As one of the elite Dividend Aristocrats, 3M Co. (MMM, Financial) boasts a stunning 65-year streak of dividend growth, highlighted by a robust 5.76% forward yield.
In this analysis, I dive into 3M's extraordinary adjusted free cash flow surge and shrewd capital management strategies while exploring its strategic initiatives like substantial debt reduction and the innovative health care business spin-off.
Finally, 3M's resilience in navigating the legal challenges reinforces its status as a solid financial powerhouse, offering investors an attractive risk-reward profile.
Financial revamp signals strong dividends ahead
Being one of the highest-yielding Dividend Aristocrats, 3M provides a forward dividend yield of 5.76% with a forward annual payout of $6. With a five-year growth rate of 1.98%, 2023 is the 65th year of dividend growth.
The dividend payout is supported by improved adjusted free cash flow. In the third quarter, 3M experienced a remarkable surge in its adjusted free cash flow, reaching $1.9 billion, marking a substantial 39% year-over-year increase. The growth continued to be solid throughout the year, with a year-to-date increase of 37%, amounting to $4.3 billion.
Source: NASDAQ
Looking at the adjusted free cash flow conversion, 3M exhibited a staggering improvement in the third quarter. The conversion rate increased by 3.6% year over year, reaching 130%. Similarly, the year-to-date conversion rate surged by 4.3%, reaching 115%. Such significant improvements in cash flow conversion rates indicate solid support for dividends. A substantial portion of this improvement can be attributed to efficient working capital management.
By optimizing accounts payable, receivables and inventory turnover, 3M likely streamlined its cash conversion cycle, ensuring quicker sales conversion into cash, bolstering free cash flow. Looking forward, the company has raised its adjusted free cash flow conversion guidance from 100% to 110% against the prior guidance of 90%.
Fundamentally, the solid surge in adjusted free cash flow, improved cash flow conversion rates and increased guidance for free cash flow conversion indicate prolonged support for sustaining and potentially increasing dividends.
Strategic shuffle: Balancing capital expenditures for future gains
Beyond operations, 3M's approach to capital expenditures in the third quarter and year to date has been noteworthy. Despite a marginal decline of 6% year over year in the third quarter, amounting to $367 million, the year-to-date figures show a 2% increase, totaling $1.1 billion.
This trend in capital expenditure management indicates a balanced investment approach. A reduction in spending reflects a balanced shift in investment priorities; based on current restructuring efforts, it can be speculated that 3M is focusing on optimizing existing infrastructure or reallocating resources to high-return projects.
Additionally, it is evident from 3M's strategic financial restructuring actions from 2023 to 2025. The company's total restructuring and related charges are estimated to be in the range of $700 million to $900 million, with first-quarter 2023 actual charges at $52 million increasing to $212 million in the second quarter, followed by $68 million in the third quarter and an estimated range of $70 million to $120 million in the fourth quarter.
Conversely, the benefits derived from these actions show a progressive increase from $89 million in the second quarter to an estimated range of $145 million to $195 million in the fourth quarter of 2023. Although it is vital to note the benefits derived from the restructuring actions equate to the costs until 2025, while the costs are incurred over program duration, the associated benefits are long term.
Source: Earnings presentation
One of the most vital strategic moves can be observed in 3M's net debt reduction. Most recently, the company substantially reduced its net debt, marking an 11% year-over-year decrease that amounted to $10.8 billion. This debt reduction is crucial under the Federal Reserve's longer-term stance, as it reduces interest expenses and mitigates interest rate risk, improving the immunity of 3M to endure the quantitative tightening cycle and potential recessionary macro conditions effectively.
Another move is the announcement of the spinoff of the health care business into an independent company named Solventum. Notably, in the third quarter, the health care business reported a 2.4% organic improvement at the top line with an operating margin of 22.2%, marking a 0.50% year-over-year improvement. Fundamentally, the focus here is on creating an independent health care company to capitalize on the full potential of the segment.
Finally, all these developments lead to substantial dividend payments, a crucial aspect of shareholders' returns. For instance, in the third quarter, 3M distributed dividends worth $0.8 billion, totaling $2.5 billion year to date. The consistent and significant distribution of dividends suggests 3M's focus is on returning higher value to its shareholders to offset the long-term negative price return.
Source: prnewswire.com
Navigating settlements with strategic financial agility
After 3M's $10 billion settlement in the Forever Chemicals suits, another settlement was reached in the earplug lawsuit for $6 billion. These settlements are small in magnitude, but they can be considered a major preventive action against the massive financial deterioration that might happen if these class actions lead to court rulings. Fundamentally, the financial flexibility and stability exhibited by 3M reflect its robustness in managing substantial settlement commitments while maintaining its financial strength.
Focusing on announcing a $6 billion agreement to resolve the Combat Arms Earplug litigation signifies a significant financial obligation. However, 3M's strategic plan is to disburse this amount between 2023 and 2029, divided into $5 billion in cash and $1 billion in 3M common stock, suggesting a structured and manageable approach toward fulfilling this obligation.
Additionally, the decision to record a pre-tax charge of approximately $4.2 billion in the third quarter might seem substantial, but it represents the present value of contributions under the agreement net of 3M's existing accrual of approximately $1.1 billion related to this matter. While this charge negatively affects the company's earnings per share, its ability to manage this charge by reflecting it as an adjustment in arriving at its results, adjusted for special items, indicates the extraordinary nature of this expense.
Therefore, over the long term, the real impact is minimized. In detail, 3M may pay the settlement evenly over six years; the company would pay $800 million per year in cash and $200 million in common stock. Thus, 3M may follow the same arrangement made for settlement in Forever Chemicals suits to be paid over 13 years.
To counter these impacts, the strength of 3M's free cash flow capability and proven access to capital markets play a crucial role in maintaining financial flexibility. This ability enables the company to allocate capital efficiently to meet its cash flow requirements for this agreement. Moreover, the agreement's structured payment plan aligns with 3M's financial strategy, allowing it to manage its cash flows and financial obligations without significantly impacting its ongoing operations or impeding its ability to invest in growth initiatives.
Overall, this financial resilience (especially liquidity) and long-term structured settlement payments position 3M favorably to manage these financial challenges while focusing on sustaining its growth trajectory.
Source: Earnings presentation
Soaring yield and undervaluation point to a lucrative future
The company's dividend yield has created an inflection point near 7% and is now moving around 5.65%, providing an attractive investment window to lock in a growing dividend income stream and long-term price return. Regarding valuation, free cash flow is a critical metric for 3M, as it is a dividend beast, and distributable cash flow influences the investor's sentiment the most.
In the same direction, the price-to-free cash flow ratio is at 12.17, suggesting undervaluation on an absolute basis. Based on mean reversion theory, the ratio is in the direction of hitting the long-term average of 16.58. Considering the mean as a conservative target, the price may hit $145 in the short term based on current fundamentals (especially when the free cash flow is improving rapidly).
From a technical perspective, the share price is at a critical level; if it provides a proper close above $105, the trend may continue into a bullish trajectory (using the supertrend), as it did during June 2020 and February 2017. Based on historical bullish momentum patterns (using a trend pitchfork), the theoretical price target of $145 looks attainable as the Fibonacci retracement signals $150 as the target by 2024.
Source: tradingview.com
Takeaway
3M's financial transformation signals a bright future for dividend enthusiasts, showcasing a robust forward yield and consistent growth. The company's strategic maneuvers in free cash flow, capital expenditure and debt reduction illustrate its commitment to financial strength.
Notably, its approach to substantial legal settlements demonstrates exceptional financial management. The potential undervaluation of its stock, coupled with strong technical indicators, presents an enticing opportunity for investors.
Overall, 3M stands out as a resilient and savvy player in the market, adept at navigating financial challenges while promising sustained growth and rewarding shareholder returns.
