3M Company (NYSE: MMM) needs sales growth. Just like peer Illinois Tool Works (NYSE: ITW), its stock price is starting to look heady -- both companies are trading in excess of their pre-recession valuations -- and it needs growth now in order to justify its rating. Moreover, with 3M's CFO Nick Gangestad claiming dividend growth would "be very similar to what we anticipate for earnings-per-share growth," 3M needs sales and earnings growth in the future -- a near 2.2% dividend yield isn't particularly exciting. Can 3M Company increase its growth rate?
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3M growth in 2017
It might seem churlish to call into a question the growth prospects of a company that's raised its full-year sales outlook in the first-two quarters of 2017 alone.
However, the reasons why 3M has been raising guidance are not necessarily indications of future growth. There are five reasons why:
- Growth comparisons are easier this year because 2016 saw revenue decline.
- Organic growth has been driven by higher volume on lower prices, which suggest that 3M's long-term pricing power is eroding.
The chart below shows year-on-year organic revenue growth, and also breaks out organic volume and organic price growth.
- Growth in 2017 has been driven by recovery in the electronics & energy segment, which may well prove temporary, and a recovery in its industrial segment that was only in-line with the general improvement in U.S. industrial production felt by Illinois Tool Works and others.
- Many industrial companies have seen strong growth from China in the first half -- 3M's Asia-Pacific local currency organic sales growth was 10% in the first half, while Illinois Tool Works's second-quarter growth in China was 13.3%.
- Management is making so-called strategic investments in order to drive growth, but it's coming at the expense of near- and mid-term margin and earnings.
In this chart, you can see the reliance on electronics & energy and industrial segments -- the highest growing segments in the second quarter. If the automotive sector (a large part of industrial) slows as expected in the second half and electronics strength proves temporary then growth prospects could be challenged.
Pricing problems and strategic initiatives
Discussion of pricing dominated the second quarter earnings call. In particular, analysts enquired whether the pricing weakness was a reflection of weakening competitive positioning due to the threat of online distributors (think Amazon) stealing market share.
Analysts and investors were treated to a variety of comments on such matters. All the quotes below come from Gangestad:
- He talked of taking "selected price adjustments" in some markets.
- The U.S. is "tracking to the low end of what we've been expecting for price growth."
- "I see the second half of the year with some uptick in that pricing"
- "These are 3M decisions we're making, not responses we're making in the market."
- "There have been these isolated places where we've taken action. In the second half of the year, we expect a more normal price growth for 3M."
Whether price adjustments are selective or not, or whether they are "3M decisions" or responses to the market (the difference is philosophical), even whether pricing actions were part of what CEO Inge Thulin described as preparation to make 3M more "competitive" and "agile" -- the fact is pricing has weakened in the last year.
Management believes strategic initiatives -- planned investments of $500 million to $600 million intended to result in an annual increase in operating income of between $125 million to $175 million by 2020 -- will contribute 50 basis points (where 100 basis points equals 1%) to 100 basis points of growth in 2017.
However, strategic investments of $178 million in the second quarter cost the company $0.24 of EPS, and management expects a $0.20 to $0.25 impact from more investment in the second-half. Moreover, margin and EPS are expected to be negatively impacted in 2018 by these investments, and it will only be until 2019 that the net impact turns positive.
The bottom line
3M is doing better on top-line growth in 2017, but it's due to a confluence of positive macro-economic developments (China, U.S. industrial sector improvement) and initiatives (price cuts and strategic initiatives). To be fair, management has outlined that pricing should improve in the second half, and the initiatives are intended to drive growth and productivity improvements -- and its track record suggests it should be given the benefit of the doubt.
However, given the heady valuation, any failure to execute and/or a downturn in economic conditions will lead to 3M's stock price disappointing investors.
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