3M Company: Uncertainty Prevails

Summary:

• 3M Company continues to be hurt by lingering legal concerns and lawsuits related to PFAS, hearing protections, and masks.
• The company is far from out of the woods, as underlying performance is soft amidst these distractions, the Food Safety divestment and closing of PFAS factories.
• Valuations have come down a long way, but uncertainty prevails, making both the long-term upside and downside scenarios for 3M Company look quite interesting.

At the start of this year, I concluded that the year 2023 would be dominated by the focus on the legal situation of 3M Company (MMM). This came as the company was hurt by a tougher 2022, amidst softer operational performance, and huge and rapidly upcoming legal concerns.

With no quick fixes apparently in sight, I was very cautious, as the range of potential outcomes regarding the legal issues was simply very big and wide.

A Base

3M Company has deserved the license to operate as a conglomerate, at least it has in the past. Traditionally, the company has been good at capital allocation, which meant that the famous conglomerate discount was not observable in the shares. That reputation has been tarnished, however, in recent years, certainly 2022.

Shares broke the $100 mark in 2013 and peaked at $250 in 2018, supported by the “America-first” policies of President Trump at the time. After an expensive $6.7 billion deal to acquire healthcare company Acelity, as well as a string of bolt-on acquisitions and divestments (often involving buying high, and selling low) I was getting more cautious on the business. After all, such an expensive M&A strategy was largely attributable to the demise of General Electric (GE).

The company posted record sales at $35 billion in 2021, with earnings reported around $10 per share. While the record sales numbers look good, remember that revenues already came in at $31 billion a decade ago. With net debt reported at $12 billion, a 1.3 times leverage multiple looked reasonable as shares had fallen to $150 early in 2022. This started to look more appealing, but shares fell further to $130 in August.

This came as the company announced an EUR150 million investment in its Belgium PFAS factory while announcing another EUR571 million PFAS settlement.

The company furthermore merged the food safety business with Neogen (NEOG) which was far from a success. More environmental and lawsuit concerns emerged over the summer as the company aimed to proceed with Chapter 11 procedures for its Aearo Technologies business following defective combat earplugs.

Courts were not willing to ring-fence liabilities to just this entity, which dismayed investors as the company cut the adjusted earnings guidance from $11 per share to $10.55 per share. The bigger issue is that the company might see as many as a quarter of a million of earplug claims, which is a huge number, resulting in potentially multi-billion lawsuits, creating an overhang for a long period of time to come.

This concern was exaggerated as the preliminary jury trials awarded as much as a quarter of a billion to victims in just 16 cases, as there were issues related to the Aearo-respirator masks as well.

With shares trading at $130 in August, the valuation looked non-demanding, but there were many concerns on the legal and lawsuit front. Since the summer, shares had fallen to $107 early in January as the company posted a 4% fall in third quarter sales to $8.6 billion as net debt ticked down to $12.1 billion. More so, the company the adjusted earnings number to $10.10-$10.35 per share, while announcing to shut more PFAS production activities. While the multiple looked compelling, the uncertainty simply was huge, making it too early to go bottom fishing.

Stuck

Since the start of the year, shares initially rose to the $130 mark, now trading at just $105 per share, after shares saw an intermediate low of $100 per share in recent weeks. On January, 3M posted its 2022 results, which revealed that full year sales fell from $35.4 billion to $34.2 billion. Full year adjusted earnings fell from $10.73 per share to $10.10 per share, which coincidentally is largely similar to GAAP earnings. This comes as the company recorded a huge profit on the Neogen deal, offset by large charges related to legal woes and PFAS. These latter two items came at a cost of $2.5 billion already this year.

Net debt ticked down to $12.0 billion while EBITDA fell to $9.0 billion, still working down to a flattish 1.3 times leverage ratio as the company spent a combined $4.8 billion in dividends and share buybacks over the past year. The outlook for the year is not inspiring, with adjusted earnings per share seen down to just $8.50-$9.00 per share. This is due to the divestment of the Food Safety business and of course the accelerating closing of PFAS activities.

Talking about dividend commitments, 3M has paid out a $1.50 per share dividend for the first quarter of this year, and while it marks just a penny increase on a quarterly basis, the $6 per share payout translates into a handsome yield with shares trading just a few dollars above the $100 mark here. Based on the adjusted earnings guidance, the payout ratio has risen to 65-70% here, steep as it is based on adjusted earnings, eliminating the potential to deleverage with the business still shrinking here.

Through the quarter, the company updated the market on the combat arms litigation, though not a lot of great news was released. In February, 3M announced that certain plaintiffs in the Combat Arms Earplugs Version 2 have filed a motion to dismiss the Aearo bankruptcy filing, with updates on the litigation seen in May.

In March, 3M Company announced that Department of Defense data suggests that the vast majority of claimants in the Combat Arms Earplugs issue did not stem from hearing losses, in fact 85-90% (depending on the definition of the hearing standard) have normal hearing. Needless to say, the $1.2 billion deal which goes back to 2008 has caused a lot of headaches for investors here.

And Now?

The reality is that the situation is still largely the same as was the case at the start of the year. Uncertainty is high, and the 2023 guidance is underwhelming, which does not come as expected given the divestments, as no progress is made on the PFAS issues and the hearing aid litigation overhang.

This makes it still a hard place as the business keeps melting in terms of profitability, making that dividends only increase in relation to adjusted earnings, and adjusted earnings become more adjusted, although the financial state is still solid.

Truth be told is that the 3M Company litigation remains a huge wild card, on multiple fronts. While the company looks cheap and leverage is moderate, the reality is that 3M Company will likely incur huge litigation costs going forward, and the core business has seen a softer performance, as is evident in the 2023 guidance. Amidst all this, the range of outcomes can either be quite good or quite poor, which makes a strategy of exposure to the fat tails (both upside and downside) potentially interesting, perhaps more so than simply buying the 3M Company dip here.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.

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