 0.47%) is a company and a stock under pressure. The shares continue to look like a good value for the long term, but that depends on management delivering on its turnaround plans.
The good news is that the company has plenty of financial firepower to do so and is actively pursuing changes. The bad news: There's little hard evidence that the restructuring is having a significant impact, and the upcoming first-quarter earnings report on April 27 might confuse more than it clarifies.
Image source: Getty Images.
The case for buying 3M stock
The investment thesis is not based on the company that 3M is now, but on what it could become. Simply put, CEO Mike Roman's task is to use the company's substantive earnings and free cash flow (FCF) to turn around 3M's performance.
The company generates bundles of earnings before interest, depreciation, amortization (EBITDA), and FCF. Its price-to-FCF valuation looks cheap, especially compared to a multi-industry peer like Illinois Tool Works, trading at nearly 28 times its FCF.
Data by YCharts. TTM = trailing 12 months.
What's been going wrong
The reason 3M trades at a discount to Illinois Tool Works comes down to a combination of its potential legal liability for PFAS chemicals and its underperformance on earnings relative to management expectations.
3M operates out of four segments. The safety and industrial segment and the transportation and electronics segment have significant exposure to the industrial economy and automotive industry. And given weak end-market conditions in recent years, it's understandable if they have performed poorly. However, what isn't forgivable is that the less cyclical segments, namely healthcare and consumer, have disappointed the most.
For example, back on investor day in late 2018, then-CFO Nick Gangestad outlined expectations for 2019-2023 total company organic revenue growth of 3% to 5% a year, with the healthcare segment up 4% to 6% and the consumer segment up 2% to 4%.
While 2020's performance is understandable in the context of the pandemic, the performance in 2018-2019 is disappointing. In case you are wondering, the consumer segment received a major boost in 2020 from stay-at-home measures lifting home improvement sales.
|
Organic Sales Growth |
2020 |
2019 |
2018 |
|---|---|---|---|
|
Safety & Industrial |
3.5% |
(3.3%) |
N/A* |
|
Transportation & Electronics |
(7.1%) |
(3.5%) |
N/A* |
|
Healthcare |
1% |
1.6%** |
2.6% |
|
Consumer |
4.1% |
1.3%** |
1.5% |
|
Total Company |
(1.7%) |
(1.5%) |
3.2% |
Data source: 3M presentations. *3M shifted to operating out five business segments to four. **In 2019, The healthcare segment added the separation and filtration business, and the consumer segment added the retail auto care business. Both relatively small businesses.
What 3M has been doing about it
The good news is that Roman is taking action, in particular with the healthcare segment. The non-core drug delivery business was sold for $650 million in 2020., On the acquisition front, 3M bought M*Modal's health information systems business for $1 billion in early 2019. Management followed up by buying Acelity (specializing in advanced and surgical wound care) for $6.7 billion at the end of 2019. Also, the food safety business is rumored to be another business that management is willing to sell.
On top of the acquisitions and divestment activity, Roman has restructured the company from five business segments to four and streamlined the operation by cutting positions. Also, he has changed the company's business model by allowing 3M's business groups to run on a global basis rather than being operated on a country-by-country basis.
Image source: Getty Images
In case there are any doubts that turning around the healthcare segment wasn't the main focus, it's not a coincidence that the former CFO of GE's (GE 4.98%) Healthcare business, Monish Patolawala, was appointed as 3M's CFO in July 2020.
It's time for 3M to deliver
With all these actions in place, investors are entitled to expect improvements to start showing through in 2021, starting with the upcoming first-quarter earnings report on April 27.
Unfortunately, the company faced headwinds in the first quarter, and they are likely to make its earnings report messy. For example, automotive production (a major end market for 3M across its industrial segments) has been hit by the semiconductor shortage, and rising raw material costs are eating into profit margins, according to Patolawala. Meanwhile, healthcare is likely to be impacted by the pandemic in the first quarter.
On the other hand, the recovery in the industrial economy is taking shape in the U.S., and many of 3M's end markets will be strengthening. Also, since management has articulated that there hasn't been an inventory buildup by its customers, it might kick in at some point in 2021 as the economy recovers.
What to expect
It's unclear what 3M will report, and the market could be disappointed if it doesn't raise guidance in an environment where many of its peers may well do so. However, what is clear is that 3M's earnings report will be messy, and if you are looking for strong evidence that the turnaround is showing in the numbers, you are unlikely to find it in the upcoming results.
There is a strong case for buying/holding the stock, but management needs to start delivering in 2021, particularly in the healthcare segment.
