Is 3M a Bargain or a Value Trap?

For more than a year and a half, the share price of the 3M Company (MMM, Financial) has trended downward:

Most recently, it was part of the spring market meltdown, from which it rebounded to some extent. As Chairman and CEO Mike Roman noted in the second-quarter earnings release on July 28th, "our results were significantly impacted by the global economic slowdown."

3M also has been wrestling with liabilities from the past, primarily around PFAS, or perfluoroalkyl and polyfluoroalkyl substances. Thus, it reported significant legal liabilities, including more than $600 million paid out in the first half of 2020. In its 10-K for 2019, the company recorded a pre-tax charge of $897 million related to PFAS liabilities.

Making circumstances more complicated is the fact that PFAS are essential to modern living. According to the company's 10-K:

"The PFAS group contains several categories and classes of durable chemicals and materials with properties that include oil, water, temperature, chemical and fire resistance, as well as electrical insulating properties. The strength of the carbon-fluorine bond also means that these compounds do not easily degrade. These characteristics have made PFAS critical to the manufacture of electronic devices such as cell phones, tablets and semi-conductors. They are also used to help prevent infections in products like surgical gowns and drapes. Commercial aircraft and low-emissions vehicles also rely on PFAS technology."

The demand for masks and other personal protective equipment has been a bright note fpr the company, but second-quarter results were mixed. Sales and earnings per share were down from the same period last year, but operating cash flow and adjusted free cash flow were both up. More important, perhaps, was the news that monthly sales numbers were improving, albeit slowly. 3M continues to withhold guidance for the full year.

With the share price relatively low, is 3M a stock that deserves investor attention, or is it a value trap? In this article, we will attempt to assess this by studying 3M's fundamentals, dividends, buybacks and guru investors.

Financial strength

The GuruFocus financial strength ratings are based on three criteria:

1. A company's debt burden as measured by its Interest Coverage for the current year (the higher the number, the better).
2. The debt-to-revenue ratio (he lower, the better).
3. The Altman Z-Score (the higher the score, the better).

3M's debt certainly has been growing, but the Interest Coverage ratio is more than 12, meaning it has more than enough operating income to cover its interest expenses.

The debt-to-revenue ratio is demonstrated by the below chart:

As we can see, the long-term debt load has been rising faster than revenue.

The Altman Z-Score, which measures creditworthiness, is well into the safe zone at 4.36 and a positive sign for prospective buyers.

I also check the ROIC vs WACC ratio, which compares the return on invested capital (ROIC) with the weighted cost of capital (WACC). For 3M, the ratio is very good, with ROIC of 14% versus WACC of 5.74%. The company is creating wealth with the capital it has received from shareholders and lenders.

Overall, 3M's financial strength appears to be satisfactory.

Profitability

The profitability rating is based on five criteria:

1. Operating Margin %.
2. Piotroski F-Score.
3. Trend of the Operating Margin % (five-year average) (a company with an uptrending profit margin gets a higher rank).
4. Consistency of the profitability.
5. Predictability Rank.

With an operating margin of 19.2%, 3M is more profitable than 93.69% of companies in the Industrial Products area.

The Piotroski F-Score is 6 out of 9, which indicates that the company's financial situation is stable.

The trend of the operating margin has been disappointing over the past three years, as shown in the chart below:

3M receives a business predictability rank of 4 out of 5 stars, which GuruFocus estimates will be worth an average gain of 9.8% per year over the next 10 years with only an 8% probability that investors would be in a loss position at the end the period.

The last three lines in the Profitability table are not encouraging; revenue growth is up in the mid-single digits but both profitability measures, Ebitda and earnings per share without non-recurring items, are negative.

Overall, the profitability score is very high, but there are some troubling data points behind that rating.

Valuation

Over the past 10 years, the price-earnings ratio has ranged between 12.21 and 35.81, with a median of 19.58. The current price-earnings ratio of 18.48 is slightly below the median.

The PEG ratio, which refers to the price-earnings ratio divided by the five-year Ebitda growth rate, is 12.33. Normally, we would expect a ratio between about 0.5 and 3.0, with 0.0 representing fair value. 3M's PEG ratio is high because the Ebitda growth rate is only 1.5%.

We also get bad news from the discounted cash flow (DCF) calculator, which finds the company is significantly overvalued at its current price according to the assumptions listed below:

Overall, the share price may be down from its previous highs, but the price-earnings ratio, the PEG ratio and the DCF model all suggest 3M is overvalued.

Dividends

3M's current dividend yield is about double the average of S&P 500 companies, and it has been growing. While the dropping share price is a factor, there is much more involved. Specifically, the company has been a Dividend Aristocrat for 62 years now, which tells us it has increased its dividend every year for more than a quarter century. This chart shows increases in the past 10 years:

Over the past decade, the dividend payout ratio has ranged between 37% and 74%, with the median at 50%. The current payout, at 66%, is well above the median but not as high as it has been. This seems reasonable for a mature company. The three-year dividend growth rate is 9.1%.

Turning to the forward dividend yield, it is slightly higher than the trailing 12-months rate, signalling an increase in the recent past. Indeed, in February, the quarterly dividend was increased from $1.44 to $1.47.

If we take what has happened with the dividend yield in the past five years, and assume it will grow at the same rate for the next five years, then we can expect an average dividend yield of just under 6% per year over the next half decade. That's assuming you buy and hold the stock for the next five years.

The share repurchase ratio stands at 1.2, which is slightly above the 10-year median of 1.1. That has been enough to reduce the share count by 19% since 2011:

A strong commitment to increasing the dividend every year, on a base of nearly 4%, plus gradual share buybacks add up to a five-year yield-on-cost of nearly 6%.

Gurus

Twelve of the investing gurus followed by GuruFocus have stakes in 3M, and there was a spike in buying in the second quarter:

Among the gurus, Ken Fisher (Trades, Portfolio) of Fisher Asset Management is the most committed, owning 4,429,230 shares, or 0.77% of shares outstanding. In the second quarter, he added a jaw-dropping 9,250% to his position.

First Eagle Investment (Trades, Portfolio) holds 2,932,099 shares after a reduction of 10.59% during the quarter, while Jeremy Grantham (Trades, Portfolio) of GMO LLC increased his stake slightly to 1,617,707 shares.

Conclusion

I began this article by questioning whether 3M, at its current low price, was a bargain or a value trap. The answer, I believe, lies somewhere between those two positions. While the price is lower, it hasn't just gone down because of Covid-19 and the associated economic crisis. This downtrend began more than a year ago, and despite that, it is still overvalued based on my regular valuation metrics.

It's also not a value trap, in my opinion. It has operated for more than a century, and for many of those 100-odd years, it has paid a steadily increasing dividend and become a Dividend Aristocrat. Underpinning that status is a history of solid revenue, earnings and free cash flow. A stretch of just a year and a half looks small compared to that history.

3M has a solid base of gurus investors, with many attracted by the current low price. Value investors may not see much of interest here, but growth investors who expect the company's fortunes to improve might see this as an entry point, and income investors may see the yield-on-cost of nearly 6% plus expectations of share buybacks as a strong incentive. That's an attractive yield, if everything works out in the company's favor.

Disclosure: I do not own shares in any companies named in this article.

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