The idea behind buying these three stocks is the same. They all have dividend yields above 3% and the potential to grow earnings significantly in the future. The downside should be protected by the dividend while the upside comes from releasing the value inherent in each company.
Let's take a look at why 3M (MMM 2.46%), Watsco (WSO 3.09%), and Eaton (ETN 3.32%) are good options for dividend-seeking investors and perhaps get a better sense for why these three stocks have high dividend yields.
1. 3M has a chance to unlock value
It's been a difficult few years for this multi-industry industrial giant. The company lost the premium valuation that it used to have over its peers, largely because it failed to meet its medium-term 2016-2020 objectives. Moreover, management can't really blame the economy because it was the segments with the least exposure to the economy, namely healthcare and consumer, that disappointed the most.
The contrast of share price performance with one of its multi-industry peers, Illinois Tool Works (ITW 3.49%), is illuminating.
However, 3M still has a formidable portfolio of businesses, and CEO Mike Roman is taking action to restructure the company. The business segments have been realigned, cost-cutting actions implemented, and underperforming businesses sold, and two major acquisitions have been made in order to boost growth in the healthcare segment.
It's not so much a revolutionary change as an evolutionary one, but that's probably a good thing. For an example of how relatively simple blocking and tackling can work, 3M needs to look no further than Illinois Tool Works under the tenure of current CEO Scott Santi.
Santi's tenure has been characterized by a relentless drive to prune less profitable product lines and refocus the businesses on the 20% of the customers that generate 80% of its revenue.
There's an opportunity for Roman to do something similar with 3M, and the upside potential comes from the restructuring actions working, while the downside is protected by the sustainability of its dividend -- currently yielding 3.5%. It's a reasonable investment on a risk/reward basis, particularly for income-seeking investors.
2. Watsco is keeping it cool
Investors can be forgiven for not being familiar with Watsco, because distributing heating, ventilation, air conditioning, and refrigeration (HVACR) equipment, parts, and replacement units isn't a glamorous activity. No matter, as the chart below should dispel any notions of only investing in "exciting stocks."
Over the last three decades, Watsco has made more than 60 acquisitions of smaller distributors in order to expand market share and/or its geographical footprint. Moreover, it has three joint ventures with HVACR manufacturer Carrier (CARR 3.52%). Watsco is agnostic on who it distributes for, but around 62% of the equipment it purchases comes from Carrier -- clearly it's Watsco's key partner.
The growth opportunity comes from three main sources. First, the company's financial strength and strong balance sheet means it can continue to consolidate the HVACR distribution industry in the downturn.
Second, having been spun off from United Technologies in 2020, Carrier is now an independent company. As such, its management is now free to make acquisitions and try to win back market share. That could help boost growth at Watsco too.
Third, the underlying growth trends for the HVACR industry remain in place. It's an essential item for residential and commercial customers in the U.S., and a combination of increasing urbanization and rising city temperatures will only increase demand for indoor climate control. Throw in Watsco's 4% dividend yield, and it's an attractive stock for investors.
3. Eaton is investing in the future
Electrical equipment company Eaton isn't the most exciting investment, nor is it ever going to win a "growth company of the year" award. However, what it does have is bundles of cash flow to return to investors and invest in growth.
Moreover, Eaton's management team is focused on increasing operating margin while exiting underperforming businesses. In short, investing in Eaton is not about what it is now, but about what it could become in a few years. Meanwhile, investors are getting a dividend yield of 3% while they wait.
It's going to be a tough year for Eaton, with analysts expecting the COVID-19 pandemic to cause a 21.5% decline in full-year sales. However, Eaton's management is pulling the levers on cost containment and reducing capital spending. As such, management expects to generate $2.3 billion to $2.7 billion in free cash flow. That figure easily covers the $1.2 billion in dividends expected to be paid in 2020.
In addition, the sale of the hydraulics business will bring in $3.3 billion as it follows the lighting business out the door -- sold for $1.4 billion in the first quarter. Meanwhile, in 2019, Eaton invested $1.4 billion in new business, including electrical equipment companies in the data center and aerospace sectors.
The divestitures and acquisitions are a sign that Eaton is using its cash flow to restructure the company for earnings growth. In addition, it's worth noting that before the pandemic hit, Eaton was planning on expanding its operating margin to 17.8%-18.2% in 2020, from 17.6% in 2019 even with no organic revenue growth.
All told, Eaton's cash flow in 2020 will continue to support a healthy dividend and allow the company to fund growth investments, and hopefully an improving economy will lead to revenue and margin expansion in 2021. That's not a bad formula for a company paying a 3% dividend yield.