3M Earnings: FX Tempers Revenue While Pricing Drives Earnings

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3M (NYSE:MMM) announced its second quarter results recently, with a 5.5% decline in revenues, reaching $7.7 billion, as a result of foreign currency headwinds, which more than offset increased volume and pricing benefits. [1] On an organic local currency basis, which excludes the impact of currency fluctuations and acquisitions, revenue grew a sluggish 1.8%. Improvements in pricing and raw materials helped boost the company’s operating margins, which drove a 5.8% increase in earnings per share, to reach $2.02, compared to analyst estimates of $2.00. Given the current scenario, we expect to see similar trends driving 3M’s results through 2015. Recent acquisitions will also have a major role to play.

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FX Headwinds Severely Temper Sales

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Despite its preparations, a strong U.S. dollar hurt the company’s second quarter top line by 7.3% and reduced its pre-tax earnings by $0.12 per share. [2] Weakness was particularly noticeable in euro, yen and real currencies.

After its fourth quarter revenue suffered from currency fluctuations, 3M took steps to counter the impact of foreign exchange translations. The company entered into currency hedging contracts with a tenor of 24 months, as opposed to its general practice of 12 months, in order to safeguard against unexpected changes in foreign exchange rates. 3M also planned to raise product prices to offset the impact of weak currencies, a strategy it has used in the past as well and is one of the driving factors behind its pricing. The company also looked to localize production; for example, in order to cater to its customers in Europe, it would utilize its production capacity in Europe and avoid having to import from regions with stronger currencies compared to the euro.

We believe that 3M’s top line will likely continue to suffer through the year due to foreign currency headwinds. Growing oil production and a possible increase in interest rates in the U.S. will likely make the U.S. dollar stronger.

Pricing Drives Operating Margins

In the second quarter, 3M’s operating margin increased 110 basis points to 23.9% as a result of 1.5% improvement in pricing and raw material costs. The increase in pricing also had a 1% favorable impact on the top line, but it wasn’t enough to offset currency headwinds.

3M’s pricing power stems from its innovation. The company frequently introduces innovative and differentiated products in the market. In fact, a third of 3M’s sales come from products that have been developed in the past five years. [3] It is able to charge premium rates for newer products, which helps in improving margins. Meanwhile, older products have to be priced competitively due to the availability of cheaper alternatives. 3M is able to regularly introduce new products by spending heavily on R&D. In 2014, 3M spent 5.6% of its revenues on R&D. The company has decided to gradually increase its annual investment in R&D to 6.0% of total sales by 2017.  As 3M continues to increase its R&D spending, it expects to see its sales from new products to increase to 37% by 2017. With a higher number of newer products accounting for sales, 3M’s pricing power and margins will likely continue to improve.

Raw materials costs have been low over the past few quarters as commodity and energy prices have been declining. We expect raw material costs to remain low through the year.

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Notes:
  1. 3M’s Q2 2015 Earnings Press Release, July 23, 2015, 3M’s Quarterly Highlights []
  2. Q2 2015 3M Company Earnings Presentation, July 23, 2015, 3M’s Presentations []
  3. 3M’s Goldman Sachs Industrials Conference Presentation, November 13, 2014, www.3m.com []