3M's Dividend Growth Likely to Remain Subdued as PFAS, Earplug Liabilities Develop

3M on Monday provided 2022 financial guidance and a strategic update on its sprawling businesses.

The industrial conglomerate's presentation contained few surprises or shifts in strategy. But management did not offer many updates on the biggest issue looming over 3M: legal liabilities tied to the firm's legacy PFAS chemicals and military earplugs.

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.

These toxic "forever chemicals" have come under significant scrutiny due to environmental and consumer health concerns. 3M faces a growing number of lawsuits across the country accusing the company's PFAS manufacturing sites of polluting water supplies.

Unfortunately, investors could be waiting for years until the full scope of PFAS liabilities is known.

Bellwether trials – essentially "test" cases in mass litigation involving thousands of plaintiffs – are expected to begin in early 2023. These trials will give involved parties a clearer idea of settlement payouts victims of PFAS contaminated groundwater should receive.

Meanwhile, the U.S. Environmental Protection Agency (EPA) seeks to classify certain PFAS chemicals as "hazardous substances" by mid-2023. 

If successful, facilities would be required to report releases of these chemicals, and the EPA would have more leeway to pursue responsible parties such as 3M as it analyzes sites and recovers remediation costs for cleanup work.
 
Ultimately, some analysts expect 3M's legal settlements and remediation expenses tied to PFAS to total around $10 billion, but a worst-case scenario could see costs spiral to as much as $30 billion, according to Bloomberg.

The company's military earplugs liability could be even larger. In 2008, 3M acquired a business that sold government-approved combat earplugs from 2003 through 2015, when the product was discontinued.

3M was hit with its first lawsuit in December 2018 when a military veteran claimed he sustained hearing damage while serving in the armed forces because the firm's earplugs were defective.

By the end of 2021, 3M had been served by lawsuits representing over 13,000 individual claimants making similar allegations. Another 290,000 unfiled and unverified claims have been maintained in the court, making this the biggest multidistrict litigation in history.

That said, unverified claims are essentially a list of military veterans with few supporting details such as where they served or if they ever really used 3M's product. Some of these claims will likely be dismissed, but the potential liabilities are nonetheless staggering.

Different types of hearing loss get different settlement amounts, ranging anywhere from an average of $14,000 for inner ear dysfunction to over $1.5 million for total hearing loss, per Johnson Law Offices.

If we assume 3M ultimately settled 300,000 claims and paid an average settlement of $100,000 per claim, then the firm would face a total liability of $30 billion. But if half the claims are dismissed and the average settlement was cut in half, the liability would stand at $7.5 billion.

Similar to PFAS, a wide range of potential outcomes exists, and investors could be left waiting a long time for clarity.

Bellwether trials kicked off in 2021, and through January 2022, 3M had won 5 of 11 trials – a mixed outcome. Another 5 bellwether trials are scheduled between March and May of this year, and 3M plans to appeal adverse verdicts, a process that is expected to take 12 to 18 months.

Only once the dust settles will 3M determine how to push forward with a potential settlement.

Overall, PFAS and earplug liabilities could cost 3M anywhere between $10 billion and $50 billion or more, with payouts likely taking place over the course of years.

3M only retains about $2.5 billion of free cash flow annually after paying dividends. To cover future settlement costs and avoid cutting its dividend to preserve more cash, the firm would need to lean on its A+ rated balance sheet to plug the gap.

Assuming settlement payouts are spread over several years and 3M uses all of its retained free cash flow to pay down debt, we estimate the firm could handle upwards of $40 billion of liability costs while keeping its leverage ratio near 4x or below (up from 1.4x today) – a level that could keep the dividend intact.

Needless to say, until the magnitude and timing of these liabilities become clearer, token dividend raises seem prudent to preserve as much cash as possible. 3M did just that earlier this month, announcing a 0.7% increase to extend its dividend growth streak to 64 consecutive years.

Shares of 3M trade at an uncharacteristically low forward P/E ratio near 15, a 20% discount compared to industrial peers and 3M's own 5-year average multiple.

This discount represents about $25 billion of market value, which could be viewed as the amount of environmental and product liabilities investors are baking in to 3M's valuation.

3M's discount appears reasonable based on the information available today. But investors should understand the potential for 3M's expected liability costs to rise, potentially significantly, as more trials take place. (We estimate every $1 billion of incremental liabilities will reduce 3M's share price by 1%, all else equal.)

Until these liabilities are resolved, they will remain an overhang on the firm's stock. Otherwise, 3M's diversified, high-margin business seems like a reasonable bet to at least track global GDP (2022 guidance calls for 5% to 10% adjusted EPS growth, excluding disposable mask sales) and grow in value over time. 

We will continue monitoring 3M's progress and provide updates as necessary.

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