3M Company (NYSE: MMM) is a diverse conglomerate that produces a broad array of products and materials for both consumers and businesses.
3M Company (NYSE: MMM), once called the Minnesota Mining and Manufacturing Company, was founded in 1902. The company, now with 80,000 employees, produces products like Scotch tape, projector systems, Post-it notes, Tartan track, and Thinsulate. This is a conglomerate that produces products for many industries and for both personal and business use, and their manufacturing, research, and sales offices are all over the world.
The company is divided into five business segments:
This segment provides adhesives, abrasives, filtration systems, fasteners, and specialty materials to a variety of industries. This is the largest segment, accounting for about 32% of sales.
Safety and Graphics Business
This segment provides display films, reflective materials, projection systems, and the like. This segment accounts for about 18% of sales.
Electronics and Energy
This segment provides products for electronics and energy businesses including films for LCD screens and splicing products for signal cables, and accounts for about 18% of sales. Nearly two-thirds of sales from this segment come from the Asia Pacific region.
Health Care Business
This segments provides several products in the areas of wound care, oral care, drug delivery systems, and more. This segment accounts for about 17% of sales. The bulk of sales come mainly come from the U.S. and Europe, as the products are more targeted towards developed countries.
Consumer and Office Business
This segment provides solutions for the home and office, and includes well-known products like Scotch tape. This segment accounts for about 15% of sales. The U.S. accounts for over half of sales from this segment.
Price to Earnings: 16.5
Price to Free Cash Flow: 19.3
Price to Book: 4.1
Return on Equity: 27%
(Chart Source: DividendMonk.com)
Revenue grew at a solid rate of 5.1% per year on average over this period.
Earnings and Dividends
(Chart Source: DividendMonk.com)
Earnings grew at a 6.3% rate over this period, and dividends grew at a rate of a bit over 5% per year on average.
The company keeps the dividend payout ratio fairly low at under 40% currently, and at most in the mid-forties during the bottom of the latest recession when earnings were weak. The current yield is a modest 2.42%, but the company does have a streak of 55 years of consecutive annual dividend growth, which is only surpassed by seven other companies that I’m aware of.
Approximate historical dividend yield at beginning of each year:
How Does 3M Company Spend Its Cash?
Over the last three years, 3M generated approximately $11.8 billion in free cash flow. Over the same period, the company spent $4.7 billion on dividends, $5.7 billion on share repurchases, and $3.5 billion on net acquisitions.
An issue here is that unlike most dividend growth companies, 3M tends to issue quite a number of shares. Over this three year period, the company issued over $2.5 billion worth of shares, and this trend stretches back far into company history. The issuing of these shares mitigates a significant portion of the share repurchases that the company does.
Total debt to equity is under 35%, total debt to net income is only 135%, the interest coverage ratio is nearly 38x (which is substantially above average), and despite the history of acquisitions, goodwill accounts for less than 45% of equity.
3M’s balance sheet is among the strongest out of the companies I publish reports on, and is the strongest or among the strongest in its industry.
3M Company is a highly diversified industrial/engineering company that makes a lot of the small pieces or details of technologies and products that define a developed economy.
Consumers know the brand mainly from office supplies, but most of the sales come from business-to-business transactions.
Over the last two decades, developing markets have played an increasingly important in growth for the company, as they’ve made up a larger and larger percentage of the total corporate sales. During the last ten years, sales to developing markets have jumped from 21% to 34% of sales, and this figure is expected to increase to the 40-45% over the next five years according to their latest investor presentation.
The company takes a layered approach to expansion into new markets. What this means is, their five business segments come into play in stages as an economy develops. In the earliest stage of development, 3M’s industrial and energy products are most relevant. In middle stages, safety products and consumer products start being the focus, and in the later stages health care sales start to become more available.
The company expects to continue with their organic growth, and to continue with their acquisition policy at a rate of $1-$2 billion in net acquisition costs per year. Recent acquisitions include electronic toll collection technology, language software, and advanced technical ceramics.
Since the company primarily sells to businesses, their sales tend to be more volatile during recessions than a defensive consumer company.
The company spends in the ball park of $1-$2 billion on research and development each year, and must continue to innovate and/or make smart acquisitions in order to remain competitive and achieve good returns for shareholders.
Conclusion and Valuation
The company has a particularly strong balance sheet, more than five decades of consecutive annual dividend growth, and a diversified global position.
A downside is that, quite simply, the sum of earnings growth and the dividend yield is not particularly attractive. With under 6.5% earnings growth (and lower dividend growth), and a dividend yield of under 2.5%, the sum of EPS growth and yield is under 9%, which is lower than many of the companies I cover. Since the sum of EPS growth and dividend yield is a proxy for the expected rate of return for the investment (assuming a static stock valuation), this leaves a bit to be desired.
This is directly related to the $2.5 billion worth of shares issued over the last three years, which was mentioned in the section about how the company spends its cash. The company issued over $500 million worth of shares in 8 out of the last 10 years (the exceptions being 2008 and 2009), and these figures increased to nearly a billion dollars and over a billion dollars, respectively, over the last two fiscal years. This significant issuance of shares opposes their share repurchases, and so despite the fact that the company has cumulatively spent nearly $18 billion on share repurchases over the last decade, the total number of shares has reduced by less than 12% in total. Share repurchases boost EPS growth, and issuing shares at this magnitude counteracts a significant portion of that.
At the current rate, that’s around 1.4% of the market cap each year in share issuance which goes against EPS growth. Going back to the aforementioned sum of EPS growth + dividend yield, adding this 1.4% back to that sum would boost the sum to around 10% which is up where many of the companies I cover tend to be. So the amount of shares issued each year is what is leading to a consistently lackluster combination of growth and yield. In the absence of these issued shares, the buybacks would be contributing another 1.4% or so per year to EPS growth.
The Gordon Growth Model can be used to estimate ranges of fair value for the stock. The dividend growth rate averaged 5% over the last seven years, and the most recent quarterly increase was over 7.5%. Due to the particularly strong nature of the balance sheet, a conservative discount rate can be used to focus the fair value assessment on risk-adjusted returns.
Using an expected 6% dividend growth rate and a 9% discount rate, the fair value is only $85, which is under the current share price of around $105. Due to the low yield, the model is particularly sensitive, and reducing the discount rate to 8.5% boosts the fair value to $102.
Currently, the combination of yield and growth just isn’t there to fully justify the current valuation at $105 in my opinion. That doesn’t necessarily mean the investment is poor; investors that are paying $105 for the shares may be expecting an acceleration of growth or willing to accept annual returns in the 8.5% range or lower, and changes of either of those two variables can adjust the fair value assessment considerably. Analysts currently predict 9% average EPS growth over the next two years, which is higher than the past period. That type of growth in the high single digits, if sustained for long periods, would raise today’s fair price substantially.
Last year, I reported that the company appeared to be fairly attractive at $75/share while it was trading at $88/share. It is now up to $105/share while I calculate a fair value of only around $85 with a 9% discount rate. Although the balance sheet is strong and the company is diverse, I don’t see a fundamental reason based on current performance to justify the current stock price (at least with any reasonable margin of safety) compared to other investments on the market that can offer a combination of growth and yield that is a percentage point or two over what 3M has been offering.
I do not view the stock as particularly overvalued, but with their significant issuance of shares which weighs down their EPS growth a bit, I’ll be looking at other companies or waiting for a lower price. Rather than making a declaration about the fair value of the stock, I’d simply recommend to investors to pay special notice towards what they expect future EPS and dividend growth rates to be and what rate of return they’d minimally expect out of this stock to consider it a good buy at $105.
Full Disclosure: As of this writing, I have no position in MMM.
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