Dividend Growth Stock of the Month for June 2019

3M (MMM) is a giant industrial conglomerate, founded in 1902 as Minnesota Mining and Manufacturing.

3M often shows up on lists of high-quality companies and “best stocks to own.” Is it a good choice for dividend growth investors? Is it selling at an attractive valuation?

Let’s find out.

As always, I will use the approaches described in these Dividend Growth Investing Lessons:

The reason I am writing this report at this time is that 3M delivered a weak earnings report late in April, and the market has punished the stock severely, taking its price from a 52-week high to a 52-week low in a matter of days – see the red arrow in the chart below.

That, of course, pushed 3M’s yield to a level that is rarely available from this Dividend Champion, Aristocrat, and King – see the green arrow.

That makes this a propitious time to take a serious look at 3M.

3M’s Dividend Record

3M’s dividend record is very strong, and it’s been made stronger by its recent increase in yield. You can get 3M now at a yield that is 1/3 higher than it was just a year ago. 3M’s yield hasn’t been this high since the Great Recession.

In Simply Safe Dividends’ scoring system, which weighs multiple factors, 3M gets a dividend safety score of 86/100, meaning that its dividend is rated as very safe and unlikely to be cut. (For more insight into dividend safety, see Dividend Growth Investing Lesson 17.)

This month, I’m experimenting with giving overall category grades. I would rate 3M’s dividend resume this way:

What’s the Story? 3M’s Business Model and Company Quality

3M is headquartered in St. Paul, MN. While classified as being in the Industrial sector, the company is in reality a multi-faceted conglomerate.

3M develops, manufactures, and markets a mind-boggling variety of products worldwide. The company operates through five business groups:

• Industrial accounts for 35% of sales. Covers advanced materials, industrial adhesives and tapes, automotive aftermarket, separation and purification, abrasives, closure and masking, automotive, and aerospace.
• Safety & Graphics accounts for 20% of sales. Covers personal safety products, commercial solutions, transportation safety, and roofing granules.
• Health Care accounts for 18% of sales. Includes food safety, health information systems, medical solutions, and drug delivery. This segment is due to expand with an announced acquisition, discussed later in this report.
• Electronics & Energy accounts for 14% of sales. This segment covers energy-related products, electronic products, materials, and systems, and display materials and systems.
• Consumer accounts for 13% of sales. This segment covers home improvement, home care, and consumer health care (such as respiratory equipment).

About 60% of 3M’s sales come from overseas.

3M had a dismal Q1 2019 earnings report, as they reported drops in sales and earnings per share (EPS), and missed estimates badly across the board.

[Image source: 3M earnings report]

In light of that, the company presented a series of steps it is taking to address its performance. 3M announced a restructuring aimed at cutting $225-$250 million annually, with $100 million of the benefit in 2019.

The restructuring will involve realignment of its businesses into four business groups from the current five:

A short time after its earnings report, 3M announced that it will buy medical device maker Acelity for $6.7 billion, which includes assumption of debt. Acelity makes wound-care and surgical products, which is a growing field given our aging population. It had $1.5 B in 2018 revenues.

Management says the acquisition will be accretive to earnings in year two of the deal, but dilutive in the first year.

To finance the deal, which is much larger than 3M’s usual small “bolt-on” acquisitions, 3M intends to use cash on its balance sheet plus debt.

The company will also slow down its share-repurchase program, which ironically means the company will be less able to take advantage of buying back shares when their prices are down.

These prospects haven’t helped 3M’s share price, which has continued to decline since the earnings announcement at the end of April.

3M recently presented its forward-looking priorities, shown in the slide below.

Frankly, this is typical vague corporate-speak, although the importance of integrating Acelity is specifically called out.

All that said, it is good to step back and recognize that 3M is overall a powerhouse player in myriad diverse markets. It has traditionally strong margins generating excellent cash flows, massive manufacturing capabilities, excellent distribution systems, and strong relationships with resellers.

3M’s success is due in large part to its commitment to research and development, combined with its strategy of leveraging its innovations across businesses. The company’s pulling together of business units reflects that integration mentality. The company directs nearly 6% of net sales to R&D, which is much more than other companies in its businesses.

Those long-term macro qualities are reflected in 3M’s business quality rankings from respected third-party sources.

In the table above, you may notice the absence of S&P’s Global Market Intelligence quality ratings as found in CFRA stock reports. I have often found those grades to be out of step with other ratings, sometimes out of step with the CFRA reports that they are found in, and rarely explained in the bodies of such reports. Therefore I have decided to stop using them.

Putting everything together, I would give this grade for 3M’s overall business model and corporate quality:

3M’s Financials

I like to begin this section by seeing how Value Line rates the company’s overall financial strength. Then I go through specific financial metrics and see if I agree with their assessment.

Value Line gives 3M its highest Financial Strength grade. I see no indication that it has changed the grade in light of 3M’s weak first-quarter earnings report.

Let’s look at some key financial categories and see if we agree.

Return on Equity (ROE) is a standard measure of financial efficiency. ROE is the ratio of profits to shareholders’ equity.

The average ROE for all Dividend Champion stocks is 14%, and for S&P 500 companies it is about 13%. The following chart shows 3M’s ROE 2009-2018.

[Source of all yellow-bar charts: Simply Safe Dividends]

You can see that MMM’s ROE runs well above average. The average ROE for Industrial companies on the Dividend Champions document is 24%, and 3M is well beyond that too.

Debt-to-Capital (D/C) ratio measures how much the company depends on borrowed money. Companies finance their operations through a mixture of debt and equity (shares issued to the open market) as well as their own cash flows.

A typical D/C ratio for a large, healthy company is 50%.

The normal use of D/C is to gauge risk, because it helps determine how strong the balance sheet is. All else being equal, stocks with high D/C ratios are generally riskier than those with low D/C ratios.

Another use of D/C is as a check on ROE, because ROE can be “goosed” by debt. And from the following chart, we can see that has happened with 3M.

From what would be considered a very safe D/C in 2009-2014, we see that 3M has increased its reliance on debt steadily since then. The years of increasing debt mirror the years of increasing ROE.

We can also expect debt levels to rise in connection with the Acelity acquisition.

This is not good news. Long term debt made up 59% of total capital at year end 2018, up from 54% a year earlier, and well up from 25% in 2010-13.

One saving grace is 3M’s strong AA- credit rating. S&P describes its “AA” rating category as follows: “An obligor rated ‘AA’ has very strong capacity to meet its financial commitments.”

Operating margin is one of my favorite financial metrics. It measures profitability: What percentage of revenue is turned into profit after subtracting cost of goods sold and operating expenses.

Per recent research, typical operating margins for S&P 500 companies have been in the 11-12% range. 3M’s operating margins have been twice that:

This is a very good metric for 3M, not only because of its high margins, but also because they have been running high and been very consistent for years.

Earnings per Share (EPS) is the company’s officially reported profits per share. We want to see if a company has had years when it officially lost money, or if its earnings are steadily increasing, declining, or flat.

3M has been delivering strong profits and profit growth for years. In 8 of the past 9 years, EPS increased, although its annual rate of growth has slowed in the past 2-3 years.

Analysts’ forward estimates for EPS growth are in the 4%-5% range. Even for a company as big as 3M, that’s not very fast. Current estimates for 2019 would be a 9% drop from 2018, per Schwab.

Free Cash Flow (FCF) is the money left over after a company pays its operating expenses and capital expenditures. Whereas EPS is subject to GAAP accounting rules, cash flow is a more direct measure of money flowing through the company. It’s the money a company has available for dividends, stock buybacks, and debt repayment.

Excess FCF allows a company to pursue investment opportunities, make acquisitions, repurchase shares, and pay/increase dividends.

3M’s cash flow record is a little erratic. While always positive, it has not grown consistently from year to year. In 5 of the past 9 years, it declined, although overall it has grown from 2009 through 2018.

Share Count Trend shows whether the company’s outstanding shares are increasing, decreasing, or remaining flat.

I like declining share counts, because the annual dividend pool is spread across fewer shares each year. That makes it easier for a company to maintain and increase its dividend. By buying back its own shares, the company is essentially investing in itself and expanding each remaining share into a larger piece of the pie.

3M has been retiring shares steadily since 2010. It has 17% fewer shares in circulation now than at the end of 2010.

In connection with the Acelity acquisition, MMM will slow its share repurchase program to around $1.0-$1.5 billion, down from $2.0-$4.0 billion.

Here is a summary of the items above:

Taking everything into account, I think that Value Line’s A++ financial rating is too generous. While 3M’s financials are excellent in several areas, its growing debt is a negative, and its expected EPS growth rate is slow even for a giant company. Here’s my grade for 3M’s financials:

3M’s Stock Valuation

I use four different approaches, then average them out.

Step 1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value.

The basic valuation estimate usually uses a price-to-earnings (P/E) ratio of 15, which is the historical long-term P/E of the stock market, to create a baseline “fair value” reference line.

In the following chart, the fair-value reference line is orange, and the black line is 3M’s actual price.

As you can see, even with its recent price plunge, 3M’s actual price is above the fair-value orange line, suggesting that 3M is overvalued. I circled 3M’s actual P/E of 16.3, which is higher than the reference ratio of 15.

To calculate the degree of overvaluation, we make a ratio out of the P/Es.

Calculating Valuation Ratio from FASTGraphs
Actual P/E ratio / Reference P/E ratio
16.3 / 15 = 1.09

So by this valuation step, 3M is overvalued by 9%. To my way of thinking, this difference is slight, and I would rate 3M as fairly valued right now using this method.

We calculate 3M’s fair price by dividing the actual price by the valuation ratio. We get $163 / 1.09 = $150 for a fair price.

Note that I round dollar amounts to the nearest dollar to avoid creating a false sense of precision. Since valuation involves future events, it cannot be precisely known.

I believe it is a good idea to keep the uncertainty of valuation in mind as an investor. We’re not measuring a physical trait like length or width. We are making an assessment. Different methods and models will come up with different results. That’s why I average four models.

Step 2: FASTGraphs Normalized. The second valuation step is to compare the stock’s current P/E to its own long-term average P/E.

This step paints a very different picture from the first step.

3M’s 5-year average P/E is 21.1 (circled). That moves the reference line up above 3M’s actual price.

Using the same calculation methods as above, we get the following results for 3M’s valuation.

• Valuation ratio: 16.3 / 21.1 = 0.77
• Fair price: $163 / 0.77 = $212

This suggests a fair price that is 41% higher than the first step.

Step 3: Morningstar Star Rating. Morningstar takes yet a different approach to valuation. They ignore P/E ratios and instead use a discounted cash flow (DCF) model for valuation. Many investors consider DCF to be the best method of assessing stock valuations.

In a nutshell, the DCF model is based on the idea that a company is worth all of its future cash flows (or earnings), discounted back to the present to reflect the time value of money.

Obviously, no one actually knows a company’s future cash flows. Estimates must be used. My experience with Morningstar is that they have an admirably comprehensive and conservative process.

Morningstar takes yet a different approach to valuation. They ignore P/E ratios and instead use a discounted cash flow (DCF) model for valuation. Many investors consider DCF to be the best method of assessing stock valuations.

In a nutshell, the DCF model is based on the idea that a company is worth all of its future cash flows (or earnings), discounted back to the present to reflect the time value of money.

Obviously, no one actually knows a company’s future cash flows. Estimates must be used. My experience with Morningstar is that they have an admirably comprehensive and conservative process.

Morningstar gives 3M 4 out of 5 stars, meaning that they consider the stock to be undervalued.

Morningstar calculates 3M’s fair price at $190, meaning that it’s selling at a 14% discount.

Step 4: Current Yield vs. Historical Yield. My last step is to compare the stock’s current yield to its historical yield. This way of estimating fair value is based on the idea that if a stock’s yield is higher than usual, it may indicate that its price is undervalued.

This chart shows 3M’s current yield (green dot) compared to its 5-year average yield.

[Source: Simply Safe Dividends]

3M’s 5-year average yield is 2.6%, while its current yield is 3.5%. When the current yield is higher than the historical average, that suggests that the stock is undervalued.

Calculating Valuation Ratio from Yield Comparison
Historical yield / Current yield
2.6% / 3.5% = 0.74

The valuation ratio from comparing yields is 0.74, suggesting 26% undervaluation.

When I use this method, I don’t use valuation ratios below 0.80, because I consider this an indirect method of valuation, and I want to cut off extremes.

Using the valuation ratio of 0.8, 3M’s fair price computes to $163 / 0.8 = $204.

Valuation Summary:

The average fair price of 3M works out to $189 compared to its current price of $163.

For comparison, CFRA has a 12-month price target of $195.

In my scoring, I would rate 3M’s valuation this way:

Miscellaneous Factors

Beta

Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility for 2 reasons:

• They present fewer occasions to react emotionally to rapid price changes like sudden price drops that can induce a sense of fear.
• There is industry research that suggests that low-volatility stocks outperform the market over long time periods.

3M’s 5-year beta is 1.0, which means its volatility has been, on average, just like the market’s.

This is a neutral factor.

Analyst’s Recommendations

In their most recent report on 3M, Schwab shows the recommendations of 20 analysts who cover the company. Their average recommendation is 3.0 on a scale of 5, which is exactly a “hold” recommendation.

This is a neutral factor.

What’s the Bottom Line on 3M?

Here are 3M’s positives:

• Very strong dividend record: Good yield (3.5%) combined with a 61-year unbroken streak of increases, many of which have been in double digits. Yield is at a multi-year high.
• “Very Safe” dividend safety grade of 86/100 from Simply Safe Dividends, suggesting that the dividend is unlikely to be cut.
• While classified as an industrial company, 3M is really a conglomerate with a myriad of revenue streams coming from a wide variety of industrial, safety, healthcare, electronic, energy, and consumer products.
• Worldwide footprint: 60% of sales come from overseas.
• Wide moat rating from Morningstar, high investment-grade credit rating from S&P, and highest Safety rating from Value Line.
• Excellent record of earnings returns, high margins, and steadily declining share count.
• A++ financial grade from Value Line, although I would give 3M a B+ for its financial picture.
• Shares are 14% undervalued.

And here are 3M’s negatives:

• Dismal Q1 results, which have led to a restructuring and cost-cutting program.
• Potential difficulty in integrating Acelity, and financial pressure of making the acquisition.
• Steadily rising debt level for several years (even ignoring Acelity), unnecessarily leveraging the company for no obvious reason.

In my opinion, 3M seems like a very attractive dividend growth opportunity, on the assumptions that it works out its operating inefficiencies, world trade wars don’t blow up the international economic system, and it integrates Acelity successfully.

The company’s stock valuation is in a rare territory right now, due to what I consider a market over-reaction to 3M’s lousy first-quarter earnings report.

For dividend growth investors, 3M is seldom available at such a high yield as 3.5%, and its dividend seems to be very safe and sound.

My bottom line on 3M is reflected in the general grades I gave it earlier in this report:

Here are some other analyses of 3M on Daily Trade Alert over the past year+.

• James Brumley picked 3M as one of 10 Stocks to Buy and Hold Forever in April.
• Jason Fieber made 3M his Undervalued Dividend Growth Stock of the Week in November, 2018. He pegged a fair price as $211.
• In January, 2018, Mike Nadel made 3M the second stock ever selected for DTA’s Income Builder Portfolio.

Finally, remember that this is not a recommendation to buy, hold, or sell 3M. Always do your own due diligence. Think not only about the company’s quality, dividend outlook, and business prospects, but also about how and whether it fits your personal financial goals.

— Dave Van Knapp

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