Sticking With 3M

Following the second-quarter earnings report, we are reiterating our $160 fair value estimate and wide economic moat rating for

Price increases combined with lower raw material costs contributed to nearly 110 basis points of year-over-year operating margin expansion to 23.9% in the quarter. That prices managed to stay positive despite weaker-than-average global demand for 3M's products is a testament to the pricing power inherent in the company's wide moat and the resilience of its business model. Sluggish economic environments in several of 3M's key markets, such as China, Western Europe, and Latin America, are likely to persist in the near term; however, we still believe that a strong product portfolio supported by a world-class research and development organization will support growth in excess of GDP over the long run. Furthermore, as 3M works through portfolio actions in order to find greater operational synergies among its business units, while feathering in acquisitions like the recently announced Capital Safety transaction, we expect a more efficient company will emerge.

Portfolio Mix Sets 3M Apart What sets 3M apart from other capital-intensive industrial firms in our coverage universe is the high percentage of consumables in its product portfolio. Representing almost 50%, consumables contrast sharply with the large-scale equipment sold by industrial peers. The other 50% is specified by original-equipment manufacturers for use in making other products, which support recurring revenue streams throughout the customer's product lifecycle as long as performance standards are met.

As we see it, 3M's products spring from four main technological competencies honed over its 100-plus years of operating history: abrasives, adhesives, filters, and coatings. Innovation in any one of these four categories drives new product development across 3M's operating segments, which are primarily aligned by end market: industrial (about 35% of 2014 revenue), safety and graphics (18%), electronics and energy (17%), health care (17%), and consumer (14%). Selling consumables and "spec-in" components allows 3M to sustain strong average year-over-year volume growth, with recurring revenue and scalable manufacturing operations supporting attractive low to mid-20s operating margins. However, unlike more commodified producers of disposable products, we believe 3M's products are differentiated by superior technology, allowing the firm to sustain modest year-over-year price increases as well.

CEO Inge Thulin is in the middle of a five-year plan focused on better portfolio management, R&D revitalization, and emerging-markets growth. Successful execution in each of these pillars should allow 3M to sustain organic revenue and profitability growth at a modest multiple to industrial production. Since 2012, 3M realigned its portfolio to encompass 27 businesses in six sectors, taking better advantage of economies of scope as well as scale. Near-term R&D spending is expected to reach 6% of sales, about 30 basis points higher than the prior 10-year average. With about one-third of sales generated by products five years old or less, R&D remains the lifeblood of 3M's growth. Emerging-market exposure is now 35% of sales, up from 21% in 2003, and targeted to reach 40% by 2017.

Powerful Brands Add to Advantage… We believe 3M's wide economic moat stems from three main moat sources: intangible assets, cost advantage, and switching costs. These factors allow the company to generate attractive returns on invested capital despite a massive portfolio of disposable, finite-use products that might otherwise be described as commoditylike. Such products, by nature, are typically difficult to differentiate on anything other than price. That said, we believe 3M's R&D prowess crafts products that are far superior, supporting performance claims that create the powerful brands for which 3M is known.

We believe patents and a strong brand are intangible assets that support 3M's wide economic moat. 3M has historically reinvested 5%-6% of sales over the past 10 years in its R&D powerhouse, which develops new products from the firm's four main technological competencies or finds enhancements to existing product lines. Patents, technology, and trade names represent nearly $1.4 billion worth of intangible assets on the balance sheet, with estimated economic lives that average between 5 and 20 years. We believe it would be difficult for competitors to match this level of investment, particularly when considering both capital costs and development time spent by 3M honing various products over numerous decades.

3M's strong brand recognition is a unique advantage that few industrial companies enjoy, in our opinion, due to the relatively mundane nature and low visibility of industrial consumables, parts, and components. Yet 3M's mastery in tweaking technology to serve specific needs of various end markets supports a cohesive brand that resonates across industrial sectors, not just on the shelves of a grocery store. For example, metal fabricators rely on Scotch-Brite sanding wheels as much as consumers need Scotch-Brite sponges to clean their pots and pans. In our view, a brand that is synonymous with quality and performance supports lucrative recurring revenue streams with enterprise customers that rely on consumables that are durable and work right the first time. This dynamic supports the strong organic volume growth reported by 3M over the past five years, as well as the ability to charge premium prices for higher-quality products (shown in modest but persistent price increases year after year on average).

…As Do Scale and Pricing Power Economies of scale provide 3M with the ability to establish manufacturing facilities across the globe and source raw materials more efficiently than smaller competitors. By demonstrating a lower cost per unit, 3M can remain more flexible and more profitable than competitors that attempt to compete on volume growth alone. Many industrial companies with large operating footprints can claim the same kind of scale advantages related to sourcing; however, we believe 3M also benefits from economies of scope that originate from a centralized R&D function. The cost of innovation is ultimately spread across the organization, as one new product is modified to serve the specific needs of end markets in all five operating segments. These adjacencies result in a highly efficient, self-supporting new product development pipeline that feeds off organizational memory and radiates from the centralized research hub to the various spokes of the organization.

Barriers to entry are few, which gives rise to numerous competitors in many of 3M's product categories. Yet we believe evidence of switching costs exists in 3M's ability to eke out modest price increases year over year despite the challenges of fending off both foreign and domestic competitors attempting to knock off well-known products and sell them for less. For example, while many substitutes exist for Scotch Tape, it is easy to experience 3M's superior adhesive strength when examining competitive offerings. Consumers will typically pay for a premium brand if such differences in quality are readily observable, and we believe industrial customers behave much the same way. An enterprise relying on sanding wheels with standard grit sizing for precision grinding will pay the much higher cost of failure should a competing knockoff wheel lack durability. Furthermore, OEMs using 3M components on product platforms rely on 3M's meeting specific performance parameters. We believe it is this level of necessity that keeps customers paying premiums for 3M's superior products, which translates into the modest but visible pricing power seen in historical metrics.

Recurring Revenue Lessens Risk Recurring revenue streams prompt us to give 3M a low fair value uncertainty rating; however, several risks could affect both near- and long-term cash flows. 3M's newly aggressive plan to pursue acquisitions of larger companies, such as the recently announced $1 billion acquisition of Polypore's separations media business, makes deal valuation a critical factor of future growth, inviting additional risk to overpay for deals. From a macro perspective, as 3M works to increase exposure to emerging markets, currency risk heightens. This dynamic could cause revenue and profitability to fluctuate more materially across the business cycle. Although 3M's diversified portfolio separates it from many geographic-specific economic challenges, the possibility of a renewed global slowdown or U.S. recession presents substantial risk to the company's near-term growth, and overlapping regional downturns could cause the entire portfolio to experience merely middling growth longer term due to diversification.

Stewardship Is Exemplary Before assuming the helm, Thulin had been with 3M for 33 years, holding a variety of operational roles within the international organization. The company's key focus and objectives under his leadership remain leveraging R&D, increasing the company's footprint in faster-growing markets, and ramping up acquisition activity in order to complement a newly concentrated portfolio. This led to slightly increased leverage relative to 10-year historicals in order for 3M to have plenty of dry powder while continuing its history of rewarding shareholders with dividends and share repurchases. (The company has paid paid dividends without interruption for 98 years.) While this decision invites a little more risk onto 3M's balance sheet, operating results coming out of Thulin's playbook justify his capital-allocation strategy. Since 2012, operating margins, earnings, and returns on invested capital have all shown improvement, validating our view of 3M's historically excellent stewardship of shareholder capital.