3M Company: Using A Sticky Note To Remind Me To Check It In 6 Months - 3M Company (NYSE:MMM)

3M reported very disappointing earnings in Q1 and lowered guidance for FY2019 while the stock has declined from $207 to $167 over the last month.

The company has a long history of raising dividends despite going through challenges, but there are additional risks that could cause that streak to come to an end.

A few weeks ago, I wrote an article on high-quality, dividend growth stocks and the Invesco S&P 500 Quality ETF ( SPHQ) that invests in these types of companies. The premise of that strategy is not that the companies pay very high dividends, but rather, are very stable, pay a decent dividend yield, and have dividend policies in place that calls for continued dividend boosts over time. The companies also exhibit very low volatility in earnings.

At the end of that article, I introduced two stocks that met some of my criteria of high quality, including:

Those two companies were 3M (MMM) and United Parcel Service (UPS) and this article is the follow up analysis of one of those companies. The second is in process. Note that neither MMM or UPS were in the top 25 holdings of SPHQ.

3M Company reported disappointing Q119 earnings results last month and the stock was hammered by the market. Sales were down and adjusted EPS were down compared to the same quarter last year, and the company announced the initiation of a restructuring.

The stock was down more than 12% in one day as lower performing China, automotive and electronics markets are expected to continue to face near-term challenges and weaker growth over the next several quarters.

The restructuring, which will reduce the operating segments from five to four, also will include the reduction of 2,000 positions worldwide and estimated pre-tax savings of between $225 million and $250 million annually. The revised guidance issued by the company was adjusted EPS of $9.25 to $9.75 per share for 2019, down from $10.45 to $10.90.

As investors we have to evaluate whether we have enough confidence in the business long term and whether the announced restructuring will turn out to be a positive catalyst for future earnings growth. When looking at similar restructuring actions in the past, we can see that management has done an excellent job of effectively taking down costs when the company was facing challenges. In 2001, the company realigned its cost structure because of a severe market slowdown, but once markets recovered, the company was well positioned to capture the strong market rebound by taking advantage of better operating leverage.

We also believe that the company has a strong track record of successful investments in research and development to drive growth and management will do everything possible to avoid actions that would negatively impact R&D spending.

With a long track record of increasing its dividend over the last 60 years and despite facing operating challenges during the most recent quarter, the company rewarded its shareholders with dividend increases and share repurchases in 2019. The question now is whether this dividend growth will continue and if so, how soon will the dividend increase?

As mentioned in the previous section, part of the restructuring is to reduce headcount by 2,000 positions globally across all business segments, but there are other initiatives being implemented as well. Some include better inventory management that should help cash flow, as well as reducing some capital expenditures. However, as I already mentioned, R&D spending will continue to grow.

The majority of cost cutting will be in Q219 and restructuring charges will be approximately $150 million. Some investors are raising doubts as to whether 2,000 job cut is really necessary at this point of time when things usually get better in the second half of the year. Following comments from the CEO Michael Roman explains why the company has to implement aggressive cost cutting actions:

Did the restructuring come too late, as many analysts have suggested? And will the company be well-positioned when the market turns around?

One area where the company is not cutting spending is investments in research and development and this combination of reduced costs and increased spending on innovation could be the right combination if implemented correctly.

According to an article in the Harvard Business Review, companies that do well after a recession are those that "master a delicate balance between cutting costs to survive today and investing to grow tomorrow." I'm not suggesting we are in a recession, but when looking at 3M and its markets, the analogy is applicable.

3M is well known for its innovations with products like Abrasive Cloth, Revolutionizing Sandpaper or Masking Tape since its inception back in the 1900s. It recently received an award from Fast Company for being one of the most innovative companies in 2019 with more than 60,000 innovative products in its portfolio.

The list of products we use almost daily is mind boggling if you stop to realize that many of those products we use are manufactured by 3M and we didn't even know it.

These innovations are driven by R&D, and if we take a look at R&D spending over the last decade the company invests more than $1.8 billion a year into R&D, which is roughly 5% of total revenues. According to the company’s long-term plan, management anticipates R&D spending to represent around 6% of total revenues between 2019 - 2023. That will likely contribute to an even higher number of new innovations which can be drivers of future organic growth of the company.

Management also provided long-term ROIC guidance of approximately 20% to 22%, which is slightly lower than the prior range of 22% to 25%. The company's weighted average cost of capital is roughly 8%, which still provides a spread of 12% to 14% of economic value added.

When Mike Roman was named CEO last year, his first corporate action was to realign the portfolio into four business segments - Safety & Industrial, Transportation & Electronics, Health Care and Consumer. He believes it will position the company to better serve its global customers resulting in accelerated growth and improved operating efficiencies.

According to a Bloomberg Article, management wants to organize segments based on the type of customer they serve, instead of organizing them by market. For example, certain products like purification tools are better positioned in 3M’s healthcare business compared to the previous Industrial segment. I don't have an opinion on whether this type of alignment is better or worse than the previous alignment but will defer to management and hold them accountable for improved operations going forward.

The company reported total revenues of $7.9 billion in Q119 or down 9% Y/Y, missing the analysts' estimate of $8.02 million. The adjusted operating margin in Q119 was 21.4% or down 160 bps Y/Y, driven by declines in organic volume and weaker-than-expected productivity which is facing challenges in industrial related business. In terms of earnings, adjusted EPS was $2.23 or down 11% Y/Y, excluding both litigation charges related to the respirators and PFAS. We find this as slightly concerning because EPS number would be approximately $1.50 or down 40% when including both litigation charges. Our readers can find more information about both legal cases in the risk section. In terms of cash flow performance, free cash flow was $657 million or up $820 million Y/Y what makes up a free cash flow margin of roughly 8.3%. It was driven by a higher reported cash flow from operations of $1,048 million in Q1 19 compared to $143 million in Q1 18. Management plans to improve cash flows by reducing inventory levels and indirect costs over the next several quarters.

Even though the company didn’t perform as expected in Q1 2019, shareholders were rewarded with a dividend increase of 6% resulting in a dividend per share of $1.44. Management announced several days earlier that the dividend will remain the same for Q219, resulting in a current dividend yield of 3.24%. The company also reported gross share repurchases of $701 million throughout the quarter and management anticipates full year share repurchases between $2 billion - $4 billion.

While management anticipates robust global macroeconomic growth in 2019, slowing conditions in certain key end markets might persist throughout the year. Therefore it has decided to cut organic local currency growth 2019 guidance from the previous range of 1% to 4% to -1% to 2%. CEO Michael Roman provides more context about the lower guidance for the year:

In addition, management lowered its expectations for adjusted EPS in the range of $9.25 - $9.75 compared to the previous range of $10.45 - $10.90. When looking at restructuring impact it will only have slight impact of $0.07 per share, while litigation-related one-time charges during Q119 will have negative impact of $0.72 per share. The company expects free cash flow in the range of $4.7 to $5.6 billion with a very high free cash flow conversion of 95% - 105%.

Realignments in the midst of an earnings miss while the US and China are causing havoc on world trade is a risky venture. So much can go wrong, from new tariffs that cause supply chain costs to increase, to challenges specific to changing how the business operates. There's no shortage of risks with an investment in 3M, but then again, we can say that about most major multinational companies.

We also see a risk in the two significant litigation matters related to PFAS and respirators the company announced during the Q119 earnings call. Both litigation matters resulted in the creation of a reserve which led to a total charge of $548 million or $0.72 a share.

3M's dividend yield is probably just below where many income-oriented investors like to invest. There's an oft-cited rule of thumb that retirement distributions should be no more than 4% so that your retirement portfolio will last a long time – and maybe forever. I understand where that number is coming from, and for the most part, I agree with that "rule of thumb" with the caveat that every person and every situation needs to be evaluated on its own merits.

That said, I understand that a 3.4% dividend yield isn't a screaming buy for many income investors, however, as I've mentioned in the past – but won't get into the details here – investors also should be looking at price appreciation AND dividend growth. After all, if inflation is at 3% and your income from investments is increasing at a rate above 3%, your purchasing power will outpace inflation. That is what you want during retirement.

So while I was never looking at 3M as a high dividend payer, I was evaluating the company based on its dividend growth potential, which if history is an indication, could be quite attractive.

Over the last five years, 3M has raised its dividend by 34%, 20%, 8%, 6%, and 16%. With the recently-announced restructuring and the horrible start to the year, those dividend growth expectations could be lowered. After all, the company already raised its dividend by $0.06 per share in Q1 and announced that Q2 would be the same. It might not be until Q1 2020 when the company raises its dividend again and certainly, if it were to remain in the Dividend Aristocrats, it would have to raise its dividend no later than Q4 2020.

I believe the recent sell off was way overdone. The price of the stock declined from $207 to $167, while adjusted EPS guidance was lowered by $1.25. That’s a PE decline of 32. A price decline of $40 for a decline in EPS of $1.25. The stock was trading at a PE of $20. If we apply a PE of 20 to the mid-point of guidance of $9.50, we get to a price of $190.

There are risks and the dividend isn't that compelling, so while this could be a strong dividend growth stock over the long term, I would personally wait a quarter or two to see how the cost cutting and realignment goes. And who knows, if the price drops a bit more – income investors just might be able to get a 4% yield after all. I'm holding off on this one and will not be adding it to our lists for now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It does not provide individualized advice or recommendations for any specific reader. Also note that we may not cover all relevant risks related to the ideas presented in this article. Readers should conduct their own due diligence and carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances. Furthermore, none of the ideas presented here are necessarily related to NFG Wealth Advisors or any portfolio managed by NFG.

Source: Seekingalpha.com

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