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Thesis

The 3M company (NYSE: MMM) has paid dividends for over 100 years and has increased its payouts consecutively for 60 years. And it must be on many CIOs’ radars lately due to its price correction and valuation contraction. To mind, it has suffered a total loss of almost 20% since the start of the year. In contrast, the overall market lost around 6.5% and the industrial sector around 11.6% over the same period.

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Such a substantial price correction led to an increase in its dividend yield, as you can see from the following chart. Currently, MMM’s dividend is 4.17%, very attractive in absolute and relative terms. That’s more than 1% above Treasury rates and almost 3 times higher than the S&P 500 yield of 2.8%. Over the past 10 years, MMM’s dividend yield has fluctuated between 3% and 4.6% with an average of 3.75%. Consequently, its current dividend yield is also significantly higher than its own historical average of 33% (i.e. 1/3). You will see later that the valuation is indeed attractive, judged by other metrics in addition.

Of course, readers who follow MMM know that a major reason for the recent price correction and contraction in valuations has to do with ongoing lawsuits. In this article, I will discuss the implications of lawsuits in more detail. My opinion is that the risks associated with the lawsuit were not properly assessed (potential losses could total up to $100 billion). In addition, the business is facing strong headwinds on both lines. Revenue has recently been plagued by lower security and industrial and transportation and electronics businesses, global supply chain disruptions and the Russia-Ukraine situation. On the cost side, headwinds from inflation and labor shortages are putting pressure on margins.

And again, my general feeling is that the higher yield and the valuation discount does not adequately compensate for these uncertainties, as we will see below.

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Attractive valuation by other metrics as well

Let’s take a closer look at the valuation discount by other metrics. The following chart shows its CFO (cash from operations) price over the past 10 years. MMM’s valuation has fluctuated over the past decade between 9.7x CFO and 25x CFO with a long-term average of 15.7x. Its current valuation is around 13.7x CFO on a TTM basis, as seen. And it is below its historical average of almost 13%. On an FWD basis, its valuation is around 11.4x CFO, a discount of around 27% to its historical average, close to the discount indicated by the dividend yield above.

In terms of P/E multiple, the stock’s median P/E over the past 10 years is 20.5x. And its current P/E TTM (on a non-GAAP basis) is 14.4x and P/E FWD (on a non-GAAP basis as well) is 13.7x, around 30% and 33% lower than the long-term median, respectively.

There is therefore no doubt that the valuation is in sharp contraction. And then let’s look at the risks.

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Earplug lawsuits

For readers unfamiliar with earplug lawsuits, the following comments from its CEO Mike Roman in the second quarter earnings report provide a good summary (abbreviated and underlined by me):

…for context, in 2008 3M acquired Aearo Technologies, which made Combat Arms earplugs. Since the acquisition, Aearo has continued to operate as a wholly owned subsidiary of 3M. These products provided effective hearing protection when used correctly, and we are confident of their performance… Nevertheless, there has been an extraordinary increase in combat arms litigation.

As of June 30, 2022, there were approximately 115,000 claims filed and an additional 120,000 claims on administrative record. The multidistrict litigation process and the the widely varying results it generated provided neither certainty nor clarity. We believe that litigating these cases individually could take years, if not decades.

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MMM Second Quarter 2022 Earnings Report

Yet the downside is enormous. For lawsuits of such complexity and magnitude, I don’t believe there is a way to get even a reasonable estimate of the financial impact at this point. But nonetheless, analysts provided an estimated total impact of up to $100 billion or even the company’s bankruptcy. Two examples are cited below.

For me, regardless of the outcome, I just don’t think the ~30% writedown adequately compensates for these “highly variable results”. Even if the lawsuits are resolved properly and the valuation returns to the mean, the return could take years or even decades, as management has acknowledged. A 30% discount reversion spread over 5 years would only add about 6% of the annual gain and only 3% if spread over 10 years.

Seeking Alpha News: 3M could face more than $100 billion in losses and even bankruptcy due to lawsuits from veterans who blame their hearing problems on faulty earplugs.

Capital.com Report: Testifying in court last week, corporate solvency expert JB Heaton said he believed up to 230,000 lawsuits could eventually force 3M into bankruptcy. “It’s increasingly likely that within the next three years we’ll see 3M go bankrupt,” Heaton said in court, according to Bloomberg information.

Other Headwinds

Apart from lawsuits, the company also faces significant headwinds due to currency conversion, inflation, supply chain issues, and more.

The following graph shows its return on equity (“ROE”) and return on invested capital (“ROIC”). The distinction between ROE and ROIC (and why ROIC is a more comprehensive measure of profitability) is detailed in my blog post here. As can be seen, MMM’s ROE currently stands at 28.57%, still a healthy level compared to the overall economy (which averages around 20%). But compared to its own historical average of 39.1%, the current level is almost 10% lower. And note the sharp decline in its ROE since 2021 as well.

ROIC paints much the same picture here. MMM’s ROIC currently stands at 12.9%. Also note the consistency of MMM’s ROIC in the past up to 2021. In the past, it has only fluctuated within a narrow range between 16% and 24% with an average of 19.5%. And its current return on investment is not only well below the historical average, but also at the lowest level in a decade.

The decline in profitability was caused by strong headwinds on both fronts. On the sales front, a multitude of factors have impacted demand, including declining demand for its disposable ventilators, lockdowns in China due to COVID, global supply chain challenges and geopolitical disputes. In progress. On the cost side, the company faces higher raw material costs, higher logistics costs, as well as general inflation costs. In total, adjusted free cash flow declined to $1.0 billion in the second quarter, down 41% year-over-year. And the adjusted free cash flow conversion rate deteriorated to 68%, down 33 ppts year-on-year.

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MMM Second Quarter 2022 Earnings Report

Final thoughts and risks

There is no doubt that MMM is currently selling at a deep discount. Various metrics, such as dividend yield, cash flow multiples, and P/E multiples, all show a discount of around 30%.

The thesis is that the ~30% discount is enough to offset the risks. Even if the perceived risks of the lawsuits are exaggerated, these lawsuits could take years or even decades to resolve, as management has acknowledged. As such, a 30% discount reversion, IF it actually occurs, would only add about a few percent to the annual gain (about 3% if spread over 10 years). But the downside of these lawsuits is essentially unlimited.

Apart from the risks associated with lawsuits, the company also faces significant headwinds due to currency conversion, inflation, supply chain issues, and more. And for me, it is very likely that these headwinds will continue and keep the pressure on its margin and cash flow in the near future.

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