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Morningstar | 3M’s Enterprise Resource Planning Rollout Helps Lift 2Q Sales

Wide-moat 3M has been mostly performing according to our expectations, and nothing about the firm's latest results alters our long-term view of the stock. We plan on raising our fair value estimate by a dollar (to $191) because of strong top-line growth, particularly in safety and graphics, which has been somewhat offset by a slight slowdown in healthcare. That said, 3M's upcoming enterprise resource-planning rollout in the United States helped this quarter's strong sales results. On the call, management disclosed that some of 3M's customers decided to accelerate purchases in anticipation of this rollout, which ultimately added about 50-100 basis points of overall year-over-year growth in the quarter. Given these tough comps, we would expect 3M to give back at least some of these gains on a sequential basis during the third quarter. Indeed, management has continued to affirm its top-line guidance of organic net sales growth of the 3%-4% for the year.

For the second quarter of 2018, net sales rose 7.4% to $8.4 billion. On an organic-local currency basis, net sales rose 5.6%, with pricing contributing an impressive 110 basis points. In the past, a typical quarter will see 3M increasing taking price about 30 to 50 basis points, but from our understanding, management will typically raise prices in emerging markets to offset foreign exchange headwinds, as well as raw material cost headwinds. Our long-term assumptions, however, assume that more of 3M’s top-line gains will come from volume, and that pricing will continue to be a "to the right of the decimal" percentage impact over time.

As for operating margins, 3M improved 100 basis points to 28.6% year over year. That said, operating margins disproportionately benefited from the divestiture of communication markets in the electronics and energy segment. Net of this impact, operating margins would have fallen to an underlying 24.0%, with 5.9% of the divergence from reported GAAP margins resulting from the actual divestiture gain, and negative 1.3% due to actions undertaken by 3M because of this divestiture. These actions were well-known as 3M had announced this intended divestiture back in December. We were able to ask 3M representatives the reason behind the divestiture of its former optical fiber and copper passive connectivity solutions business at the Electrical Products Group conference earlier this year. Our takeaway is that 3M is likely to divest assets where it does not have leading market share and where it can't add value through its powerful research and development.

As for the firm's segments, three factors surprised us the most. First, operating margins in the industrial segment rose 370 basis points year over year to 23.0%, even as footprint rationalization actions had a negative impact on margins by negative 180 basis points. Historically, industrial has lagged the firm's other segments, and margins clearly benefited from strong organic sales growth, which grew nearly 6% organically year over year. Second, stronger-than-expected safety and graphics sales growth, particularly on the heels of strong personal safety growth. We've anticipated personal safety being one of 3M's strong growth drivers given more stringent government regulations regarding the use of personal protective equipment, coupled with increasing awareness about the importance of work safety. Finally, healthcare, which along with safety and graphics, is the other segment we expect to supply 3M with higher growth, grew 3.8% on an organic basis, slightly below our expectations. It appears to us that drug delivery has been a slight headwind over the past couple of quarters. On the call, we asked management about the long-term prospects of drug delivery, and were told that fundamentally, the firm is still optimistic about its opportunities in the space, particularly coupled with its technological capabilities moving forward.