3M (MMM): A Buy and Hold Forever Dividend King

When it comes to dividend growth stocks, there are few better core holdings for one’s portfolio than the legendary dividend kings, companies that have raised their dividend for 50+ straight years. Investors can view all of the dividend kings here.

 

These are companies that have not just proven to have an ability to steadily grow throughout any kind of economic, interest rate, and political environment, but also have a very dividend-friendly corporate culture that endures periodic management changes.

 

3M (MMM), with 58 consecutive years of rising dividends, is one such dividend king, and we happen to hold the company in our Top 20 Dividend Stocks portfolio as well.

 

Let’s take a deep look at what makes up 3M’s secret sauce and if this is the type of company that deserves to be a core holding in almost any income growth portfolio.

 

Business Description

Founded in 1902 in St. Paul, Minnesota, Minnesota Mining & Manufacturing, or 3M, is one of the world’s largest diversified industrial conglomerates. The business operates in over 70 countries and sells its products in over 200 nations and territories. More than 60% of its sales come from outside of the U.S.

 

Over the past 114 years, 3M has obtained over 100,000 patents for products in nearly every industry on earth. The company operates in five main business segments which market 23,230 products:

 

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.

 

Business Unit	Q3 2016 Sales	Q3 2016 Operating Income	% of Sales	% of Operating Income	Operating Margin
Industrial	$2.582 billion	$591 million	32.7%	29.4%	22.9%
Healthcare	$1.361 billion	$429 million	17.2%	21.3%	31.5%
Safety & Graphics	$1.448 billion	$364 million	18.3%	18.1%	25.1%
Electronics & Energy	$1.293 billion	$312 million	16.4%	15.5%	24.2%
Consumer	$1.209 billion	$317 million	15.3%	15.7%	26.2%
Total	$7.893 billion	$2.013 billion	100%	100%	24.7%

Source: 3M Earnings Presentation

 

In the 3rd quarter of 2016, the plurality of the company’s sales came from its industrial division. However, healthcare was the most profitable division.

 

Business Analysis

As an industrial company, 3M’s business is somewhat cyclical and driven by global economic growth trends, which have remained sluggish in recent years.

 

However, this is a trend that affects all of its rivals as well, which is where the company’s superior management team and innovative corporate culture can make a big difference for investors.

 

For example, 3M’s claim to fame is that it’s less an industrial company and more of a material’s science company; investing heavily into R&D to make sure it offers customers a superior choice to meet their needs.

 

In recent years, the company has steadily increased its R&D spending and plans to continue doing so up to about 6% of sales.

 

 

That spending will be primarily focused on its healthcare information systems (expected to boost sales of this division by 2% to 4% annually) as well as its industrial segment to continue improving its adhesives, abrasives, filters, and coatings.

 

These are the products that give 3M the wide moat that allows it to consistently enjoy strong pricing power and stable margins and returns on shareholder capital that are far above the industry average. It’s also important to note that most of the company’s technologies are useful across a wide range of end markets with just slight tweaking, further improving the company’s returns.

 

 

One of the reasons why 3M is so profitable is the very nature of most of its products. Many of the goods it sells represent just a small proportion of a total product’s cost but are mission-critical components.

 

As an example, 3M sells structural adhesives to auto manufacturers. The company’s adhesives bond plastics and metals together and need to maintain their strength for the car’s entire life.

 

3M’s strong brands, technology innovation, and favorable product dynamics (low portion of the car’s total cost) provide nice pricing power, and it’s not worth it for the OEM to switch suppliers and risk the reliability of its vehicles.

 

Also helping the bottom line is the fact that 50% of sales are from consumables, meaning quickly used up products that customers need to purchase frequently. This helps to create a large recurring revenue stream, as well as boost turnover and allow for higher returns on capital.

 

Company	Operating Margin	Net Margin	Free Cash Flow Margin	Return On Assets	Return On Equity	Return On Invested Capital
3M	23.5%	16.4%	17.8%	14.7%	40.8%	21.1%
Industry Average	12.6%	8.8%	NA	4.6%	15.0%	NA

Source: Morningstar

 

What’s most impressive, and perhaps most valuable to long-term dividend investors, is the discipline that management, led by CEO Inge Thulin (who’s been with the company for 37 years), has shown when it comes to investing shareholder capital.

 

This has resulted in lighter than average capital spending (4.5% to 5% of sales) which results in free cash flow (FCF) margins generally only seen in very capital light industries; such as technology or biotech.

 

For example, in addition to being capital intensive, the industrial sector is generally one characterized by slow growth. This means that many of 3M’s rivals try to boost their growth rates through acquisitions, often overpaying for hard-to-integrate assets that result in subpar returns on investment.

 

3M, on the other hand, prefers to make many smaller, bolt-on acquisitions, such as the five firms purchased in the past year for just $4.6 billion. But that doesn’t mean that 3M is a no growth company, far from it.

 

Rather, management chooses to focus on improving operational efficiency to boost FCF and EPS growth. Specifically, when Mr. Thulin took over in 2012 he initiated a new efficiency program that streamlined the company’s business segments from six to five and total subsidiaries from 40 to 26.

 

In addition to boosting productivity from existing assets, the company sold off underperforming brands and refocused R&D spending on its most popular and profitable products. The result has been a: net margin, return on equity, and the return on invested capital that is up 10%, 51%, and 3%, respectively, in the last four years. Given that this is an improvement from already industry-leading levels, management’s operational improvements are all the more impressive.

 

In the coming years, 3M plans to continue to focus on maximizing the productivity of its employees and assets, with a $500 to $600 million five-year plan that management expects to result in 1.5% annual EPS accretion.

 

Key Risks

There are three risks to keep in mind with 3M.

 

First, under Mr. Thulin the company has ramped up its leverage in order to be able to continue investing and growing its business while still rewarding investors with buybacks (3.9% CAGR share count reduction over past five years) and dividends.

 

 

While the amount of additional debt is far from dangerous (more on this shortly), as interest rates rise in the future a higher debt load could reduce the financial flexibility 3M has to stay competitive in the markets in which it operates.

 

Speaking of rising interest rates, higher U.S. rates relative to those in other countries could result in the dollar remaining strong or even getting stronger. That creates a headwind to growth because 3M needs to convert local currencies into dollars for accounting and capital return purposes.

 

Finally, 3M’s overall sales can be highly affected by the cyclical nature of the industries in which it operates. For example, due to the ongoing oil crash, sales fell 10% in its energy division, dragging down its overall top line revenue into the red last quarter.

 

Eventually a recovery in oil prices, as well as the global economy, should help boost the company’s revenues, but when that happens is anyone’s guess.

 

Dividend Safety Analysis: 3M

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 94, meaning its dividend is extremely safe and dependable. This is due to two major factors.

 

First, despite the negative effects of the oil crash in the last two years, 3M’s dividend remains very well covered by both earnings and free cash flow, as seen by its low payout ratios.

 

 

This means that, even in the event of a severe economic downturn, such as 2008-2009, the company’s diversification, stable portfolio of well-known brands, and healthy payout ratios help the dividend not only remain safe but continue growing.

 

After all, 3M is very proud of its dividend king status and it would take a ferocious economic catastrophe for the company to voluntarily give up such an impressive payout growth streak.

 

Also, keep in mind that 3M has been paying dividends every quarter for 100 years, including during World War I, the Depression, and World War II. So even in a worst case scenario in which the company was unable to increase its payout, the chances of a large cut or outright dividend suspension are extremely small.

 

The second protective factor for the dividend is the very strong balance sheet. While 3M’s leverage ratio may have risen in recent years, as you can see by the strong current ratio, low leverage ratio, and very high interest coverage ratio, 3M is nowhere near dangerous debt levels.

 

 

This becomes especially evident when we compare 3M’s balance sheet with those of its rivals.

 

As you can see below, in every important metric 3M has a lower debt burden than the industry average, especially when it comes to its low leverage ratio (Debt/EBITDA) and stronger current ratio.

 

This explains the very strong credit rating that lets 3M access very cheap debt and helps keep its cost of capital low, thus boosting margins, free cash flow, and dividend security.

 

Company	Debt / EBITDA	EBITDA / Interest	Debt / Capital	Current Ratio	S&P Credit Rating
3M	1.44	47.63	45%	1.90	AA-
Industry Average	3.60	NA	46%	1.77	NA

Source: Morningstar

 

Dividend Growth Analysis

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

3M has a Dividend Growth Score of 85, meaning that 3M investors can expect the company to continue growing its payout at a faster rate than the average member of the S&P 500 (6.1% median dividend growth over the last 26 years).

 

3M has paid uninterrupted dividends for 100 years and increased its dividend for nearly 60 consecutive years. As seen below, annual dividend growth has averaged over 9% during the past decade.

 

 

3M’s amazing history of growing dividends, and at a very generous pace, is almost certain to continue. In fact, according to CFO Nick Gangestad, investors can expect dividends to continue to grow in line with EPS.

 

And since 3M is planning on continuing to invest heavily into faster-growing developing markets (to boost top line sales) and innovate and optimize its product lines, supply chains, and distribution channels, management expects long-term earnings growth of 8% to 11% going forward.

 

Dividend growth will likely follow at a similar pace.

 

 

That should allow 3M to deliver long-term total returns of 10.5% to 13.5% (2.5% dividend yield plus 8-11% earnings growth), above the market’s historic 9.1% CAGR since 1876.

 

Valuation

Since the bull market began in March of 2009 3M has been on a tear, rising 404% versus 283% for the S&P 500. Unfortunately, this level of outperformance has resulted in shares now trading at historically frothy levels.

 

P/E	13-Year Median P/E	Yield	13-Year Median Yield
22.5	16.3	2.5%	2.5%

Source: Gurufocus

 

While 3M’s P/E is still below the 26.2 of the S&P 500, shares are nonetheless trading at a substantial premium to their historic P/E value. The company’s shares also trade at a forward P/E multiple of 20.7, which seems far from being an obvious bargain.

 

On the other hand, from the perspective of yield, which is perhaps the most relevant valuation metric to income growth investors, shares appear to be more fairly valued.

 

However, it might be worth holding off until a better price presents itself.

 

For example, assuming a 9.5% payout increase in the next quarter, at a price of $138 to $162, (a 9% to 22.5% decline from the current price) 3M would offer a yield of 3% to 3.5%, and represent a potentially excellent buying opportunity.

 

Closing Thoughts on 3M

3M has proven itself to be one of the best and most dependable dividend growth stocks in American history. The corporate culture, which emphasizes a strong focus on innovation, disciplined uses of shareholder capital, and a fortress-like balance sheet, should continue to serve both the company and dividend growth investors well for decades to come.

 

That being said, given the current valuation, which indicates that 3M is likely trading at fair value or above, investors looking to initiate a position in the stock might be best served staying patient for a more appealing price.

 

Perhaps foreign currency exchange rate fluctuations or volatility in international markets will provide a correction in the stock. These events have no bearing on the company’s long-term competitive advantages and growth opportunities, which is why they would make for appealing buying opportunities.

 

As a long-term dividend growth investor, I plan on continuing to hold my 3M shares.