3M: Near-Term Growth Looks Limited, But A Fresh Start Is Welcome (Upgrade)

Summary:

• 3M Company’s second quarter results are expected to be lackluster compared to peers in the multi-industrial sector, with organic contraction of around 1% versus 2%-3% growth for the group.
• Auto electrification and electronics should be comparatively healthier businesses, but short-cycle manufacturing consumables could be weak; 2H ’24 guidance will be important.
• 3M made a surprising move, naming Bill Brown as the new CEO; I like the prospects for meaningful transformation, but there’s likely a lot of work ahead.
• Revenue growth of around 3% and high-teens FCF margins can support a fair value around $115 today, but transforming 3M back into a top-quartile multi-industrial could unlock a lot more.

It has been a rough road to get to this point, but 3M Company (NYSE:MMM) investors actually have some reason to be optimistic about the future, and it’s been too long since that has been the case.

While not everything that has bedeviled this industrial conglomerate can be laid at the feet of the now-former CEO – the acquisition of Aearo and its earplugs, as well as the production of PFAS chemicals predate his tenure by a wide margin – unimaginative leadership has nevertheless left the company with a lackluster collection of assets that have been underperforming more dynamic peers like Eaton (ETN), Honeywell (HON), and Parker-Hannifin (PH) for some time.

There is still quite a lot of work to be done at 3M. This includes resolving additional PFAS litigation. While there are some attractive businesses within this conglomerate, there are also quite a few businesses unlikely to outgrow underlying industrial production by all that much. The valuation is not demanding for investors who can afford to be patient, but the sharp run up in the shares does reflect a lot of benefit of the doubt already.

Second Quarter Results Are Likely To Be Lackluster Once Again

I don’t expect that 3M will post a meaningful miss with its upcoming second quarter results (expected pre-market on July 26th), but I think a standout performance is also a bit much to expect. Relative to a multi-industrial sector that I expect will report around 2% to 3% organic revenue growth, I expect around 1% contraction from 3M.

I’m not particularly bullish on companies with a lot of short-cycle industrial exposure right now, and that certainly includes 3M, as well as names like Fortive (FTV) and Illinois Tool Works (ITW). Instead, I expect companies like Dover (DOV), Eaton, Emerson, and Honeywell to be the better performers.

Working in 3M’s favor, I expect content gains to drive another quarter of growth in auto above underlying production volumes (how much above is a great question, as the prior quarter was a strong performance). While EV sales have been disappointing so far this year, 3M has nevertheless seen meaningful content gains from electrification, both within and beyond the powertrain.

I’m also relatively bullish on the electronics business. Consumer electronics demand is looking a little better, and 3M also has leverage to improving conditions in semiconductors and ongoing growth in data center (it’s not enough exposure to make it a “data center play,” but it’s enough to help boost results).

I’m not as bullish on core areas like abrasives, adhesives, masking solutions, and the like. Although not impossible, it would be a little strange to see companies like Lincoln Electric (LECO) and Fastenal (FAST) to have the challenges they’ve had lately and see businesses like these doing well at 3M. The bigger question I have is really about second half guidance and whether 3M (as well as other short-cycle industrials) expects growth against what should be easy comps.

Time For The New CEO To Get To Work

The market did not expect the announcement of the CEO change in March, but it certainly has liked the appointment of former L3Harris Technologies (LHX) CEO Bill Brown as the new CEO of 3M. Given the success of his tenure there, as well as the relatively quick results produced at some other turnarounds lately (I’m thinking specifically of Larry Culp at GE (GE), but the same could be said for ABB (OTCPK:ABBNY) and a few others), the Street definitely thinks this move will improve 3M’s fortunes.

I agree, but I do think there is likely a lot of work that needs to be done. Maybe this is an unfair take, but I look at what we know about Solventum (SOLV) now that that is independent and disclosing more detail, and I’m not impressed. Likewise, while you can certainly make the argument that Neogen (NEOG) has flubbed the acquisition and integration of 3M’s food safety operations, it also appears to be the case that those businesses weren’t in the shape that Neogen management expected.

In other words, I’m concerned that now that Brown has started poking around under 3M’s hood, he’s going to find a lot of work that needs to be done. It is my belief that 3M has not really invested properly in innovation for some time (focuses on iterations/reiterations of existing products rather than developing new ones) and that the company has taken a counter-productive approach to margin improvement (focusing more on costs than process or value). None of that being true would mean that the turnaround is doomed, but it may change Brown’s priorities for returning 3M to a more attractive growth and margin story.

It’s likely too soon to expect the new CEO to have a lot to say about new directions for the company, but I think this needs to be part of the conversation. Quite a few of 3M’s peers have refined, remodeled, or remade themselves over the last decade, while 3M was more or less content to stand pat.

The company does have leverage to some growth markets (including electronics / electrification, automation, and renewable energy), but there’s a lot here that’s core short-cycle industrial. It’s high-margin, to be sure, and 3M still enjoys strong share in many of its legacy businesses, but I think it’s going to take some M&A (including additional potential sales or divestitures) to get 3M where it needs to be again.

The Outlook

I’m expecting a pretty undramatic second quarter; as I said, I expect 3M to generate pretty lackluster growth on a comparative basis, but that’s already expected. I see some modest risk of the Street being disappointed if the CEO isn’t ready to make meaningful remarks about the new direction he sees for the business (I said it’s a risk, I didn’t say it was a fair or reasonable expectation). There also is some risk of a softer 2H ’24 guide for a market that definitely wants some reassurance.

Modeling the business is a special challenge now, as I expect whatever I model to likely be wrong, as it does not anticipate major strategic shifts for the business. That said, I still think that a little less than 3% long-term revenue growth is a reasonable expectation for the business as it stands today. I do expect EBITDA margins to move toward 28% over the next three years, and I expect high-teens free cash flow margins to support mid-single-digit FCF growth.

One significant unknown remains the outstanding litigation over PFAS contamination/pollution. 3M has settled its Combat Arms earplug litigation and settled with public water supplies on PFAS. However, there are still outstanding personal injury, civil litigation, and resource damage claims to resolve, and those are likely to amount to many billions of dollars of payouts over the years (I believe my prior expectation of around $30B in payouts for all of 3M’s litigation issues could still prove in the ballpark).

Between discounted cash flow and margin/return-driven EV/EBITDA (12.5x), I get a fair value of around $115 for 3M today. In both cases, this includes an estimated net present value of future payouts for unresolved litigation.

The Bottom Line

Maybe this will sound a little counterintuitive, but the thing I like least about 3M right now is how so many sell-side analysts have reversed their opinions and gone from neutral or sell ratings to buy ratings following the CEO change. I do think it is very much a change for the better, but I feel like these actions (and the stock price reaction) already prices in many successful turnaround efforts. None of that makes 3M a bad call, but it does likely set a higher bar for the CEO’s messaging and execution over the next 12–18 months. Of course, I’m guilty of this too, as I’m moving to a “Buy” now as well, even after the shares have climbed about 20% since my last update (underperforming the industrial sector over that time, though). I do think the shares offer comparatively interesting upside in an otherwise expensive-looking sector.

I do still believe that 3M is fixable, and I have a great deal more confidence that new leadership will be willing to go beyond the staid and predictable steps I’m used to from 3M. However, it’s still going to take time to reshape 3M back into a top-tier player in the multi-industrial space.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of ABBNY, 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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