3M At Multi-Year Lows, Investors Predict More Troubles Ahead

Summary:

• 3M became a victim of negative sentiment that has been surrounding the business for an extended period of time.
• Despite its strong financial position and diverse portfolio, 3M’s valuation is exceptionally low compared to the market and other large-cap companies.
• Common sense suggests that a company of this scale with a palette of products that big a size should at least match inflation over the long term.
• The market is valuing 3M for a gloomy future with a perspective of eternal stagnation due to the earplug litigation as well as the PFAS lawsuit.

Investment Thesis

The valuation of 3M (NYSE:MMM), a multinational conglomerate that operates in a wide range of industries, is trading at a 10-year low! With a long history of innovation, a strong international presence, and a wide range of products, many of which are protected by patents, 3M can’t attract investors who have flown out of the stock. The firm became a victim of negative sentiment and litigation risks that have been surrounding the business for an extended period of time.

From an investment perspective, 3M has several aspects that undoubtedly make it an attractive option. The company’s high number of patents demonstrates its ongoing commitment to innovation and product development. This helps ensure that 3M remains competitive and can adapt to changing market conditions. Additionally, 3M’s diversified portfolio of products helps insulate the company from fluctuations in any one industry or market. This can help provide stability and consistency in earnings, which is sought by many investors. Furthermore, 3M has a history of paying a high dividend, which makes it an attractive option for income-seeking investors. The company has consistently increased its dividend payments over time, demonstrating its commitment to rewarding shareholders. 3M is a dividend king which means that the company has consistently increased its dividend payments to shareholders for at least 50 consecutive years. In the case of 3M, it has been paying dividends to shareholders for over 100 years and has increased its dividend payments annually for the past 63 years, making it one of the most reliable and consistent dividend-paying companies in the world.

Despite its strong financial position and diverse portfolio, 3M’s valuation is exceptionally low compared to the market and other large-cap companies. This could potentially make it an attractive option for value investors who are looking for stocks that are out of favor and may generate ample returns. On the other hand, risks are there and the uncertainties have been mounting.

Slow Recovery

The first quarter of 2023 has been uncertain for 3M due to significant destocking at retailers and slow consumer discretionary spending. The management is cautious, but hopeful that the situation will improve in the second half of the year as supply chains ease with material shortages and inflation getting under control. As of the fourth quarter of the previous year, the following picture could be observed.

• Consumer electronics experienced a steep drop and this continued into the first quarter of this year. Smartphones and TVs saw declines between 10% to 30%, while semiconductors and the auto industry saw mid-single-digit declines. In the electronics business, 3M has experienced cycles, but the long-term growth is expected to continue.
• On the automotive industry front, the company aims to get as many applications onto a car as possible. A good growth rate in EV-related products can be seen but the company still sees growth in internal combustion engines.
• On the general industrial side, certain areas of industrial destocking could be seen, especially in Asia and China, but also in some regions in the US.
• When it comes to consumer spending, it slowed on discretionary goods and increased in groceries due to inflation.
• When looking at healthcare, the management believes it is a business with a return higher than the GDP in the long run. When coming into the fourth quarter, 3M was supposed to be at 90% of pre-pandemic levels. The management believes the company will start seeing sequential increases in elective procedures as time goes on and as the hospitals sort out some of their staffing shortages.

The pandemic has made it difficult to get a clean look at the company’s core margins due to several factors such as hyperinflation, raw material availability, shorter runs, logistics cost, and the availability of carriers. However, the outlook is that the company can achieve a 30% to 40% gross margin in the long run through volume, yield, and efficiency benefits, and the work 3M does on dual-sourcing. Besides that, the company has been keeping buffer stock and increasing inventory levels to keep factories running and avoid line downs, but as changes start to heal, 3M will start to take inventory levels down.

Biggest Uncertainty

Dark clouds over 3M come from the ongoing litigation over supposedly faulty earplugs that led to the hearing damage of more than 200,000 army veterans. The company is in the midst of a challenging court battle whose results remain highly uncertain.

However, on March 1, 2023, 3M made a press release that stated that the U.S. Department of Defense has revealed that the vast majority of claimants in Combat Arms earplug litigation have normal hearing according to medically accepted standards. Over 175,000 plaintiffs were analyzed, and the data showed that almost 90% of plaintiffs had no hearing impairment under the American Medical Association (AMA) standards, and more than 85% of plaintiffs had normal hearing under the World Health Organization (WHO) and National Institute of Health standards. It should be noted that the analysis did not account for other causes of hearing loss that may have impacted the small percentage of servicemembers with hearing loss. Third-party organizations that tested the product found that it was safe and effective to use.

A response from the attorneys Bryan Aylstock and Chris Seeger, co-lead counsel for the service members and veterans, was ruthless alleging a purposeful data manipulation by the defendant:

3M has purposefully skewed this data by relying on hearing standards that do not measure frequencies most affected by noise, concealing the hearing damage suffered by veterans.

Liability risk is real and it has been steadily priced into the stock. According to a Wall Street analyst, it could potentially be in the billions.

Do the math on the number of plaintiffs, which is north of 200,000 and you take the average settlement value — the simple math on that gets you well north of $10 billion to $20 billion,”

– JPMorgan analyst Stephen Tusa

3M negates the estimates and reiterates that the claims don’t have complete information. However, the situation should be assessed before investing in the company to form an outlook. It should be conservative, but at the same time, it should consider the most likely outcome based on the currently available information. The analysis performed by the U.S. Department puts the whole case in question. Regardless of how many of the 175,000 plaintiffs did indeed suffer from a hearing impairment, it suggests that there is a possibility that a certain number of complainants may be trying to use the trial as a chance to abuse the industrial giant. The veterans suing 3M for faulty earplugs are a group of individuals who served in the military between 2003 and 2015. This fact alone makes the number of plaintiffs to be suspiciously high considering that the peak number of US troops in Iraq was approximately 170,000 in 2007, while the peak number of US troops in Afghanistan was approximately 100,000 in 2011. To picture the number, it would suggest that 75% of soldiers from the peak deployments in Iraq in 2007 and Afghanistan in 2011 combined suffered hearing damage.

Valuation

3M is currently trading at multi-year low levels. The stock price has been dropping since early 2018 and the company’s Price to Earnings (PE) Ratio is oscillating around 10. It was lower only in the depth of the financial crisis of 2008.

Usually, there is a reason why a company is trading at its multi-year lows in terms of stock price and valuation. In the case of 3M, it’s the uncertainty around the earplug litigation as well as the PFAS lawsuit. Both cases are hanging over the company like dark clouds that may bring a downpour of rain. The task of an investor is to assess the unknowns by applying conservative assumptions about the future. These projections applied to a valuation model should result in an intrinsic value of the business and give a hint of where the company’s price is and where it should be.

A Discounted Earnings Model with four scenarios was used to value 3M. In the first two scenarios, the following assumptions were made.

1. Earnings growth will equal 5.0% in the next five years and 5.0% and 2.5% in the five following years respectively.
2. The discount rate in both cases is 10.0%.
3. The company will trade at the terminal PE multiple of 12.0 which is below the average long-term PE ratio of the broad market.

Normal and Best Cases give the first clue how much the company should be worth if the growth assumptions and the valuation at the end of the 10-year period will materialize. There is also the discount rate which may vary depending on the current interest rate environment. Nevertheless, these two scenarios suggest that 3M is heavily undervalued. The 5.0% growth in the Normal Case may be too optimistic indeed, especially for the next five years taking into consideration current developments on a global scale. That’s why these cases were followed with two additional scenarios.

The Worst Case assumes that the company will grow its earnings by 1.7% CAGR over the next years and will be valued at the PE ratio of 9.0 which may be equivalent to no future growth at all. The Hell Case is based on the normal case with the additional subtraction of $3.64 each year which corresponds with a $10 billion expense amortized over the whole period. The terminal multiple is also set at 9.0.

The market is valuing 3M for a gloomy future with a perspective of eternal stagnation. Even if a mean average of the intrinsic values from both scenarios were taken, the result would be $104.57 which is above the current stock price. Assuming it’s the intrinsic value of the business, buying 3M today should result in a 10.0% compound annual growth rate over the next 10 years which is a great return.

Conclusion

3M’s strong international presence, many patents, diversified product portfolio, high dividend payments, and low valuation make it an attractive option for a wide range of investors. Common sense suggests that a company of this scale with a palette of products that big a size should at least match inflation over the long term. Although the current level of price increases is much higher than in the recent past, the ultimate goal of the Federal Reserve and central banks is to get it back to the 2.0% range. Gloomy scenarios assume 3M’s earnings growth below the inflation rate and still a return on investment in the 10.0% range. Besides that, Monish Patolawala – EVP & Chief Financial & Transformation Officer, has recently sent a reassuring message to investors at the Bank of America Global Industrials Conference.

And overall, I just think where we are 2023, big execution year. But we’re going to set ourselves both companies up for tremendous success in the future. You will see us continuing to grow. Margins will start expanding as things settle down.

Company has always been a strong cash generator. Working capital will be an adder. And then digital is a multiplier for 3M. When you look at data, data analytics and where customers are going, this is an area that we can add a lot of value. And a lot of new trends like Climate Tech, et cetera, that 3M can play very strong in. And so long-term growth at or above macro is a good calculus keep in mind.

These words may be reassuring that 3M stays in the game and will keep adapting and continuing its high-quality execution. The industrial conglomerate may be a choice for value-oriented investors who have the stomach to acquire a great business that however involves substantial risk. Yet, with the stock price and the valuations on multi-year lows, buying 3M now may generate ample returns over time.

---

Analyst’s Disclosure: I/we have a beneficial long position in the shares of MMM either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

---