3M Company: Lingering Lawsuits (NYSE:MMM)

Shares of 3M Company (NYSE:MMM) have rapidly lost a reputation as being a solid long-term investment. In January, I last looked at the shares as I concluded that 3M was mixed, mediocre and modest, as lagging operating performance, and sequential lagging share price performance, has been going on for years now.

The company has rightfully gained the license to operate a conglomerate over the past decades, but has lost this claim rather quickly. While valuations and leverage came down a bit, real execution was needed, and this is exactly where 3M has been lagging.

Some Perspective

Shares of 3M peaked at $250 in 2018, a time when industrial names were in great demand following “America-first” policies, or promises being put in place by the president at the time. The company announced a huge deal in the summer of 2019, paying $6.7 billion to acquire Acelity to add healthcare exposure at quite a demanding price.

I was fearful of a flawed M&A strategy to buy expensive assets, while divesting cheaper assets, all while growth was not really seen and debt was inching up, cooling my enthusiasm on the shares. Early in 2022, shares had fallen to the $170 mark, with shares lagging quite a bit since the outbreak of the pandemic.

Ahead of the pandemic, 3M posted its 2019 results with revenues flattish at $32 billion, with adjusted earnings per share down from $10.46 per share in 2018 to $9.10 per share, as the company guided for modest growth in 2020 (of course ahead of the pandemic). The company did see earnings fall to $8.74 per share in 2020 on the back of the pandemic and initially guided for 2021 earnings around $9.50 per share. 2021 has been a strong year after all, a year in which sales rose 10% to just over $35 billion, while earnings rose to $10.12 per share, as net debt fell further to $12 billion and change, reducing leverage ratios to 1.3 times.

Given that a premium valuation contracted a bit to 17 times earnings, all while leverage has come down a bit, I was slowly getting more constructive, with the dividend yield having increase to 3%. While I held a small position at those levels, I failed to have enough conviction to add to the position.

What Happened?

Fast forwarding since January, shares have lost quite a lot more ground, with shares down another quarter to $130 at the moment of writing. The reason for that is a myriad of news event, many of which were not too pretty.

In March, 3M announced that it was taking more actions to address PFAS issues in Belgium with an initial “investment” of EUR 150 million. Alongside the first quarter earnings report, the company reiterated the adjusted earnings guidance at $11 per share, although the GAAP earnings was cut, in part because of the PFAS issues. In July, the company reached another deal to address PFAS issues, now at a total cost of EUR 571 million.

Later in the month, the company announced a plan to spin off the healthcare business, and this came after the company has already announced a deal late in 2021 to merge its food safety business with Neogen (NEOG).

More Claims

Late in July, 3M announced that its Aearo Technologies business have initiated Chapter 11 procedures after litigation procedures following defects with combat arms earplugs, potentially facing up to a quarter of a million claims. To address the issue: the company has committed a $1 billion fund to the trust after it acquired the activities in 2008.

While the company took on some reserve for legal expenses, at a combined $1.2 billion, the company claimed that it has ring-fenced the liabilities as Aearo indemnified 3M with its liabilities, but as it turned out, the judge did not share this thought. Late in August, the bankruptcy court in the Southern District of Indiana denied Aearo’s request for a preliminary injunction.

The timing of the news comes after momentum already cooled off. Second quarter results were a bit softer amidst the impact of a strong dollar and softer economic growth, as the company cut the full year adjusted earnings guidance to $10.55 per share all while net debt inched up to $13.2 billion.

The issue for 3M relates to the concerns about the earplugs. Shares fell $13 dollar, or about 10%, on a very weak day for the market at large. This move cut the market value of the business by more than $7 billion, of which a significant portion can be attributed to the general market sentiment, but it seems safe to say that shares fell some $5 billion following the Aearo news.

It is not just the Aearo news as the PFAS issues in Europe and other chemicals lawsuits (forever chemicals) appear on the horizon as well. The issue is that the earplug litigation appears to be far worse than the $1.2 billion reserved, equal to about $5,000 per (potential) case. As it turned out, the judge is not keen on using the Chapter 11 plan, as all options are on the table now.

The liabilities could be huge as juries already awarded $265 million in damages on a mere 16 trials, as this leaves the room for tens of billions, or more, of damages to be paid out to the claimants. Even at “just” a $100k per case this already comes down to $23 billion, equal to $40 per share. If this is a realistic number and will have to be paid out in the coming years, it could really be worth $20-$30 based on the present value here (depending on the timing of course) as it seems that the market has priced in such liabilities of course. While this final amount could become much less, the alternative case could become a reality as well.

Some Upside

Trading at $130 here, while earnings power comes in around $10 per share, valuations are non-demanding all while leverage is not high, yet some money will go into various lawsuits, but the amount and timing of these payments is a wild guess of course. If these liabilities come down, there is room for great valuation multiple inflation, as the spin-off of the Healthcare business could unlock quite some value as well, as the $8.6 billion healthcare business undoubtedly will be granted quite a demanding valuation.

Right now, all of this makes the situation very tricky and close to uninvestable. The earplug lawsuit is huge and could run in the tens of billions, a huge lawsuit of course, all while economic conditions are changing as well, and more and other lawsuits are apparently on the rise as well, related to PFAS.

Hence, I see no reasons to alter a cautious stance and while I am appealed to the lower valuation, the situation is very tricky and close to uninvestable here, as I see no reason to be the hero and buy the dip, despite great track record and the observation that this likely will blow over in all likelihood. Lawsuits will not disappear overnight as the risk-reward simply does not strike me as very compelling here to get more involved.