A Closer Look at 3M

3M MMM recently completed its acquisition of Acelity, which at an enterprise value of $6.7 billion represents the largest acquisition the company has ever made. We took this opportunity to revisit our assumptions and scrutinize each of 3M’s divisions after its resegmentation from five to four segments earlier this year. We have reduced our fair value estimate to $177 per share from $188 and raised our uncertainty rating to medium from low. We’re retaining our wide moat, stable trend, and exemplary stewardship ratings.

Even after increasing since the deal’s close, the stock still trades at a discount to what we consider its intrinsic value in a diversified industrial space with few bargains (we note that our 5-star price is about $124). As a GDP-plus business, 3M doesn’t offer much in the way of top-line growth. Even so, with speculation regarding an upcoming recession, we like 3M as a defensive stock.

In our view, the market traditionally values 3M like a consumer healthcare stock with industrial exposure. While most industrial stocks typically trade somewhere between 15 times and 20 times next-12-month earnings per share, 3M has traditionally traded at the upper end of the range, typically between 19 and 20 times. During the Great Recession, the stock performed well as 3M was able to retool a significant portion of its manufacturing operations and benefit from the subsequent economic recovery. We think the market pays up for certainty, and 3M has earned that premium multiple.

At this juncture, the market has discounted the stock for the three reasons: (1) slowing organic growth as the company matures; (2) recent weakness in the automotive, semiconductor, and Chinese markets; and (3) environmental and product liability litigation risks related to PFAS, or per- and polyfluoroalkyl substances. Some prominent bears now go so far as to maintain that 3M’s model is irretrievably broken. We disagree. Industrials with significant short-cycle exposure (where orders are placed and immediately filled), like 3M, Rockwell Automation, and Illinois Tool Works, have seen their stock prices take significant hits recently. By contrast, those with significant aerospace exposure, like Honeywell and United Technologies, have been in the fortuitous position of seeing upward support on their guidance. Even so, we believe 3M’s long-term competitive advantages are intact.

At its core, 3M is a materials science company. Its legion scientists and engineers improve everyday products down to their basic chemistry. We can cite several examples of the phenomenon at play. Take, for instance, microreplication technology, which is akin to covering large sheets of surfaces like plastic with thousands of microscopic pyramids in precisely sculpted uniformity. This technology is proprietary to 3M and has existed since the 1960s, when it was used in overhead projectors. Aside from improving the luminosity and reflectivity of objects used in highway safety, as well as reducing the friction in aerospace and marine applications, the technology can now be used as a vaccine delivery tool. About 10% of patients are afraid of needles. Microreplication technology enables delivery of a trial therapeutic cancer vaccine directly through the skin, all in a relatively painless manner on a surface the size of a dime.

These products now give 3M a firmer foothold in the growing healthcare market, particularly amid several secular trends like value-based care. Other positive trends include a growing geriatric population, rising incidence of surgical procedures, greater access to care in developing economies, and rising incidence of chronic disease like asthma and diabetes. For instance, diabetics may use microreplication technology to extract blood and measure blood sugar levels. All these collective scientific breakthroughs translate to a strong competitive position in a market that we think will grow by midsingle digits over the next five years.

The personal protection equipment market is another business we believe offers 3M investors both high growth and high impact. Over the medium term, we think this is a 6%-plus annually growing business, given greater awareness concerning employee health and safety. Asides from positive secular trends like rising construction, government agencies like the Occupational Safety and Health Administration have promulgated strict regulation regarding the use of personal protection equipment, and many of its global counterparts are following suit, given the high risk to worker safety in auto and metal manufacturing. We like 3M’s positioning here, given its ability to meet market demand for innovative products that balance comfort, light weight, and premium materials. Products like chemical protective coveralls, for instance, need to have these qualities because they ultimately affect both worker safety and productivity.

We don’t think the market’s concerns about 3M’s potential PFAS liability are valid, at least to the extent baked into the stock price (which we estimate is now in the midteen billions). We believe this is a lower single-digit billion-dollar overhang on the stock (our current estimate of $3.4 billion includes both total product and environmental liability). We used several methodologies to uncover this number, including estimating the extent of the liability based on pending suits, comparable historical precedents from other major environmental and product liability suits, and percentage of market capitalization (which appellate judges have occasionally employed as a guidepost).

One thing we think the market misses is that the amounts juries award are not necessarily amounts ultimately awarded to plaintiffs on appeal; recoveries are usually cents on the dollar. A couple of points of comparison we’ve used are the $5.15 billion Anadarko environmental settlement from 2015 and the $2.4 Dow Corning product liability settlement. However, we balance these considerations with the fact that 3M has already settled an $850 million suit in its home state of Minnesota, as well as present value assumptions. We note that its $235 million reserve of course does not cover potential product liability cases.

We reiterate our view that Acelity is a relatively value-neutral acquisition, only adding about $1 to our fair value estimate. When baking in Acelity, we think 3M’s stock is worth just over 17 times adjusted 2020 EPS. While our numbers lead us to conclude that the acquisition made sense more strategically than financially (with potential upside from unannounced revenue synergies), we maintain our exemplary stewardship rating.

The company has maintained its level of research and development investment at just a hair under 6% of sales, yet we believe it will maintain a best-in-class five-year return on research capital (gross profit over prior-year R&D spending) of nearly $8.70, in line with historical figures. We believe a large part of this success rate is a testament to 3M’s model, whereby 70% of all sales are generated from spec-in orders. Also, 3M has consistently increased its dividend for over 60 years, a feat accomplished by only four other diversified industrial companies. We estimate that 3M’s payout ratio will exceed 60% as a proportion of 2019 adjusted EPS, which exceeds the industrial average of typically 30%-plus. We think this demonstrates the company’s commitment to returning cash to shareholders.