If you're a value investor or a dividend-seeker, chances are you've considered buying some 3M (MMM 0.46%) stock lately.
After all, it has the makings of a great dividend stock at an initial glance. It's a titan of American industry, innovating in areas such as consumer products, healthcare, and industrial equipment, and it's been a profit machine for ages. In fact, the stock is a Dividend King, one of a handful of U.S. companies that have raised their dividend every year for at least 50 years. 3M's streak of dividend hikes has now reached 64 years, and it's paid uninterrupted dividends for more than a century. It currently offers a dividend yield of 6.7%, about the highest its yield has been in modern history.
According to the headline numbers, this also looks like a great time to buy the stock as it's trading for bargain prices. 3M stock recently hit an 11-year low and now trades at a price-to-earnings ratio of 10 based on expected earnings this year.
However, before you jump on this cheap industrial conglomerate stock, you should be aware of a few things that could soon change your investing thesis.
Image source: 3M.
1. A dividend cut could be around the corner
3M's lofty dividend yield certainly sweetens its appeal to investors, but the current dividend payout may not be sustainable.
The company settled two massive lawsuits this year, for pollution from PFAS "forever chemicals" and for faulty military earplugs. It's expected to pay out roughly $16 billion to $18 billion over the next decade for those two settlements, and that will make a significant dent in its cash available to return shareholders.
Already, 3M's dividend payout ratio is approaching the threshold of 80% that's usually considered safe. Through the first three quarters of the year, 3M paid out 72% of its free cash flow as dividends, and it had roughly $1 billion in cash flow left over after its dividend payment. In other words, covering its dividend and paying out cash to claimants in the lawsuits is going to be difficult without significant growth in profits.
In its recent third-quarter earnings call, management did not address the prospects for the dividend, but in a conference call to address the Combat Arms earplugs settlement back in August, the company said that the dividend was a priority, but the decision ultimately belongs to the board of directors.
The company is scheduled to declare its next dividend in November so we should get some insight into its status in the coming weeks.
2. The healthcare business about to be spun off
3M will be a much different company in a few months as the company is preparing to spin off its healthcare unit as a separate publicly traded company by the end of the year.
The healthcare business has been the only one of its four segments to deliver revenue growth in recent quarters, and by spinning it off, 3M will give investors a choice between a more recession-proof healthcare business, and the remaining company, "New 3M," which is more exposed to the ups and downs of the business cycle.
3M management argued in the initial announcement that the move would allow each company to pursue their respective priorities and tailor their capital allocation strategies toward their needs.
3M will retain a 19.9% stake in the healthcare business and the spinoff is expected to have a net debt to earnings before interest taxes depreciation and amortization (EBITDA) ratio of 3 to 3.5. 3M is also set to get a one-time dividend from the spinoff though it's unclear how much that will be, and the spinoff will affect 3M's dividend as well.
Investors who want to own both stocks can buy 3M now, but if you have a preference between the two, it makes sense to wait until the spinoff is completed.
3. Cost-cutting drove the recent outperformance
Investors bid the stock higher as much as 6% on Tuesday after its earnings report came out as 3M beat estimates on the top and bottom lines and raised its earnings guidance. However, the better-than-expected results came largely from cost-cutting efforts, including multiple rounds of layoffs and controls and efficiencies in its factories.
Meanwhile, the company actually lowered its organic sales guidance for the year, calling for a decline of about 3%, compared with the lower end of its previous range of flat to a 3% drop.
In other words, the business is still struggling in the current macro environment and revenue is shrinking. While the margin improvement is nice to see, cutting costs is not a sustainable growth strategy.
Management did note some stabilization in some of its product markets like electronics, but it seems like it will take at least a few quarters before the business starts to return to growth.
When you take into account the struggles to deliver top-line growth, the prospects of a dividend cut, and the impact of the healthcare spinoff, 3M stock doesn't look like the bargain it does based on the numbers.
That doesn't necessarily mean that buying 3M is a bad move, but investors should be clear-eyed about the risks ahead before they go diving in the bargain bin for this blue-chip stock.
