3M (MMM 0.86%), an industrial giant, has long been a favorite among dividend investors, and rightly so. It's a highly cash-generative company with a stable of world-class brands across many end markets including healthcare, transportation, consumer, electronics, and the industrial sector. As such, investors rarely doubt the viability of its dividend, which is currently yielding 5.7%. However, is it time to change that view in light of the company's challenges?
3M's dividend yield
First, let's crunch some numbers. 3M's current dividend is $6 a share, and its cash dividend paid out last year was $3.4 billion. Turning to how well its free cash flow (FCF) covers its dividend, 3M's management gives a figure of $4.7 billion for its adjusted FCF in 2022, and is guiding toward adjusted FCF equivalent to 90%-100% of net income in 2023.
However, 3M's adjusted FCF in 2022 was adjusted for "Net costs for significant litigation after-tax payment impacts." Given 3M's significant legal issues and the potential for ongoing issues, it's prudent for investors not to exclude them. Following that approach leads to an FCF figure of just $3.8 billion in 2022. It's an approach that Wall Street analysts favor, and the current consensus is for FCF of $4.3 billion in 2023, $5 billion in 2024, and $5.7 billion in 2025. Based on these figures, the current dividend-to-FCF ratio is 79% in 2023, 68% in 2024, and 60%.
Frankly, these ratios are high but not unsustainable. However, there are other considerations here.
3M's cash calls
The industrial company's cash flexibility is coming under scrutiny from investors because the matter came up at the recent Citi 2023 Global Industrial Tech and Mobility Conference. Citigroup analyst Andrew Kaplowitz asked 3M CEO Mike Roman under "what circumstances would you pull back on things like CapEx, R&D, dividend to conserve cash?" given that 3M has "separation costs, getting out of PFAS, [and] a drag from continued liabilities."
By separation costs, he's referring to costs associated with spinning off the healthcare business. Meanwhile, "PFAS" refers to per- and poly fluoroalkyl substances, a group of chemicals believed to be harmful. In December, 3M announced it would discontinue PFAS manufacturing by the end of 2025 and would "work to discontinue use of PFAS across our product portfolio by the end of 2025." In doing so, management said it would take pre-tax charges of $1.3 billion to $2.3 billion, with 70%-80% of them being non-cash charges. 3M had $0.8 billion in "PFAS manufacturing exit costs" in the fourth quarter. So presumably that leaves $0.5 billion to $1.5 billion, implying cash charges of around $0.1 billion to $0.5 billion to come.
By "continued liabilities," Kaplowitz is probably referring to the ongoing cost of dealing with litigation over PFAS and the ear protection litigation -- 3M used up over $1 billion in cash in 2021 and 2022 in "net costs for significant litigation after-tax payment impacts."
Naturally, management will have made assumptions for the PFAS exit costs and PFAS litigation costs in its guidance, which will be baked into the Wall Street analyst guidance consensus. Still, there is no guarantee that these costs won't overrun expectations, and based on an FCF estimate of $4.3 billion in 2023, there isn't that much leeway to get things wrong when the cash payout is $3.4 billion.
In response to Kaplowitz, Roman said 3M had an opportunity to improve cash flow generation, notably from improving working capital, which would give management more flexibility in capital allocation. That's fair enough, but there are other issues.
Image source: Getty Images.
More cash calls could come
The great unknown around 3M centers on its potential exposure to PFAS and earplug liabilities -- they could significantly drain cash in the coming years. On top of all of this, 3M has a recent history of missing guidance, weak growth, and stagnating profit margins. Furthermore, there are question marks around its 2023 guidance -- notably the margin ramp it needs to achieve in the second half.
In short, 3M is a business whose operational performance needs to be turned around.
Is 3M's dividend safe?
The company's dividend is safe for now, but the company can't afford too many more mishaps or any more significant charges. Meanwhile, the PFAS liability hangs over the stock. It's not inconceivable that management could cut it in the future.
Finally, even though the dividend may be safe, at least for now, its size may constrain management's flexibility in allocating capital (for, say, increased research & development, capital spending, or mergers & acquisitions) to improve 3M's underperforming business. That might well be what investors' biggest concern should be right now.
