3M Co.: Be Greedy When Others Are Fearful

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About: 3M Company (MMM)
by: Cashflow Capitalist
Summary

3M has steadily paid dividends for a hundred years and raised its dividend for 61 straight years.

The company faces headwinds that won't be around forever, but the company has faced these kinds of headwinds before while remaining profitable.

Board member Gregory Page recently purchased $360K worth of shares around current prices.

By several valuation metrics, shares have not been this cheap since the 2016 correction.

Shares could potentially fall further, and if so, would make an even better buy.

Investment Thesis

3M (MMM) manufactures a wide variety of products for both personal and business uses in the healthcare, industrial, automotive spaces as well as everyday necessities like its famous Post-It Notes, Scotch tape, and Duct tape. It operates in five key segments: Industrial, Safety & Graphics, Healthcare, Electronics & Energy, and Consumer.

Overall, the manufacturing conglomerate produces over 60,000 different products across its business segments, making it akin to an industrial mutual fund.

Over its long lifespan, 3M has performed phenomenally well, handily beating the S&P 500 over long time periods while paying a steady dividend. It has not missed a dividend payment in a hundred years, and it has raised its dividend over the past 61 years — through the Great Inflation of the 1970s and 1980s, through the Dotcom bubble and crash, and through the Great Financial Crisis and Recession.

The 3M stock price has fallen by about 20% since the announcement of poor Q1 results on April 26th. The current price of ~$175 appears to be a good value for patient dividend growth investors, but under $160, shares would offer an excellent value as well as a rare buy-in opportunity.

Source

Recent Performance

After a very rough Q1 2019 in which sales fell 5% YoY, organic sales guidance was lowered to basically flat for the year, and earnings guidance was cut (for the fifth time in a year) by 11% from its previous guidance. Considering that ~60% of 3M's revenue comes from international sales, currency exchange fluctuations can have a sizable impact on the company's financial performance. Much of this is due to the trade war, as roughly 25% of 3M's sales come from China. Sure enough, sales from China/Hong Kong fell especially hard this quarter.

It appears that a majority of the negative performance in Q1 is attributable to (1) foreign exchange and (2) the trade war's impact on Asian markets. A majority of the declines in sales were experienced in the company's Industrial, Safety & Graphics, and Transportation & Electronics segments.

Given the headwinds facing 3M, it is surprising to hear management reaffirm its 5-year financial expectations for 2019-2023 of 3-5% organic sales growth, 8-11% earnings per share growth, and 20% return on invested capital. While it's heartening that management is focused on such an important metric as ROIC, and it's likewise encouraging to know that the company has consistently achieved double-digit ROIC even during downturns, I cannot help but feel that the five-year plan is unrealistic.

Chart Data by YCharts

In response to this "disappointing start to the year," in the words of CEO Mike Roman, 3M has initiated cost-cutting measures, including 2,000 layoffs, that aim to save the company $225-250 million per year. In my view, being forced to trim the fat in the face of challenges, as 3M currently has to do, can be a healthy exercise long term. It can make the company leaner and more efficient, which will help it to emerge from the next recession stronger than before.

Company insider, Gregory Page, who sits on the Board of Directors, bought around $360K of 3M stock last week in two trades of a thousand shares each. On May 7th, he picked up shares for $179.60, and on May 9th, he scooped up more for $176.26. Mr. Page doubled his position in 3M this past week, now owning about $700K of 3M stock total. It will be interesting to see if other company insiders join Mr. Page in the weeks and months ahead.

Now, insiders do not always make the most profitable trades when it comes to their own company's stock, but their purchasing of shares on the open market is a vote of confidence in the company as well as a signal that the stock might be underpriced. So by standard valuation metrics, is 3M underpriced?

Valuation

The stock has not traded at the current price-to-earnings since February 2016, the current price-to-book since November 2016, or the current price-to-cash flow since January 2016. This signifies that, while the stock price is cheaper than it has been the last few overvalued years, it's not quite bargain basement yet.

Chart Data by YCharts

The current dividend yield of 3.28% compares quite favorably to the 4-year average yield of 2.59%. Investors have not been able to buy into the company at this current yield since January 2016.

Worst case scenario (i.e., a global recession), how much further could investors reasonably expect the stock price to fall? In the stock's last bearish trend from the Fall of 2007 until Spring 2009, the stock lost around 50% of its value.

Chart Data by YCharts

Compare to the stock's current bearish trend, in which it has shed 32% of its value since its peak in January 2018.

Chart Data by YCharts

If the stock price were to lose another 18% from its current price of $175, it would bottom out at $143.50. It would not be surprising if 3M's stock hit its trough around this number in the next recession. So long as the dividend remains safe, I cannot imagine value investors not swooping in at that point to cushion the stock's fall and take advantage of the 4% entry yield.

Dividend Discount Model Valuations

Let's perform DDM calculations based on a few different scenarios. In the Optimistic Scenario, 3M manages to achieve its five-year financial projections and the dividend grows by 8% annually. In the Base Case Scenario, management's projections are too optimistic but the company is still able to grow its dividend payout by 6% per year. In the Pessimistic Scenario, the company is only able to grow its payout by 4% annually.

We'll use a discount rate (aka required rate of return) of 10% and consider the current annual dividend of $5.76.

Optimistic: Fair Value = 5.76 / (0.10 - 0.08) = $288

Base: Fair Value = 5.76 / (0.10 - 0.06) = $144

Pessimistic: Fair Value = 5.76 / (0.10 - 0.04) = $96

As you can see, the speed of the company's growth in the years ahead will largely determine the fair value of the stock. Sure enough, my base case comes in right around where I expect the stock to trough in the next recession.

Of course, 3M's stock historically tends to trade at a premium to fair value, so it wouldn't likely remain in the mid-$140s very long unless the dividend was frozen or cut.

I think 6% average dividend growth over the next ten years is realistic as it would balance a few years of slower (~2%) growth with faster growth (~10%) experienced during good economies.

Given that average annual dividend growth over the previous ten years came in at a little above 10%, assuming 6% average annual growth over the next ten years might be a bit too conservative. But the payout ratio is higher now than its average over the last ten years, so that should balance out the potential for a faster annual growth. Assuming 7% dividend growth per year, we arrive at a DDM valuation of $192.

Given an entry yield of 3.28%, average annual dividend growth of 7% would render investors a yield on cost after ten years of 6.45%.

Recommendation

I recommend 3M's stock as a buy under $175, a safer buy under $160, and a strong buy under $150. At $160 per share, 3M would offer investors an entry yield of 3.6%, about the same as what they could get at the trough of the Great Recession. However, the higher payout ratio today (~57%) versus in the years prior to the Great Recession (under 40%) indicates that the dividend yield could reasonably spike up to about 4.1%.

At an entry yield of 4%, assuming 7% average annual dividend growth, investors would enjoy a yield on cost after ten years of 7.87%.

In any case, 3M's strong management, expansive product base, long-term focus, high R&D budget (with consistent return on invested capital to show for it), and long history of dividend growth make the company a must-own for dividend growth investors. If purchased at the right price, 3M's stock stands to continue enriching shareholders with double-digit total returns as it has done for many decades.

It would be natural for investors to want to wait until the challenges are past and sales growth turns positive before investing their hard-earned money into a company. But often it is precisely when a company is facing challenges that its stock is the best value. This is especially true for a blue chip name like 3M.

As Warren Buffett likes to say, "Be greedy when others are fearful and fearful when others are greedy." It may be time to get greedy with 3M's stock.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MMM over 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.