3M Stock: Showing More Dynamism, But More Is Needed (NYSE:MMM)

Maybe 3M‘s (NYSE:MMM) management gets it after all.

For some time now, I’ve taken issue with 3M’s overly conservative steady-as-she-goes operating philosophy. While I’m a firm believer in the basic principle of “if it’s not broken, don’t break it”, the reality is that companies like Danaher (DHR), Eaton (ETN), Honeywell (HON), and Parker-Hannifin (PH) have created value for shareholders by being willing to reexamine and restructure their businesses, shifting away from slower-growing and/or more commoditized end-markets in favor of more attractive, higher-margin opportunities.

With the announcement of the spin-off of the Health Care segment, though, there’s some real change coming to 3M. Still, I’m concerned that management needs to do even more, including making more substantive investments (and possibly M&A) into more attractive end-markets and product categories, and the ability to make those investments may yet be constrained by significant and ill-defined legal liabilities.

I was lukewarm on 3M back in March, and the -4% stock performance since then (roughly in line with the overall industrial space, but inferior to each of those four comps) fits that view. I do see modestly better prospects now, though, and this is closer to a borderline “buy” call if these are the first steps towards a more comprehensive value-creation strategy.

Restructuring The Business And Trying To Ring-Fence Some Liabilities

Since my last update, 3M management has taken significant steps to address two of my largest concerns about the company. The announced spin-off of the Health Care business suggests that management may be taking a more aggressive stance on ways to create (or preserve) value for shareholders, and the proposed bankruptcy of Aearo Technologies could be a significant step forward in reducing the company’s legal liabilities.

Taken the second first, the company has announced its intention to pursue bankruptcy for Aearo Technologies, the manufacturer of military earplugs that many plaintiffs have alleged were defective. As I suggested they might, 3M is pursuing a “Texas two-step” legal strategy similar to what Johnson & Johnson (JNJ) has pursued with its talc litigation, and 3M has proposed funding Aearo with $1 billion for payouts to claimants and $240M for other administrative expenses.

Time will tell how this goes. A ruling from a federal judge on August 16 will allow 3M to move forward with this, but the judge sharply criticized the move, and there are multiple complicated and overlapping legal questions (and jurisdictions) still to resolve. While I think there’s a reasonable chance 3M will be able to pursue this bankruptcy-based approach, I will be surprised if the $1B holds – I believe the company will eventually need to contribute more to resolve claims.

The announcement of the Health Care spinoff is interesting on several levels. First, it’s a high-margin business that generates good free cash flow, which makes it a curious spin-off candidate. On the other hand, it should get a generous multiple in the open market given its high margins, and it’s a business where I’d argue there are significant opportunities to reinvest in growth R&D and M&A.

At my most cynical, I could argue that maybe 3M is doing this as a way of preserving value for shareholders in the face of uncertain legal liabilities for the earplugs and PFAS litigation, and the health care business is certainly the most easily separable of the businesses. In any case, while I do question the logic of sending off the biopharma filtration and purification assets with this spinoff, I think it’s a good move on balance.

Significant Questions Remain For RemainCo

Absent the health care operations (and the soon-to-be-spun-off food safety operations), 3M RemainCo is basically a short-cycle/early-cycle industrial materials and consumer products company that grows roughly in line with GDP. It’s a high-margin, high-ROIC collection of business that generates good cash flow, has strong brands, and has a good record of sequential R&D, but it isn’t particularly dynamic. It also still faces substantial liability risk from the earplug and PFAS litigation.

Management has paid lip service to attractive markets like EVs, green energy, digitization, robotics, automation, and so on, but the company’s exposure to these markets is modest – something in the single-digits today. By comparison, companies like Danaher, Dover (DOV), and Honeywell moved aggressively to better-position themselves in some of these same growth areas; while Honeywell was acquiring Intelligrated (a leader in logistics automation), 3M was acquiring Capital Safety and Scott Safety – good businesses, yes, but not on par with what Intelligrated will offer Honeywell for years to come.

I believe the potential is there. As I said, 3M generates substantial free cash flow, and there are a lot of opportunities to redirect some of that cash flow into R&D and M&A focused at repositioning the company into markets with attractive long-term secular growth and margin potential.

What I want to see, though, is more definitive action from management, and not just hand waving from management about how important these markets are to the company – for instance, while the company talks about robotics as an important growth market, a lot of the company’s present day positioning there is simply in abrasives and other products that can be used by robotic systems. There’s nothing wrong with that per se, and it’s part of that “sequential R&D” strategy that I really like (building on prior R&D and products to address new adjacent markets), but making consumables that robotic systems can use is not exactly on par with the leverage that Honeywell has built in warehouse automation.

The Outlook

Valuation remains complicated by the uncertain payouts tied to earplug and PFAS litigation, both of which could amount to billions of dollars, and quite possible tens of billions of dollars collectively. I try to incorporate this risk by assigning estimated payouts from cash flow in the years to come. I’m still using $20B for PFAS (paid out from 2026 to 2030), and I’ve changed my earplug payout estimate from $16.5B to $8.25B (paid out from 2025 to 2028). These numbers could of course be wrong, but I believe some attempt at estimating the impact to DCF is better than just ignoring it or blithely reassuring readers that “it’ll all be fine…”.

I’m still expecting around 3% long-term revenue growth from 3M; I expect this company to remain a global GDP grower, even if I do see opportunities to pivot toward faster-growing opportunities. I’m likewise still expecting mid-to-high-teens FCF margins over time, driving mid-single-digit long-term FCF growth (4% to 5%).

Discount that all back, including my litigation payout estimates, and I think 3M is priced for a 7% to 8% long-term total annualized return, which isn’t too bad. Likewise, if I put my current margin and return (ROIC, ROA, ROTA, et al) assumptions into my EV/EBITDA model, I get a fair value of 13.5x on my 12-month EBITDA estimate and a fair value of around $175, and that includes an estimated NPV for those litigation payouts of over $17 billion.

The Bottom Line

The near-term outlook for 3M is still challenging, as growth is coming under pressure from a slowing global economy, including a downturn in consumer electronics demand and ongoing challenges to markets like autos from component shortages. The company is also still pressured by supply chain (materials and logistics) costs that will resolve slowly over the next year.

On the positive, I think management is getting more creative and dynamic about ways to preserve and create value for shareholders, and I see a lot of potential here if management is willing to be bold. I also think that 3M’s heavy early-cycle leverage will see it come through this slowdown sooner; the company is significantly lagging other multi-industrials today in terms of growth, but they’ll be earlier to return to growth as well.

Given all of that, I’m leaning more towards “buy” than “hold” than I was before. There are still substantial challenges and risks here, and I won’t argue that 3M’s current management has earned the benefit of the doubt, but the underlying assets still have value and the negatively on the Street (3M is a popular “sell” call with sell-side analysts) offers a lower bar for outperformance.