For much of the 20th century, 3M (MMM 0.46%) was an engine of growth and innovation.
The company was the inventor of popular consumer products like Scotch tape and Post-it notes, as well as a wide range of industrial, electronic, and healthcare components, including adhesives, abrasives, and chemicals.
More recently, however, the stock has been a value destroyer for investors. 3M shares peaked in 2018, and as you can see from the chart below, the stock is actually down over the last 10 years.
The conglomerate got hit with several headwinds in recent years. Sales have declined over the last few quarters as businesses and consumers became more cautious, and the company issued multiple rounds of layoffs in order to streamline the business and grow profits.
3M also recently settled two multi-billion-dollar lawsuits. The first was over its PFAS chemicals, which polluted water supplies in several municipalities, and the second was for faulty earplugs sold to the military that led to hearing damage. While investors generally cheered the settlements because they removed a degree of uncertainty from the company's future, the company will end up paying pay close to $20 billion over the next decade to settle the various claims.
Finally, as a recent Wall Street Journal article detailed, 3M's culture of innovation has atrophied and the company is no longer the powerhouse of invention that it once was, falling victim to a familiar trap at mature, profitable companies. While 3M is developing next-gen products related to electric vehicles and climate science, investors no longer see it as a growth stock or a groundbreaking company.
3M's valuation is clearly in the value stock range at a forward P/E of roughly 10 based on its forecast of $8.60-$9.10 in adjusted earnings per share. And for many investors, there's one clear reason to own the stock today: the dividend.
3M is a Dividend King, having raised its annual dividend payout for 64 years, and it currently offers a dividend yield of 6.6%. But amid the challenges in the business, the massive liabilities from the lawsuits, and the upcoming spin-off of its healthcare division, there are real doubts about the company's ability to maintain its dividend.
Image source: 3M
Will 3M's dividend get cut?
Historically, 3M's dividend has been well funded, but its yield climbed to all-time highs as the stock price dwindled and its cash flow shrank in recent years.
In 2022, the company generated $3.8 billion in free cash flow, but paid $3.37 billion in dividends, giving it a dividend payout ratio of 89%. That's above the 80% threshold that's generally considered the upper limit for a safe dividend. For the first half of 2023, the payout ratio improved slightly to 86%, but it's clear that nearly all of 3M's cash is going to fund its dividend.
To settle the PFAS lawsuits, 3M has agreed to pay up to $12.5 billion over the next 10 years, and it will pay up to $6 billion, including $5 billion in cash and $1 billion in 3M stock over the next years, to settle the claims over faulty earplugs.
Based on those agreements, 3M is essentially on the hook for $2 billion a year for the next six years and $1 billion for the following four. The company cannot fund that directly out of free cash flow if it maintains its dividend. In 2022, it had less than $500 million in free cash flow left over after paying the dividend.
3M has options to continue funding the dividend if it chooses. It had $4.3 billion in cash at the end of the second quarter, and it can take on debt to fund the payouts. But that could be an expensive proposition. Borrowing $2 billion to fund one year of settlements would likely cost the company around $140 million in annual interest expense, if not more.
There's the possibility of selling some of its assets, and the healthcare spin-off is expected to generate a debt-funded dividend of roughly $7 billion, which would help bridge the cash flow deficit. The spin-off, however, will also impact the company's free cash flow and would lower its dividend anyway, or break it into two companies.
Asked about the prospects for the dividend on a recent investor call, SVP of Investor Relations Bruce Jermeland said the dividend was the company's second-biggest capital allocation priority after investing in the business. Jermeland, however, made no promises that the dividend would be maintained, saying that decision was ultimately up to the board.
Prepare for the worst
With the core business already facing challenges and its payout ratio pushing up against unsustainable levels, it seems likely that 3M will have to cut its dividend now that it faces $2 billion in annual payments related to the lawsuit settlements.
How much of a cut the company will suffer is an open question, but considering that $2 billion represents more than half of its 2022 free cash flow, the reduction is likely to be substantial.
A turnaround is still possible for the stock, especially in a stronger economy, and the healthcare spin-off could help provide a jolt. But it will take significant improvements in the underlying business for the stock to respond.
At this point, 3M stock seems likely to be under pressure until investors get more clarity about the dividend. We could learn more when the company reports third-quarter earnings on Oct. 24. If management doesn't cut the payout, expect some kind of communication about its future, especially with the healthcare spin-off expected by the end of the year.
