3M Stock: Risks Likely Embedded (NYSE: MMM)

josefkubes

Well, it’s a bloodbath over there. I have found it beneficial to my mental health to spend as little time as possible looking at my brokerage balances. However, I also found myself spending less time researching businesses. I think it’s human nature, but it might just be me. The problem with this is that this is the most important time for investors to actively look to buy. The market turns before the economy does, and just when all is at its darkest, a heartbreaking rally could begin that takes all the top companies back to nosebleed valuations.

It’s been said a million times before, but the stock market is the only place people are excited to buy when things are most expensive and most hesitant when things are on sale. That being said, I want to take a look today at a loyal dividend king, 3M (NYSE: MMM).

I’ve written about the company before, back in 2017. At the time, I basically said this company was fantastic, but leave it on the watch list. I will attach the table I used in this article below:

3M company chart

fastgraphs.com

Watch this company crush it, huh? It was on a real tear, up to 25x earnings, down to a 2.3% return, and well above its current long-term averages. I warned that if it returned to its normal P/E with no significant change in company performance, you could be looking at total returns of around 5% over the medium term. Well, that didn’t happen.

3M Valuation Chart

fastgraphs.com

Since its peak, it has fallen by around 45 to 50%. The yield is over 5% and the P/E is down around 11X. Talk about a huge rerate in the space of four years. So what happened?

There are a few major factors affecting the business right now.

Litigation risk

This was partly a known issue when I last wrote about the company in 2017. 3M is currently facing litigation over PFAS contamination near its Minnesota headquarters (the name of the company d origin was Minnesota Mining and Manufacturing). The company reached a settlement with Minnesota for $850 million, but the PFAS problem has spread and 3M is now considering paying likely in other operating areas, including Belgium and other U.S. states. United States.

In a regulatory filing Wednesday, 3M announced plans to levy a pretax charge of $360 million for the second quarter of 2022 for PFAS. The agreement “will build the foundation for future certainty in 3M’s Belgian operations and address potential future liabilities,” John Banovetz, its executive vice president and chief technology officer, said in a statement.

While the new deal gives 3M a way forward, Belgian officials are focused on the limits of the deal. The pact does not prevent local residents from bringing civil lawsuits against 3M, stop an ongoing investigation into the company’s environmental crime, or limit future liability for damages to the health of local residents. , said a representative of Demir.

Source: Bloomberg, July 2022

It doesn’t look great, and it’s not going to be fixed soon. Aside from the human element, which is terrible, this won’t be an easy problem for 3M to solve. Adding North Carolina and Michigan to the existing problems in Minnesota, adding allegations that 3M knew about the problem before it came to light, you have a big, nasty problem that throws a lot of uncertainty into the stock. The company began phasing out chemicals in 2000, but these “chemicals forever” seem to be an ongoing headache for the company.

If that wasn’t enough, one of 3M’s subsidiaries, Aearo, is facing significant litigation over its combat earplugs, with 115,000 claims filed and another 120,000 on the administrative docket. 3M management elected to file Aearo into Chapter 11 bankruptcy and set aside $1.24 billion to settle the claims. One of the more interesting quotes from a Reuters article is below:

The Florida judge overseeing the earplug lawsuits, U.S. District Judge Casey Rodgers, chastised 3M for “naked duplicity” in attempting to offload its debts to a bankrupt subsidiary.

3M and Aearo in turn criticized Rodgers for allowing consolidated litigation to swell, pointing out that earplug cases now account for 30% of all cases pending in US federal courts.

The current decision is to pursue the litigation while the bankruptcy proceedings are pending for Aearo. Uncertainty is high here, and if 3M suffers a significant legal setback with its plans to effectively separate Aearo and settle the defect in court with each case, that could further impact the stock. I will attach below a slide from 3M describing their update on the issue in the most recent quarterly presentation:

Table dealing with disputes

3M Investor Presentation

Changes in the company

Already optimistic about 3M? Neither does the market, of course. Let’s take a look at the actual company. If you want a quick refresher on what the company produces and what led to the company’s success, feel free to take a look at my latest article.

Coming out of COVID, 3M is facing some headwinds in respirators to the tune of 2% of sales this year. Supporting this headwind as well as a factory shutdown in China for COVID lockdowns, and the company saw organic growth of 5% year-over-year in the last quarter. I’m not a big fan of adjusted sales growth numbers, so let’s stick with 1% growth on the year, adding those headwinds to last year’s 21% growth.

Earnings were $2.48 per share in the last quarter, and management expects $10.30 to $10.80 for the full year, which, at the low end of the scale, puts the share at 11 times earnings this year. The company is looking at inflationary, supply chain and currency headwinds similar to other large multinational companies that create real physical products, which could continue to impact results in the short to medium term. Management didn’t provide earnings estimates, but analysts (using FAST Graphs) have earnings of $10.70 next year and $11.27 in 2024. There’s plenty of wiggle room in these numbers based on some of the issues I described above.

Business group performance

3M Investor Presentation

So, looking above, health care stands out. I assume that is also the case for the management, as they plan to split it next year. The segment currently represents $8.6 billion in sales with an EBIT margin of 31%, and is growing organically at 4.4% year-over-year. 3M will retain a 19.9% ​​stake in the new company. 3M also sends it on its way with debt at 3.0 to 3.5 times EBIT leverage, which the new company will strive to reduce. Although the company is growing organically, likely helped by recent acquisitions in recent years, it appears to be a strategic move to refocus the business while deleveraging and strengthening the balance sheet.

Distribution of activities after the merger

3M Investor Presentation

It smashes a pretty big part of the business and removes some of what I’ve loved about 3M for years. Specifically, the business is built on innovation, and in many cases innovations from one group are applied across the business to find additional use cases. Post-it notes are the ultimate example, where an adhesive invented elsewhere in the company was applied to office products, and a legend was born. This must be factored into a business investment decision today.

Dividend Security

Chart showing business metrics

Y-Charts

3M currently carries $17.4 billion in long-term debt and recently paid $848 million in second-quarter dividends. Free cash flow covers the dividend relatively well and its payout ratio is around 82%, which doesn’t leave much room for growth from its current yield of 5.1%. Management is dividend-minded and the company has an incredibly long history of dividend increases. The debt figure will be interesting to see after the spin-off.

Notes on evaluation and closure

chart

QUICK charts

I’m torn on 3M. The chart above shows the best return scenario if the company simply returns to its normal P/E ratio of around 20X based on earnings projections that are relatively flat in the mid-single-digit growth range. However, there are significant legal overhangs for the stock, and it’s unclear how far the business will be able to grow once the healthcare segment is separated. Best case scenario is probably ‘GDP-plus’, but investors are being paid to wait with a safe 5.1% dividend yield that has been maintained and increased for over half a century with comprehensive management backing that up. .

Uncertainty and financial risks from litigation and the economic environment are likely priced in at this stage, although the company could of course fall further. Savvy investors may be able to see through the short-term noise surrounding 3M and get a substantial discount on a blue-chip dividend aristocrat.

Disclaimer: This article is for informational purposes only and represents the author’s own opinions. This is not a formal recommendation to buy or sell stocks, as the author is not a registered investment adviser. Please do your own due diligence and/or consult a financial professional before making any investment decisions. All investments involve risk, including loss of principal.

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