Updated on February 15th, 2019 by Nate Parsh
The Dividend Aristocrats are a group of 57 companies in the S&P 500 Index, with 25+ consecutive years of dividend increases.
Once per year, we review each of the 57 Dividend Aristocrats. The next stock in the series is industrial manufacturer 3M (MMM).
3M has a very impressive track record. It has paid dividends for over 100 years, and it has raised its dividend for 60 years in a row.
This makes 3M a Dividend King, an even smaller group of companies with 50+ consecutive years of dividend increases. There are fewer than 25 Dividend Kings, including 3M.
3M has a highly secure dividend payout. The following video further discusses 3M’s dividend sustainability in further detail:
Even after so many years of raising its dividend, the payout ratio stands at just 52% in 2018. However, just because a company has a long history of raising dividends, does not automatically make the stock a buy.
In this case, the stock appears to be slightly overvalued. This article will analyze whether 3M has enough growth potential to outweigh its overvaluation.
3M’s history goes all the way back to 1902, when it was a small mining venture. 3M was originally known as Minnesota Mining and Manufacturing.
Its founders started out with a very simple goal: to harvest corundum from a mine called Crystal Bay. There wasn’t much corundum to be mined, but over the next 114 years, 3M grew into one of the biggest industrial conglomerates in the world.
Today, 3M is a diversified global industrial. It manufactures 60,000 products, which are sold in 200 countries around the world.
3M came to dominate the industrial manufacturing industry through a sharp focus on the most attractive market segments. It has invested heavily across its core areas of focus to build a product portfolio that leads the pack.
Source: Investor Day Presentation
The business is organized into five major operating segments: Industrial, which produces products such as industrial tapes, abrasives, adhesives and supply chain management software; Safety & Graphics, which manufactures personal protective gear and security products; Healthcare, which supplies medical and surgical products; Electronic & Energy which produces fibers and circuits for use in renewable sources of energy; and Consumer, which sells offices supplies, home improvement products and stationary supplies.
3M generates nearly $33 billion in annual revenue, and each of its five operating segments generates healthy profit margins.
3M has generated steady earnings growth in recent periods. In 2018, organic revenue increased 3.2% for the year and earnings-per-share increased 14%, thanks to gains in adjusted operating income margin growth, organic growth in all divisions of the company, a lower tax rate and share repurchases.
2019 is likely to be another year of growth for the company. 3M expects earnings-per-share in a range of $10.45-$10.90. At the midpoint, this would represent 2.1% growth from the prior year. It should be noted that this guidance is down slightly from the company’s initial guidance of $10.60 to $11.05 for earnings-per-share. Organic growth is expected in the 1% to 4% range for the current year.
3M going forward demonstrated growth in both domestic and international markets.
U.S. organic sales grew 4.4% in the fourth quarter. This is well above results in recent years for the region. Latin America/Canada continues to be a source of strength for the company, as organic sales increased 5% last quarter. While sales were flat year-over-year in Japan and Western Europe, Canada, Mexico and Brazil grew 5% each. China, on the other hand, grew just 1%.
3M maintains a highly promising outlook over the next few years.
Source: Investor Day Presentation
The company expects to generate returns on invested capital above 20% each year through 2023, thanks in large part to a lean cost structure. It also aims for 3%-5% organic revenue growth in constant currency, along with 8%-11% annual earnings-per-share growth.
3M’s portfolio optimization, characterized by various acquisitions and divestitures, has made the company leaner and more efficient.
3M expects to generate at least $125 million in annual cost savings each year through 2020. The company also repurchased almost $5 billion worth of its own stock in 2018 and expects to buy back another $2 to $4 billion in 2019.
Competitive Advantages & Recession Performance
To raise dividends for over 50 years, requires multiple durable competitive advantages. For 3M, technology and intellectual property are its biggest competitive advantages.
3M has 46 technology platforms and a team of scientists dedicated to fueling innovation.
Innovation has provided 3M with over 100,000 patents obtained throughout its history, which helps fend off competitive threats.
3M continues to invest heavily in research and development. The company aims to spend ~6% of annual sales on R&D. The company’s recent R&D investments are:
- 2014 research-and-development expense of $1.77 billion
- 2015 research-and-development expense of $1.76 billion
- 2016 research-and-development expense of $1.73 billion
- 2017 research-and-development expense of $1.9 billion
- 2018 research-and-development expense of $1.8 billion
3M R&D is so successful in creating new products that approximately 30% of annual sales came from products that didn’t exist five years ago.
3M has established itself as an industry leader, across its product segments. Their competitive advantages also help 3M remain profitable, even during recessions.
3M’s earnings-per-share during the Great Recession are below:
- 2007 Earnings-per-share of $5.60
- 2008 Earnings-per-share of $4.89 (13% decline)
- 2009 Earnings-per-share of $4.52 (7.5% decline)
- 2010 Earnings-per-share of $5.75 (27% increase)
The company is not immune from recessions, and its earnings-per-share fell in 2008 and 2009. However, it bounced back in 2010. And, it remained steadily profitable throughout the recession, which allowed it to continue raising its dividend.
Valuation & Expected Returns
There is nothing wrong with 3M’s business model. In fact, 3M has one of the strongest business models in the entire S&P 500.
Instead, the problem for 3M is that the stock is slightly overvalued today. For example, 3M now expects full-year earnings-per-share of $10.68, at the midpoint of 2019 guidance. At its current share price of $207, the stock is trading at a forward price-to-earnings ratio of 19.4.
This is higher than its average valuation. 3M has held an average price-to-earnings ratio of 17.2 over the past 10 years.
3M is trading at a roughly 13% premium to its historical average. In other words, the stock is currently trading more than 110% above our estimate of fair value.
This doesn’t make the stock extremely overvalued, but this does limit gains made from expansion of the P/E multiple. Shareholders would see total annual returns reduced by 2.4% per year if the stock reverted to its average valuation by 2024.
Owners of 3M stock can also see returns from earnings growth and dividends. 3M has experienced earnings-per-share growth of 6.4% over the last decade. A combination of organic growth and share repurchases should allow the company to see this level of growth in future years.
A breakdown of potential returns through 2024 is as follows:
- 6.4% organic EPS growth
- 2.4% multiple reversion
- 2.8% dividend yield
Through earnings growth and dividends, partially offset by a declining valuation multiple, we estimate that 3M can generate a total annual return of 6.8% through 2024. This is a modest expected rate of return, and does not result in a buy recommendation at this time.
3M remains a high-quality business, and is likely to continue raising its dividend each year. There are very few companies that can match the company history of dividend growth. 3M has raised its dividend for 60 consecutive years, and will likely continue to increase the dividend each year for many years to come.
However, the current valuation, though not extreme, reduces total return possibilities. 3M remains a strong holding for dividend growth. That said, investors looking to add 3M to their portfolio are encouraged to wait for a pullback in the share price, for a lower stock valuation and higher dividend yield.