EUR 850.00 For Business Accounts Only

Morningstar | Our Thesis for Wide-Moat Rated 3M Remains Intact as the Firm Continues Performing as Expected

Wide-moat rated 3M had a decent fourth quarter that was broadly in line with both our fourth-quarter and full-year expectations. As we roll our model forward, we anticipate modestly raising our fair value estimate by about 1% based mostly on time value of money and new pension assumptions. We are leaving our long-run expectations relatively intact. We may make some additional minor changes as the firm releases both its annual report and its sub-segment information. Even so, we are retaining our wide-moat, low uncertainty, stable trend, and exemplary stewardship ratings.

3M reported full-year sales of $32.8 billion versus our expectations of $32.9 billion with growth of 3.5% year over year (or 3.2% on an organic local-currency basis). GAAP EPS was also modestly in line with our expectations at $8.89 for the full year compared with our $8.92 estimate. Adjusting for a net tax expense of 29 cents per share and an after-tax expense of $1.28 related to a first-quarter legal settlement, adjusted EPS for the year came in at $10.46. Our current GAAP EPS expectations for 2019, prior to announced results, come in at $10.64 compared with management’s current guidance of $10.45 to $10.90, or just below the midpoint. Management expects that a large proportion of 3M’s improvement from full-year 2018 results will come from both organic sales growth and portfolio management. Based on management’s commentary during the call, we expect that a majority of organic sales growth will be back-end loaded for 2019, particularly given tougher first-half comps. We note that 3M’s free cash flow conversion dipped this year relative to the prior four years (at 91% compared with a range of 100% to 104%), but we’re not overly concerned and expect this will improve and hover around 100% next year. 3M remains one of the highest quality diversified industrials in our coverage in terms of free cash flow conversion (free cash flow divided by net income).

Turning to 3M’s segments, a couple of items stood out to us. Health Care returned as a strong performer this quarter, with organic sales up 4.8% year over year for the quarter. Sales in Health Care grew through multiple sub-segments including food safety, health information systems, medical solutions, and even oral care, which had been a laggard in the earlier parts of this year. Drug delivery continued its decline. We expect growth there to be more volatile given the project-based nature of this business. We expect to continue seeing growth flow through here with the acquisition of M*Modal’s technology business. Safety & Graphics, 3M’s other traditionally strong performer saw organic growth up 3.3% year over year for the quarter. One item that we found interesting was that the acquisition of Scott Safety is performing well, and growth is up double-digits. Based on management dialogue with analysts, Tyco never was able to achieve this type of growth with the unit. CEO Mike Roman touted the winning combination between the two teams (specifically in terms of its personal safety portfolio), as well as some projects they’ve picked up recently that have been a nice tailwind. Electronics & Energy had a nice quarter, with sales particularly strong in the Americas.

Surveying both the firm’s results and management’s commentary, we believe our thesis remains intact. We’ve consistently believed that most of the growth in 3M’s portfolio will be driven by both Health Care and Safety & Graphics given longer-term secular trends that will drive forward organic growth, including increasing industrialization and urbanization in the developing world, a need to update aging infrastructure, a growing awareness of worker-related safety and related regulation, an aging population at risk of increasing chronic illnesses (like diabetes and asthma) and surgical procedures as well as a need to manage large amounts of health data. One item we’ll continue monitoring is slowing growth in China, particularly given 3M’s geographic exposure to the Asia-Pacific region (typically about 30% of revenue in any given year). Returns on research capital (current year gross profit divided by prior year R&D spend) of $8.64 dipped slightly this year compared with prior-year results of $8.84 but were in line with our expectations for the year, and more importantly, over our long-term expectations. While we continue to believe that 3M is a high-quality, well-run company, we believe the market adequately appraises its future earning potential.