Is 3M's Dividend Safe Following Latest Litigation Developments?
Earlier this month, the United States Bankruptcy Court rejected 3M's attempt to place its subsidiary Aearo Technology, which houses all of its military earplug litigation estimated to potentially cost the firm around $10 billion to $15 billion, into bankruptcy.
Based on the company's earlier plans, this maneuver would have potentially capped 3M's liability at around $1 billion.
Instead, it now represents one of many setbacks in 3M's years-long struggle to limit its liability in what has become the largest mass tort in American history, with nearly 330,000 cases filed and another roughly 260,000 pending.
3M plans to appeal the decision and explore other options, claiming the firm's earplugs worked when appropriately used and attesting that many claimants have not suffered hearing loss.
Nevertheless, with each legal setback, it seems increasingly likely 3M will be on the hook for a substantial payout to earplug claimants.
Compounding the company's challenges, in April the EPA designated PFAS, often called "forever chemicals," as a hazardous substance with cancer-inducing potential.
This development preceded a $12.5 billion settlement (paid out over 13 years) reached on Thursday by 3M and over 300 cities on claims the firm's PFAS manufacturing contaminated the drinking water of millions.
3M manufactured PFAS from the 1950s through the early 2000s to help make a wide variety of consumer and industrial products, including firefighting foams, nonstick coatings, fast food wrappers, and water-resistant clothing.
While this settlement provides more clarity on 3M's outlook, the agreement is only with municipal drinking water providers – just a piece of the overall litigation puzzle.
Not included in the settlement are outstanding allegations from state attorneys and the federal government or claims for personal injury and property damage, not to mention substantial cleanup costs.
It's hard to gauge how significant these outstanding PFAS liabilities will prove (yesterday's settlement was the 7th largest in American history), especially when analyst estimates range from $20 billion to over $140 billion.
But even sticking to more conservative projections, 3M's approximately $3 billion cash reserves and the roughly $10 billion (cash plus equity) it expects to raise from the healthcare business spinoff in the next 12 months barely cover yesterday's settlement and will likely require the firm to add a substantial amount of debt to the balance sheet.
According to some analysts, doing so would likely trigger a downgrade by credit rating agencies and could inflate the firm's interest expense by as much as $1 billion.
Spreading PFAS-related payments over 13 years (nearly $1 billion annually on average) could reduce the need to take on so much debt upfront. But more legal costs and settlements are ahead of the company, and 3M does not retain much cash flow to service these growing obligations.
For example, the firm's annual dividend is almost $3.5 billion compared to free cash flow projected to hover around $4 billion to $5 billion annually for the next few years.
To alleviate the firm's tightening payout ratio as higher interest costs and settlement payments arrive, 3M could have the healthcare spinoff assume part of the payout, reducing its dividend commitment while keeping income investors whole.
However, even if the healthcare company opened with a 50% payout ratio, we estimate 3M's dividend obligation would remain near $3 billion and continue to represent a major capital outlay relative to ongoing free cash flow.
When pressed on a recent conference call about its intentions with the dividend, which could soon feel uncomfortably large, 3M's CFO responded with a rather non-committal answer:
Stephen Tusa, Research Analyst at JPMorgan Chase & Co
Do you expect the combined companies, Health Care and 3M, to pay the same dividend as 3M is paying today?
Monish D. Patolawala, CFO at 3M
So we'll have to see as that plays itself out, Steve. I think at the end of the day, the capital allocation priorities for 3M don't change. There will still be R&D, dividend, M&A and share buyback. At the same time, the dividend for SpinCo will get decided by SpinCo management and SpinCo Board. So a little too early right now to talk about it, but I would say capital priorities don't change.
Knowing how much to read into management's comments is never easy. But this response failed to offer reassurance for the payout and could suggest support for maintaining 3M's 65-year dividend growth streak is waning.
Considering 3M's attempts to limit legal liabilities continue to fall short and appear increasingly likely to squeeze dividend coverage, we are downgrading the firm's Dividend Safety Score within our Borderline Safe bucket from 60 to 50.
Another downgrade could occur if management does not present more specific financing plans that effectively support the payout, or if any adverse developments arise regarding ongoing litigation, the capital allocation plans of the healthcare spinoff, or the standalone earnings trajectory of 3M.
There are still many moving pieces in 3M's story, and a lot could change over the next six to twelve months.
And with few growth prospects on the table, management may be willing to ride out a few years with stretched dividend coverage to attract investors, many of whom own the stock solely for its dividend at this point.
That said, we continue to believe that conservative investors may want to move to alternative investments in case 3M's outlook worsens and management's options dwindle.
In our February note, we provided a few options investors may want to consider. We replaced 3M with Air Products in our Top 20 Stocks Portfolio last October.
We'll continue monitoring litigation developments and news surrounding the healthcare spinoff that could alter the dividend's outlook, providing updates as needed.
