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Morningstar | 3M’s Disastrous First-Quarter Results Represent CEO Mike Roman’s First Challenge at the Helm

Wide-moat 3M’s first-quarter earnings were nothing short of a swing and a miss. We’ve been longtime fans of the company and its unique corporate culture. Even so, we think the 13% decline in the stock’s market price April 25 was largely foreseeable (at least at some juncture in the future), as we indicated by our 2-star rating before the April 25 announcement. Around this time last year, our fair value estimate represented the lowest price target in consensus estimates. As we built our bottom-up analysis by business subsegments, we simply couldn’t understand how 3M’s constituent businesses would support the $219 stock price at April 24’s close, particularly amid markedly slowing top-line organic growth in its end markets. 3M has significant amounts of exposure to the slowing automotive and electronic end markets, as well as China, compared with peers (the entire Asia-Pacific region represents nearly one third of 3M’s sales).

Under Roman’s stewardship, moreover, the company has walked back guidance on several occasions (five, by our count), and that’s only in one year’s time. While we understand short-cycle businesses are inherently hard to predict (3M lacks the massive backlog in long-cycle businesses that Honeywell can count on in 40% of its businesses, for example), we think prudence could have spared the irrational rise in the stock price before the April 25 announcement. However, we only expect to modestly reduce our fair value estimate, despite what we view as continued near-term headwinds, by about 1% to 2%. Still, we retain our wide moat, low uncertainty, stable trend, and Exemplary stewardship ratings.

For the quarter, total 3M sales were down to $7.9 billion, a 5% year over year reduction, or negative 1.1% on an organic local-currency basis. Adjusted operating margins, moreover, fell by about 160 basis points to 21.4% year over year (these are adjusted for significant litigation charges flowing through). In 3M’s biggest sore spots, automotive (which similarly vexed Rockwell Automation earlier), the OEM channel was down 9% year over year, driven by first quarter global car and light truck builds. China negatively contributed to the automotive OEM channel, as well. Electric-related businesses were down 6% year over year. Management also reported that China and Hong Kong saw top line down 4% year over year against tough comps from last year (which saw sales rise 11% year over year).

As a result of these pressures, 3M previously announced re-segmentation earlier this quarter that will see its segments reduced to four from five. These segments will now include Health Care, Safety & Industrial, Transportation and Electronics, and Consumer. Contemporaneously with the April 25 announcement, the company announced it will now undergo a restructuring that will witness a broad-based reduction of 2,000 jobs globally. These restructurings will mean 3M will take a $150 million charge in 2019, but according to management, should expect to see annual savings of $225 million to $250 million, with $100 million this year alone. We think these restructurings signal two things: 1) going forward, 3M will continue to struggle to grow materially faster than global GDP on an organic basis given its sheer size, and 2) this restructuring represents Mike Roman’s first real test as CEO.

Even so, we think the wide moat around the business and our thesis both remain intact. We were assured by CEO Mike Roman’s comments on the call when he said, “our investment in R&D and I would say innovation, more broadly, is fundamental to what we promised our investors.” For the firm to preserve its intangible asset base and premium pricing of its products relative to competitors (about 15%, give or take), we think it’s imperative that it continues to spend about 6% of sales on research and development. 3M’s high returns on capital afford it the opportunity to have a few misses.

For example, one area of near-term poor performance that we’re not concerned with is in drug delivery. The Health Care segment remains a fundamental part of our thesis. Consumables in this business should still see high growth given the rise of surgical procedures and chronic illnesses like diabetes, particularly as the baby boomer population ages. Drug delivery, specifically, is a project-based business line and works on solutions that may target the rise in pulmonary disease around the world. It’s a lumpy business, and growth is not consistent. But we’d rather 3M invest money within its moat to protect it, despite year-over-year double-digit declines.

One area we’re keeping a longer-term eye on, however, is the effect of litigation related to PFAS and respirators, which have popped up increasingly on our radar after speaking with media sources and reviewing the firm’s 10-K filing. The firm promised additional disclosures in the 10-Q. Our main concern is that the PFAS litigation, particularly, represents a common fact pattern to the $850 million settlement 3M paid in Minnesota last year and the risk of contagion (in the form of far more lawsuits) spreading to other states. We reserve judgment until we can test the adequacy of 3M’s reserves once we review the 10-Q and other sources, but at minimum, we anticipate a slog given that resolution depends on a state-by-state approach.