Shares of 3M are trading essentially flat to where they were eight years ago, as consistent sales growth has remained elusive and litigation concerns continue to cloud the outlook for the industrial juggernaut.
Facing a wide range of possible outcomes from the company’s legacy PFAS chemicals and military earplugs legal challenges, 3M is taking bold steps to enhance its liquidity and hopefully cap some of its liabilities.[In late July] 3M announced plans to spin off the firm’s healthcare business, a big move considering the unit contributes around 25% of earnings and has often been heralded as the conglomerate’s most notable growth driver.
But with competing healthcare equipment and services companies trading at higher multiples than 3M, an argument can be made this business unit is worth more to investors as a standalone company, and the spin-off is in the best interest of shareholders.
Even so, the healthcare separation decision may also have been inspired by a need to shore up the balance sheet in the event of adverse litigation outcomes; the healthcare business will take on debt to pay 3M a dividend once the transaction occurs, providing 3M with additional liquidity.
Although few details have been provided, the general assumption is that 3M shareholders will receive a proportionate amount of shares in the new healthcare company when the tax-free transaction closes by the end of 2023.
And while no update has been given regarding the dividend, we expect 3M will want to maintain its Dividend Aristocrat status and keep income investors whole.
If that’s the case, it’s reasonable to expect something along the lines of 3M reducing its dividend by around 25% to maintain a pro forma payout ratio of about 60% while the new healthcare company initiates a dividend equal to the amount of 3M’s reduction – keeping the total payout from the two companies the same for shareholders.
Following the separation, 3M will retain a nearly 20% stake in the healthcare company, focused on wound care, oral care, healthcare IT, and biopharma filtration. That stake, which could be worth as much as $9 billion, can be liquidated over time in the event 3M needs to raise cash to cover legal liabilities or fund other capital allocation priorities.
In addition to its spin-off plans, 3M unveiled a new strategy to cap liabilities tied to its military earplug litigation, which has already cost the firm about $300 million after losing 13 of 19 bellwether suits filed against the company.
With over 200,000 more claims filed, 3M cannot afford similar outcomes and has moved to place subsidiary Aearo Technologies into Chapter 11 bankruptcy protection; a controversial legal maneuver often referred to as the “Texas Two-Step Bankruptcy.”
The bankruptcy of Aearo Technologies would indemnify 3M of all liabilities related to the military earplugs. And all earplug-related claims will be paused until the courts provide a ruling on the bankruptcy proceedings, providing at least some short-term relief for the company.
In the meantime, 3M has committed to funding a trust with $1 billion to help resolve claims, well below the $7.5 billion to $30 billion potential liability we previously estimated. Externally, this funding is viewed as woefully insufficient and has garnered negative attention, with critics suggesting that 3M cares more about profits than wounded soldiers.
But considering 3M’s failure rate to date battling earplug litigation and the crippling amount of potential claims, the company is unlikely to roll over.
The situation will probably get ugly with how much is at stake for both sides, making it increasingly difficult to separate the “news from the noise” when assessing likely liabilities and their impact on 3M’s dividend profile.
Overall, 3M’s legal battles will likely go on for years. While these legal challenges play out, 3M should keep generating a reliable cash flow stream from its diverse and well-entrenched product portfolio, while the healthcare spin-off helps build a fortress of a balance sheet that already boasts an A+ credit rating from S&P.
Furthermore, 3M remains committed to continuing the firm’s long history of paying uninterrupted dividends for over 100 years. As such, we are reaffirming 3M’s Safe Dividend Safety Score.
Despite the strong foundation, 3M has struggled to increase sales above GDP growth rates, and without its healthcare business, this doesn’t look likely to change. With modest growth prospects coupled with ongoing litigation concerns, we don’t expect much more than low single-digit dividend growth for the next few years.
For investors trying to decide whether to buy or sell 3M, with the company trading nearly 30% below historical valuations, it’s safe to assume some bad litigation outcomes are already baked into the stock price.
And while there’s potential for the stock to fall further if litigation outcomes worsen, there is also the potential for the stock to trend back towards historical valuations if 3M is successful in ringfencing its military earplug liabilities with Aearo Technologies’ bankruptcy strategy.
In our Top 20 Dividend Stocks portfolio, 3M remains under review for potential sale as we would prefer to own a business with a stronger financial outlook and better dividend growth prospects.
The company’s latest news is incrementally positive and, coupled with 3M’s weak valuation, reduces the urgency to sell, but it doesn’t change our long-term outlook.
We will continue monitoring 3M’s efforts to unlock shareholder value, manage its mounting legal liabilities, and improve underlying business performance, providing updates as necessary.
— Simply Safe Dividends
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Source: Simply Safe Dividends