Yahoo Finance 3M’s Return on Equity Jumps: Should Investors Be Excited?
What Were 3M's Key Growth Drivers in 1Q16?
DuPont analysis of 3M’s 1Q16 performance
3M’s (MMM) return on equity (or ROE) of 38.4% in 1Q16 was substantially higher than the 31.6% in 1Q15. However, as seen in the formula below, ROE could be distorted by excessive leverage taking.
ROE = profit margin * financial leverage * return on assets
On further analysis, we understand that an increase in the ROE was majorly due to a 22% increase in the leverage ratio. Leverage has increased majorly due to lower equity and partly due to an increase in debt. The company made acquisitions of nearly $4 billion in 2015, some of them by issuing debt. Investors should note that in February 2016, 3M’s management approved a revised plan to repurchase shares worth $10 billion. Approximately $4 billion–$6 billion worth of shares are expected to be repurchased in 2016 itself. Of these, $1.2 billion worth of repurchases has already been completed in the first quarter. These actions are likely to further inflate the company’s leverage ratio and ROE. Excessive leverage entails a fixed cost component that may push weaker earnings to further lows if global demand declines. Thus, we see this as a concern and source of risk, despite the increasing ROE.
Margin expansion in 1Q16
A smaller portion of the increase in ROE was also driven by a 140-basis-point increase in net profit margins, which came in at 17.2% in 1Q16. Margin expansions were due to higher pricing, which led to a 90-basis-point rise in gross profit margins from 49.6% in 1Q15 to 50.5% in the current quarter. Pricing increases occurred in geographies outside the US in response to challenges in depreciating local currency in the concerned economies. Productivity and cost actions resulted in a 40-basis-point benefit in operating margins.
Investors interested in trading in the industrials sector could look into the Industrial Select Sector SPDR ETF (XLI) and the iShares US Industrials ETF (IYJ). Major holdings in IYJ include Honeywell (HON) at 3.3%, 3M (MMM) at 3.9%, and General Electric (GE) at 11.5%.
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