I have just looked at 3M and have a few questions based on my analysis:
- R&D expenditure is about 30-40% of net profit. Is there a figure that points towards how dependent the company is on R&D? I ask this because my impression was that 3M needs a fair bit of R&D to get products that tailor to consumers requirements. My impression also is that R&D is a capital intensive business and I would expect less consistent revenue. However, this is not the case with overall increasing revenue and net profit since 2017.
- Am I right to say that 3M is a high margin high volume business? NPM is not <10%. GPM is decent at 45-50%. FA/TA ratio is 30-35% and FCF/E is 40-60%.
- Are the business segments mostly recurring? I think that consumers need to continuously buy to replace old products, and there is not much variation in their purchasing habits.
- Please I would appreciate feedback on my analysis in general, below.
3M operates in 4 main segments.
Briefly, they do R&D and bring the products or services to a wide range of industries and consumers. Their products are sold directly to users through e-commerce and traditional distributors and dealers.
My gut feel is that it is a high margin, high volume business.
I feel that R&D dependent company can be semi-cyclical in nature, but this may be offset by the broadcustomer base that 3M caters to.
The business is surprisingly asset light with FA/TA ratio of about 30-35% and FCF/E ratio of about 40-60%.
Most of its revenue is recurring as consumers need to continuously buy to replace old products, and there is minimal variation in revenue (the consumer products such as stationery and office supplies hardly change).
The company enjoys strong economic moat in the form of economies of scale and wide distribution network. There is a certain brand equity as well. Patents and trademarks contribute too. For some segments like Safety and Industrial and Health Care, I can imagine that there is a “network effect” when their customers are more likely to first look into what 3M has to offer before exploring elsewhere. Certain items especially in Health Care may be cost prohibitive to change quickly e.g. VAC therapy systems for poor healing wounds. Regulations probably also contribute to recurring revenue especially in the “Safety and Industrial” segment.
Two potential growth drivers I identified are pricing power and change in trends. The net profit margin is 14-20% in the past 5 years, and although I cannot find data for average product price or volume of sales, I suspect that 3M is more likely to be a price setter rather than a price taker especially in certain industries where they have an edge over their competitors. From Health Care perspective, Tegaderm wound dressings and VAC therapy systems are commonplace in local hospitals. COVID probably also offers a potential temporary growth driver in the form of vaccine development (requiring equipment from 3M) and masks. Work from home is another potential source of revenue growth.
Given 3M’s diversity, I do not identify any concentration or key man risk. That said, 3M is susceptible to external costs of raw materials and regulatory risks that may change demand for 3M’s products. Scientific advancements also lead to change in perception of certain materials, for example certain fluorochemicals as detailed in the 2021 10-k were previously widely accepted but have recently been identified as harmful to the environment.
- When looking at R&D, you should divide it by sales instead of net profit. It is about 5.6% for the 2021 result. That is quite a reasonable figure. Note that some businesses must consistently spend on R&D to keep their competitiveness. 3M is one of them; their new product is usually patent, and once the patent ends, everyone can copy, which is why they have to keep spending on R&D to develop better products.
- Yes, you can classify them as that, but they are probably close to the end of the runway, as you can see from their slow revenue growth.
- I would say their business is recurring because there is a need for their product daily. On top of that, they also build their products for specific industries which require daily use of their products.
- Great analysis Benjamin; you are spot on. For the risk part, their drop in share price is due to potential lawsuits of faulty earplugs that they need to compensate for. The amount is still unknown, but investors are estimating a considerable amount which is the reason for their share price to trade at a low valuation. You can find the news here: https://www.bloomberg.com/opinion/articles/2022-02-14/3m-adds-an-earplug-legal-worry-to-its-pile-of-headaches
One cannot expect good news and low valuation at the same time. Hence, if you see the current lawsuit as a temporary issue, the current valuation provides an opportunity since it is trading at a historical high yield and low PE multiple. Note: 3M is more towards dividend stocks rather than growth stocks.
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Just to add on valuation of 3M Co, I used P/E method as the company has quite predictable earnings although it is on a semi cyclical uptrend in the past 5 years. So I used the average 5y P/E. Based on this, the average P/E since 2012 is around 22.6 and intrinsic value of 227. This gives margin of safety currently about 43%.
As mentioned, the company growth have slow, so you should use a 10Y PE chart rather than a 5Y chart.