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Resumen
Business Strategy and Outlook | by Joshua Aguilar Updated Aug 31, 2022
Litigation fears hover over 3M stock, which we think are responsible for the shares’ persistent price/value gap. While we think this discount implies far too high a liability related to its PFAS and Combat Arms litigation, 3M’s bankruptcy court loss removes a vital catalyst in the stock.
In our view, 3M is a GDP-plus business. We attribute 3M’s ability to remain ahead of GDP based on its suite of innovative products that are a byproduct of its research and development efforts. At its core, 3M is a materials science company. The firm’s legion of engineers improves everyday products down to their basic chemistry. For instance, 3M’s microreplication technology, which has been around since the 1960s, was originally used in overhead projectors. That technology has now been adapted into multiple use cases, including making signs brighter and reducing friction in aerospace applications, and is now being developed for vaccine delivery as an alternative to hypodermic needles.
The firm’s proprietary secrets are closely held as 3M rarely grants licenses, and its technology is difficult to imitate. As a result, 3M typically charges a 10%-30% price premium relative to the market. 3M’s ability to adapt its technology into multiple use cases also gives it economies of scope, which helps reduce overall unit costs, evident in its superior gross margins.
We believe the firm can increase its top line safely between 3% and 4% over the medium term thanks to broad-based strength, even as respirator sales now become a near-term headwind. With the more recent acquisitions of workflow solutions provider MModal and negative-pressure woundcare solutions provider Acelity, we believe the firm can capitalize on the stable and ever-growing healthcare market. Healthcare benefits from multiple positive secular trends, including an aging population, greater access to care, as well as rising incidence of chronic disease and surgical procedures. That said, 3M hasn’t increased intrinsic value over the past four years by our measure, which we attribute to a combination of self-inflicted wounds and pandemic-related headwinds. Even so, we think the firm is well positioned in some higher-growth markets.
Economic Moat | by Joshua Aguilar Updated Aug 31, 2022
We believe 3M has a wide economic moat based on intangible assets and cost advantage. In the diversified industrials space, we believe having a central, leverageable core competence can be pivotal to building an enduring competitive advantage. 3M is an innovative powerhouse that leverages its R&D platform across multiple product categories, with byproducts that include patents, brands, and proprietary technology.
The firm spends about 6% of its net sales on R&D compared with the median 5.5% in the Global Innovation 1000 and the median 2% to 3% for diversified industrial firms. While many firms say they innovate, 3M’s yield on these investments is quantifiably superior. 3M’s returns on research capital in 2018 outpaced each name on 2018’s top 10 Most Innovative Companies as named by Boston Consulting Group. For every dollar spent on R&D in 2017, 3M yielded $8.60 in 2018 gross profit versus about a $5.50 average for the top 10. This is the case even as every name on that list is in the technology sector, and in aggregate, according to Statista, the technology sector accounts for nearly 38% of global R&D spending compared with just over 10% for the entire industrials sector. Over a three-year cycle, returns on research capital for 3M outpaced each firm in the top 10, except for BCG’s number-one ranked firm, Apple. While returns on research capital trended down toward $8.15 in 2020, we expect them to trend back up to nearly $8.70 at our midcycle projections. We think this is a testament to 3M’s business model, which emphasizes effective commercialization through two processes: 1) customer-inspired innovation (which focuses on customer spec-ins, at 70% of revenue) or 2) insights 2 innovation (which is a traditional market-driven approach, at about 30% of revenue). The firm receives about 120,000 customer interactions annually. These customer relationships are difficult-to-replicate intangible assets cultivated by over a century’s worth of operations. They have the additional benefit of more efficiently eliminating R&D programs that bear little probability of commercialization, or in the alternative, accelerating those that are potentially high impact and have a high probability of success. Also, 15% of the firm’s senior engineers’ time is unbudgeted to work on any new ideas and projects independent of their normal responsibilities.
3M has strong brands with high share of mind, including household names like Scotch tape, Scotchgard, Post-it, Scotch-Brite, and ACE bandages. Many of the brands command premium pricing. For example, a 12-pack of standard yellow Post-it notes typically sells at a 33% price premium over a comparable generic counterpart. We believe consumers are willing to pay the extra premium associated with 3M’s products given their reputation for quality, as well as superior efficacy. The overall firm has steadily risen in brand value in recent years, climbing from 90th in Interbrand’s Top 100 Best Global Brands to 60th in 2018 and ahead of well-known brands like Nestle and Colgate. With over 55,000 products that touch and concern nearly every industry, the firm’s portfolio is not overly dependent on any single product or category, which increases our confidence in its long-run returns on invested capital.
Additionally, throughout its history, the firm has benefited from over 118,000 global patents awarded to it. According to a search of the U.S. Patent and Trademark Office, 3M has been awarded 9,000-plus U.S. patents since 2001. We believe 3M’s current patent portfolio exceeds the carrying amount of $538 million listed on its 2019 balance sheet. While GAAP accounting does not permit the writing up of an intangible asset, our belief is anchored in the firm’s proven and consistent ability to use these assets to generate excess returns. We further think that the majority (between 80%) of its more recent U.S. patent portfolio is from utility patents based on data from the Intellectual Property Owners Association. To qualify for this designation, these inventions must be novel, new, and non-obvious. Given the comparably higher hurdle to obtain them, utility patents offer advantages over design patents given the intellectual property protection around an invention’s function. They can also protect many different variations of a product with a single approved filing. We think the complexity of 3M’s disruptive technology reflects the strength of its intangible asset moat source, as is the case with microreplication technology used in road signs, grinders, and overhead projectors.
3M’s 51 technology platforms and its manufacturing scale allow it to achieve the lowest unit cost in most of the categories in which 3M competes. As a result, 3M typically enjoys gross margins between 47% and 49% of sales versus about 37% median for comparable peers; and while this number came down just below 47% in 2019 and 2021, we expect gross margins to rebound to over 48% at our midcycle projection. The firm’s shared resources provide for economies of scope, such as in abrasive technology, which affects industrials, construction, and home improvement retail, as well as automotive aftermarket collision repair. The firm’s adhesives can also be used in a wide range of applications, from Scotch tape and Post-it notes to Tegaderm medical dressings.
3M’s emphasis on regionalizing its supply chain reduces complexity in the manufacturing process and allows for shorter supply chains, fewer stock-keeping units, and common processes. This ultimately translates to diminished demand for working capital and greater capital efficiency, drives down unit costs, and improves customer experience with fewer back orders. These cost and customer service benefits are amplified with a common enterprise resource planning platform, which further integrates various functions across the supply chain, from procurement to production.
In addition to the benefits 3M gets from being geographically proximate to its customers, the firm also derives economies of scale from managing a supply chain across a broader geography that is vertically integrated. The firm manufactures many of its own raw materials at a lower cost than competitors. Moreover, 3M has 200 plants around the world, and these are anchored to sites that are 4-5 times larger than a typical plant. These larger plants are on average 40%-45% more productive than smaller plants and tend to drive inventory turns that are on average 15% faster. This same phenomenon holds true for the firm’s distribution centers, which are 20%-25% faster than smaller local distribution centers.
By our calculations, during the 10-year period from 2009-18, 3M achieved incremental returns on tangible assets of about 31%. For at least the past 27 years (since 2019), its returns on capital (including goodwill) have more than doubled our estimated cost of capital, even during years when the company endured negative sales growth. That said, 2020 saw ROICs of just under 13% by our count, meaning the ROIC-WACC spread fell under 2 times for the first time in recent history. This persisted in 2021, as ROICs remain just below 14% in 2021, although they’re close to doubling our assumed WACC. Nevertheless, on average during the past 10 years, 3M still managed to earn returns on invested capital including goodwill that cleared its weighted average cost of capital hurdle easily by more than 2 times (and in some years, more than 3 times). As a result, we have a high degree of confidence that 3M will continue to produce excess returns for at least the next 20 years.
Fair Value and Profit Drivers | by Joshua Aguilar Updated Aug 31, 2022
After reviewing second-quarter results, we’ve lowered our fair value estimate by just under 2%, to $183 per share. The primary driver of our revision is lower-than-expected revenue relative to what we were earmarking during the first quarter. We’ve also reduced margins and in turn earnings, given supply chain and inflation-related headwinds. We value 3M at roughly 18 times 2022 adjusted earnings.
There are positive impacts to our valuation as well. The primary positive came from management’s announcement that it will seek to ringfence its Combat Arms earplugs liability through a Chapter 11 bankruptcy proceeding of a subsidiary. We believe that a liability in the low-single-digit billions is roughly fair, based on comparable fact patterns on a per-plaintiff basis, adjusted for inflation. That said, our number is somewhat higher than the $1 billion 3M is committing to fund its settlement trust. Furthermore, most Chapter 11 proceedings are heavily contested. Therefore, we are probability-adjusting the impact in our valuation based on a 50%, 75%, and 25% probability of success for our base, bull, and bear cases.
Over the medium term, we believe 3M can increase revenue safely between a 3% and 4% compound annual growth rate, when baking in acquisitions. Some of the most influential growth drivers we expect from 2023 to 2026 include the personal protection equipment, global medical dressings, and medical software markets, as well as transportation safety and industrial adhesives and tapes. With 3M’s current lineup, we forecast the firm will increasingly direct its R&D and capital expenditures toward these divisions, which we conclude are higher-growing portions of GDP. Generally, the PPE market is driven by growing concerns over employee health and safety that is met with new regulations. We believe the firm is well positioned in this segment, given its material science core competency. The PPE market demands innovative products that balance comfort, aesthetics, lighter fabric, and premium quality in protective materials. Rising manufacturing and construction production in developing economies should further propel growth.
In medical solutions, we project a rising incidence of wound infections globally. Diabetes and chronic diseases are on the rise. Aside from legacy strength, the acquisition of Acelity should continue to provide 3M with a stronger footing in the negative-pressure woundcare market and mid-single-digit top-line growth.
Risk and Uncertainty | by Joshua Aguilar Updated Aug 31, 2022
3M is exposed to several risks, including slowing organic growth and supply chain-related disruptions, end-market weakness, a slowdown in industrial production, execution risk related to its recent acquisitions of MModal and Acelity in 2019, and market rejection of new product introductions.
Of these risks, we think the most critical risks are ESG and litigation risks related to earplugs and PFAS, the latter of which are a class of organic fluoride-based compounds created by 3M in the 1940s. Combined, we consider these risks greater than 50%, but less than 10% to the fair value of the company from a materiality standpoint, which we’ve incorporated into the bull-, base-, and bear-case scenarios of our model. We point out PFAS compounds aren’t easily broken down in nature, but are found in the water supply in portions of the United States and Europe. 3M originally manufactured them in everyday products like nonstick pans and fire-retardant materials, but were voluntarily phased out by the company; this process began in the early 2000s.
Nevertheless, the firm had to settle environmental suits, including against its home state of Minnesota in the amount of $850 million versus a suit that originally sought a payout of $5 billion from the office of the state attorney general. In 2021, 3M reserved $412 million related to its manufacturing sites it deemed “probable and estimable.” However, we point out that this reserve does not account for product liability risks, which are significant given an association with higher cholesterol among exposed populations, with a limited association of low birth weights and immunological effects.
Our survey of prior environmental and product liability cases leads us to assume that a low- to mid-single-digit billion-dollar liability (present value) is far more likely.
For 3M’s Combat Arms earplugs litigation, we earmark a liability of just over $3 billion based on inflation-adjusted comparable cases and the number of cases pending.
Capital Allocation | by Joshua Aguilar Updated Jul 27, 2022
We assign 3M a Standard capital allocation rating. As we see it, management hasn’t really grown intrinsic value in the last three years, even when accounting for the fact that 3M is a short-cycle business that typically faces headwinds in the latter parts of a cycle. Nonetheless, while we consider the balance sheet strong and distributions for the company appropriate, we believe the repeat guidance misses translated to subpar execution on the part of management as we don’t believe the business was rightsized appropriately, leading to multiple rounds of restructuring. Additionally, given that 3M’s internal investments haven’t generated the same amount of organic growth they have in the past, the company has had to rely more on M&A, which gives us some hesitation since it’s not traditionally a key component of 3M’s operating model.
Michael Roman became CEO in July 2018, taking over from well-regarded predecessor Inge Thulin. He has been with 3M for over 30 years. In his prior capacity as chief operating officer and executive vice president, Roman had purview over the firm’s international operations as well as its then-five business segments. Before serving as COO, Roman was head of the industrial business group.
Roman previously indicated he would not materially pivot from 3M’s prior playbook as laid out in its 2020 road map, particularly since he was intimately involved with the firm’s strategic planning process. In the past, 3M emphasized growth through organic investments by leveraging insights around 3M’s critical customers in product development. Recently, however, the firm reorganized its segments from five to four to better align with the firm’s customers and its go-to-market strategy and curtailed country team responsibilities so that international people now report directly to the firm’s segments. In our view, this eliminates another layer of management and gives 3Mers greater autonomy while also allowing for a greater focus on its customers. After R&D and capital expenditure (organic) spending of nearly 6% and typically 5.5% of sales, and servicing of its attractive dividend (with a yield of nearly 5% at the time of writing), 3M’s capital allocation framework under Roman favors acquisitions, which we think will be increasingly relied upon to augment 3M’s organic growth. The acquisition of Acelity, 3M’s largest ever, while not optically cheap, should continue to improve 3M’s position in the advanced woundcare market, and management previously announced that those cost synergies of 8% of revenue remained on track.
3M generates strong free cash flow conversion of about 95% typically (about 99% in 2021), which gives us confidence in its earnings quality. Second, and perhaps more importantly, 3M has a strong shareholder orientation, and the firm’s payout ratio typically ranges between over 50% on the low end to the low 60s on the high end, which is at the top end of the range from multi-industrial peers, which typically pay out between 10%-40% of earnings (compared with healthcare firms, which typically pay out about 35% to 60% of earnings). We appreciate this as 3M operates in a steady but low-growth industry, and we prefer returning capital to shareholders to overpaying for acquisitions. However, given where the stock trades relative to our intrinsic value estimate, we much prefer management return cash to shareholders in the form of repurchases. We point out management repurchased $2.2 billion shares in 2021. We also appreciate 3M’s commitment to preserving its 15% time policy for unallocated assignments for the firm’s employees, as well as its reluctance to impose too much process in R&D at the cost of innovation. We believe these factors will help ROICs to recover to nearly 16% at our midcycle (when baking in goodwill).
Finally, while we recognize PFAS somewhat tarnishes 3M’s brand promise, which is commonly associated with maintainable practices, we point out that the company has taken a number of actions to address the underlying issues. These include cleanup initiatives, settling with the Minnesota attorney general, and voluntary phasing out the use of the chemical in everyday products. More recent initiatives include coordinating research into PFAS, establishing a clearinghouse to share best practices on detection, and supporting science-based regulation. While it will take 3M time to restore public trust, we think it is working hard and responsibly to do so.
