When it comes to dividend growth stocks, there are few better core holdings for one’s portfolio than the legendary dividend kings, companies that have raised their dividend for 50+ straight years. Investors can view all of the dividend kings here.

These are companies that have not just proven to have an ability to steadily grow throughout any kind of economic, interest rate, and political environment, but also have a very dividend-friendly corporate culture that endures periodic management changes.

3M (MMM), with 58 consecutive years of rising dividends, is one such dividend king, and we happen to hold the company in our Top 20 Dividend Stocks portfolio as well.

Let’s take a deep look at what makes up 3M’s secret sauce and if this is the type of company that deserves to be a core holding in almost any income growth portfolio.

Business Description

Founded in 1902 in St. Paul, Minnesota, Minnesota Mining & Manufacturing, or 3M, is one of the world’s largest diversified industrial conglomerates. The business operates in over 70 countries and sells its products in over 200 nations and territories. More than 60% of its sales come from outside of the U.S.

Over the past 114 years, 3M has obtained over 100,000 patents for products in nearly every industry on earth. The company operates in five main business segments which market 23,230 products:

Industrial: tape, sealants, abrasives, ceramics, and adhesives for automotive, electronic, energy, food, and construction companies.

Healthcare: Infection preventions supplies, drug delivery systems, food safety products, healthcare data systems, dental and orthotic products.

Electronics & Energy: insulation, splicing and interconnection devices, touch screens, renewable energy components, infrastructure protection equipment.

Safety & Graphics: Personal protection and fall protection equipment, traffic safety products, commercial graphics equipment, commercial cleaning and safety products.

Consumer Products:  post-it notes, tape, sponges, construction & home improvement products, indexing systems, and adhesives.

Business Unit Q3 2016 Sales Q3 2016 Operating Income % of Sales % of Operating Income Operating Margin
Industrial $2.582 billion $591 million 32.7% 29.4% 22.9%
Healthcare $1.361 billion $429 million 17.2% 21.3% 31.5%
Safety & Graphics $1.448 billion $364 million 18.3% 18.1% 25.1%
Electronics & Energy $1.293 billion $312 million 16.4% 15.5% 24.2%
Consumer $1.209 billion $317 million 15.3% 15.7% 26.2%
Total $7.893 billion $2.013 billion 100% 100% 24.7%

Source: 3M Earnings Presentation

In the 3rd quarter of 2016, the plurality of the company’s sales came from its industrial division. However, healthcare was the most profitable division.

Business Analysis

As an industrial company, 3M’s business is somewhat cyclical and driven by global economic growth trends, which have remained sluggish in recent years.

However, this is a trend that affects all of its rivals as well, which is where the company’s superior management team and innovative corporate culture can make a big difference for investors.

For example, 3M’s claim to fame is that it’s less an industrial company and more of a material’s science company; investing heavily into R&D to make sure it offers customers a superior choice to meet their needs.

In recent years, the company has steadily increased its R&D spending and plans to continue doing so up to about 6% of sales.

3M Co (MMM)

Source: 3M Investor Presentation

That spending will be primarily focused on its healthcare information systems (expected to boost sales of this division by 2% to 4% annually) as well as its industrial segment to continue improving its adhesives, abrasives, filters, and coatings.

These are the products that give 3M the wide moat that allows it to consistently enjoy strong pricing power and stable margins and returns on shareholder capital that are far above the industry average. It’s also important to note that most of the company’s technologies are useful across a wide range of end markets with just slight tweaking, further improving the company’s returns.

3M Co (MMM)

Source: Simply Safe Dividends

3M Co (MMM)

Source: Simply Safe Dividends

One of the reasons why 3M is so profitable is the very nature of most of its products. Many of the goods it sells represent just a small proportion of a total product’s cost but are mission-critical components.

As an example, 3M sells structural adhesives to auto manufacturers. The company’s adhesives bond plastics and metals together and need to maintain their strength for the car’s entire life.

3M’s strong brands, technology innovation, and favorable product dynamics (low portion of the car’s total cost) provide nice pricing power, and it’s not worth it for the OEM to switch suppliers and risk the reliability of its vehicles.

Also helping the bottom line is the fact that 50% of sales are from consumables, meaning quickly used up products that customers need to purchase frequently. This helps to create a large recurring revenue stream, as well as boost turnover and allow for higher returns on capital.

Company Operating Margin Net Margin Free Cash Flow Margin Return On Assets Return On Equity Return On Invested Capital
3M 23.5% 16.4% 17.8% 14.7% 40.8% 21.1%
Industry Average 12.6% 8.8% NA 4.6% 15.0% NA

Source: Morningstar

What’s most impressive, and perhaps most valuable to long-term dividend investors, is the discipline that management, led by CEO Inge Thulin (who’s been with the company for 37 years), has shown when it comes to investing shareholder capital.

This has resulted in lighter than average capital spending (4.5% to 5% of sales) which results in free cash flow (FCF) margins generally only seen in very capital light industries; such as technology or biotech.

For example, in addition to being capital intensive, the industrial sector is generally one characterized by slow growth. This means that many of 3M’s rivals try to boost their growth rates through acquisitions, often overpaying for hard-to-integrate assets that result in subpar returns on investment.

3M, on the other hand, prefers to make many smaller, bolt-on acquisitions, such as the five firms purchased in the past year for just $4.6 billion. But that doesn’t mean that 3M is a no growth company, far from it.

Rather, management chooses to focus on improving operational efficiency to boost FCF and EPS growth. Specifically, when Mr. Thulin took over in 2012 he initiated a new efficiency program that streamlined the company’s business segments from six to five and total subsidiaries from 40 to 26.

In addition to boosting productivity from existing assets, the company sold off underperforming brands and refocused R&D spending on its most popular and profitable products. The result has been a: net margin, return on equity, and the return on invested capital that is up 10%, 51%, and 3%, respectively, in the last four years. Given that this is an improvement from already industry-leading levels, management’s operational improvements are all the more impressive.

In the coming years, 3M plans to continue to focus on maximizing the productivity of its employees and assets, with a $500 to $600 million five-year plan that management expects to result in 1.5% annual EPS accretion.

Key Risks

There are three risks to keep in mind with 3M.

First, under Mr. Thulin the company has ramped up its leverage in order to be able to continue investing and growing its business while still rewarding investors with buybacks (3.9% CAGR share count reduction over past five years) and dividends.

3M Co (MMM)

Source: Simply Safe Dividends

While the amount of additional debt is far from dangerous (more on this shortly), as interest rates rise in the future a higher debt load could reduce the financial flexibility 3M has to stay competitive in the markets in which it operates.

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