The case for 3M (NYSE:MMM) is that an iconic American company has gone on sale. The MMM stock price dropped 27% in less than six weeks following first quarter earnings in April. 3M stock did manage a brief rally, but amid market-wide trade tensions the declines have resumed — and the sale has returned. MMM sits less than 3% above a three-year low reached in late May.
At this lower price, 3M stock looks somewhat cheap at just 17.4x 2019 analyst EPS estimates. Its dividend yields a healthy 3.5%. Given its 100-year-plus history, bulls argue, these problems, too, shall pass — and the MMM stock price eventually will rally.
Perhaps. But as I pointed out in arguing against 3M stock before Q2 earnings, similar cases have applied to a number of disastrous investments in recent years. Investors could have said the same thing about General Electric (NYSE:GE), Kraft Heinz (NASDAQ:KHC), or Anheuser-Busch InBev (NYSE:BUD).
The world is changing. Companies that don’t keep up get in trouble. 3M may be able to get out of this tailspin — but this isn’t a selloff that has come from a simple overreaction. 3M has real problems. At the least, they may get worse before it gets better.
Why Did the MMM Stock Price Run So Far?
In retrospect, at least part of the problem for 3M stock appears to be that it simply ran too far. Before the disastrous Q1 release, MMM was trading at over 20x the midpoint of what was then its 2019 EPS guidance. That was simply too high — for two reasons.
First, 3M’s growth already was decelerating. Organic constant-currency revenue increased just 3% in 2018. Adjusted EPS seemed to grow nicely, at 14% year-over-year. But about nine points of that growth came from a lower tax rate driven by U.S. tax reform. Adjusted operating income rose just 5.4%.
Those might be figures that suggest a low-20s P/E multiple, particularly in this market. Indeed, I argued that 3M stock looked attractive last June, albeit at a price below $200. But there was a second issue which colored even that growth: 3M is a cyclical company.
Given a strong macro environment in the U.S. — which drove about 40% of revenue last year, per figures from the 10-K — 3M should have been growing. And while MMM stock was rising, cyclicals across the board were falling in the second half of last year and (mostly) into 2019. Whether construction-related stocks or other machinery makers like Caterpillar (NYSE:CAT) and John Deere (NYSE:DE), investors were discounting most other companies that had cyclical exposure. For whatever reason, 3M was excluded.
The problem for 3M stock now is that it’s only ‘cheap’ relative to the MMM stock price in April. But that price simply looks like it was too high, even ignoring the results since. In a market where the likes of CAT and DE are trading at 11-13x forward earnings — and many cyclicals have single-digit multiples — 20x+ seems far too much to pay.
3M Stock Going Forward
If that’s the case, then there’s an obvious issue with 3M stock in the near to mid term. If 20x EPS is too expensive — and that seems like the case — then 17x+ isn’t exactly cheap. Put another way, 3M stock might have fallen quite a bit, but part of the reason it fell is because it went too high in the first place.
3M potentially could grow earnings next year, admittedly. Consensus next year is for EPS of $10.22, which suggests 7.6% from the midpoint of updated 2019 EPS guidance.
But I’m not quite ready to start baking in growth just yet. That guidance was slashed after Q1 to $9.25-$9.75 on an adjusted basis. That’s suggests a steep decline from 2018 levels (about 7-11%). Even worse, the high end of the range is actually below 2017 profit levels, normalized for the company’s tax rate.
3M isn’t growing right now. And while the Street believes that could change in 2020, analysts also didn’t see the Q1 guidance cut coming. And some caution is warranted, as there are obvious near-term risks to growth.
After Q2, 3M again talked up weakness in China and in automotive end markets. Neither headwind seems likely to fade any time soon. 2018 revenue growth was driven by the company’s Industrial and Safety and Graphics segments — likely the two most cyclical businesses 3M has. Are we sure 3M is simply bouncing back next year, even with easier year-over-year comparisons?
We shouldn’t be. Because, again, this is a story that has played out before. No one expected GE stock to hit the single digits. Few expected a dividend cut from the likes of General Electric, Kraft Heinz and Anheuser-Busch.
To be sure, 3M’s situation isn’t as dire as those became. But those stories prove how dangerous it can be to ignore real risks because the company has “been around a long time”.
New Lows on the Way?
From here, it wouldn’t be at all surprising if 3M stock headed below $160 — and potentially well below that figure. From a multi-year standpoint, this looks like a business that has stalled out. Looking forward, there are real risks in key end markets and in a suddenly nervous market. Execution has been spotty, between the guidance cut and an internal bribery investigation. Valuation is acceptable, but hardly compelling.
The dividend yield might help the cause for some investors. But it’s still 10%+ downside to even a 4% yield, which wouldn’t be completely out of line. 3M has been aggressive in growing its payout, which has more than doubled since 2013. It’s going to have to pull back on those increases. The payout ratio on an earnings basis is headed to 60%, and the company already has paused share repurchases after its purchase of Acelity.
Indeed, if 3M hadn’t run to $220 in April, it simply wouldn’t look all that cheap or necessarily all that attractive right now. And it’s probably not going to look either cheap or attractive until performance improves or the MMM stock price drops quite a bit further.
As of this writing, Vince Martin has no positions in any securities mentioned.