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Investment Thesis
3M’s (NYSE:MMM) sales should benefit from the re-opening of cities in China, easing comps in automotive business, improving elective healthcare volumes, strong demand for semiconductor chips, and pricing actions. The company’s margins should benefit from the pricing actions and sales leverage. 3M also announced the spin-off of its healthcare business and the strong fundamentals and the favorable trends in the business should help it achieve good valuations. The company is also moving forward with a new legal strategy to handle the Combat Arms Earplug litigation efficiently and trying to ring fence liabilities.
MMM’s Q2 FY22 Earnings
MMM recently reported its Q2 FY22 financial results that were better than expected. The net sales in the quarter were down 3% Y/Y at $8.7 bn (vs. the consensus estimate of $8.58 bn). The adjusted EPS dropped 10% Y/Y to $2.48 (vs. the consensus estimate of $2.45). Net sales in the quarter grew 1% on an organic basis. However, the continued strengthening of the U.S. dollar resulted in a foreign currency translation impact of negative four percentage points, leading to negative sales growth. The adjusted operating margin in the quarter dropped 240 bps to 21% due to the decrease in disposable respirator demand, Covid-19-related lockdowns in China, inflationary pressures in raw materials and logistics, and unfavorable currency translation. These headwinds were partially offset by selling price actions, restructuring savings, and strong spending discipline.
Revenue Outlook
The Y/Y decline in the sales of a disposable respirator by ~$150 mn and the sales decline of ~$140 mn due to the Covid-19-related lockdowns in China resulted in low single-digit organic growth. The impact in China was lower than the company’s anticipation of $300 mn as the facilities in China started to re-open in June. Adjusting for the impact of these headwinds, the organic growth of 3M was ~5% in the quarter.
So, the underlying trend is really encouraging and once comp headwind from N95 respirator masks goes away and China continues to reopen, the company’s growth rate should accelerate. The backlog in China remains healthy which should support the revenue growth in 2H FY22.
The Safety & Industrial business grew 0.7% organically, due to low double-digit organic growth in abrasives, electrical markets, and closure and masking businesses, and low single-digit organic growth in roofing granules, the automotive market, and industrial adhesives. This growth was partially offset by the ~$150 mn headwind from the decline in disposable respirator sales and Covid-19-related lockdowns in Greater China. The Transportation & Electronics segment grew 0.5% organically due to mid-single digit growth in advanced materials and commercial solutions and low single-digit growth in auto-OEM business, partially offset by a high-single-digit decline in transportation safety and a low single-digit decline in electronics-related business. The lockdowns in China and the ongoing impacts of semiconductor supply chain constraints in automotive and consumer electronics end markets adversely impacted the organic growth in the quarter.
The Healthcare segment delivered the highest organic growth of 4.4% compared to the other three businesses. Medical solutions and oral care businesses were up low single digits, with the U.S. elective procedures and oral care volumes at 90% to 95% (vs. 85% to 90% in Q1 FY22) of pre-Covid levels. Health Information Systems grew in the mid-single digits, driven by growth in revenue cycle management. The separation and purification business increased by high single digits with sustained demand for biopharma filtration solutions for Covid-19-related vaccines.
The Consumer segment was down 2.5% on an organic basis compared to 18% in Q2 FY21. The home improvement business was down by a high single digit organically, with consumer health and safety declining by low single digits, partially offset by mid-single-digit growth in stationery and office businesses and low single-digit growth in homecare businesses.
3M lowered its full-year organic growth guidance range to 1.5% to 3.5% vs. the previous range of 2% to 5%. I believe strengthening of USD against major currencies is the main reason of this reduction. Foreign currency translation, which was supposed to impact FY22 revenue by 1% previously, is now expected to impact the revenues by 4%, resulting in a reduction of over $1 bn in annual sales.
While macro’s overall are challenging, some of MMM’s key markets are poised to recover. The build rate trends in the automotive industry are improving, the demand for semiconductor chips is strong, healthcare elective procedure volumes are increasing, pricing actions, and the re-opening of China in June should act as tailwinds for the company’s revenue growth. The healthcare elective procedure rate should improve to 100% by the end of the fourth quarter, benefiting the healthcare segment. In automotive business the build rates in Q3 FY22 should improve given the easier comps compared to Q3 FY21. So, I expect organic growth to accelerate in 2H22 and FY23.
Margins
The adjusted operating margin in Q2 FY22 was down 240 bps Y/Y. The decline in disposable respirator demand negatively impacted the margins by 40 bps in the quarter, whereas the Covid-19-related lockdowns in China affected the margins by 70 bps. The unfavorable foreign currency translation resulted in a 10 bps headwind to the margins. Inflationary cost pressures resulted in a Y/Y headwind of ~$270 mn or a negative impact of 310 bps on the adjusted operating margin. The company has experienced ~$480 mn of raw material and logistic headwinds in 1H FY22. The company is working towards offsetting the cost pressure through pricing actions over the past few quarters. In Q2 FY22, the company took a price hike of mid-single-digit.
The adjusted operating margin in the Safety & Industrial segment was down 210 bps Y/Y at 21.5% due to the Covid-19-related lockdowns in China and manufacturing productivity headwinds, partially offset by spending discipline and benefits from restructuring actions. The operating margin of the Transportation & Electronics segment was down 80 bps Y/Y at 21% due to the impact of productivity in China and the shutdown of operations at the Zwijndrecht factory. The operating margin of the Healthcare segment was down 260 bps Y/Y at 22.7% due to the impact of manufacturing productivity, investments in business, and costs related to the food safety separation, partially offset by the benefit of volume leverage, and strong spending discipline, and restructuring actions. The consumer segment operating margin was down 220 bps Y/Y at 18.5% due to the impact of ongoing supply chain constraints and manufacturing productivity impacts, partially offset by strong spending discipline and benefits from restructuring actions.
Looking forward, the company plans to take additional price hikes to offset the inflationary cost pressures. I believe with the re-opening of facilities in China in June 2022 and the company’s plan to restart manufacturing operations in Zwijndrecht, the adjusted operating margins of the company should improve in 2H FY22. Additionally, as the volumes across some of the business portfolios, such as healthcare, improve, the margins should grow sequentially.
Healthcare Spin-off
Recently, 3M announced its plan to spin off the healthcare business, resulting in two public companies. Given the strong capabilities of the healthcare business and the trends in the business’s end market, 3M decided to spin off the business. Through organic investments in innovation, strategic M&A, and updates to its operating model, 3M has made its healthcare business strong enough to be successful as a stand-alone company. In 2019, the company acquired Acelity and M*Modal to expand its advanced wound care and health information systems. Also, the company divested its drug delivery business in FY20 and should complete the split-off of its food safety business by September 2022.
Post the spin-off of the healthcare business, 3M will be a $26.8 bn business with diverse end markets, including industrial, safety, automotive, electronics, and consumer. The healthcare business drove $8.6 bn in sales in 2021, with $400 mn in revenue from the food safety business. The end markets of the healthcare business will include wound care, oral care, health care, IT, and biopharma filtration. 3M plans to pursue a tax-free spin-off and retain a 19.9% stake in the healthcare company and monetize it over time. The healthcare business will be spun off with net leverage of 3 to 3.5+ adjusted EBITDA and de-lever quickly as the healthcare business has strong cash flow. This transaction is expected to be completed by the end of FY23. The separation cost is expected to be in the range of $1 bn to $1.5 bn spread out over the next 24 months.
I believe this spin-off will create a good value as the new healthcare entity can command much better valuation multiple compared to what 3M is currently getting.
Litigation Update
Other than the company’s fundamental performance, one thing which investors were closely watching for was update on the litigation it is facing related to combat arm earplugs and PFAS. In a previous article, I gave an example of how Johnson & Johnson (JNJ) dealt with such liabilities. Johnson & Johnson while facing similar kinds of liabilities from consumers spun off a separate company – LTL management – to deal with these liabilities and LTL management later filed bankruptcy, shielding JNJ from significant legal costs.
3M seems to be following a similar strategy to reduce the uncertainty related to the Combat Arms Earplug litigation by filing bankruptcy of its completely owned subsidiary Aearo Technologies. Aearo Technologies has been operating as a wholly owned subsidiary of 3M since its acquisition in 2008. Aearo Technologies has been a co-defendant in this case since the beginning. The litigation related to Combat Arms Earplugs has been extraordinarily increased and Aearo has voluntarily elected to use Chapter 11 procedures to resolve this litigation.
3M has entered into a funding agreement and has committed to fund a trust of $1 billion to resolve all claims determined to be entitled to compensation. In addition, 3M is committing $240 mn to cover the projected case-related expenses. The company strategy seems to be ring fencing Combat Arms liabilities and, if successful, the company’s valuation multiple can re-rate meaningfully. According to 3M management, Aearo actually sold the majority of the Combat Arms Earplugs under dispute before the 2008 acquisition by 3M. So, I see a reasonable chance of 3M succeeding in its efforts to limit damage. The company has recorded a pre-tax charge of ~$1.2 bn or $1.66 per share, in Q2 FY22 with regard to it. And while it may change, I don’t think we will see damages to the tune of tens of billion as envisaged by some of the sell-side analysts.
The other litigation which 3M is involved in is related to PFAS. The company is managing the PFAS-related litigation by defending itself in court and is working towards achieving a 99% reduction in PFAS discharges from its operations by deploying state-of-the-art technology. In July 2022, 3M Belgium announced its plan to invest more than $571 mn to benefit the people of Flanders and carry out certain previously agreed upon PFAS-related remedial actions. I believe the company will be able to limit damages to parent company in this case as well.
Valuation & Conclusion
The stock is currently trading at 13.26x FY22 consensus EPS estimate of $10.39 and 12.72x FY23 consensus EPS estimate of $10.92 which is lower than its five-year average forward P/E of 19.14x. In the near term, the company should benefit from pricing actions and strengthening in demand across certain key end markets which will help the revenue growth as well as margins in second half of this year and beyond. While there is a good deal of macro uncertainty, 3M’s business is defensive in nature and I believe improvement in automotive production, elective surgeries, Chinese reopening etc. should more than offset any slowdown. The company’s new legal strategy to defend itself against litigations gives us some clarity on 3M’s future prospects and with clouds of uncertainty fading, the company’s P/E multiple can re-rate higher. Hence, I have a buy rating on the stock.
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