3M's Lackluster Results Continue as it Eyes Its Healthcare Spin

Senior Equity Analyst

Joshua Aguilar

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Litigation fears and weak fundamentals continue to plague 3M, which we think are responsible for the shares' persistent price/value gap. While we think this discount implies too high a liability related to its perfluoroalkyl and polyfluoroalkyl substances and Combat Arms litigation, 3M's bankruptcy court loss removes a vital catalyst in the stock.

At its core, 3M is a materials science company. The firm boasts suite of innovative products that are a byproduct of its research and development efforts. 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 adjusted top line over a 2% CAGR over the long term thanks to broad-based strength, even as respirator sales and supply chain disruptions remain a near-term headwind. Acquisitions like negative-pressure woundcare solutions provider Acelity should allow the firm to 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 has meaningfully impaired intrinsic value over the past five years by our measure, which we attribute to a combination of self-inflicted wounds and macro-related headwinds, though we don't expect fundamentals will materially improve over the near to medium term.

Business Strategy & Outlook

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 43% in 2022, we expect gross margins to rebound to 45% 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 27 years before 2019, 3M's 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 dip to 13% by our count and 12.5% in 2022, meaning the ROIC-WACC spread fell under 2 times for the first time in recent history. 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.

Wide

Economic Moat

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ocelo

Scotch Tape is a brand name used for pressure-sensitive tapes manufactured by 3M as part of the company's Scotch brand. Their magnetic recording tape products were also sold under the Scotch brand.

Scotch Tape

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Command

3M Co. is a technology company, which manufactures industrial, safety, and consumer products. It operates through the following segments: Safety and Industrial, Transportation and Electronics, Health Care, Consumer, and Corporate and Unallocated. The Safety and Industrial segment consists of personal safety, industrial adhesives and tapes, abrasives, closure and masking systems, electrical markets, automotive aftermarket, and roofing granules. The Transportation and Electronics segment includes electronics, automotive and aerospace, commercial solutions, advanced materials, and transportation safety. The Health Care segment offers medical and surgical supplies, skin health and infection prevention products, oral care solutions, separation and purification sciences, health information systems, inhalation and transdermal drug delivery systems, and food safety products. The Consumer segment covers consumer healthcare, home care, home improvement, and stationery and office products, such as consumer bandages, braces, supports, respirators, cleaning products, retail abrasives, picture hanging, and consumer air quality solutions. The Corporate and Unallocated segment refers to special items and other corporate expense-net. The company was founded by Henry S. Bryan, Hermon W. Cable, John Dwan, William A. McGonagle, and J. Danley Budd in 1902 and is headquartered in St. Paul, MN.

Earnings data Q2 2023

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3M Company (NYSE:MMM ) Bernstein 39th Annual Strategic Decisions Conference May 31, 2023 9:00 AM ET Company Participants Mike Roman - Chairman and CEO Bruce Jermeland - SVP, IR Conference Call Participants Brendan Luecke - Bernstein Brendan Luecke Good morning. My name is Brendan Luecke.

3M Company (MMM) Presents at Bernstein 39th Annual Strategic Decisions Conference (Transcript)

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