Is It Time to Buy 3M Co. Stock?

3M world headquarters in Maplewood, Minnesota. Source: Flickr/Nick schwartz.

3M is a legendary American manufacturer that's been around for 112 years. For products ranging from household adhesives to flame-retardant aircraft sealants, 3M is the brand customers turn to again and again.

From a business perspective, standing out from the rest of the pack has serious perks. For example, 3M's well-known brand gives the company impressive pricing power in an industry that's typically lacking. And pricing power is just one of the characteristics of 3M that an astute investor like Warren Buffett would love about this company (though he's yet to buy shares, from what I can tell).

Given its time-tested qualities, is 3M a stock investors should add to their portfolios today? Let's take a closer look.

The pros

Source: Wikipedia.

In my mind, two things stand out first and foremost when it comes to 3M: the strength of its brand and its hefty margins. Its products might seem simple -- Scotch Tape is just sticky plastic, after all -- but they are not easily replicated. And the company does an excellent job of manufacturing proprietary products while keeping costs low.

If you hold 3M up against some of its diversified manufacturing peers, it comes out on top in terms of operating margin, a measure of a company's pricing strategy and operating efficiency:

As of the last 12 months. Source: Morningstar.

What's more, 3M's operating margins are on the rise, reaching 22.8% in the second quarter of 2014 from 20.9% at the end of 2011.

I don't see this characteristic of 3M fading in the near future. The company continues to invest heavily in research and development to make its products even better over time. In fact, management intends to up the ante in R&D expense from 5.6% of revenue today to roughly 6% looking to 2017. For comparison, its peers like GE and United Technologies spent 4.4% and 4.1% of their revenue on R&D in 2012, respectively.

To date, 3M's brand is well intact, as are its enviable margins. And 3M's CEO Inge Thulin has done a commendable job focusing the company on internally driven growth instead of expanding through acquisitions. The latter was the tactic employed by prior CEO George Buckley, but I would prefer to see these two strategies go hand in hand. As a result of Thulin's efforts, organic growth jumped from 2.6% in 2012 to 4.8% as of the end of the latest quarter.

All things considered, 3M is a rock-solid company operationally, with a healthy dividend yield of 2.25% and a well-rounded product portfolio. Peering into the future, I expect its core segments of industrial, healthcare, and electronics and energy to benefit from rising demand -- and these three areas represent nearly 70% of the company's revenue, compared a small 15% slice for consumer products. 

So, with of these aspects in mind, you might be wondering, "What's not to like about 3M?" Well, let's kick the tires a bit more.

The cons

As I look at 3M from a different perspective, there are a few troubling aspects that stand out in my mind.

First off, 3M's stock price as it stands today is far from cheap. In fact, it's about as expensive as it has been in the last half-decade. Trading around $137 per share, 3M's stock commands a price-to-earnings ratio of 19.8, a figure 19% higher than its five-year average of 16.6.

MMM data by YCharts.

I would venture to say that "cheap" ceased to be an apt adjective three years ago, when 3M traded at 13.7 times earnings. And we were merely two years into the bull market then, rather than five.

What's more, 3M's valuation seems out of step with the company's earnings growth. Over the past five years, in the midst of the U.S. economy's steady turnaround, net income growth at 3M has hovered right around 6%. The same goes for earnings per share. Thus, 3M's price-to-earnings growth, or PEG, ratio stands at 2.4, quite a bit higher than the desired metric of 1.

Could future growth outpace the recent past? That's a possibility. As of now, Wall Street analysts predict a five-year growth forecast of 7.3%. That's not a huge increase, but management expects earnings per share to get an additional boost from the company's ongoing ambitious buyback program. This could be true, but I have some skepticism that management should even be allocating a huge chunk of the company's spare change toward its own shares. And this leads me to my second bearish argument.

Late last year, 3M announced it would embark on a massive share buyback program that would amount to $17 billion-$22 billion in total through 2017. The midpoint of that range is 73% higher than the midpoint of its previous range of $7.5 billion-$15 billion. It ranked as the largest buyback announcement in corporate America in 2013.

Such a move would be nifty if the company was scooping up shares at an attractive price, but that doesn't look to be the case, as laid out above.

At this particular moment, it's hard to see the merit in management's capital allocation strategy. Instead, I'd rather see management load up on shares precisely when they seemed cheap instead of embarking on a giant four-year buying spree.

Brand-new 3M products have failed to contribute significantly to revenue growth in recent years.

Finally, as I've described before, this is a research-driven company. 3M's leadership makes that perfectly clear. But in recent years, the company's frequently touted "New Product Vitality Index," or NVPI -- which shows percent of revenue from products less than five years old -- has hovered around 33%, despite the fact that management set goals for it to reach 40% by 2015. As we drew nearer to 2015, that target was subsequently revised last year. And their latest goal has been both ratcheted down and pushed back: NVPI is now projected to reach 37% by 2017.

Given this trend of moving the goalposts, I'm not convinced the capital plowed into R&D is generating the results shareholders would like to see.

The takeaway for investors

Taking the pros and cons into consideration, I would hold off on purchasing 3M's shares. I appreciate the company's strong brand and steady margins, but can't wrap my head around a giant buyback program that could ultimately destroy shareholder value given the stock's lofty price. I'm also not keen on the lack of discussion from management about whether the company is getting the most bang for its buck on R&D spending.

If the shares pull back, or if my concerns are discussed frankly by 3M's leadership, this is a company I would definitely consider for a long-term investment. For now, however, I'm content to fish around for a more enticing manufacturing stock.