2 Reasons To Sell 3M Stock Despite The ‘Good’ News

Summary:

• 3M’s gross margin continues to deteriorate, raising questions about the company’s economic moat and pricing power.
• High inventory levels, deteriorating asset turnover, and stagnating cash conversion cycle underscore 3M’s operational challenges.
• The combination of legal headwinds, operational inefficiencies, a rather poor balance sheet, and a weakening debt-servicing capability are too many headwinds to warrant a long position in 3M.
• Even if the dividend appears safe on the surface, a rebasement to prioritize deleveraging cannot be ruled out, also in view of the upcoming recurring legal charges.

Introduction

Shares of industrial conglomerate 3M Company (NYSE:MMM) remain under pressure, largely due to continued uncertainty surrounding environmental and earplug-related litigation.

I wrote about 3M stock in an article that focused on potential red flags at several blue-chip companies. Based on an estimated $10 billion to settle all claims, I thought it was reasonable to hold the stock, while cautioning that investors should only expect a continuation of token-like dividend increases.

However, taking into account recent events and looking closely at the company’s historical and more recent results, I don’t think the situation has improved, even if the market initially reacted positively to the reduced legal uncertainty.

Now, before you condemn me for “buying high and selling low,” let me explain the main reasons – apart from the obvious litigation-related headwinds – that led me to sell my stake in 3M Company.

3M Is Increasingly Inefficient And Its Economic Moat Should Be Questioned

There is no doubting 3M’s degree of diversification, the sheer number of patents and industries in which it operates. In essence, a bet on 3M is a bet on the progress of the global economy, as the company’s technologies are incorporated into an unimaginably large number of products. However, staying at the forefront of technology and managing such a diversified technology empire is extremely complex, in part because of the complexities associated with integrating acquired businesses. Since 2006, 3M has spent about a quarter of its free cash flow on acquisitions.

A look at the company’s financial statements provides some cause for concern.

First, 3M’s gross margin has deteriorated in recent years, with the 300 basis point decline in 2022 being particularly troubling. Now, one can argue that 3M is a cyclical company, but I still think the decline in 2022 points to weakness in the company’s pricing power. 2022, in my view, was a year that separated the wheat from the chaff. Those struggling to pass on price increases to their customers can be identified quite easily by a decline in gross margin. It’s also worth remembering that the decline in gross margin during the 2008/09 recession was nowhere near as severe:

Second, consider how 3M’s inventories have evolved over the years (Figure 2). Inventories are approaching 16% of net sales, which is well above the historical average and not comparable to the Great Recession. This is also underscored by the weak 2023 net sales guidance of -6% to -2% (organically -3% to flat) and expected operating cash flow of only about $6 billion (well below the prior five-year average of $7.1 billion).

Third, in an environment where many companies have improved their working capital management by:

• decreasing days sales outstanding (the time it takes to collect customer payments),
• increasing days payables outstanding (the time it takes to pay suppliers),
• and at least maintaining inventory days (the time inventory is held on hand),

These ratios have not changed significantly for 3M Company. Cash conversion cycle, a financial ratio that combines the three ratios above, confirms that 3M has not really improved its working capital management over the past decade. Figure 3 also shows the turnover rate of the company’s assets, confirming that 3M is increasingly inefficient in using its assets to drive sales.

I acknowledge that 3M’s operational challenges are by no means big news, but the continued decline in gross margin in particular is concerning. The company announced in its first-quarter 2023 earnings release a restructuring program aimed at reducing corporate overhead, simplifying its supply chain and streamlining its geographic footprint, in an effort to generate pretax savings of $700 million to $900 million.

Clearly, 3M’s investment case is increasingly becoming that of a turnaround stock. The company’s fundamentals definitely look much weaker than before the Great Recession.

Deteriorating Balance Sheet Quality And Potential Financial Engineering

Figure 4 shows 3M Company’s net debt since 2006. I don’t mind companies taking advantage of favorable financial conditions to grow their businesses through debt, but in 3M’s case, debt is becoming a growing concern, particularly due to the fact that free cash flow has not grown at least in line with debt.

Since 2006, free cash flow (normalized with respect to working capital movements and adjusted for stock-based compensation) grew at an average annual rate of 4%, while net debt increased by 23% per year. Using 2006-2008 and 2020-2022 averages, free cash flow and net debt grew at compound annual growth rates (CAGR) of 5% and 11%, respectively. 3M Company’s growing debt is best examined by looking at the ratio of net debt to free cash flow (see my recent article on this topic):

I wouldn’t call 3M’s leverage prohibitive, but it is definitely substantial, and the company is entering a period of great uncertainty with a rather poor balance sheet. 3M’s cash flow has been treading water since 2014, and combined with the growing debt, the company’s interest coverage ratio has fallen to a level that I would describe as worrisome from a historical perspective:

That said, at 11 times normalized free cash flow before interest, the ratio is still very acceptable, but it should be kept in mind that 3M is likely to face significant recurring litigation-related expenses that will put further pressure on free cash flow. Also, a look at the maturity profile of 3M’s debt shows that the company faces further headwinds related to its debt service ability. The maturity profile is quite skewed to the left, and nearly $7 billion of debt will need to be refinanced by 2025, assuming no repayments from cash on hand. Assuming interest rates remain high for an extended period, the company should be expected to refinance the debt at higher rates – the weighted-average interest rate of the debt maturing by 2025 is quite low at only 2.5%. In this context, it is also worth noting that 3M’s still has an A1 senior unsecured debt rating (S&P equivalent to A+), but Moody’s changed its outlook to negative in February 2023.

Finally, 3M’s deteriorating balance sheet quality raises questions about the possible reasons. There are several aspects worth noting.

Since 2006, 3M Company generated normalized free cash flow of about $73 billion, of which 23% was spent on acquisitions, 53% on dividends, and 62% on share repurchases. The company clearly overspent, and even assuming that the acquisitions were fully financed by debt, 3M’s cash flow was still not enough to fund the dividend and share repurchases.

As for acquisitions, recall Figure 4 which shows a significant increase in net debt in 2019. In that year, 3M acquired Acelity, Inc. for an enterprise value of approximately $6.7 billion (i.e., including net debt assumed) to strengthen its presence in advanced and surgical wound care. While I didn’t question the acquisition at the time (except perhaps from a valuation perspective), it doesn’t speak well to the consistency of management’s long-term plans. After all, 3M spun off its healthcare business at the end of 2022 – citing, among other things, that the two separate companies should benefit from “enhanced agility and focus to better position for long term success.”

As for share buybacks, I have absolutely nothing against this form of returning cash to shareholders, but I don’t like it when they are conducted at unfavorable valuations and at the expense of balance sheet quality. I acknowledge that it’s always easy to criticize management’s decision after the fact, but there’s no real reason to take on debt to fund share repurchases when the stock’s valuation is not compelling (Figure 8), unless to boost earnings growth on a per-share basis.

To support my point, I plotted 3M’s adjusted earnings per share (EPS) and compared it to EPS excluding buybacks (Figure 9). To reiterate: I have nothing against share repurchases as a means of returning cash to shareholders (thereby reducing the cost of the dividend and increasing EPS), as long as they are funded over the long term with cash from operations. 3M’s adjusted EPS has grown at a CAGR of 5.2% since 2006, and without the effect of share repurchases, growth would have been only 3.3%. In other words, share buybacks are responsible for about one-third of 3M’s earnings growth over that period. While this all sounds very negative, I concede that 3M Company was generating excess free cash flow after dividends, so the buybacks were not fully funded by debt. However, I maintain that the increase in net debt since 2006 is due in significant part to share repurchases.

Conclusion

The article focused on 3M’s ongoing operational problems and weakening balance sheet.

3M’s gross margin continues to deteriorate, raising questions about the company’s economic moat and pricing power. High inventory levels will likely continue to weigh on profitability and underscore 3M’s operational challenges, same as the deteriorating asset turnover. At a time when most large companies have been able to improve their working capital management – evidenced by a declining cash conversion cycle, for example – 3M has merely been treading water.

Management has aggressively bought back shares in the past, boosting EPS by over 30%. While there is nothing wrong with opportunistically executed share buybacks from a valuation perspective – especially if they are financed with cash from operations – 3M’s actions in this regard reek of financial engineering. As a result, 3M’s balance sheet is in comparatively poor shape. The company’s leverage is still manageable, but given the upcoming debt maturities and weak after-dividend free cash flow (payout ratio of about 80%), the company’s debt servicing ability is likely to decline. While the dividend appears safe on the surface, the already high payout ratio will be further impacted by litigation expenses. Against this backdrop, and given the rather weak balance sheet, I don’t think it’s unrealistic to expect a rebasement of the dividend, in an effort to prioritize debt reduction. Being a dividend king that has raised its dividend for 64 consecutive years is inherently a poor argument when assessing dividend safety – sad examples like that of V.F. Corporation (VFC, see my latest article) bear this out.

3M’s difficult situation related to its environmental (per- and polyfluoroalkyl substances, PFASs, PFCs) and earplug-related litigation is well known. While there was no major news since my last article related to the Combat Arms litigation, other than 3M’s CEO being ordered to participate in mediation talks, there was news that the company has apparently agreed to a tentative $10 billion (or more) settlement with a number of U.S. cities and municipalities to resolve claims of PFAS and PFC-related water pollution. Personally, I couldn’t quite understand the positive reaction in the stock, apart from the somewhat lowered uncertainty. However, given that the tentative settlement represents the low end of the scale and does not include overseas litigation, I think it is reasonable to expect significantly higher costs, possibly in the $20 billion range or more. Thus, combined with the earplug litigation, which Morningstar estimates at “just over $4 billion based on inflation-adjusted comparable cases and the number of cases pending,” investors should expect free cash flow to be significantly impacted in the coming years and decades.

I don’t think the ongoing litigation will bankrupt 3M, but the combination of operational inefficiencies, a rather poor balance sheet, and a weakening debt-servicing capability are too many headwinds, in my opinion, to warrant a long position.

Investors need to ask themselves if they want to own a company that is in turnaround mode and facing significant litigation headwinds in a recession. I bought 3M stock a few years ago as a blue-chip company with a wide economic moat, moderate cyclicality and good growth prospects.

Obviously, my investment thesis is no longer valid. I realize that selling 3M stock at $100 can be viewed as “buy high, sell low,” but I think the stock could go quite a bit lower, especially with the still significant uncertainties related to litigation and operational issues that will take a long time to resolve. I sold my position in 3M last week – realizing a significant tax credit – and have begun redeploying the proceeds into opportunities that I will cover in an upcoming article. Of course, and to avoid any potential misunderstandings, my “Sell” rating should not be taken as a recommendation to short 3M stock.

As always, please consider this article only as a first step in your own due diligence. Thank you for taking the time to read my latest article. Whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments below. And if there is anything I should improve or expand on in future articles, drop me a line as well.

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