Is 3M Stock a Buy?

The case for buying 3M (MMM -0.66%) is a value-investing one. In a nutshell, you aren't buying 3M for what it is now, but rather for what it could become if CEO Mike Roman's restructuring begins to generate operational improvements and its end markets start to improve. Furthermore, you will earn a 3.4% dividend yield while you wait for the improvements to take shape. As such, 3M is attractively priced on a risk/reward basis. Here's why.

Image source: Getty Images.

3M stock valuation

One of the most popular ways to value a mature industrial conglomerate stock is to look at its free cash flow (FCF) yield. In plain English, this is the FCF divided by market cap, so a higher number is better. FCF is important as it's the flow of cash in a year that a company has free in order to pay down debt, make share buybacks, and pay in dividends. Theoretically, at least, a company could pay all of its FCF in dividend, but in reality most companies aim to pay a share of their FCF in dividends.

The chart below shows how high 3M's FCF yield has become and also how well-covered 3M's dividend yield is. As such, income-seeking investors can sleep safely in the knowledge that 3M's dividend is sustainable.

Data by YCharts

To be fair, 3M's current FCF yield is probably at a near-term high. The reason is that industrial companies often focus on holding back capital investment, running down inventory, and collecting cash from accounts receivable in a downturn. These positive cash actions often offset the reduction in earnings so FCF can rise in a slowdown. However, they then tend to fall during a recovery as these actions are reversed.

Indeed, based on Wall Street analyst forecasts, 3M's FCF will fall in 2021, even as earnings before interest, taxation, depreciation, and amortization (EBITDA) increase. Nevertheless, as you can see below, 3M's FCF yield is still forecast to be at a very attractive rate in the coming years. For reference, the figures in the table below assume 3M's market cap will stay at the current value.

Data source: marketscreener.com. Author's analysis.

Why 3M is low-rated

There is, of course, a reason why 3M's valuation has become cheap. The company has consistently underperformed its own expectations in recent years, and its management has given guidance which often proved significantly too optimistic. 

In particular, the consumer and healthcare segments have disappointed expectations. For example, in 2016 management gave expectations for healthcare to grow at an annual rate of 4% to 6% from 2016-2020. Then, in 2018, management said healthcare would grow at an annual rate of 4% to 6% from 2019-2023. For the consumer segment, the expected 2016-2020 growth was supposed to be 3% to 5% from 2016-2020, and then 2% to 4% from 2019-2023. As you can see below, 3M has been nowhere near these figures on a consistent basis in the last few years.

Data source: 3M presentations.

Restructuring actions are being made at 3M

However, in response to a series of disappointing earnings reports, Roman is taking action to restructure 3M for growth. Unsurprisingly, most of the corporate activity has been focused on the underperforming healthcare segment. Two major acquisitions -- M*Modal's artificial intelligence systems for $1 billion and advanced wound care company Acelity for $6.7 billion -- were bought in 2019. https://investors.3m.com/news/news-details/2019/3M-Completes-Acquisition-of-MModals-Technology-Business/default.aspxMeanwhile, drug delivery businesses were sold for $650 million in 2020. 3M is also rumored to be exploring a sale of its food safety business for $3.5 billion.

On a companywide level, 3M announced a new operating model and streamlined its organization in early 2020. A new enterprise resource planning (ERP) system has been implemented, and business groups will now be run on a global basis rather than on a country level.

It's too early to discern whether the changes are working or not, but one positive sign came from the positive pricing performance in 2020 in the face of sales declines. 

The case for buying 3M

Will the restructuring actions work and turn the company around? Possibly. But what investors should acknowledge is that 3M isn't a company trading on a hefty valuation. In other words, there's a margin of safety for error on the downside. Thinking more positively, if Roman does get sales and margin growing together again, then the upside opportunity is significant. On a risk/reward basis, 3M looks worth buying for value investors who are also looking for some income from the 3.4% dividend yield.