3M’s First Quarter Beat Undermined By Guidance And More-Of-The-Same Restructuring

Summary:

• 3M posted surprising strength at the segment operating profit line, but Q2 guidance was soft, and a higher weighting to 2H’23 performance seems risky to me.
• Management announced a restructuring effort that includes headcount reduction, streamlined supply sourcing, and refined go-to-market approaches, but this sounds like more of the same and less than what is needed.
• Litigation remains a major risk. PFAS litigation will likely take years to resolve, but there could be more progress on the earplug litigation in the coming months.
• 3M is arguably undervalued. But it’s tough to be positive when I don’t believe management has a real vision or strategy to position 3M as a leading multi-industrial in secular growth markets.

For some time now I’ve been arguing that 3M (NYSE:MMM) management needs to fundamentally reevaluate the businesses and markets in which the company operates and consider large-scale moves to better position the business for future growth. Relative to peers like Danaher (DHR), Dover (DOV), Eaton (ETN), Honeywell (HON), and Parker Hannifin (PH), 3M has seemed more than just reluctant to rock the boat and rethink about what the company should look like in 2025 and beyond, and the company’s approach to M&A has been lackluster at best.

I continue to believe that this is the biggest risk facing investors – that management is simply too staid and too unimaginative to make the changes that are needed. Whether or not that’s truly the biggest risk is of course debatable, as the company continues to face potentially huge payouts for its PFAS and earplug liabilities. In the meantime, 3M remains leveraged to weak consumer markets and softening industrial markets.

Down almost another 20% since my last update, 3M has underperformed the broader industrial group by a similar amount, as well as better-performing names like Dover, Ingersoll Rand (IR), and Parker. Although the shares do look potentially undervalued at this point, I believe there’s more turbulence ahead and I think it may take activist investor involvement to force more meaningful changes.

Strong Earnings Against A Lowered Bar

3M management set relatively low expectations for 2023 results when it gave guidance with Q4’22 results, and it seems as though better industrial markets (or at least “less bad”) helped drive some of the upside.

Revenue fell 5.6% in organic terms, but that was still good for a 2% to 3% beat vs. sell-side expectations (depending upon which source you use). Only Healthcare grew (up a little more than 1%), but all four segments beat sell-side expectations.

Gross margin fell 270bp year over year and 60bp quarter over quarter to 42.6%. Adjusted operating income declined 27%, with margin down 410bp to 17.9%, while segment-level profits declined 23% and 3M beat expectations by a hefty $0.18/share at this line.

Safety and Industrial revenue declined 6%, beating by more than 4%. Abrasives, electrical materials, and autos were all strong (up high single-digits) as manufacturing and auto end-markets have held up better than expected – which should bode well for companies like Illinois Tool Works (ITW), Parker, and so on. Segment profits fell 19%, with margin down 240bp to 20.2%.

Transportation and Electronics revenue fell 11%, beating by 1%. Auto and aerospace sales were strong (up low double-digits), and advanced material sales (a business leveraged to EVs) were up high single digits, but electronics sales declined 35% on well-known weakness in phones, tablets, TVs, and other consumer electronics. Segment profits declined 36%, with margin down 550bp to 16.7%.

Healthcare revenue rose a bit more than 1%, with a little bit of growth in oral care and medical products offset by high single-digit declines in separation and purification tied to higher comps created by the pandemic in the year-ago period. Segment profits declined 19%, with margin down 300bp to 17.9%.

Consumer revenue declined almost 7%, but did beat by close to 5%. Home improvement declined significantly (down double digits) and only stationary and office products showed growth (low single digit at that). Profits declined 19%, with margin down 180bp to 15%.

Restructuring – An Opportunity Likely To Be Squandered By “More Of The Same”

With first quarter earnings management also announced a new restructuring effort. This looks like a fairly by-the-book restructuring effort, with management looking to fire 6,000 workers, streamline go-to-market efforts, and simply its supply chains to drive $700M to $900M in savings.

Management also talked about prioritizing high-growth markets like auto electrification, personal safety, home improvement, semiconductors, and healthcare, while also investing in opportunities in climate tech, industrial automation, next-gen electronics (including AR/VR), and sustainable packaging.

Unfortunately, this collection of initiatives looks quite similar to numerous prior initiatives… which all accomplished rather little. Improving supply sourcing and go-to-market is fine, but I’m skeptical about the ability to execute on these growth initiatives – remember, this is a company that has claimed in the past that it’s leveraged to industrial automation because it makes abrasives and adhesives that can be used by robots (technically correct, then, but not exactly the sort of leverage most investors are looking for). I also take issue with the notion that personal safety and home improvement are true “high-growth markets.”

I’ve said before that I think management needs to take a much more serious look at a comprehensive restructuring of its businesses. Many of the companies I’ve mentioned before in this article have used business sales and spin-offs to alter their capital structures and pave the way toward acquiring more promising businesses. I’d like to see 3M follow that path, but the reality is that management’s M&A track record is not good and large legal liabilities tied to PFAS and earplug litigation limit flexibility. Spinning off the Healthcare operations is certainly a big move, but I do think there’s more to do as 3M minus Healthcare is hardly a better company.

The Outlook

Management’s guidance for the second quarter was weaker than expected, and full-year guidance is looking more weighed to the second half now. It’s certainly possible that industrial end-markets could hold up better than feared, but I do have concerns about further weakness in industrial end markets.

I continue to value 3M on the basis of estimates that work out to around 2% long-term revenue growth and mid-single-digit free cash flow growth. I likewise use a 12.5x forward EBITDA multiple that is driven by 3M’s margins and returns (ROIC, et al). These approaches give me a fair value range from $122 and $143, and that includes an estimate of over $30B in legal payouts tied to PFAS and earplug litigation – estimates which could certainly prove to be meaningfully wrong in either direction despite recent updates suggesting that a meaningful percentage of plaintiffs in the earplug litigation may not have the hearing damage they claim.

The Bottom Line

I still hold a small position in 3M, but I have less and less faith in management at this point. I feel they have been too slow to recognize new opportunities across its broad range of industrial markets and have been all to willing to settle for run-of-the-mill restructuring efforts to drive improvements. I do think the potential for better is here, but it may well require the involvement of activist investors and the scale of potential legal payouts still remains a major risk factor.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of MMM either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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