Keep Your Expectations In Check For 3M Company
Summary
- 3M Company is a Dividend Champion with 58 consecutive years of dividend growth.
- 3M is a one stop diversification shop with exposure to just about every sector of the economy and the globe.
- There's a difference between a quality company and a quality investment.
3M Company (NYSE:MMM) has long been a favorite for dividend growth investors and there's a lot to like about the company. Many people know 3M as the maker of the Post It Note and Scotch Tape; however, they're much more than that.
Over the last year 3M generated over $30 B in revenue across their 5 business segments. 3M operates in the consumer space, electronics & energy, health care, industrial and safety & graphics. The great thing about 3M is that they have exposure to just about every economic sector and sub-sector imaginable. So when one business segment falls on hard times, such as the energy segment for the last year or so, the others are there to pick up the slack. Essentially when one or two operations are zigging the others are zagging. This has afforded 3M the ability to continue to grow over time since it's very rare to see every business segment struggle at the same time.
As a diversified technology company their moat firmly falls into the patents/secrets category. The secrets/patents moat style is one of my favorites because there is legal protection of the business from competitors.
While there's a lot to like about 3M the company that doesn't necessarily mean that 3M the stock would make a good investment at these prices.
Dividend History
One of my favorite quick screens to narrow down the universe of quality companies is to look at their dividend history. A company won't just haphazardly find themselves in the midst of a decades long streak by accident. Rather it takes a quality company with some kind of intrinsic characteristic that defends the business model and management that's willing to reward shareholders along the way. This doesn't mean the future will look like the past; however, sticking with companies that have a proven track record will push you towards quality companies.
3M Company has paid and increased dividends for 58 consecutive years giving them the title of Dividend Champion. For some perspective on that feat there's only 7 companies out of the 768 on the CCC list that have a streak longer than 3M. Over the past 58 years there's been no shortage of economic and geopolitical crises du jour, yet 3M Company has been there every single year to give investors a raise.
*Image Source: Author / Data Source: 3M Company Investor Relations
**An interactive version of this chart can be found here.
3M Company has certainly given raises every year, but it's important to make sure those raises a meaningful. The next stop in identifying quality companies is to examine the dividend growth rates on a rolling basis at the 1-, 3-, 5- and 10-year levels. Some companies march forward each year like clockwork, but others, such as 3M have a cyclical nature to their business so I place more stock in the longer period growth rates.
*Image Source: Author / Data Source: 3M Company Investor Relations
**An interactive graphical version of this chart can be found here.
Quantitative Quality
3M Company's dividend growth history shows that it's likely a high-quality company; however, we can't rely on just one metric. Identifying quality companies is quite subjective and very few investors will have the same requirements. My own preference is to examine companies through their cash flow to ascertain the strength of the company.
*Image Source: Author / Data Source: 3M Company SEC filings
3M Company's revenue growth wouldn't exactly be placed in the barn-burner category although $30B+ annual revenue generators usually aren't. From 2006 through the end of 2015 3M Company has managed 3.1% annualized revenue growth.
Growth in cash flow from operations has nearly doubled the pace of revenue growth coming in at 5.9% per year over the same time period. Free cash flow has seen an even better outperformance growing with annual growth of 7.1%.
*Image Source: Author / Data Source: 3M Company SEC filings
With operating and free cash flow generation outpacing revenue growth we see that 3M Company has improved their already hefty cash generation margins. Operating cash flow margins have improved from the 16.7% in 2006 up to 22.6% over the TTM. Likewise, free cash flow margins have strengthened from 11.7% in 2006 to 17.8% over the TTM. The higher cash flow margins signify that management is doing a better job with managing expenses as well as improving the efficiency of the business.
Cash flow margins represent the cash flow generation in comparison to the revenue that 3M has brought in. Looking at it through another lens I like to see how 3M's free cash flow stacks up per dollar of equity and total capital invested in the business.
*Image Source: Author / Data Source: 3M Company SEC filings
3M Company earns excellent free cash flow returns on equity coming in well above 20%. The 10% threshold is a fairly standard qualitative measure of a company. One thing to remember is that the return on equity can be gamed by a company increasing debt and thus reducing their equity levels.
For companies where debt makes up a significant portion of their capital structure the free cash flow ROIC is the better metric to use. In 3M's case that's appropriate as the debt has increased from 26% of the capital structure in 2006 up to 48% for 2015. That's why you don't see the same kind of improvement in the ROIC as compared to the ROE. That's not to say that 3M Company is a poor cash generator and to the contrary it's an extremely strong on with free cash flow ROIC fluctuating around the 20% level.
Free cash flow is excess cash that companies generate above and beyond the required capital expenses to maintain and grow the business. This cash can be used to build up their balance sheet, reduce debt, repurchase shares or, my personal favorite, pay a dividend to shareholders. In order to understand how 3M uses their excess cash flow I like to examine 3 variations of the metric.
- Free Cash Flow (FCF) - The traditional calculation of free cash flow of operating cash flow less capital expenditures.
- Free Cash Flow after Dividend (FCFaD) - FCF less the total cash spent on dividends.
- Free Cash Flow after Dividend and Buybacks (FCFaDB) - FCFaD less net cash used on share buybacks.
High quality companies generate high levels of free cash flow and remain free cash flow positive across all 3 variations. If a company is positive across all 3 that signifies there's plenty of excess cash flow to buffer the balance sheet or to further increase dividends and share buybacks in the future. Likewise, if a company is free cash flow negative on any of the variations the company is having to fund that with cash already on the balance sheet or through additional debt and is unsustainable in the long run.
*Image Source: Author / Data Source: 3M Company SEC filings
For starters, 3M Company has been FCF positive every year which gives management the opportunity to move down the capital allocation chain.
FCFaD has also been very strong and showing a general uptrend over time. That's given management the ability to grow the dividend payment by 9.2% per year from 2006 through 2016 while still maintaining excess cash flow coverage. The free cash flow payout ratio has averaged 44% from 2006 to 2015 and ended 2015 at 52%.
However, FCFaDB is a different story and is where we see significant variations. 3M Company's FCFaDB was as high as $3.021 B in 2009 and as low at -$2.205 B in 2015. I think it's understandable that management preferred to hoard all excess cash during the period surrounding the financial crisis. However, it appears that management ramped up the share repurchase program after the great value opportunities were long gone.
While there's been significant variance from high to low of FCFaDB the cumulative total comes to a positive $0.062 B of FCFaDB. So 3M Company has been able to fully self fund their dividend and buybacks over time, but the current pace of excess buybacks will have to slow down or management will be forced to further increase debt.
Is The Valuation Right?
Unfortunately, identifying a quality company is only half of the battle; the other half is finding a quality company where the valuation makes sense as an investment.
*Image Source: YCharts
The P/E ratio that investors have been willing to pay per dollar of 3M's earnings have fluctuated significantly over the last decade. Unsurprisingly the lowest P/E ratio came during the midst of the financial crisis and represented a great bargain for investors. However, now investors have moved 3M's valuation is now sitting near the highest levels of the last decade.
One method I like to use to determine the valuation of a prospective investment is to estimate the future earnings and dividends and look at the returns across varying future P/E multiples. If the return is adequate then shares could represent a solid value and a potential buy.
On average analysts expect 3M Company to earn $8.63 for FY 2017, $9.38 for FY 2018 and to grow earnings 6.3% per year through FY 2021. For the subsequent 5 years I've assumed that earnings will grow at 5.0% per year.
The dividend rate for fiscal year 2017 has yet to be set by 3M; however, we can make a reasonable assumption of the dividends to be paid. Based on 2016's dividends of $4.44 and the earnings estimate of $8.15 that puts the payout ratio around 55%. I've assumed that 3M Company will maintain that payout ratio into the future with dividends tracking earnings growth.
The following table shows the price targets assuming a purchase on January 23rd with varying future P/E multiples and a 12% minimum acceptable rate of return. Returns are calculated as internal rates of return and include estimated dividend payments based on the historical payment and increase schedule that 3M Company has followed.
*Image Source: Author
So how do you use the chart? The price targets listed are the price levels, assuming the earnings and dividend growth play out as forecast, that you could currently pay to generate at least a 12% internal rate of return. For example, if 5 years from now at the end of FY 2022 investors are willing to pay only 17.5x for 3M's earnings, then the maximum that you could pay today and generate a 12% IRR would be $130.99. That's a far cry from the current price level near $178.50.
The problem is the valuation that investors have bid 3M up to. At a future P/E ratio of 17.5 you have to give up 20%+ of your return. Companies growing 6% per year just can't make that up through growth.
Although maybe a 12% MARR is a bit aggressive for a company as large and established as 3M. However, erring on the side of caution has usually served me well. Maybe a 10% MARR is more appropriate for other investors considering 3M. I've re-run the price target calculations with a 10% minimum acceptable rate of return and the results are in the following table.
*Image Source: Author
As expected we see the price targets rise since we're requiring less return and can therefore pay more for every share. The price targets for 5 years out are approximately 10% higher for the 10% MARR scenario compared to the 12% MARR.
Conclusion
I think it's pretty obvious that 3M Company is a high quality company and the instant diversification that you get is fantastic. They have exposure to the industrial world, graphics, health care, energy, the consumer and much more. On top of the various economic sectors you have exposure to they also do business all around the globe giving geographical diversification too.
3M's cash conversion is fantastic with free cash flow margins routinely in the high teens and free cash return on invested capital hovering around the same levels. The massive amounts of free cash flow that 3M generates year after year has allowed them to invest in the business as well as reward shareholders with a dividend that's increased for 58 consecutive years.
Looking forward the debt load is the one thing that is a bit concerning. While I prefer companies that don't carry debt, or a very minimal amount, on their balance sheet the more telling thing is seeing significant increases in debt levels. This is the one negative when it comes to 3M the company and something to keep an eye on in the future.
In regards to 3M the stock I have a lot more concerns. The problem is that the valuation is currently quite expensive right now with the TTM P/E ratio up near 22.5x, although 3M is set to report 4Q and full year 2016 earnings on Tuesday which should lower the valuation assuming 3M does in fact show growth year over year.
In order to generate a 12% internal rate of return from today's price, including dividends, you're banking that the current lofty valuation will push even higher over the next 5 years. That's a bet I'm just not willing to take.
A 12% annual return might be a bit aggressive for 3M; however, even in the more conservative 10% MARR case the current price still requires the high valuation to at least stay put over the next 5 years.
3M the company should continue to do well if the global economy improves and if we hit a speed bump 3M is positioned well to weather the storm. However, there's a disconnect between 3M the company and 3M the stock. For that reason I would not feel comfortable adding shares of 3M to my portfolio at these prices. Should we see the share price retreat to the low $160's I would begin to get interested in adding shares to my portfolio, but for now I'll be looking for other investment opportunities while I wait for 3M's valuation to return to more attractive levels.
This article was written by
Analyst’s Disclosure: I am/we are long MMM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
I am not a financial professional. Please consult an investment advisor and do your own due diligence prior to investing. Investing involves risks. All thoughts/ideas presented in this article are the opinions of the author and should not be taken as investment advice.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
Recommended For You
Comments (6)
boekel
