Is 3M Still A Bargain?

About: 3M Company (MMM)
by: Aristofanis Papadatos

3M has paid a dividend for 100 consecutive years and has raised its dividend for 59 consecutive years.

It has grown consistently and has outperformed S&P in almost any time horizon one can check out.

On the other hand, it currently has a lofty valuation while its management rewards itself with an excessive number of shares.

3M (NYSE:MMM) has been enjoying a remarkable rally this year and has been posting new all-time highs for months. It has also outperformed the market by a wide margin. Nevertheless, while the performance of this stock has been spectacular, it is reasonable to wonder whether the stock remains a bargain or the easy money has been made.

First of all, 3M has outperformed the S&P 500 (NYSEARCA:SPY) by a wide margin in almost any time horizon one can check out. To be sure, the company has outperformed S&P 500 during the last 5 years (136% vs. 81%), 2 years (32% vs. 17%) and one year (21% vs. 15%). In addition, 3M has paid a dividend for 100 consecutive years and has raised its dividend for 59 consecutive years. Moreover, it has doubled its dividend during the last 5 years. This exceptional record confirms that the company is very well-managed while it advances in a reliable growth trajectory.

Even better, the company does not rest on its laurels. More specifically, it is planning to invest about $1.8B in R&D this year to support its organic growth. It is also remarkable that it has been able to achieve ample free cash flows despite its generous spending on R&D. To be sure, during the last 3 years, the company has achieved approximate free cash flows of $5B per year while its free cash flows have amounted to about 80% of the operating cash flows. To make a long story short, most of the earnings are not lost in the maintenance of the business but instead they are available for shareholder distributions.

It is also worth noting that 3M returned to its growth trajectory in Q1, after two years of slightly declining revenues. The company increased both its sales and its earnings by 3.7% over last year. Moreover, thanks to its share repurchases, its earnings per share [EPS] rose at a somewhat higher pace, i.e., 5.4%.

Investors should also note that the strong dollar has been a strong headwind for the earnings of the company in recent years. However, this trend seems to be in the early phases of a reversal. The Fed has been the only major central bank that is in the process of raising interest rates so far. However, the ECB and the Central Bank of Japan are expected to terminate their QE programs in the next few months. Therefore, the dollar is likely to further depreciate over the other main currencies in the near future. While the degree of depreciation is unknown, investors can rest assured that the dollar has peaked, as it will not enjoy the combination of the recent strong tailwinds (hikes of rates by the Fed while the other central banks are maintaining their QE programs) any time soon. As a result, 3M is likely to enjoy an additional boost in its earnings, as it generates about 60% of its sales abroad.

It is also remarkable that 3M is a defensive stock for the event of a recession or a bear market. As the ongoing 8-year bull market is already the second-longest in history, this attribute of the stock should not be underestimated by investors. The latter should make sure that they own only stocks that will prove resilient in the event of a market downturn in order to avoid excessive bleeding of their portfolio and panic-selling. 3M proved markedly resilient during the Great Recession. To be sure, its EPS decreased only 9% in 2009. Even better, they increased 25% in 2010 and have grown every single year since then. Of course, 3M is likely to incur compression of its P/E ratio in the event of a market downturn, but at least its shareholders will avoid the double hit that most investors will suffer; a shrinking P/E ratio combined with lower earnings.

On the other hand, investors should not overlook the rich valuation of the stock. While the broad market is in overvalued territory, this does not mean that investors should stop checking the valuations of their stocks. 3M is currently trading at a forward P/E of 23, which is certainly a rich valuation. Therefore, if the market experiences a correction or a bear market, the stock will be prone to compression of its P/E ratio. Nevertheless, thanks to its consistent growth over the years, the stock is still likely to offer decent returns to its long-term shareholders. Those who keep the stock during both bull and bear markets have greatly benefited so far and are likely to continue to benefit in the long run.

However, apart from the lofty valuation, there is an additional caveat for 3M. More specifically, its management has been issuing a ton of new shares in order to reward itself at the expense of the shareholders. During the last 5 years, the company has spent $22.1B on share repurchases, but at the same time, it has issued new shares worth $5.2B. In other words, the management of the company has offset almost 1/4 of the share buybacks and has spent more than 20% of the earnings to reward itself. The shareholders should certainly feel disappointed for this poor use of the funds of the company. The management should have preserved the excess cash for turbulent times, when share repurchases will be much more efficient than they are now, around all-time highs. Moreover, the shareholders should realize that the actual earnings of the company, i.e., those that end up in the company or in the pockets of the shareholders, are about 20% lower than the reported ones.

To sum up, 3M has an exceptional growth record, but it is currently overvalued, just like the broad market. This does not mean that the stock will not offer decent returns to its shareholders in the long run. It only means that these returns will be somewhat limited due to a potential P/E contraction. Finally, I never recommend purchasing shares of companies whose management rewards itself with a huge portion of the earnings at the expense of the shareholders.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.