Is 3M Running Out of Steam?

By Markets Fool.com

Diversification can be a double-edged sword. On one hand, it provides relative stability during challenging periods, with poor performance from one division potentially made up for by strong performance from others. However, if a company becomes overly diversified,it can also cause inefficiencies and an inability to post top- and bottom-line growth. In my view, 3M continues to be in the former camp rather than the latter, but is in the process of becoming a highly appealing growth play, too.

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Major change
A key reason for this is 3M's restructuring program. Investors should be under no illusion -- this is a major program of change for the company, and it had a negative effect on EPS by $0.14 in the final quarter alone. However, the restructuring is not limited to the 1,500 job cuts that will help to generate savings of $130 million in fiscal year 2016; it also involves a reshaping of the company's divisions and its mind-set.

For example, it has agreed to sell the assets of its pressurized polyurethane foam adhesives business, as well as to purchase Polypore International's separations media business for $1 billionand Capital Safety, a fall-protection equipment company, for around $2.5 billion. In addition, a renewed focus on cost reduction, and a strengthening of the company's portfolio in Europe and Latin America, in particular, also offers improved long-term growth potential that could positively catalyze earnings and investor sentiment in 3M.

Additionally, there is more cash available to spend on further acquisitions. With free cash flow conversion expected to be around 100% in 2016, 3M has the financial flexibility not only to spend big on capex (around $1.4 billion expected in FY 2016), share repurchases ($5 billion expected in 2016), and dividends ($2.56 billion in FY 2015), but also to buy up high-growth/high-margin businesses. As a result, 3M is gradually tilting its portfolio toward more-appealing assets that are likely to reposition the company as a stronger growth prospect.

Non-U.S. potential
The idea of maintaining and developing non-U.S. assets while the dollar is relatively strong may seem like a wrong move to some investors. While the impact of currency translation has been negative in recent months -- revenue was reduced by 5.8% in Q4 due to a stronger dollar-- the Fed's pace of interest-rate increases may prove to be slower than expected as a result of continued uncertainty surrounding global growth.

In any case, a business such as 3M must focus on the best long-term growth geographies, and not potential currency changes. As such, its 63% sales exposure to non-U.S. geographies holds huge long-term potential, especially with 3M's largest division (industrial) reporting upbeat growth numbers from Asia-Pacific last quarter.

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3M's revenue has been rather flat in recent years, with it hovering around the $30 billion mark,and falling by 5.4% last quarter. While currency translation has hurt it lately, 3M has focused on improving margins over sales growth, and has benefited from lower raw materials prices (which added 200 basis points to operating margins last quarter alone). While this has helped earnings to grow by 35% in the last five years, this strategy is unsustainable because there are limits to what can be cut, rationalized, and restructured.

Looking ahead
Therefore, 3M's focus on acquisitions, as well as on R&D, is likely to be key to its future sales and profit growth. Although some investors may feel that it is moving too fast on these fronts, with spending of $3.7 billion on acquisitions and $1.8 billion on R&D in FY 2015, they hold the key to 3M's long-term growth prospects.

For example, acquisitions and divestitures alone added 1.7% to the industrial segment's Q4 sales, and 4.6% to the safety and graphics division's top line last quarter. Further acquisitions and product development will not only aid this growth, but could change the market's perception of 3M as a slow-moving, diversified cash cow with a big yield.

In terms of its valuation, 3M's forward P/E of 17.7seems relatively appealing, compared to the S&P's forward P/E of 16.2. That's because 3M continues to offer a diverse geographical and product mix, as well as strong cash flow, which could prove popular among nervous investors during volatile periods.

However, it also has the potential to change and transform into a higher-growth, higher-margin, and more innovative business. For it to be able to maintain its profitability during such a transition shows that, far from running out of steam, 3M is more likely in the process of adding coal to the fire for long-term share-price growth.

The article Is 3M Running Out of Steam? originally appeared on Fool.com.

Robert Stephenshas no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.