3M (MMM): A Dividend King With a Wide Moat

While fast-growing momentum stocks might get the headlines, some of the best long-term investments are often far less exciting dividend growth stalwarts such as 3M (MMM).

 

This industrial powerhouse has made countless investors amazingly wealthy over the years (12.9% total returns vs 9.1% for the S&P 500 over the last 22 years) thanks to its disciplined and steady growth strategy, which includes 59 straight years of dividend increases at a double-digit annualized rate.

 

Let’s take a look at what has made this venerable dividend king one of the best choices for almost any long-term income growth portfolio and if 3M’s valuation looks attractive today.

 

Business Overview

Minnesota Mining and Manufacturing, or 3M, was founded in 1902 in St. Paul, Minnesota. The global industrial conglomerate markets over 60,000 products used in homes, businesses, schools, and hospitals in over 200 countries around the world. The company has five main business segments.

 

Industrial: tape, sealants, abrasives, ceramics, and adhesives for automotive, electronic, energy, food, and construction companies.

 

Healthcare: Infection preventions supplies, drug delivery systems, food safety products, healthcare data systems, dental and orthotic products.

 

Electronics & Energy: insulation, splicing and interconnection devices, touch screens, renewable energy components, infrastructure protection equipment.

 

Safety & Graphics: Personal protection and fall protection equipment, traffic safety products, commercial graphics equipment, commercial cleaning and safety products.

 

Consumer Products:  post-it notes, tape, sponges, construction & home improvement products, indexing systems, and adhesives.

 

3M is a highly diversified company with industrial products representing its largest business unit, while healthcare is its most profitable segment by far.

 

 

Geographically 3M is also diversified, with a large amount of international sales:

• US: 62% of sales
• Asia & Pacific: 18%
• Europe, Middle East, Africa: 11%
• Latin America & Canada: 9%

Over time, 3M’s international exposure will only grow given that its foreign sales are growing much faster than its US revenues.

 

 

Business Analysis

The industrial components industry has a lot of factors that might make it seem unattractive for dividend investors. After all, it’s a cyclical and highly capital intensive industry, with relatively low barriers to entry.

 

In addition, most industrial products are highly commoditized, meaning that it’s hard to maintain strong pricing power and good margins over time.

 

However, 3M has managed to carve out a very wide moat and has shown an incredible ability to continue growing its earnings and cash flow over time, despite the occasional industry downturn such as 2015 and 2016 (due largely to tumbling commodity prices).

 

 

The key to 3M’s success is largely thanks to its conservative management and disciplined long-term focus. CEO Inge Thulin has been with the company for 38 years and understands that the key to 3M’s growth lies in its continued dedication to strong R&D and new product development.

 

Over the past 115 years, 3M has obtained over 100,000 patents thanks to one of the industry’s highest R&D budgets (as a percentage of revenue). The company is constantly improving its existing product range and introducing new ones. In fact, about 33% of 3M’s sales are from products launched in just the past five years.

 

 

Another benefit 3M has is that about 50% of its products are consumables, meaning that customers need to continually repurchase them. This creates a far more stable cash flow stream for the company. Finally, 3M benefits from selling many specialized, mission critical, but still relatively low cost products to industrial customers.

 

This means that the components it makes represent a small fraction of the total cost of goods, and because of their industry-leading reliability and performance characteristics, industrial customers are less likely to switch to competing products.

 

Or to put it another way, 3M has a very sticky product line that allows it to steadily increase its prices each year while retaining strong customer loyalty and a rising market share. This is why its industrial segment has historically grown at 1.5x the rate of the global manufacturing components industry.

 

Finally, 3M has been among the most adaptable industrial companies in the world, with a great track record of investing in a disciplined manner into the industries and markets that offer the best growth potential.

 

For example, 3M is investing heavily into products that serve the needs of the rapidly evolving automotive industry. That means a focus on adhesives, connectors, and cooling systems for driverless and electric cars. In addition, 3M is rapidly gaining market share in data center cooling systems, which is an industry that is expected to grow strongly for decades.

 

3M Market Priorities

 

3M has also proven its ability to successfully enter and win market share in emerging economies, which are growing at double the rate of mature, developed markets. This includes entering China in 1984, where 3M now has nine factories and six R&D centers (it has 60 R&D centers global R&D facilities in total).

 

 

3M’s China business is its fastest-growing unit, with 23% sales growth in Q3 of 2017 and 10% to 15% projected revenue growth in 2018.

 

Sales growth is great, but at the end of the day, dividends are paid out of cash flow. This means that profitability is very important for a dividend growth stock. 3M excels here as well, with industry-leading margins and returns on capital.

 

3M Trailing 12-Month Profitability

 

High returns on capital are a good proxy for long-term management’s capital allocation skills, and as you can see, 3M’s figures are much higher than the industry’s average. There are three key factors to good capital allocation.

 

First, 3M has excellent capital discipline, meaning it has struck a near perfect balance between returning cash to shareholders but also investing for future growth.

 

 

This includes numerous small, bolt-on acquisitions, as opposed to large and often overpriced mergers that many of its rivals pursue.

 

 

In fact, in the past five years, 3M has only purchases six small firms and divested $1.4 billion in underperforming non-core assets, making for net acquisitions of just $4.2 billion in that time. This shows that 3M is dedicated to growing organically, rather than risking overpaying for big splashy deals to increase the top line at the risk of lowering overall profitability.

 

3M’s impressive organic growth is courtesy of two things. Lavish R&D spending, and highly disciplined capital investment. For example, not only does 3M’s high R&D spending help the company maintain an edge in product quality and premium pricing power, but the firm’s surprisingly low capital spending (4.5% to 5% of revenue historically) is put to work with laser-like focus.

 

 

Specifically 3M has been investing heavily in recent years in efficiency improvement, including more advanced quality control testing procedures based on automation, wireless internet sensing, and data analytics.

 

The result has been a tripling of quality control testing speed, while achieving an 80% decrease in product defects. This is just one example of 3M’s rigorous data and statistics driven management culture. In fact, the compamny has retrained 77,000 employees and completed 110,000 efficiency improvement programs since 2001, resulting in $17 billion in cost savings.

 

3M is currently in the late stages of a corporate restructuring it undertook in 2015 during the last industry recession. The goal was to streamline the company’s businesses and organization to maximize efficiency and cut costs wherever possible.

 

 

Management also set a goal to improve the company’s economies of scale, via its global supply chain, to minimize its costs of raw materials. This has led to a steady decline in costs of goods sold and rising operating margins and returns on invested capital.

 

 

Those margins should benefit from ongoing cost savings plans, including a $500 million to $700 million reduction in annual expenses between 2016 and 2020.

 

Going forward, 3M believes that its excellent mix of fast-growing industries, emerging markets, and higher margins should allow it to grow its EPS and free cash flow per share at 8% to 11%, an impressive and industry-leading pace.

 

 

More importantly, 3M has a good track record of meeting or even exceeding its long-term growth goals, which bodes well for the future of its dividend growth. All in all, 3M’s management team has proven it has the ability to constantly adapt to a rapidly changing world. But do so in a highly disciplined, increasingly profitable, and very shareholder -friendly way.

 

While 3M is among the highest-quality industrial companies in the world, that doesn’t mean that there aren’t risks current and potential investors need to consider.

 

Key Risks

Obviously investors in 3M need to keep in mind that all industrial stocks will experience cyclical sales growth or declines over time. However, 3M’s efficient low cost supply chain and operational leverage mean that its overall earnings and cash flow are far more stable than the typical industrial firm. However, there are two other potential risks to watch for.

 

The first is that the company has greatly increased its leverage (i.e. taken on debt) over the last few years in order to acquire slightly larger companies than it has in the past.

 

 

Now the good news is that 3M’s debt levels are far from dangerous (more on this in a moment). However, we might now be in the later stages of the economic expansion which means that industrial company valuations are rising to rather frothy levels. That creates the risk that 3M may end up overpaying for new acquisitions in the future.

 

In addition, with interest rates potentially rising, 3M’s borrowing costs are likely to rise over time as it refinances older bonds and continues to gradually take on new debt each year (about $2 billion expected in 2018). The good news is that in recent quarters management has begun to gradually deleverage the balance sheet, which is a wise move at this stage of the economic/interest rate cycle.

 

The other major risk is that 3M’s success overseas, especially in fast-growing emerging markets, means that over time currency risk will increase. For example, by 2020 analysts expect that fully 50% of sales will come from emerging markets such as China. The currencies of such countries can be volatile relative to the dollar, which means that should the dollar appreciate in value, local sales and profits will translate into fewer dollars for accounting and dividend payment purposes.

 

In 2017, the US dollar depreciated substantially against most currencies after several years of strong growth.

 

However, in 2018 there are two potential catalysts that could cause the dollar to appreciate and create stronger growth headwinds for multi-national companies than is currently expected.

 

First, under the new tax code, companies will be able to repatriate overseas cash at a lower 15.5% rate (vs the old rate of 35%). This means that many companies will need to convert foreign currency cash reserves into dollars, increasing the demand for the greenback relative to other currencies.

 

Second, rising US interest rates will likely make the US a more attractive investing location relative to other economies where interest rates remain far lower and aren’t likely to rise as quickly. For example, European and Japanese investors might continue aggressively buying US Treasury bonds because the yield is much higher than what they can get at home where bond investors still face negative inflation adjusted interest rates. This too could increase demand for dollars and thus create a reversal of the positive currency trend we saw in 2017.

 

3M’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

3M has a Dividend Safety Score of 95, indicating a very safe and dependable dividend. This isn’t surprising given that 3M has paid an uninterrupted dividend for over 100 years and will soon raise its payout for the 60th consecutive year.

 

There are three keys to 3M’s amazing dividend growth record and high safety. First, as explained, the company’s revenues are less volatile than most industrial rivals due to its high proportion of consumable products, which create large amounts of recurring revenue.

 

Next, the company’s impressively stable and growing EPS and FCF per share mean that management is able to steadily grow the payout while still maintaining modest and very safe payout ratios. As a result, 3M’s dividend is very well covered, providing a safety buffer for those rare times when earnings and free cash flow do fall.

 

 

Finally, 3M has a very strong balance sheet, meaning modest amounts of very manageable debt.

 

 

For a company of 3M’s size, and one in a capital intensive industry, 3M’s net debt position of about $8 billion is remarkably small. This is why the rising leverage ratio of the past few years poses very little risk to the safety of the dividend.

 

In fact, when we compare 3M’s relative debt metrics to its peers we find that it has one of the strongest balance sheet in its industry. This is courtesy of its very low leverage ratio (Debt/EBITDA), very high current ratio (short-term assets/short-term liabilities), and sky-high interest coverage ratio. This is why the company enjoys such a strong investment grade credit rating that allows it to borrow at an average interest rate of just 1.9%.

 

 

The bottom line is that 3M’s relatively stable earnings and cash flow, low payout ratios, and industry-leading balance sheet allow the company to continue investing in disciplined growth while still providing one of Wall Street’s safest and steadiest growing dividends.

 

3M’s Dividend Growth

Even more impressive than 3M’s six-decade streak of annual dividend increases is the company’s fast pace of payout growth. As you can see below, 3M has increased its dividend by 8% annually over the past 20 years.

 

 

Going forward, management plans to grow the dividend in line with earnings and free cash flow. Given that 3M believes it can achieve 8% to 11% long-term EPS and FCF per share growth, this seems like a realistic long-term expectation for annual dividend growth.

 

Valuation

In 2017, optimism about the recovery in the global industrial sector caused 3M to rise 38% and outperform the red hot S&P 500 by 15%. Unfortunately, 3M’s superior business quality and strong growth prospects appear to be priced in and then some.

 

For example, 3M’s forward P/E ratio of 24.5 is not only much greater than the S&P 500’s lofty 18.4, but also above the industry median of 23.1. It’s also much higher than the stock’s historical median of 16.7.

 

Meanwhile, 3M’s dividend yield of 2.0% is below its five-year average yield of 2.5%. In other words, 3M appears to be overvalued relative to its historical norms.

 

 

That being said, even shares bought at today’s rich valuation could be capable of generating long-term total returns close to 10% if everything goes well (2% dividend yield + 8% to 11% annual earnings growth). This is a testament to the company’s ability to continue innovating and adapting in order to maintain such a strong long-term earnings and dividend growth rate.

 

Conclusion

Dividend aristocrats and dividend kings often make excellent long-term income growth investments. When it comes to industrial dividend kings, there are few better run and wider moat names than 3M.

 

The track record of 3M’s long-term focused and disciplined management team is unmatched, making the company a fundamentally lower risk dividend growth stock and a great choice for many dividend portfolios at the right price.

 

However, given the epic bull run the stock has had, 3M’s valuation is looking a bit rich, so waiting for a pullback before getting more serious seems prudent for investors looking to initiate a new position.