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Morningstar | 3M's Lackluster 2018 3Q Does Not Alter Our Already Conservative Long-term Outlook

Wide moat-rated 3M reported disappointing results for the 2018 third quarter, but this does not alter our long-term fundamental outlook for the firm. As a result, we don’t expect a material change to our $193 fair value estimate. The firm improved third-quarter organic sales by 1.3% year over year (down 0.2% year over year on a reported basis) on a tough comp from last year's third quarter, which rose 7% year over year. Sales also had a tough sequential comp with last quarter’s enterprise resource planning system, which saw sales front loaded based on customer anticipation of the roll out. That said, 3M’s third quarter free cash flow rose 24% year over year, and free cash flow conversion was an impressive 114%. This allowed 3M to return $794 million to shareholders in the form of dividends, as well as $1.1 billion in the form of share repurchases.

Looking closely at its operating segments, 3M's performance was a bit of a tale of two cities. Our thesis largely depends on how 3M's overall portfolio is managed, and we expect both safety and graphics and healthcare to deliver most of the portfolio's growth. Safety and graphics was once again a bright spot for the firm. Organic sales only grew 2.2% year over year, but the acquisition of Scott Safety has been a strong growth engine and has exceeded management’s expectations, boosting reported sales 7% year over year, even with a negative 2.2% year-over-year headwind.

Healthcare, however, had some adverse headwinds and revenue decreased 1.1% year over year. Healthcare has been running below management’s 4%-6% sales growth target for the segment. We're not overly concerned with some of the near-term weakness in the healthcare segment. Most of the weakness here can be attributed to the firm’s drug delivery business, as well as a tough comp from last year (which rose 7.6% year over year).

Investors will recall that our question to management on last quarter's earnings call focused on this business line. Management has explained drug delivery is a project-based business and is tied to the pharmaceutical industry's regulatory cycle. We've found this answer convincing in the past and continue to do so. Encouragingly, management still sees a strong pipeline ahead, and we're looking forward to an update on the project pipeline at 3M's investor day next month. We expect pulmonary drug delivery systems will continue to grow as respiratory diseases are on the rise around the globe.

Growth from the acquired Scott Safety has been important for 3M as certain business lines have seen strong headwinds, like roofing granules, which declined midteens as shingle manufacturers slowed production in the quarter. Also offsetting this weakness is the firm’s transportation safety business, which grew midsingle digits and ahead of our expectations.

Turning to the firm's regions, the firm's EMEA business has fallen off recently. On the call management reported that both industrial and auto build rates softened a bit, with a slowdown across Western Europe. Growth is tracking in the low-single digits, at the bottom end of 3M's projected range. One item that perked up our ears during the call is an upcoming slowdown in the Chinese respiratory protection space, as well as some slow automotive build rates. Moving forward, we'll look out for these items, particularly as we view the personal safety business as an important component of 3M's long-term growth trajectory.

Finally, the firm lowered both its top-line growth and EPS full year 2018 guidance, and management expects free cash flow conversion for full year 2018 will run below the firm’s five-year historical performance (100%-plus), despite this quarter's outperformance. We will be lowering our expectations for the year, as this quarter's performance no doubt makes it difficult for management to fulfill our existing sales and earnings expectations for the year. That said, we think the firm's share price decline of nearly 8% this morning (as of this writing) is an overreaction to the firm's latest results. We've been at the bottom of the sell side's price target range with our $193 fair value estimate, so we simply believe market expectations have been divorced from realistic growth assumptions for 3M's addressable markets.