Most investors won't need reminding that 3M's (MMM 0.84%) latest earnings report caused yet another sell-off of the stock. It's becoming a tiring refrain that's testing the patience of most investors. However, within the sales disappointments and weak-looking margin guidance, there are some positives for investors to consider. Let's take a look at what 3M's latest report means for investors.
3M earnings
There are probably two key things that disappointed investors about the results. The first is the organic sales decline of 13.1% in the second quarter. The second is the adjusted operating margin guidance of 20% to 21% for the third quarter, a figure that looks weak compared to the operating income margin of 25.2% reported in the third quarter of 2019.
A slowdown in automotive end markets has hit 3M hard. Image source: Getty Images.
Starting with the sales decline, a breakdown of the sales by segment helps to shed light on the reasons behind the shortfall. The weakness in the safety and industrial segment is largely a consequence of the slowdown in the automotive and aerospace markets (responsible for 41% of the segment decline in the quarter) with a further 29% of the decline coming from commercial solutions. It's obviously disappointing, but it's hardly surprising given that industrial supply company MSC Industrial Direct's (MSM +0.41%) management had talked of "acute weakness" in automotive, aerospace, and oil and gas.
Meanwhile, the safety and industrial segment also took a hit from weakness in the automotive aftermarket, as well as industrial adhesives and tapes. The performance in the consumer segment was mixed with slight growth in home improvement and home care failing to offset declines in stationary and office products as stay-at-home measures impacted demand.
The healthcare segment's sales decline may seem surprising, but it comes down to the fact that the COVID-19 pandemic has caused delays in elective procedures and closed dental offices all over the world.
It appears that 3M's disappointing sales performance in the quarter really does come down to its exposure to certain end markets that have been very badly hit by the pandemic.
|
Organic Sales Growth |
Q2 2020 |
Q1 2020 |
|---|---|---|
|
Safety & Industrial |
(6.1%) |
2.2% |
|
Transportation & Electronics |
(18.9%) |
(3%) |
|
Health Care |
(12.4%) |
1.2% |
|
Consumer |
(5%) |
6.1% |
|
Total |
(13.1%) |
0.3% |
Data source: 3M presentations.
Operating margin guidance
3M's operating margin guidance was explored extensively during the earnings call, with management almost entering a philosophical discussion with analysts. Analysts on the call focused on the fact that the adjusted operating income margin guidance implies a significant drop from the margin achieved in last year's third quarter.
However, management argued that the guidance for 20% to 21% should be compared with the 19.6% achieved in the recent second quarter, rather than a year ago. For example, during the earnings call incoming CFO Monish Patolawala pointed out that "as sequential revenue goes up, margin rate is going to go up to 20% to 21%, which is 50 to 150 [basis points] better than Q2."
One can see both sides of the argument. On the one hand, outgoing CFO Nick Gangestad noted that the year-over-year decline from 25.2% largely came down to a one-off gain from the sale of a building flattering last year's margin performance. In addition, the wound-care business Acelity (acquired in October 2019) will dilute margin as it wasn't in last year's third-quarter results.
As such, it's reasonable to compare 3M's third-quarter 2020 margin on a sequential basis because Acelity is in the second-quarter 2020 margin.
On the other hand, Patolawala also said he is seeing "a broad-based pickup in growth across our businesses and geographies as we start the third quarter. With one week left in July, total company sales are currently up low single digits year on year." Indeed, analysts have 3M's third-quarter sales as being roughly equal with last year's third-quarter figure. In this context, it's reasonable to expect a better margin performance than what management is guiding for.
Ultimately, Gangestad sees healthcare margins (the worst impacted) normalizing as healthcare volumes come back -- something to look out for in the next quarter's results.
Does it matter?
3M has disappointed investors a lot in the last couple of years, so the market is likely to be sensitive to any negative news. The sales performance in the quarter wasn't great news, but it's not out of line with what many other industrial companies have been reporting.
In addition, it's worth noting that the sudden nature of the slowdown has probably caught 3M's customers carrying too much inventory, so it may take a while before they build inventory again and start ordering from 3M.
If volumes come back as expected, margins should start to recover too, and with 3M trading at less than 17 times forward earnings estimates, the stock continues to look like a good value. However, investors will be closely watching margin performance in the coming quarters.
