Is This Industrial Giant's Stock a Buy?

Industrial giant 3M's (MMM 0.19%) second-quarter earnings report left more questions than answers. On the plus side, the reopening of the economy is creating a positive backdrop for many of 3M's cyclically exposed businesses. On the other hand, 3M faces cost pressures from rising raw material prices and supply chain issues (a familiar refrain in the current earnings season). As a result, investors could be forgiven for expecting a bit more from its earnings and guidance.

Image source: Getty Images.

3M's earnings and guidance

First things first, it's important to note that 3M did report a good quarter, and management raised its full-year guidance. Organic sales growth came in at a whopping 21.4%. As you can see below, the increase was broad-based across its various segments. However, that's largely down to an easy comparison with the horrific second quarter of 2020 when the COVID-19 pandemic affected markets, so don't expect 3M's revenue to grow at anything like this rate again soon.

Data source: 3M presentations. YOY = year over year. Chart by author.

That performance in the second quarter was enough to encourage management to raise its full-year guidance.

Data source: 3M presentations.

On a superficial level, it's a positive earnings report, and investors have cause for optimism. That said, there are some concerns here.

Two factors for investors to consider

First, the increase in earnings per share (EPS) guidance is not that impressive. 3M increased its organic sales growth from a range of 3%-6% to a range of 6%-9%. That's a pretty significant increase, and speaks to the improvement in the global economy. However, the EPS guidance hike is only 4.8% at the midpoint. In fact, the high point of the old range ($9.70) is the same as the low point of the new range.

Part of the reason for this comes down to issues that most other industrial companies are also facing: Raw material price rises and supply chain issues. To be fair, it's important to note that the main reason raw material prices are rising is that the same end markets that 3M is exposed to are growing strongly. However, the net result is that 3M is having difficulty translating sales growth into significant earnings growth.

Rising commodity prices are negatively impacting 3M's profit margin. Image source: Getty Images.

Pricing power?

Second, management plans to deal with rising raw material prices by increasing its selling prices. However, CFO Monish Patolawala seems to be behind the curve on this issue. Having started the year expecting EPS headwinds of zero to $0.10, he increased it to $0.20, then to a range $0.30-$0.50 on the first-quarter earnings call, only to increase it to $0.65-$0.80 on the recent earnings call. 

The company plans to respond by raising prices to offset the cost increases. Unfortunately, Patolawala expects the "selling price and raw materials headwind" to continue in the third quarter, negatively impacting profit margin. However, he anticipates it "will turn to a net benefit in the fourth quarter as our selling price and other actions start catching up to the increased costs."

Herein lies the problem. Does 3M have the overall pricing power to push through sales increases to offset cost increases? Price increases may result in a net benefit to profit margin, but what will they do to volumes? As the chart below demonstrates, 3M managed to increase price and volume in only four of the last 13 quarters before the pandemic in its home Americas region.

Data source: 3M presentations. Latin America and Canada were merged with the U.S. into the Americas region in the first quarter of 2020.

Is 3M a buy?

On balance, 3M still looks like a good value, but some investors will be watching 3M's second-half earnings like hawks. Any pressure on sales volumes resulting from the planned price increases will lead to a disappointing sales performance, and ultimately disappointing earnings. As a result, 3M still deserves the benefit of the doubt, but investors' patience will wear thin if there are any disappointments in 2021.