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Industrial Markets Drive 3M, but What Else Is There?

We examine 3M's key divisions and potential leading indicators.

Adam Fleck, CFA, 07/25/2011

We believe 3M MMM is one of the highest-quality industrial companies we follow. The firm's research and development capabilities across multiple end markets, strong returns in each of its core segments, and ability to defend its market share have led to a wide economic moat, in our opinion. However, we think many investors occasionally misunderstand the economic drivers behind the firm's key end markets. For instance, 3M's LCD television optical film business often dominates headlines, but we note that industrial production seems to truly drive the firm's demand. That said, we also think the company is executing a strategy that should enable above-market growth rates.

Many know 3M for its consumer-facing products such as Post-it Notes and Scotch tape. However, these businesses make up just a portion of the office and stationery division (embedded in the firm's consumer & office segment), comprising just 5.5% of 2010 revenue. We believe this business is one of 3M's most stable, but it is likely much more mature than several other larger, faster-growing opportunities.

Adhesives and tape is actually 3M's largest business segment, accounting for about 10% of the firm's total business. Within this segment, the company participates in a wide variety of end markets, including automotive, aerospace, marine, construction, and electronics, with more than 200,000 customers in just the U.S. Importantly, the average customer of this business unit spends just $5,000 per year, garnering 3M a great deal of power over its clients. Moreover, although the firm competes with a number of substitute offerings in the segment (such as industrial staples, nails, or welding), management targets 50% market share in the top end of the value chain. Before 2007, this segment saw five straight years of declining volumes, but a renewed focus on new product innovation helped to push increased volumes.

3M's next-largest business is its transportation division, driving another 10% of last year's revenue. We estimate that about a third of this business stems from sales to automotive OEMs, with products such as protective coatings, acoustic management applications, and light-controlling films. 3M also sells paint preparation and flame protection products into the aerospace and marine arenas, and items such as Scotchgard and engine cleaners for automotive aftermarket end markets.

Beyond these two key divisions, 3M's optical film business is the next largest, at 7% of 2010 sales. Housed within 3M's display & graphics segment (about 15% of sales), this business produces light-enhancing film for LCD televisions, laptop computers, and mobile devices. We've previously highlighted the importance of the segment's research and production capabilities for the rest of 3M that goes beyond its direct revenue contribution; however, we note that while sales of film for LCD TVs tend to be the tail that wags the dog for the company, the subsegment is less than 3% of sales (about 40% of the optical division). In addition, although the company faces annual price-downs in the business, 3M has found success in selling this product on its energy-saving capabilities; this division grew 45% in 2010, one of the fastest rates across the firm's major areas.

Outside of industrial- and consumer-driven businesses, 3M's robust health-care division comprises about 18% of end-market demand for the company, led by infection prevention and oral care (each 4.6% of total sales). Along with skin and wound care (3.6% of revenue), infection prevention products offer the firm a very short-cycle opportunity, given the disposable and low-cost nature of most of the division's products. Conversely, we think oral care, which includes orthodontic products such as braces, is one of 3M's more-cyclical businesses due to the premium cost of the company's discretionary offerings.

Nonetheless, 3M has also enjoyed success in its safety & security segment, led by personal protection (6.9% of revenue in 2010). Events such as 2009's H1N1 flu outbreak have highlighted the firm's respiratory masks, but 3M also manufactures hearing protection products, welding helmets, and gas detection systems. As such, we think general industrial activity is a decent metric by which to measure this division.

In all, 3M has about 30 operating divisions, with each averaging roughly 3% of the company's consolidated revenue. The aforementioned businesses make up about half of 3M's total revenue; other large remaining divisions include electronics (5.6% of sales), home DIY (4.2%), and traffic safety products (3.8%). Importantly, however, 3M has enjoyed broad-based success across all six of its major segments over the past several years. Health care and consumer & office have led the pack, but all have seen returns on assets on a segment-level basis north of 10% in each year since 2004 (after applying a 33% tax rate on each segment's operating income); on average, we estimate the company's ROA at 13% annually over the time period.

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