3M: N95 Masks cannot Solve its Growth Problem

Introduction: This article was originally published at Seeking Alpha. Note that, it is an article not exclusive to Seeking Alpha.

1. Due to the Covid-19 outbreak, there is an unprecedented demand for N95. However, N95 only accounts for a small portion of 3M revenue and cannot solve its preexisting growth problem.
2. A significant portion of 3M products are in the manufacturing sector, and thus the slowdown of the global economy hurts 3M’s sales.
3. 3M’s active acquisitions and divestitures in recent years aim to strengthen its core business, but those actions have not successfully improved 3M’s sales and EPS.
4. While the dividend consistency makes 3M stocks attractive, the high payout ratio becomes a financial burden and poses constraints on seeking acquisition opportunities.
5. Looking ahead, dividend growth is expected to be a low-single-digit amount, and I have a hold recommendation for 3M.

3M (MMM) is an American multinational conglomerate corporation operating in the fields of industry, safety, health care, and consumer goods. 3M has been struggling with its growth, evidenced by its stock price dropping since 2018. With the outbreak of Covid-19, you might wonder whether the increased demand for N95 respirators can solve 3M’s growth problem. My short answer is that it’s far from enough and I will detail my reasoning in this article. Further, while the dividend king title makes 3M attractive to dividend investors, its high payout ratio not only becomes a financial burden to 3M but also poses constraints on the management team in exploring new acquisition opportunities, which are necessary to achieve long-term growth and higher margins.

In this article, I first provide a summary of the 2020 Q1 conference call. Next, 3M’s financial performance in the last 10 years and its recent acquisitions and divestitures are discussed. Finally, I analyze 3M’s sales and dividends, as well as explain why 3M has not successfully solved its growth problem, aiming to give readers a more comprehensive and updated outlook.

Key Takeaway From 2020 Q1 Conference Call

1. Covid-19: At the beginning of the conference call, 3M CEO Michael Roman paid tribute to healthcare workers, first responders, as well as 3M employees in this public health crisis. 3M has shown strengths and weaknesses simultaneously under the environment of Covid-19. On the positive side, the increased demand for N95 respirators showcases 3M’s important role in the health care segment. However, we can also see a mix of results across its four segments in 2020 Q1 (see Table 1). Note that, the 21% sales growth in the Health Care segment is not because of the increased demand for N95, but rather from the acquisitions of Acelity and M*Modal (see Table 2 for financial details and Table 3 for acquisition information).

2. Operation: The management team has taken measures to cope with the current difficult business environment, such as suspending share repurchase programs. The unpredictable nature of Covid-19 prevents the management team from providing clear forward-looking guidance, so they will alternatively report monthly sales information starting in May to provide investors with needed information.

3. China: 3M generates approximately 60% of its sales outside the United States, and analysts in the conference call were interested in the economic recovery in China and the overall observations from there. Regarding this aspect, the key takeaway is that China indeed is recovering but the management team needs more time to observe before drawing any conclusions.

4. Dividends: 3M’s dividend king title reflects its excellent dividend record. The management team in the conference call mentioned dividends twice and expressed their commitment to it. Thus, dividend investors who are worried about the dividend safety can be assured.

3M Overview

3M has iconic products such as N95 respirators and Post-it Notes, which can provide investors an intuitive understanding of 3M’s playing field. However, focusing on specific products could lead to a biased perception of how 3M has been performing financially. Instead of diving into 3M’s specific products, I provide below an aggregated financial performance in the last 10 years, including sales, EPS, dividends, and payout ratios (see Figures 2, 3, and 4).

(Figure 2; Data: 3M 2019 and 2014 Annual Reports; Credit: The author)

(Figure 3; Data: 3M 2019 and 2014 Annual Reports; Credit: The author )

(Figure 4; Data: 3M 2019 and 2014 Annual Reports; Credit: The author )

I provide summaries as follows.

Sales (Figure 2):While there is an increase when comparing 2019 ($32.1 billion) to 2010 ($26.7 billion), the general trend is flat or even negative.

EPS (Figure 3): EPS increased from 2010 ($5.63) to 2019 ($7.81), but the growth is just moderate (38.72%). In November 2018, 3M’s Board of Directors authorized a repurchase of up to $10 billion of outstanding common stock. Thus, the evaluation of increased EPS needs to consider the reduced number of outstanding stocks.

Dividends (Figure 3): Dividends have increased in the last ten years from $5.76 in 2010 to $7.81 in 2019 (174.28%). While 3M’s past dividend record is impressive, I caution investors that such a record is unlikely to replicate in the next 10 years and I will discuss my reasoning below with more details.

Payout Ratio (Figure 4): Due to the low growth in EPS but a steady increase in dividends, unsurprisingly its payout ratio has increased significantly from 37% in 2010 to 74% in 2019.

3M actively manages its portfolios in order to achieve growth in the long term. In recent years 3M has strategically strengthened its core business by acquiring other companies. Table 3 includes an incomplete list of 3M’s recent acquisitions, and we can see that 3M prioritizes the Health Care and Safety industries. Specifically, the integration of Acelity strengthens 3M’s leading role in advanced wound care. M*Modal, a provider of clinical documentation and Speech Understanding, further expands 3M’s business in Health Information Systems. As a result, 3M’s Health Care business grew from $1.5 billion in 2018 Q1 to $2.1 billion in 2020 Q1. A more balanced product line across different business sectors helps 3M lower risk. For example, as shown in the 2020 Q1 report (see Table 1), the loss in Transportation & Electronics is partially offset by the growth in Health Care and Consumer.

Year	Company	Product	Segment	Acquisition Cost	Annual Revenue
2019	Acelity	advanced wound therapeutics	Health Care	6.7 B	1.5 B (2019)
2018	M*Model	speech recognition solution and others	Health Care	1B	0.2B (2018)
2017	Elution	test kits for food and beverage companies	–	–	–
2017	Scott Safety	respiratory protection	Safety and Industry	2B	0.57B (2016)
2016	Semfinder	semantic coding of medical services	Health Care	–	–
2015	Capital Safety	fall protection, confined space, and rescue equipment	Safety and Industry	2.5B	0.43B (2015)
2015	Ivera Medical	disinfection products	Health Care	–	0.03B (2015)
2014	Polypore’s Separations Media Business	microporous membranes and modules for filtration in the life sciences, industrial and specialty segments	–	1B	0.21B (2014)
2014	Treo Solutions	data analytics and business intelligence to healthcare payers and providers	Health Care	–	0.021B (2014)*
2012	Ceradyne	advanced technical ceramic products	Safety and Industry	0.86B	0.5B (2012)
2012	Federal Signal Technologies Group (FSTech)	electronic toll collection and parking management hardware and software services	–	0.11B	–
2012	Office and Consumer Products (“OCP”) of Avery Dennison Corp	Office and Consumer Products	Consumer	0.55B	0.76B

3M has not only acquired but also divested in recent years. To name a few, in December 2019 3M announced the divestiture of its drug delivery business (annual sales of approximately $380 million) to Altaris Capital Partners and would receive approximately $650 million. In June 2019, 3M reported the sales of its gas and flame detection business (annual sales of approximately $120 million) to Teledyne Technologies Incorporate and would receive approximately $230 million. Dating back to 2007, 3M also sold its slow-growing global pharmaceuticals business for about $2.1 billion to several different companies.

Analysis and Outlook

Growth: An Uphill Battle

While 3M does not have imminent risk regarding its business sustainability, it faces an uphill battle for growth. For instance, 3M’s sales increased from $26.7 billion in 2010 to $32.1 billion in 2019 (a 20.22% increase), and its EPS increased from $5.63 in 2010 to $7.81 in 2019 (a 38.72% increase). A few reasons account for such low growth in sales and EPS. First, a significant portion of 3M’s products are in the manufacturing sector, and thus the macroeconomic environment plays an important role in 3M’s growth. Global industrial production growth has started to slow down since the end of 2017. Such a global economic slowdown has a significant impact on 3M’s segments of Transportation & Electronics and Safety & Industrial.

Second, 3M’s recent acquisitions prioritize Health Care and business related to information systems (e.g., M*Model, Semfinder, and Treo Solutions). While the acquired business helps strengthen 3M’s competitiveness and margins within the segments, their growth is moderate and they only account for a small percentage of 3M total sales (e.g., M*Model: 0.6%). Finally, the new revenue and growth generated from acquisitions are offset by the sales loss due to divestitures. Although 3M divests business that are deemed to have low growth or be non-core business, such divestitures inevitably lead to significant loss of revenues and EPS.

Dividends: A Bleak Future

(Figure 5; Data: 3M 2019 and 2014 Annual Reports; Credit: The author )

3M’s year-over-year (YOY) dividend growths ranged from 4.8% to 34.6% in the last 10 years (see Figure 5). Dividends are an important factor when evaluating 3M’s stock value. The intriguing question arises as to how the YOY growth rate would look like moving forward. In January 2020, 3M announced an increase of 2%, namely from $1.44 in 2019 to $1.47 in 2020; such a growth rate is historically low for 3M. Given the impact of Covid-19 and 3M’s low growth even prior to Covid-19, I would expect 3M to continue such a low-single-digit dividend growth in the next 5 years.

Without significant acquisitions or a dramatic improvement in the global economy, I would not expect 3M to have significant growth in sales. Thus, a 2% growth in both sales and dividends is not an unreasonable estimation. If both EPS and dividends keep increasing at a YOY rate of 2% in the next 10 years, the payout ratio would be always above 70% (see Figure 6). In 2020, given the dividends of $5.88 and the price of $145, the yield is 4.06%. A 2% YOY dividend growth thus will result in a 4.49% yield in 2029. Beyond dividends, 3M stock price has dropped significantly since 2018 and has underperformed compared to Vanguard S&P 500 ETF (VOO) and Johnson & Johnson (JNJ) (see Figure 7). Thus, for both dividends and stock prices, 3M has limited upside in the next few years.

(Figure 6; Data: Based on projections by the author; Credit: The author)

(Figure 7; Data: Tiingo; Credit: The author)

Conclusion

While 3M’s current high dividend yield looks attractive at its first glance, its outlook is not too bright due to the expected low-single-digit growth rate. In the last decade, 3M had low growth in EPS but high growth in dividends, leading to a high payout ratio (e.g., 74% in 2019). Of importance, 3M’s recent sales growth in Health Care was predominantly driven by acquisitions, and thus a high payout ratio would pose constraints upon the management team in exploring potential acquisitions and could negatively impact 3M’s long-term growth. Consequently, while there is no imminent sustainability risk, 3M faces significant challenges in terms of finding new growth opportunities. Combining all the analyses, I therefore rate 3M a hold.

Disclosure: I am/we are long JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.