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3M (MMM) appeals to many investors because 64 consecutive years of dividend increases qualify it to be a Dividend King. This Dividend King is a train wreck, however, so this designation is no reason to invest in the company.
Investing based on dividend yield and consecutive years of dividend increases is a fundamentally flawed method by which to initiate a position. The same applies when determining whether to remain an investor.
I fault myself for not having exited my MMM position several years ago. In hindsight, I should have exited my MMM position in October 2017 when MMM was grossly overvalued. At the time, JP Morgan's analyst who covers MMM downgraded the company to 'Sell'. Many investors lambasted him for this call but I agreed with his assessment.
As MMM struggled in recent years, I would periodically write covered calls against a portion of my position. The covered calls always expired worthless which allowed me to retain 100% of the option premium (less nominal commission incurred at the time of writing the calls). I was essentially lulling myself into not exiting my position because I was collecting dividend and option premium income.
Finally, I have come to my senses and have exited my position.
MMM was my 10th largest holding when I completed my early January 2022 Investment Holdings Review. A little over 1 month after completing this review, MMM had fallen out of my top 20 just before I executed my MMM sell orders on February 14, 2022.
Now that MMM has held its Investor Day on February 14, 2022 (Valentine's Day), I take this opportunity to explain why I don't want MMM to be my Valentine.
Overview
Most investors are undoubtedly familiar with MMM to some degree. I highly encourage the review of Part 1 in the FY2021 Form 10-K and the Investor Relations section of MMM's website if you are not fully familiar with the company,
MMM is essentially a stagnant company. Annual revenue (in billions of $) in FY2012 - FY2021 was 30, 31, 32, 30, 30, 32, 33, 32, 32, and 35.
Operating income during the same timeframe was (in billions of $) $6.483, $6.666, $7.135, $6,899, $7.112, $7.234 $6.733, $6.059, $6.906, and $7.666.
Operating cash flow (in billions of $) has been $5.300, $5.817, $6.626, $6.420, $6.662, $6.240, $6.439, $7.070, $8.113, and $7.454.
Free cash flow (in billions of $) has been $3.816, $4.152, $5.133, $4.959, $5.242, $4.867, $4.862, $5.371, $6.612, and $5.851.
At first blush, some investors might deem these results to be acceptable. The past is, however, the past and MMM's future does not look that great.
The Elephant In The Room
I can't think of one company in which I have invested that does not have Legal Proceedings.
In MMM's case, however, its Legal Proceedings are truly significant. If the Courts rule in favour of the plaintiffs, MMM could be in a whole heap of trouble.
Details of MMM's legal headwinds are found in NOTE 16 - Commitments and Contingencies in FY2021's Form 10-K....pages 97 to 116! It takes 20 pages to cover all the Legal Proceedings.
Back in 2018, a single lawsuit that was filed alleged MMM sold faulty earplugs to the U.S. military. That case unleashed a torrent of lawsuits and now MMM faces several thousand suits over the issue and ~280,000 pending claims; the earplug suits alone already stand as one of the largest mass torts in U.S. history!
The plaintiffs claim that MMM and a subsidiary supplied defective earplugs to U.S. combat troops that led to hearing loss and tinnitus. MMM discontinued the production of these earplugs in 2015 yet it claims they were safe and effective to use.
MMM is defending itself in the litigation and has prevailed in five bellwether trials. Service members, however, have won six trials with the most recent having resulted in two US Army veterans having each been awarded $15 million in compensatory and $40 million in punitive damages in late January. Including these two recent awards, the total sum of damages awarded to date exceeds $0.16B according to lawyers for the plaintiffs.
Although MMM will appeal the verdicts and has already begun the process to overturn the first two plaintiff victories, there are 5 more test trials scheduled through May 2022 before the pace accelerates.
Since any liability related to the faulty earplug cases is not probable and reasonably estimable at this time, MMM has not reserved any funds to cover liabilities from the trials. At this stage, it is impossible to know what may be the ultimate cost and the actual claims count may end up being much smaller than 280,000. The legal process is such that juries must decide each of the tens of thousands of cases that could reach trial. Many could be dismissed as borne out by 8 other bellwether cases already dismissed by the plaintiffs.
'Forever Chemicals' Litigation
MMM faces another wave of litigation with a multitude of cases tied to its past production of so-called 'forever chemicals'. There are currently multiple lawsuits with individuals, states and water authorities tied to MMM’s past manufacturing of certain per- and polyfluoroalkyl chemicals, collectively known as PFAS. According to Bloomberg Intelligence, settlements in those cases could total as much as $20B.
MMM is working with authorities to fulfill its 'commitment to compliance and environmental stewardship' regarding the 'forever chemicals'.
Pension and Postretirement Benefit Plans
MMM's legal issues are not the only headwinds it faces.
MMM has company-sponsored retirement plans covering substantially all US employees and many employees outside the US. In total, MMM has over 75 defined benefit plans in 28 countries.
Details of MMM's pension plans and their end-of-year Benefit Obligations, Funded Status, and the changes in both from one year to another are found in the Notes contained within every Form 10-K.
II randomly selected various Form 10-K reports to look at the 'Funded status at end of year' and this is what I noticed; the figures expressed below are in millions of $.
- FY2006 - US ($89) International ($480)
- FY2009 - US ($898) International ($788)
- FY2015 - US ($1890) International ($653)
- FY2020 - US ($2249) International ($576)
- FY2021 - US ($1151) International $74
All figures expressed in brackets mean the plans are underfunded.
The low-interest-rate environment for the last several years has placed pressure on many defined benefit pension plans. This is because the returns generated from the assets held in these pension plans generate insufficient returns to offset the disbursement obligations.
Although higher interest rates help improve the performance of defined pension plans, the forecasted rate increases might be insufficient to eliminate the need for MMM to have to make further contributions to narrow their shortfall gap.
I am not suggesting MMM pensioners should be worried...for now. If MMM eventually has to make additional sizable contributions to the pension plans to shore up the deficiencies, however, it might find itself in a predicament if the outcomes of its legal issues are unfavourable.
Financials
Q4 and FY2021 Results
MMM's Q4 and FY2021 results are accessible here.
Supply-chain turmoil has forced MMM's factories to swap products more frequently with shorter production runs negatively impacting efficiency. Soaring raw material and logistics costs impacted the bottom line as MMM struggled to raise prices quickly enough, only offsetting the higher costs in Q4.
MMM's management says surging demand in 2021 pushed raw material and logistics costs beyond its expectations and the company has had to work through customer contractual obligations as it coordinated company-wide pricing actions.
If supply chains normalize and MMM's price increases stay ahead of inflation then its profit margins could see an improvement.
FY2022 Outlook
MMM presented its outlook at its 2022 Investor Day on February 14, 2022.
After reviewing the messages communicated to the investment community at its Investor Day, I am even more concerned that MMM is likely to be a poor investment going forward.
Credit Ratings
MMM's credit rating has deteriorated over several years.
In February 1998, Moody's downgraded MMM's domestic senior unsecured credit rating from AAA to Aa1. That downgrade wasn't good enough so MMM proceeded to take appropriate steps to gradually lower its credit rating to A1; it was lowered to this level in March 2016.
S&P Global also started to lower MMM's ratings in February 1998! Now, S&P Global assigns an A+ rating with a negative outlook.
Both ratings are the top tier of the upper-medium-grade investment-grade category. These ratings define MMM as having a strong capacity to meet its financial commitments. However, it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.
MMM's domestic senior unsecured credit rating from the two major rating agencies has been knocked back 4 tiers! Not bad! If the 'Elephant in the Room' tramples on MMM, we could see further downgrades.
Although MMM's current ratings meet my risk tolerance, I am not waiting for another shoe to drop. I think the probability of further rating downgrades exceeds that for any upgrades.
Dividend and Dividend Yield
Although MMM has been consistently increasing its dividend, we see from its dividend history that the dividends in recent years have been abysmal. The magnitude of the dividend increases gives investors the impression that MMM is desperately trying to prolong the consecutive number of years in which it has increased its dividend.
The new $1.49/share quarterly dividend (up from $1.48/share per quarter) is to be distributed on March 12, 2022 to shareholders of record as of February 18, 2022. Using the current ~$157 share price, the dividend yield is ~3.8%.
Many investors will find this dividend yield to be enticing and will invest in MMM for its dividend.
In several previous posts, I have discussed the fundamental flaw of making investment decisions on the basis of dividend yield and consecutive years of dividend increases. Investors would be far better off to invest based on total potential investment return.
Although MMM is a Dividend King with 64 consecutive years of dividend increases, it makes little sense to invest in a company for a negligible dividend return when management repeatedly finds ways in which to destroy shareholder value.
The trend in MMM's share count (in millions of shares outstanding) in FY2012 - FY2021 looks great (703, 694, 662, 637, 619, 613, 602, 585, 582, and 585). We will see in a moment that MMM even managed to use share repurchases to destroy shareholder value!
I would much rather a company repurchase shares than distribute dividends.
Unless I hold shares in tax-efficient accounts, I have to claim dividend income on my annual tax return.
Shareholder returns improve if a company WISELY repurchases shares. Until such time as I sell shares, I incur no tax liability. If/when I sell shares, capital gains receive more favourable tax treatment than dividends.
The caveat is.....'If a company WISELY repurchases shares'.
MMM has most certainly not met this criterion! Look at how many millions of shares MMM repurchased in FY2014 - FY2021 and the average purchase prices. Bear in mind that the current share price is ~$157 and also factor into consideration the time value of money.
- 2014 - repurchased 40.235 million shares @ an average price of $138.92
- 2015 - repurchased 33.666 million shares @ an average price of $155.56
- 2016 - repurchased 22.164 million shares @ an average price of $164.04
- 2017 - repurchased 9.879 million shares @ an average price of $201.13
- 2018 - repurchased 23.289 million shares @ an average price of $207.46
- 2019 - repurchased 7.311 million shares @ an average price of $181.22
- 2020 - repurchased 2.045 million shares @ an average price of $156.29
- 2021 - repurchased 11.65 million shares @ an average price of $185.92
FY2020 is the year in which MMM should have backed up the truck to repurchase shares. It did not, however, because it could not. Any significant share repurchase would have likely required MMM to take on more debt thus potentially leading to another rating downgrade.
Valuation
MMM's diluted PE ratio in FY2012 - FY2020 is 21.68, 21.59, 22.42, 22.79, 23.62, 22.85, 20.55, 18.85, and 21.46.
In FY2021, MMM generated $10.12 of diluted EPS ($9.36 in FY2020 and $7.12 in FY2019). With shares trading at ~$157, the current PE is ~15.5.
On an adjusted basis, MMM also reported $10.12 ($8.85 in FY2020 and $8.88 in FY2019) so the diluted adjusted PE is the same as on a GAAP basis.
While MMM reported an improvement in earnings relative to FY2020, the improvement is primarily attributed to factors that are nonoperating in nature. These items include other expenses like pension and net interest expense and a lower tax rate given a geographic mix benefit.
At the February 14, 2022 Investor Day, management presented FY2022 diluted EPS guidance of $10.15 - $10.65. Using the current ~$157 share price and the ~$10.40 mid-point of guidance, the forward diluted PE is ~15.
The brokers which cover MMM might be revising their adjusted diluted EPS outlook over the coming days. For now, however, the following is the current forward valuation based on current estimates.
- FY2022 - 20 brokers: $10.36 mean and $9.83 - $10.85 range. The valuation using the mean is ~15.2.
- FY2023 - 18 brokers: $11.07 mean and $10.51 - $11.52 range. The valuation using the mean is ~14.2.
- FY2024 - 10 brokers: $11.82 mean and $11.12 - $12.19 range. The valuation using the mean is ~13.3.
The forward adjusted diluted PE levels are certainly attractive relative to historical levels. However, there is a reason for this! Investors are not willing to pay up for MMM because of its outlook and significant potential liabilities that are not currently reflected in the financial statements.
Final Thoughts
I consider this Dividend King to be a train wreck....in slow motion.
When MMM's current CEO took the helm on July 1, 2018, shares were trading just shy of $200. Shares are now trading at ~$157. MMM is essentially one of the worst performers in an S&P 500 index of industrial companies; Bloomberg Intelligence estimates MMM's valuation relative to its manufacturing peers implies a discount of about $33B tied to the legal battles.
Given the elephant in the room, negligible top-line growth, and management's success at using various means by which to destroy shareholder value over several years, I do not feel comfortable being a shareholder. Heck, this is a company that has not been able to grow its top line for years. If it can't grow during good times then when will it grow?
After reviewing MMM's FY2021 results and the material presented at MMM's February 14, 2022 Investor Day, MMM's attractive valuation does not come close to compensating me for the potential risk.
I fault myself for not having taken more decisive action with my MMM investment several years ago. Now that I have exited my position I feel an immense sense of relief!
I wish you much success on your journey to financial freedom!
Note: Thanks for reading this article. Please send any feedback, corrections, or questions to [email protected].
Disclosure: I do not have a position in MMM nor do I intend to initiate one at any time in the foreseeable future.
Disclaimer: I do not know your circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decisions without conducting your research and due diligence. You should also consult your financial advisor about your specific situation.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
