Industrial giant 3M (MMM 0.11%) will release its fourth-quarter 2021 results on Jan. 25 in what is likely to prove to be a pivotal year. To understand why and what 2022 might have in store for the company, you have to look back at what's happened in the last few years. Either 3M is a value stock about to engineer a significant turnaround in its stock's fortunes, or it's a company needing a fundamental restructuring. The potential outcomes are that polarized. Here's the lowdown.
3M stock no longer commands a premium
3M stock used to command a valuation premium compared to much of the industrial conglomerate sector. As you can see below, that premium has disappeared in recent years, and now the stock trades at a discount. For reference, EV is enterprise value (market cap plus net debt), and EBITDA is earnings before interest, taxes, depreciation, and amortization. It's an excellent way to compare companies with different debt loads.
Data by YCharts
3M vs. Illinois Tool Works
Its closest peer is probably Illinois Tool Works (NYSE: ITW), as both companies sell across a range of industrial sectors (common end markets include automotive, electronics, materials, and construction). However, 3M and ITW operate very different business models.
In a nutshell, 3M is a company that emphasizes spending on research & development (R&D) to develop and produce differentiated products that command pricing power. In contrast, ITW is a business that, according to the company, innovates "from the customer back, not from the research development center out." It's fair to say that ITW is more focused on refining products and solutions for its largest customers (so-called 80/20 rule whereby 20% of customers do 80% of its business) rather than developing brand new products as 3M does.
The difference in the companies has traditionally shown up in their metrics, too. The best way to judge pricing power is to look at gross profit margin (gross profit is profit after cost of goods sold, such as labor and expenses). You would expect 3M to have a higher gross profit margin, and that's still the case now.
Image source: Getty Images.
However, it's a different story regarding operating profit margin, as you can see below. This is simply the profit left after costs of goods and other items such as selling, general, and administrative, R&D, sales and marketing, depreciation, and amortization are excluded.
The evidence is clear; ITW is now significantly ahead of 3M. Part of this comes down to its highly successful enterprise strategy that emphasizes continually reshaping the company and its product lines to focus on its most profitable products and customers. It's a strategy that the highly impressive CEO Scott Santi set in place after taking over in 2012.
The other part comes down to lackluster performance on operating margin from 3M. In addition, 3M has been a serial underperformer in meeting its own guidance.
Data by YCharts
What management is doing to improve
CEO Mike Roman has not stood still since he became CEO in 2018. Since then, 3M has been restructured to operate out of four segments, not five. Roman changed the operating structure so its business groupings would be run globally instead of on a country-by-country basis. The underperforming healthcare business has been subject to multibillion-dollar acquisitions and divestitures , and 3M continues to restructure the segment. Meanwhile, the company spent $325 million on restructuring in 2021 to streamline the company and cut costs.
None of Roman and CFO Monish Patolawala's actions have shown up in 3M's margin performance as yet.
3M in 2022
The optimistic view will argue three things. First, the pandemic has obscured the optics around 3M's underlying progress. Second, end markets such as automotive and electronics have not been kind in recent years. Third, the company's valuation discount makes it an excellent value option.
Image source: Getty Images.
In contrast, the bearish view will argue that ITW and Santi started generating margin expansion pretty soon after implementing its enterprise strategy. This should be the case when a company aggressively implements a successful strategy. Moreover, 3M's R&D-heavy business model may need reassessing in light of the failure to expand margins. As a result, more large-scale restructuring than currently countenanced by Roman and Patolawala may be required.
The truth probably contains something from each side of the argument, but the bottom line is 3M needs to demonstrate some margin expansion in 2022. The good news is that management has the financial firepower to do so, and the stock's valuation is such that an improvement could lead to a strong bounce for the stock. On that basis, 3M is an attractive value stock, but cautious investors may want to wait and see what management says on margin first.
