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Better Buy: 3M vs. Union Pacific

Motley Fool - Fri Mar 24, 4:17PM CDT

These two stocks have not covered themselves in glory over the last few years. Multi-industry industrial 3M(NYSE: MMM) and West Coast railroad Union Pacific(NYSE: UNP) have underperformed the S&P 500 over the last three and five years. Both have been toward the bottom of their respective peer groups, too. Moreover, their operational performance has also fallen behind their rivals. So which company stands better placed to deliver returns for investors? Here's the lowdown.

Value investing 101

One form of value investing argues that buying the laggard in a peer group often makes sense. The idea is the company has an opportunity to play catch-up with its peers in terms of operational metrics and, in doing so, release a significant amount of value for investors.

It's a beautiful idea, but it comes with the caveat that management is willing and able to do so.

Union Pacific makes changes

The value investing case for Union Pacific is best based on criticisms against the company made by long-term shareholder Soroban Capital Partners. The investment firm's main point is that under Lance Fritz's tenure as CEO, Union Pacific's performance on safety, carload volume growth, revenue growth, cost management, earnings growth, and shareholder return has been the worst in class. Of particular note, its performance has lagged that of its closest rival, Berkshire Hathaway-owned BNCF.

Soroban argues that UNP's performance improved when industry veteran and precision scheduled railroading (PSR) expert Jim Vena was the chief operating officer in 2019 and 2020, only to deteriorate notably after he left. For reference, PSR is a set of management techniques that aims to run the same volume but using fewer assets. For example, PSR practitioners emphasize things like increasing train length, cutting terminal dwell, and increasing train speed.

In presentation to the board of directors, Soroban said he believes Fritz should be held "accountable" for the railroad's disappointing performance, and that "Fortunately, we believe Jim Vena would be keen to return to UNP in a new leadership role."

From Soroban's point of view, the good news is that Union Pacific has now publicly acknowledged it's looking for a new CEO to assume the position in 2023. However, it's unclear at this stage whether Vena will be brought back as CEO or in another leading capacity.

3M's problems keep growing

The industrial conglomerate's position is arguably much more difficult. Its management is under fire from an unhappy key investor; the disgruntlement is understandable. After all, 3M has a recent history of missing guidance while delivering lackluster returns and a deteriorating profit margin. Meanwhile, the threat of legal liabilities (for PFAS and combat arms earplugs) hangs over the company as its dividend cover is stretched.

Simply put, the company's 5.8% dividend yield is enticing, but it's not enough to justify buying the stock -- it could get cut in the future.

The legal issues are one thing, but the failure to turn around 3M's operational underperformance, despite significant restructuring and merger and acquisition activity, suggests a more fundamental rethink of the company's business model might be needed. 3M traditionally invests a relatively high amount (for an industrial company) of its revenue in research and development to create high-quality, differentiated products that command good profit margins and generate the volume growth that leads to margin expansion through reducing the cost of unit production over time.

Unfortunately, the investment in research and development hasn't led to margin growth or earnings before interest and taxation (EBIT) growth in recent years.

MMM R&D to Revenue (TTM) Chart

Data by YCharts

Union Pacific stands better positioned

All told, Union Pacific is the better pick. Its board has taken action over the disappointing performance, and whether Vena is involved or not, the new CEO must improve metrics in line with its peers. Its task looks simpler than 3M's. In contrast, 3M management's challenge looks more difficult because its non-legal problems may need more fundamental restructuring. In addition, the cash call from potential legal liabilities may restrict management's ability to make the necessary changes to generate shareholder value.

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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway and Union Pacific. The Motley Fool recommends 3M. The Motley Fool has a disclosure policy.

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