3M Pre-Earnings: Another Quarter Of Solid Organic Growth To Be Marred By Currency Effects?

3M (NYSE:MMM) is scheduled to report its Q3 results on October 22, and we expect another quarter where net sales will be dragged down by the unfavorable impact of currency translations. The American multinational conglomerate generated approximately 63% of its top line from markets outside the U.S., and with the dollar continually strengthening against foreign currencies, organic growth might be wiped out yet again in Q3. Last quarter, organic sales grew by 1.8% year-over-year, but the negative impact of currency conversion was a 7.3 percentage point headwind. With a business spreading across over 70 countries, 3M is highly exposed to the risk of currency fluctuations.

We have a price estimate of $152 for 3M, which is slightly above the current market price.

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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. However, with crucial emerging market currencies remaining weak into the second half of the year, there is bound to be a material impact on the top line.

Apart from the currency impact, what could hurt 3M’s growth this quarter is possible slower growth in Asia-Pacific sales. Organic local currency growth in Asia Pacific was 0.5% in Q2, brought down by the 2% decline in China/Hong Kong. Although Asia-Pacific has traditionally been a ground of hope and investment for foreign companies, the uncertain macroeconomic environment, especially in China, which is coming to terms with normalization, could make it difficult to extract meaningful growth from this region in the near term.

Now for the positives. Solid growth in the domestic market should boost organic growth, and strategic pricing and improved efficiency should help protect profitability. The domestic market is the biggest contributor to the top line and with economic conditions holding strong this year, organic growth could be solid again in Q3, after a 4.1% growth in the last quarter. The U.S. GDP expanded at a solid 3.9% last quarter, which reflects stronger economic conditions.

Although revenues declined 4.4% through the first half, the combination of lower raw material costs and higher selling prices resulted in a full one percentage point improvement in operating margins to 23.4%. 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.

Pricing has been a key driver of 3M’s bottom line growth. In Q2, 3M’s operating margin increased 110 basis points to 23.9% as a result of  a 1.5% improvement in pricing and raw material costs. 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. ^[1] 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.

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1. 3M’s Goldman Sachs Industrials Conference Presentation, November 13, 2014, www.3m.com [↩]