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Morningstar | 3M’s Largest Deal Ever for Advanced Wound Care Provider Doesn’t Bandage Its Latest Cut. See Updated Analyst Note from 03 May 2019

On May 2, wide-moat rated 3M announced by far its largest deal ever for advanced wound care provider Acelity. After reviewing the deal, the initial impact of 3M’s re-segmentation, and incorporating first-quarter results and management’s significantly lowered full-year 2019 guidance, we lower our fair value estimate to $190 per share from $197 previously. The primary driver of the lower valuation is management’s most recent outlook on organic growth throughout the rest of the 2019 year, which markedly fell below our near-term expectations. Nevertheless, from an intrinsic valuation perspective, we remind investors that we saw the previously 2-star stock as overvalued when it rallied to $219 prior to first-quarter earnings. We believe our long-term thesis on the stock remains intact, and we continue to retain our wide-moat, stable trend, Exemplary stewardship, and low uncertainty ratings. At a stock price of $185, we think that stock now trades within a realm of reasonableness in terms of its price to fair value ratio.

Net of synergies, the deal seems on the expensive side to us at 15 times unadjusted EBITDA. We model the deal as only slightly value dilutive, akin to the market reaction today which saw the stock drop about 1% throughout the trading day. We believe the deal’s rationale highly depends on management’s ability to extract ambitious cost synergies from its target (at 8% of revenue over the course of three years). We have several concerns with this daunting task. First, management has acknowledged it was slow to react to market headwinds that prompted its lowered guidance. Short-cycle businesses are inherently hard to predict, but we had some early clues of the slowdown trickling through China as well as automotive and electronics from the rest of our coverage. Second, management is undergoing a restructuring program that was only recently announced and is also juggling several lawsuits related to PFAS and asbestos litigation related to its respirators.

While we’re not overly concerned with these developments yet, we do think they’re greater than we initially appreciated and we will continue monitoring them. Third, Acelity was set to IPO just a couple of weeks ago or so, suggesting 3M was willing to pay an even higher multiple at the top of an economic cycle--generally not a formula for creating long-term shareholder value. Fourth, at a $6.7 billion enterprise value (including agreeing to assume roughly $2.4 billion in debt), this more than doubles 3M’s previous large deal of $2.5 billion for Capital Safety in 2015. Fifth, organic growth has been slowing. The company dumped the use of the new vitality index based on its logic that the fruits of its R&D spend would show up in organic top-line results. 3M has pulled back slightly on its R&D spend at 5.6% relative to its aspirational 6%.

While not a silver bullet figure by any chance, they’ve spent less while also having the unfortunate side effect of earning less. Our metric we use to track this is returns on research capital (gross profit over prior-year R&D spending). Last year, that metric dipped down to $8.60 compared with last year’s $8.84 and our medium-term expectations of about $8.96. Nevertheless, we think these issues are short term and just a normal ebb and flow. We still see the moat around the business intact compared with the lower price target estimates we’re now seeing out there in consensus. While the firm’s intangible asset moat doesn’t offer it greater than inflation annual price increases, it does generally price its consumable products about 15% above its competitors. Last year, 3M was able to offset inflation with price, without sacrificing volume while still maintaining this premium.

Sixth, 3M recently had its credit outlook downgraded to negative by one of the Big Three rating agencies. While its debt doesn’t overly concern us, it’s at higher levels than we’ve seen historically amid some headwinds. Finally, we’ve thought of 3M historically as preferring organic growth, and large-scale M&A has not been a regular part of the firm’s DNA. Acelity, moreover, doesn’t appear to be growing materially faster than 3M’s long-term Health Care segment expectations (at 4% to 6% organically for Acelity).

On the positive side of the ledger, however, we like that the company has focused on acquiring a target that fits in with the firm’s strategic rationale. This doesn’t appear to take 3M too far outside its core compentency, and the Acelity portfolio seems to complement 3M’s offerings. The Health Care segment, in tandem with the Safety portfolio remains a large part of our long-term thesis for the stock. We expect strong secular trends. Acelity has about 75% exposure to the U.S. market, and as the baby boomer population ages, we expect 3M to benefit from rising incidence of both chronic diseases (like diabetes) as well as surgical procedures. In other words, we’re glad 3M is fishing in the right pond. While we could be wrong and acknowledge management could extract value from what we see as a slightly rich deal, we prefer to sit on the sidelines for 3M stock given present day prices.