Published by Bob Ciura on November 15th, 2017
The Dividend Aristocrats are a group of 51 companies in the S&P 500 Index, with 25+ consecutive years of dividend increases.
Once per year, we review each of the 51 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 59 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 just 23 Dividend Kings, including 3M. You can see all 23 Dividend Kings here.
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 significantly overvalued. 3M has soared over the past several years, to the point that the shares are trading well above fair value.
Business Overview
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.
The business is organized into five major operating segments:
Source: Jefferies Industrials Conference, page 5
3M generates over $30 billion in annual revenue, and each of its five operating segments generates healthy profit margins.
Growth Prospects
3M has generated steady earnings growth in recent periods. In 2016, organic revenue declined 0.1% for the year, but earnings-per-share increased 7.7%, thanks to margin improvements. Cost cuts drove a 110-basis point expansion of 3M’s operating margin last year.
2017 is likely to be another good year for the company. After providing third-quarter results, the company raised its full-year guidance. Management now expects earnings-per-share in a range of $9.00 and $9.10 in fiscal 2017.
Source: Q3 Earnings Presentation, page 16
Earnings-per-share are expected to increase 10%-12% this year. Earnings growth will be driven by a combination of organic revenue growth, and cost cuts.
Two of the most attractive catalysts for 3M going forward, are growth in the international markets, and cost cuts.
Growth in the international markets is outpacing growth in the U.S. In 2016, 3M’s organic sales rose 3.7% in Latin America and Canada, compared with 0.5% organic growth in the U.S.
These trends have continued in 2017. Organic revenue grew 1% in the U.S., over the first three quarters. In the same period, organic sales increased 9.7% in the Asia-Pacific region, and 4.7% in Latin America & Canada.
Separately, 3M expects to generate returns on invested capital above 20% each year through 2020, thanks in large part to a lean cost structure.
Source: Jefferies Industrials Conference, page 12
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. Organic revenue growth and cost cuts fuel management expectations of at least 8% earnings growth each year.
Competitive Advantages & Recession Performance
To raise dividends for over 50 years, requires multiple durable competitive advantages. For 3M, its technology and intellectual property are its biggest competitive advantages.
3M has 46 technology platforms and a team of scientists, dedicated to fueling innovation.
Source: Jefferies Industrials Conference, page 14
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’s R&D investments over the past three years are below:
- 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
3M has established itself as an industry leader, across its product segments. These 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)
3M 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. The problem is that the stock is significantly overvalued. For example, 3M now expects full-year earnings-per-share of $9.05, at the midpoint of 2017 guidance.
At its current share price, the stock is trading at a price-to-earnings ratio of 25.3, based on the midpoint of earnings guidance.
This is highly above its average valuation. 3M has held an average price-to-earnings ratio of 16.4 over the past 10 years.
Source: Value Line
3M is trading at a roughly 54% premium to its historical average. In other words, the stock is currently trading more than 150% above our estimate of fair value.
This makes 3M a potential sell. With such a high valuation, there is significant risk of contraction of the price-to-earnings multiple. If 3M traded back to its 10-year average price-to-earnings ratio, the stock would decline by 35%.
3M’s high valuation casts a dark shadow over its potential returns. The company will still generate shareholder returns through earnings and dividends. A breakdown of these returns is as follows:
- 4%-5% organic revenue growth
- 5%-1% margin expansion
- 2% share repurchases
- 2% dividend yield
Assuming a stable price-to-earnings ratio, the stock could return 9%-10% per year. However, these returns could be nearly wiped out, if the price-to-earnings ratio contracts toward its 10-year average.
Final Thoughts
3M is a high-quality business, and is likely to continue raising its dividend each year. However, now is simply not a good time to buy.
The stock has gone on a virtually non-stop run since the Great Recession ended. 3M has more than quadrupled off its 2009 low. Shares have returned more than 150% in the past five years alone.
The impressive rally has taken the stock well beyond its fair value. As a result, investors should consider harvesting some of the massive gains, and redeploying the proceeds in stocks with lower valuations and higher dividend yields.
