For 3M, Inertia May Be The Bigger Long-Term Threat (NYSE:MMM)

3M (NYSE:MMM) has been hit hard by growing concerns over the company’s potentially large financial liabilities tied to PFAS (per- and polyfluoroalkyl substances) contamination and allegedly defective military earplugs. It certainly also hasn’t helped that the company’s revenue and margin leverage performances have been lackluster at best, all contributing to a nearly 25% decline in the stock price since my last update on the company – far worse than the basically flat performance of the broader multi-industrial sector.

I do still see some value in these shares, but for reasons I’ll discuss in greater detail, I don’t have as much confidence in management as I’d like, and it’s harder to argue for owning these shares given the sentiment headwinds from the legal liability issues.

Legal Liabilities – Potentially Scary Numbers And Huge Unknowns

There’s little question that 3M’s potentially enormous financial liabilities tied to PFAS contamination and personal injury cases from the combat earplugs dominate the story today.

Just the other day, 3M lost another jury verdict in one of its bellwether earplug cases, with the jury awarding the plaintiff $50M. With over 3,600 filed cases, another 24,000 or so recently added to active dockets, and potentially 285,000 litigants/claimants, the numbers can get very big very quickly.

Thus far, 3M has lost 7 of 12 bellwether cases and had 8 dismissed – a “success rate” for 3M of roughly two-thirds. Were these $50M awards to become the new standard and hold up on appeal, the potential liability even if 3M continued to win two-thirds of the cases would be a mind-boggling $4.7 trillion (285K x 0.33 x $50M), or somewhere between the GDP of Japan and Germany.

Clearly, that’s an absurd example, but there’s really just so little to go on right now when it comes to sizing the liability. Doing some digging, one of the attorney groups pursuing litigation against 3M claims past payouts in hearing loss-related cases were $25K or $50K to $300K. If 285K cases are adjudicated and 3M loses one-third, the total payout (excluding legal fees) could range from around $2.4B to $28B, but that assumes that $300K/case would be the upper limit.

Adding in another twist, I expect 3M to argue in appeals that as a government contractor who designed the earplugs to military specifications, they should be shielded from liability. There is precedent here, Boyle vs. United Technologies, but I’m nowhere near qualified to comment definitively on why Boyle would or would not apply to 3M’s case. It does raise the possibility, though, that many of these claims will ultimately be dismissed.

While the earplug litigation is getting attention now, the PFAS issue is still in play, and will be for some time. The AFFF MDL case (which includes multiple defendants and not just 3M) likely won’t start until 2023 and the EPA still hasn’t made its final rulings on maximum PFAS contamination levels. I still think that $20B is a reasonable estimate for potential liability, but like in the case of the earplugs, it’s easy to construct a wide range of outcomes ($10B to $40B, for instance) based on prior cases that appear similar.

There is also an outstanding question over whether 3M might pursue what is known as a “Texas two-step”, like what Johnson & Johnson (JNJ) has done in its talc cases. Basically, the gist of this is that 3M would establish a separate company that would take on the liabilities and that company would then declare bankruptcy, with 3M offering a “funding agreement” to the liability company to pay claims. This is understandably controversial, and I don’t know if 3M could (or would) pursue a similar course, but a court recently upheld JNJ’s right to do this.

Inertia – A More Insidious Long-Term Threat?

While the legal liabilities at 3M are indeed potentially serious, that isn’t my prime concern. My prime concern is, and has been, what I see as a lack of vision or ambition in the company’s overall strategy. While companies like ABB (ABB), Danaher (DHR), Eaton (ETN), Honeywell (HON), Parker-Hannifin (PH), Raytheon (RTX), and Roper (ROP) have reimagined their long-term core opportunities and undertaken (or are undergoing) meaningful change in recent years to leverage long-term secular growth opportunities, 3M’s approach is more equivalent to putting some new throw pillows on the couch in my view.

To be clear, 3M is a good company; few companies can match it in terms of profitability, brand value, and internal integration. But that may also be its greatest long-term downfall – what they do has really worked in the past, and is working now (sort of), so why upset the apple cart?

Management’s recent Investor Day continued a trend of top-level discussion of valuing growth and investing in R&D, but a lot of hand-waving when it came to the specifics. Targeting opportunities like electric vehicles, bioproduction, robotics, grid automation, and so on sounds great, but the company gave considerably more detail about its Filtrete home air filtration business than it did robotics or most other potential drivers. Moreover, while a lot of these “growth opportunities” do indeed offer attractive long-term growth, they’re only about 5% of the business today, and I’m concerned they’ll be overshadowed and dragged back by slow-growing legacy businesses.

In EVs, for instance, the company has talked about opportunities in lightweighting, acoustics, bonding, and films, with clear target market opportunities like battery/thermal management. That’s great, but why didn’t 3M move early to take up positions in areas like high-voltage connectors and contactors?

3M has a strong presence in filtration, so why haven’t they moved into other adjacencies in bioproduction like specialty membranes and materials? Likewise, it’s great that 3M is talking about robotics, but thus far it seems like the company’s offerings are mostly in the area of abrasives and adhesives that can be delivered/used by robots.

Perhaps I’m giving management too little credit, and this company continues to spend quite a bit more on R&D than most of its multi-industrial peers. After all, why buy companies through M&A if you have or can develop similar capabilities internally? 3M has a long history of innovation and using its R&D to introduce products, maintain brand value, and maintain strong margins.

Still, look at what companies like Danaher, Eaton, Honeywell, and Parker have done in recent years to transform themselves and tell me that 3M doesn’t look comparatively stuck in its ways. The Reverse Morris Trust transaction with Neogen (NEOG) is a good start, but I’d like to see more, and it doesn’t necessarily have to be on the disposals side.

The Outlook

As I said, 3M has a very profitable core business, and I can understand not being particularly eager to sell off slower-growing legacy businesses that generate great margins and throw off copious free cash. That’s fine, keep them.

My issue is more about a lack of M&A to build on growth opportunities in areas like EVs, automation, bioproduction, advanced materials, and so on – deals that could augment 3M’s existing capabilities and accelerate that high-margin growth. The M*Modal deal was a step in the right direction, but there haven’t been enough deals like that in my opinion.

I’m looking for long-term revenue growth of around 3% from 3M, and I’m expecting about one point of EBITDA leverage over pre-pandemic levels by 2024. Long term, I expect FCF margins to hit 20%, driving around 5% FCF growth.

To account for the legal issues, I assume multiyear payouts from cash flow. In other words, basically adding a “penalty” amount to more distant cash flows to reflect expected payouts for the earplug and PFAS litigation. If 3M ultimately has to pay out $16.5B for the earplugs and $20B for PFAS over 2025-2030, I get a discounted cash flow-based fair value of about $158 today and a long-term annualized total potential return of around 7%.

If there are no meaningful payouts tied to the earplug litigation (if 3M can win appeals based on the Boyle case), the fair value would jump to $177 and the prospective return would go up about 100bp. As you might imagine, there’s a range of outcomes depending on what assumptions I make about the total payouts, the timing, and so on.

The Bottom Line

While the scenario that drives my $158 fair value result isn’t a “worst case” scenario, I think it’s a fairly conservative one. It suggests 3M is modestly undervalued relative to many other quality industrials, but given the risk of larger final liabilities/payouts and what I think is a more lackluster growth outlook, I can’t say that discount is completely unwarranted.

It’s actually rather tempting to call this a “buy” on the notion that all of the bad news is basically in the stock. Likewise, for my complaints that management hasn’t yet done enough to promote growth and position itself for attractive secular growth opportunities, there still are meaningful growth-oriented R&D programs and product lines here. Still, without better near-term growth and margin leverage or good news on the legal front, these shares could languish a while longer even as other investors try to tout the company’s FCF-driven capital return potential.