It's no secret that 3M (MMM 0.46%) needs management action to improve performance. Growth has been hard to come by in recent years, and the company's earnings margins have disappointed. With this in mind, the announcement of a deal to combine its food safety business with Neogen Corp (NEOG 1.50%) grabs the eye. But what does it mean for investors and the investment thesis? Here's the lowdown.
What happened
3M agreed to combine its food safety operations with Neogen in a deal to create a company with $1 billion in revenue in its first full year. 3M will separate its food safety business and combine it with Neogen in a tax-free "Reserve Morris Trust" transaction. The details of the deal:
- 3M shareholders will own 50.1% of the new company, with Neogen shareholders owning the remaining 49.9%.
- 3M will receive $1 billion in consideration, subject to adjustments.
- According to 3M's management, the deal "implies an enterprise value for 3M's Food Safety business of approximately $5.3 billion" and "represents an implied multiple of approximately 32x" adjusted earnings before interest, taxation, depreciation, and amortization (EBITDA) before synergies come from the combination.
Image source: Getty Images.
Initial thoughts
Two points immediately spring to mind. First, the implied multiple may seem high, but the fact is the market is valuing such businesses very highly. For example, Neogen itself trades on an enterprise value (market cap plus net debt) of 41 times its estimated EBITDA for fiscal 2022. As such, the deal shouldn't be seen as value-enhancing in itself. However, if 3M's business is better run by Neogen and the new company generates significant synergies, then the 50.1% stake owned by 3M shareholders will indeed be valued higher.
Second, divesting the food safety business will not move the needle much in terms of 3M's investment proposition. In the third quarter, the food safety business represented just 4.3% of the healthcare segment and a paltry 1.1% of the total company revenue.
As such, the deal in itself will not change much about the investment thesis for the stock. However, there is another way to look at it.
What it does mean to investors
A more positive take on the deal is to welcome it as a sign of management's recognition that its healthcare segment lies at the heart of its disappointing performance in recent years. Moreover, it implies that management intends to do something about it.
To illustrate just why the healthcare segment is so vital to 3M's restructuring, first, here's a look at how 3M's total full-year organic growth rate has matched up to the initial guidance given at the start of the year. Unfortunately, it does not make for satisfying reading.
| Metric |
2014 |
2015 |
2016 |
2017 |
2018 |
2019 |
2020 |
|---|---|---|---|---|---|---|---|
|
Organic local currency growth |
4.9% |
1.3% |
(0.1%) |
5.2% |
3% |
(1.5%) |
(1.7%) |
|
Initial guidance |
3% to 6% |
3% to 6% |
1% to 3% |
1% to 3% |
3% to 5% |
2% to 4% |
0% to 2% |
Data source: 3M presentations.
The healthcare segment has disappointed the most. For example, on the investor day presentations in 2016 and 2018, management told investors it was targeting 4% to 6% annual growth for the healthcare segment over a four-year horizon.
As you can see below, the healthcare segment only broached the midpoint of the medium-term healthcare annual guidance (5%) in two quarters from 2015 to the third quarter of 2020. The extra growth from the third quarter of 2020 to the second quarter of 2021 is primarily due to the distortive impact of the COVID-19 pandemic.
Data source: 3M presentations, YOY= year over year.
The good news is that the food safety deal continues management's restructuring of the healthcare segment. For example, 3M bought medical device company Acelity for an enterprise value of $6.7 billion and M*Modal's technology business, which provides artificial intelligence for physicians, for an enterprise value of $1 billion. Both deals took place in 2019. Meanwhile, 3M sold "substantially all" its drug delivery business for $650 million in 2020.
In addition, management continues to restructure the overall company, and it's probably not a coincidence that CFO Monish Patolawala (appointed in 2020) was hired from General Electric, where he served as the CFO of GE Healthcare.
The key takeaway
All told, the deal is not particularly significant to the investment thesis unless it's looked at in the context of management's ongoing restructuring of the company. It's another step in the right direction, but management will have to demonstrate some hard evidence of progress in 2022 before investors are fully confident in the stock.
