U.S. Markets close in 3 hrs 20 mins

3M: Why Buying This Accidentally High-Yielder Makes Sense

One of my favorite investment strategies is to find stocks that are trading with a dividend yield that is well in excess of the long-term average yield. This usually means that the underlying company is experiencing some pain in its business, such as rapid decline in fundamentals, and should be avoided at all costs. It could also mean that the company is experiencing temporary issues that are likely to subside at some point.

If the accidently high-yielding stock belongs to the latter group, then long-term investors could see outsized returns or at least receive a higher amount of income from this investment while they wait for the turnaround.

A high yield might also imply a future cut is possible if the headwinds in the business don't produce the necessary profits or cash flow to continue paying the dividend.

One company that I believe will overcome short term headwinds while offering a safe dividend is 3M Co. (NYSE:MMM).

Company background

Following a reorganization during the second quarter of 2019, 3M now has four reportable business segments. They include Safety & Industrial (which provides such products as tapes, abrasives and supply chain management software), Health Care (which produces drug delivery systems, medical and surgical products), Transportation & Electronics (which produces products used in automotive, commercial and aerospace industries) and Consumer (which markets office and stationary supplies and home improvement products). With operations in more than 200 countries, 3M truly is a global company. It has a current market capitalization of nearly $89 billion.

Recent earnings results - not bad, but headwinds

3M last reported earnings results on April 28.

Source: 3M's First-Quarter Earnings Result Presentation, slide 11.

Quarterly revenue increased 2.7% to $8.1 billion, which was $220 million more than Wall Street analysts had expected. Adjusted earnings per share declined 3.1% to $2.16, though this topped estimates by 15 cents. Currency exchange was a headwind during the quarter, a theme that dates back many quarters for the company. Currency exchange reduced revenue by 1.8% and knocked 8 cents off of earnings per share results. The combination of financing of acquisitions and divestures was a 5-cent headwind to earnings as well.

Organic growth in local currency inched higher by 0.3%. This may not seem like much growth, but for 3M it marks a bit of a turnaround as the company hasn't had positive organic growth since the first quarter of 2019.

Individual business units had somewhat mixed results. Consumer showed the most growth, with sales improving organically by 6.1% to $1.3 billion. The smallest unit within 3M had strength in home improvement and consumer health care. This growth was offset by declines in stationery and office supplies. Higher sales led to an operating margin of 21.4%, a 1.8% increase from the previous year.

Safety & Industrial, the largest segment within 3M, grew sales 2.2% to $2.9 billion, while operating margins improved 3.2% to 24.7%. Personal safety, footing granules and industrial adhesives and tapes saw especially high demand. Closure and masking, electrical markets and automotive aftermarket were weak.

Organic sales for Health Care were higher by 1.2% at $2.1 billion. The operating margin was down 4.7% due primarily to acquisitions. While acquisitions of Acelity, which provides advanced medical products, and M*Modal, which provides cloud-based artificial intelligence powered systems, did negatively impact operating margins, they did add 21% to sales growth due in large part to gains made in medical consumables. Health care and oral care also contributed to the drop in operating margin. Drug delivery systems, food safety, medical solutions and separation and purification were identified as areas of growth for 3M.

Transportation & Electronics was the lone segment to suffer a sales decline, with organic sales decreasing 3% to $2.2 billion. While electronic sales were higher for the quarter, commercial solutions, automotive and aerospace were all a drag to results. Advanced materials and transportation safety were flat for the quarter.

By region, the U.S. performed quite well, with organic growth up 4% through the middle of March. From that point on, the region had declining sales. The Europe, Middle East and Africa region also experienced an accelerated decrease in March. Much of this deceleration across the regions was due to the Covid-19 impact. Asia-Pacific improved near the end of the quarter.

3M did end the quarter with a solid balance sheet position. The company had $15.1 billion in current assets, including $4.5 billion in cash and equivalents against current liabilities of $9.1 billion, including $3.5 billion of current debt and lease obligations. Operating cash flow improved 16% and free cash flow was up 34% from first-quarter 2019.

The company did pull its 2020 guidance due to the unknown economic impact of the Covid-19 pandemic. Market analysts, according to Yahoo finance, expect earnings of $8.12 per share.

Second quarter will be ugly, but the stock has been a solid long-term investment

In addition to reduced economic visibility, 3M said the second quarter is expected to be the weakest of the year.

Source: 3M's First-Quarter Earnings Result Presentation, slide 13.

There's no way to hide the impact of Covid-19 on results as organic sales through late April were down significantly. The Americas and EMEA were hit especially hard. On the plus side, Asia-Pacific was returning to growth with the ever-important market of China growing again.

And it appears things got worse in May. Total sales dropped 20% for the month with organic sales in local currency declining 21%. All business segments saw a decline, but Transportation & Electronics was hit especially hard as sales were down 28%. Asia-Pacific was lower by 15%, with China down 6% and Japan decreasing 18%. Sales for the Americas region declined 24%, with the U.S. down 22%. Much of these declines are directly related to the Covid-19 pandemic and the lockdowns imposed by governments around the world.

Impacting results was two fewer business days compared to the prior year, which contributed 9% to the overall decline in total sales. June will have two additional business days, so the second quarter will be an apples-to-apples comparison to second-quarter 2019. Even excluding the impact from fewer business days, May was dreadful for 3M. I also expect that June won't be much different as the pandemic continues to cause disruptions.

Despite the headwinds, 3M has been and likely will be a solid investment in the long term. The company has been in existence since 1902, when it was founded as a mining company. 3M has found numerous ways to innovate and change its business over its nearly 120-year history

The company spends heavily on research and development (6% of sales of $1.9 billion in 2019) and this capital investment has a habit of paying off. More than a quarter of annual sales are from products that weren't even in existence five years ago. 3M also has more than 100,000 patents in its portfolio, speaking to its ability to create and bring new products to market for customers.

As an industrial company, 3M is sensitive to recessions. Earnings per share declined nearly 20% peak-to-trough during the 2007 to 2009 recession. The company rebounded very quickly and made a new high for earnings per share in 2010. Earnings have compounded at a nearly 5% growth rate over the last decade. Outside of last year, EPS has increased every year since 2010.

While 3M has repurchased more than 2% of its share count annually over the last decade, both sales and net profit have generally increased from year to year during this period of time.

All of this has allowed 3M to have one of the longest dividend growth streaks found anywhere in the market.

Dividend and valuation analysis

While the company's last dividend raise was an underwhelming 2.1%, this increase gave 3M 62 consecutive years of dividend growth. There are just seven companies with a longer dividend growth streak according to the U.S. Dividend Champions.

3M has increased its dividend by an average of:

  • 9.1% per year over the past three years.
  • 11% per year over the past five years.
  • 10.9% per year over the past 10 years.

Obviously, the most recent increase doesn't compare to the listed growth rates. The payout ratio likely has something to do with that.

Shareholders should receive $5.88 in dividends per share in 2020. Using earnings per share estimates, the stock has a payout ratio of 72%. While this is elevated, it isn't exactly on dangerous ground. The stock's average payout ratio over the last 10 years is 47%, but rose to 55% over the last five years.

3M distributed $847 million worth of dividends in the first quarter while generating free cash flow of $881 million. While free cash flow was higher than the prior year, the payout ratio was still 96% for the quarter.

I believe the most recent increase was low as the short-term payout ratios had become uncomfortable to management.

Looking further back, 3M's free cash flow looks much better. For 2019, the company paid out $3.3 billion in dividends while free cash flow came to $5.4 billion for a payout ratio of 61%. From 2016 through 2018, the company's dividend payments totaled $8.7 billion and free cash flow reached $15 billion for an average payout ratio of 58%.

Of course, 3M's business was performing well during these times and the company is likely to struggle for at least the next few quarters. The company, however, has managed to pay and raise its dividend through the last seven recessions. Past performance doesn't predict the future, but it seems likely that the company will be able to weather this storm given its leadership and ability to bring innovative products to market.

As for how to value an individual stock, normally I would consider the stock's price-earnings ratio as a way to determine price targets. Using Monday's closing price of $156 and expected earnings of $8.12, the forward price-earnings ratio is 19.2. This is slightly above the 10-year average multiple of 18.4 times earnings according to Value Line.

Instead of using this traditional method, I am going to use the five- and 10-year average yields to help set the perimeters of my price target range. The reason that I am doing so is that shares of 3M trade well above its historical averages. Currently, shares yield 3.8%. Were 3M to average this yield for all of 2020, then this would be the highest average yield in more than 15 years. In fact, the stock has averaged a 3%-plus yield for an entire year just once since 2004 (2019).

The stock's five- and 10-year average yield is 2.7% and 2.6%, respectively. Understanding that there are issues with the business in the short term, I don't expect the stock to achieve the price needed to achieve this yield in the coming months.

A dividend yield range of 3.2% to 3.4% seems fair due to the company's business strengths balanced with Covid-19-related headwinds. For the yield to drop to my target levels, the share price would have to reach a range of $173 to $184. This would be a gain of 11% to 18% off of the most recent closing price.

Final thoughts

3M had a decent first quarter, topping analysts' estimates on both the top and bottom lines. The company posted its first organic growth increase in a year and three out of four business segments had positive growth results.

The company did pull its guidance and warned that second quarter would be difficult. Looking at April and May results shows that 3M was upfront about how poorly sales would be for the quarter.

3M has stayed in business for more than a century, so overcoming difficult environments is something the company has proven successful at doing. The company's dividend growth track record reinforces this belief.

The stock trades with a yield rarely seen for long periods of time. Even a slight retracement toward the average yield could mean a handsome reward for shareholders. Factor in the dividend and investors could be looking at minimum of a mid-teen percentage total return. For those investors with a long-term horizon who don't mind an ugly quarter or two, 3M could be a great investment.

Disclosure: The author has a long position in 3M Co.

Read more here:

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.