3M: Buy, Sell, or Hold?

Industrial giant 3M's (MMM 0.33%) 6.4% dividend yield is eye-catching and will likely have tempted some income-seeking investors into the shares lately. That's fair enough, but is 3M a stock that most investors might want to buy considering all of its current challenges? Here's the lowdown. 

3M is full of uncertainty

The company's high-profile legal issues have been well-documented, but they shouldn't keep investors from identifying the underlying issues around the company. I'm talking about management's efforts to try to turn around its long-term profit margin decline. 

I'm highlighting gross profit margin and earnings before interest, taxation, depreciation, and amortization (EBITDA) margins to demonstrate two issues with the company. First, gross margins (a helpful indicator of how much pricing power a company has) have declined, indicating the company's competitive position has declined overall. Second, EBITDA margin has fallen too, suggesting the company's productivity isn't what it once was. 

MMM Gross Profit Margin (Annual) data by YCharts

3M's model isn't working anymore

Complicating matters somewhat is that 3M relies on volume growth to drive margin expansion. This isn't unusual in the industrial world, and certainly not in a multi-industry company like 3M, which makes roofing granules, adhesives, safety products, advanced materials, wound care products, medical solutions, home goods, stationery, and many more items. 

In a nutshell, 3M tries to use its research and development facility to create high-quality, differentiated products and then build sales volumes on the back of the quality of its products. If you are interested in such matters in more detail, consider the comparison with a company like Illinois Tool Works, whose product development and portfolio of products are led by the feedback from its leading customers rather than by its research and development. 

Turning back to 3M, as its volume grows, the company should generate economies of scale, meaning that the cost per unit production is falling -- and, hey presto, margin expansion. Unfortunately, there have been a couple of problems with this idea for 3M in recent years. 

Image source: Getty Images.

First, 3M's gross margin performance (see chart above) indicates it is losing pricing power, which suggests its products are not commanding the same market presence as they used to; hence, the company is struggling to increase volumes. 

Second, as previously outlined, 3M's management has a poor track record of meeting its sales guidance, which implies it is also missing its volume guidance. That's problematic because it suggests management isn't accurately addressing its product portfolio. It also means wasteful costs as the company is structured for a level of volume that it doesn't ultimately hit and then encumbers the company with expensive and disruptive restructuring actions. 

All told, 3M isn't generating the volume growth to drive EBITDA or operating profit margin expansion, and there are questions about its product pricing power. 

Some good news on profit margins?

3M's management hasn't stood still in the face of margin decline. Earlier this year, it announced another major restructuring plan to streamline its corporate operations, change its marketing model in multiple countries, cut jobs, and simplify its supply chain structure. 

CFO Monish Patolawala pointed out some good news on the second-quarter earnings call by pointing out that going into the year "operating margin will be somewhere in that 18.5% to 19% range. Sitting right now with a lower revenue number with a higher EPS number, we believe that we'll be somewhere in that 19.5% to 20% range, which includes all the charges and all the benefits."

Image source: Getty Images.

Declining expectations

If the upgraded margin performance expectation is a sign of a turnaround in progress, then there would be reason to argue that 3M is starting to show investors it has a handle on the issue.

Unfortunately, any underlying progress on its margin could be undermined by the company missing its sales guidance. On the Q2 earnings call in July, management told investors that sales were tracking toward the low end of its full-year organic sales guidance of a 3% decline to being flat on 2022. Fast-forward to September, and management told investors that its third-quarter sales would be $7.9 billion to $8 billion compared to prior guidance of $8 billion.

Moreover, the segment best positioned to meet its full-year guidance (healthcare) is set to be spun off.

Data source: 3M presentations. LSD = low single digits. MSD = mid single digits.

All told, 3M looks likely to miss, or at best, hit the bottom of its full-year sales guidance. That lack of sales and sales volumes will impact its margin performance, making it even harder to see if management is turning the corner on its margin generation with its restructuring efforts. That will likely make it hard for many investors to buy the stock.