MMM – Increasing A Bet That The Industry Makes Poorly: Could 3M Do Better?
This week we saw 3M increase its R&D bet, raising the percentage of revenues that it directs towards R&D and raising expectations for what we consider to be a particularly meaningless index – the amount of revenues generated from products less than 5 years old.
We have published a couple of pieces this year on R&D in the Industrials space, concluding broadly that it is not an effective use of cash and should not been seen by investors as something to get too excited about. Interestingly, 3M is a slight outlier.
Much of what goes on in these industries is what we would call defensive R&D; work that needs to be done either to keep up with competitors or to keep up with customer needs. Seldom is it real innovation, resulting in something that can price based on value in use rather than cost.
3M did not fare too badly in the work that we did earlier in the year, but it did not do well either. Our focus was not on revenues, as we think this is a meaningless measure; it was on returns. Why are revenues a meaningless measure; in part because companies do not generally disclose what percent of new products are replacing old products. For some companies this is the majority, and we are really talking more about product line extension rather than real innovation. More important; it is the return on R&D that matters – not the revenue.
If 3M was getting an effective return on its R&D we would expect to see return on capital improving. 3M has a good return on capital trend from 2000 to 2004, but a poor one from 2004 to 2013. Interestingly, and different from many in the broader sector, the recent point of flattening in return on capital seems to coincide with a drop in R&D spending as a percent of revenues. This might suggest that an increase in R&D spend is warranted – see chart. We would encourage 3M to come up with a different measure of R&D productivity, focused on returns rather than revenues. This might help highlight the relative attractiveness of the stock today.
We encourage clients to revisit our work on R&D effectiveness, but broadly, 3M is not an expensive stock today – suffering as others from a more complicated story in a world looking for certainty and simplicity. The stock is trading below our view of its normal value, despite earnings that are line with historical average returns on capital – the stock is around 7% below our view of normal value, while many sectors are trading well above normal today.