3M’s Stock Is a Value Trap, as PFAS Settlement Doesn’t End the Risks to Shareholders

We’re reducing our fair value estimate for 3M MMM to $121 from $127, based on the company’s June 22 $10.3 billion settlement of various lawsuits over perfluoroalkyl and polyfluoroalkyl substances, or PFAS, in its products. However, we currently maintain our wide moat rating and Morningstar Uncertainty Rating of High. We think 3M’s total PFAS liabilities are about $20 billion, including this latest settlement. When adding the lawsuits against the company over its Combat Arms earplugs, we believe its total liabilities rise to about $24 billion.

That said, estimating such liabilities is a highly uncertain process. We’ve tried our best assessment but expect to reevaluate as additional facts surface. The settlement is an important step, as it contains some of 3M’s exposure. It’s positive for the stock since some market participants believe the firm’s total legal risk is greater than its market capitalization. While management acted too slowly, this was ultimately the right move for shareholders. However, while the stock rose after the news, we now think 3M is a value trap. Consequently, we still encourage investors to search elsewhere for industrials exposure.

3M’s operating performance has been disappointing during CEO Mike Roman’s tenure. We’ve frequently modeled appreciably below FactSet consensus, and continue to do so. However, we believed the stock embedded a discount and the market was overestimating the company’s legal risks. We were wrong. We thought our edge came from analyzing similar legal fact patterns, with some adjustments for inflation, number of plaintiffs, and so forth. Despite identifying the risks associated with PFAS early on, we didn’t fully appreciate the breadth or depth of 3M’s risks.

3M Stock at a Glance

• Fair Value Estimate: $121
• Morningstar Rating: 4 stars
• Morningstar Uncertainty Rating: High
• Morningstar Economic Moat Rating: Wide

3M’s Lawsuit Vulnerability

In fact, the size of this new settlement signals to us that 3M potentially had unfavorable facts that it didn’t want to emerge during litigation. These facts are in dispute but could include the alleged effects of PFAS on the human body and how long 3M knew of their possible harm, including from its own scientists. While we don’t think 3M’s exposure reaches the heights of Big Tobacco (which incurred legal settlements greater than $200 billion), we think it’s worrisome enough to compare to the BP oil spill settlement.

As we previewed in a prior note on June 4, a settlement of over $10 billion would reduce our fair value estimate by a mid-single-digit percentage point. We now make that change since such a settlement has been confirmed. We’ll wait for a future 8-K to implement the specifics, but the cash call represents an enterprise-value adjustment in our model.

If the overseeing U.S. district court approves the settlement, 3M will pay municipalities between $10.5 billion and $12.5 billion over 13 years, beginning in 2024. To some extent, the amount will depend on whether class-action members receive positive test results for PFAS by 2025. Consequently, 3M expects to incur a $10.3 billion charge in the second quarter of 2023, which it will adjust out of its operating results (though it’s clearly a true cost to shareholders).

Our fair value estimate charge reflects the present value of expected payments based on the high end of the range. Importantly, this settlement only resolves claims from public water systems in the United States, mostly concerning the effects of aqueous fire-retardant foam which allegedly seeped into drinking water. 3M’s risks continue beyond this case. This settlement doesn’t resolve potential personal injury suits, other environmental suits, or even foreign suits, which are likely considerable.

Risks to 3M’s Dividend

Of course, the biggest question on equity investors’ minds is the risk to the dividend. It’s complicated, but we think the dividend likely remains intact for now but will be in danger in the future. We expect 3M will generate just over $4 billion in free cash flow (to the firm). We use free cash flow because 3M’s priority will rightfully remain investing in its internal business. While returns on capital won’t ever return to the 20%-29% range, we think 3M can still safely invest over its hurdle rate and create value.

3M’s next priority is the dividend. If the dividend is cut then its stock will crumble, as the dividend is paramount to 3M’s shareholder base. The company’s dividend payments total between $3 billion and $3.5 billion, meaning about 80% of its free cash flow services the dividend. But it also has over $3.8 billion of cash on its balance sheet and a strong credit rating. Still, using leverage to make payments has obvious limitations, since debt represents greater priority in the capital structure.

Shareholders will be adversely affected no matter what. We think 3M will have to end its share repurchase program, and that it may also have to end its acquisition program and accept a more modest reality. While management doesn’t agree, we believe 3M must tap the mergers and acquisitions market to fully support its growth aspirations. The firm hasn’t grown organically as it used to. In fact, gross profits over prior-year research and development have meaningfully trickled down to about $7.50, when they used to clear over $9.00. Of course, less growth means less free cash flow to support the dividend, which creates a vicious cycle. And 3M will also spin off its healthcare business, which means it will have less free cash from one of its highest-growth verticals (it represents about one-third of 3M’s earning power).

3M will have to tender legal payments of just under $1 billion per year. It really can’t afford another major settlement, and we don’t think the firm may have a choice in that matter, between its Combat Arms suit and lingering PFAS liabilities. If legal payments eventually total over $2 billion, we think the math would become too difficult without a cut, particularly without the contribution from healthcare. Either way, 3M’s risk/reward isn’t too attractive at current prices.