3M's (MMM 0.33%) management raised its full-year sales guidance midpoint but lowered its earnings during its third-quarter earnings report. Its earnings highlighted one of the themes of the current earnings season. Underlying demand is good, but there's pressure on costs and the ability of companies to meet that demand.

In such an environment, it's becoming increasingly important for companies to raise prices, but unfortunately, 3M had some bad news on that front. Let's look at the details behind the third quarter, and why its margin performance is so important.

3M's guidance

Looking at the changes in 3M's guidance through 2021 says a lot about the industrial sector this year. 3M started the year in recovery mode. However, in January, management gave some pretty broad guidance for sales growth, something reflective of the uncertainty over the pace of the reopening of the economy.

Person holding arrow and looking forward through binoculars.

Image source: Getty Images.

Fast forward to the summer, and 3M significantly upgraded sales guidance and nudged earnings guidance higher too. The reason for the sales guidance hike comes down to a generally better-than-expected economic recovery. In contrast, the relatively milder earnings guidance hike reflects the growing pressure on costs from rising raw material prices and increased supply chain costs.

Of course, the two things (raw material and supply chain costs) come from a common source. As a result, demand is coming back strongly. However, supply is struggling to keep pace due to a combination of many factors. These include cutbacks and a shortage of investment spending during the pandemic, the disruptive effect on spending trends caused by COVID-19, and the difficulty in reopening offices, schools, and factories with the pandemic still in place. Simply put, demand is outstripping supply for many vital materials and services right now.

In such an environment, it becomes increasingly important to increase productivity, raise prices to offset cost increases, and take advantage of strong volume demand. Unfortunately, the latest guidance from 3M (full-year sales guidance increased but earnings guidance cut) suggests the company is struggling to do so. Changes are in bold.

3M Guidance As of October As of July As of April As of January
Organic local-currency sales growth 8%-9% 6%-9% 3%-6% 3%-6%
Earnings per share $9.70-$9.90 $9.70-$10.10 $9.20-$9.70 $9.20-$9.70
Free cash flow conversion 90%-100% 90%-100% 95%-105% 95%-105%

Data source: 3M presentations.

3M's price and cost relationship

When discussing margin performance, 3M's management highlights two essential items that help move margin. The first is the contribution to margin from "organic volume/productivity and other." This combines the change in margin from increases or decreases in volumes and the costs and benefits from productivity. In the current climate, volume growth is strong, but it's more than offset by increased costs due to supply chain challenges.

The second is "price/raw material" -- in other words, the contribution to margin from the difference in price movements and costs.

The movements are measures in terms of basis points, where 100 basis points (bp) equals 1%, so the 290bp move (see chart below) in the margin in the third quarter represents the year-over-year decline in margin from 22.9% to 20%.

The chart shows how substantial volume increases offset increased supply chain costs and a decline in price/raw material in the second quarter. However, supply chain costs surged in the third quarter despite increasing prices by "140 basis points in Q3 versus ten basis points in Q2" according to CFO Monish Patolawala on the earnings call, and price/cost was negative again.

Chart showing 3M's margin breakout.

Data source: 3M presentations.

A disappointing performance

Frankly, it's a somewhat disappointing performance. 3M certainly isn't alone in facing cost pressures, but price/raw material has been negative for the last three quarters, while it appears 3M needs substantial improvements in volume to generate a positive contribution to margin from volume/productivity.

There was some more slightly disappointing news from Patolawala. He disclosed that 3M now expects the restructuring actions announced last year would now result in "pre-tax restructuring charges of $300 million to $325 million versus our original expectations of $250 million to $300 million."

Moreover, as a reminder, 3M has been restructuring its business over the last few years. However, it's not showing up much in its numbers just yet.

A "Buy stock" button on a keyboard.

Image source: Getty Images.

Looking ahead

Trading on 18.4 times estimated 2021 free cash flow and 18.2 times its estimated 2021 earnings and sporting a 3.3% dividend yield, 3M remains a decent value investing option. However, for the stock to move meaningfully higher, its management will have to demonstrate better pricing performance and some productivity improvements in the future.