What to do with 3M (MMM 0.46%) stock? The bulls will argue that the company's valuation and 6.3% dividend yield make it a compelling buy for a company in turnaround mode. Meanwhile, the bears will point to the company's lackluster growth history, disappointing 2024 guidance, and failure to generate meaningful margin expansion over the years. Here's what you need to know before buying the stock.
3M's challenges
In a previous article, I discussed the company's outlook for 2024 while outlining management's poor track record of meeting sales guidance. This isn't just an issue of management overpromising and underdelivering (although that's bad enough). It's also a question of whether the business is being run well.
It stands to reason that management structures its business and costs with its guidance in mind, and when it fails to meet expectations, there's likely to be margin pressure due to the extra cost in its structure. As such, it's no surprise that 3M has struggled with margins over the years. The following chart shows its gross margin performance, alongside that of multi-industry industrial Illinois Tool Works (ITW 0.05%) -- more on that in a moment.
MMM Gross Profit Margin data by YCharts
In a nutshell, a combination of lackluster growth (and remember, you should expect a company to grow revenue and earnings, at least a little bit, to keep up with inflation) and weak margin performance have led to mediocre earnings growth. And that's before considering the multi-billion dollar cash the company will drop due to legal settlements relating to its manufacture and use of PFAS chemicals and, allegedly, faulty combat arms earplugs.
3M's business model
I've referenced the importance of its sales guidance because sales, or volume growth, lies at the heart of its business model. 3M's management sees the company as an innovating company whose research & development teams are charged with developing high-quality, differentiated products. Indeed, 3M invented the so-called "vitality index" -- a measure of the share of revenue coming from recently developed products.
As such, the company doesn't use pricing to drive revenue growth, but instead relies on producing high-quality products that generate volume growth. From the volume growth, 3M gets margin expansion as it benefits from the scale advantages of ramping production. CFO Monish Patolawala noted in earnings calls that "volume gives us the best leverage."
Image source: Getty Images.
By leverage, he means the ability to grow margins as sales increase. Unfortunately, as alluded to earlier, this model isn't working. If 3M's sales (and therefore its volumes, as management doesn't use pricing to increase revenue) continually disappoint expectations, so will its margins -- and, ultimately, its earnings.
What next for 3M?
In response to these challenges over the years, 3M's management has tried to acquire its way to growth, notably with multi-billion dollar acquisitions in its healthcare segment. In 2019, it attempted to restructure the business by reducing its segments from five to four. In 2020, management announced significant job cuts and investments in IT to improve efficiency. In 2022, it announced it would spin off its healthcare business (to be completed soon), and more restructuring action followed in 2023.
Judging by the share price performance, none of these actions have worked, and they certainly haven't made money for shareholders over extended periods.
What 3M's management can do
All the measures above speak to piecemeal changes around the company's core business model of developing innovative products to drive volume growth. As such, management appears to have three loosely defined options:
- More piecemeal changes as it works through the current restructuring plan.
- Execute its business model better and rely on its research & development team to develop new products through more investment.
- Change its business model to be closer to something like Illinois Tool Works's model, which produced the kind of margin expansion shown above.
The ITW model focuses on its most significant revenue generators, its most important product lines and geographies (by ruthlessly paring less profitable ones), and, above all, "customer back innovation." The latter refers to innovating products in line with customer feedback rather than being research & development-led in the 3M model. Focusing on its most profitable products and customers would allow 3M to use pricing more to drive revenue growth.
Image source: Getty Images.
To be fair, management is now doing some of the things more associated with the ITW model in its current restructuring. For example, on the recent earnings call, CEO Mike Roman noted that "in our consumer business, we have identified approximately 5% of the portfolio where we have limited market growth and a poor right to win" and intends to exit them.
Still, until management can demonstrate a sustained period of acceptable revenue growth with margin expansion, there will still be concerns that it's not on the right track.
Buy, sell, or hold?
There is a value case for the stock; it would be substantial without the fundamental questions around its business model, as discussed above. At the least, 3M needs to break the cycle of missing sales guidance, delivering disappointing margins, and then embarking on restructuring activity. Until 3M does this, cautious investors will put it on the monitor list.
