3M's Weaker Cash Flow Projection, Ongoing Legal Pressures Cloud Dividend Outlook

3M, the once steady industrial giant, faces a challenging outlook as a souring economic backdrop tempers earnings expectations and attempts to maneuver away from PFAS and earplug litigation lose momentum.

Retailer inventory reductions, soft consumer electronics demand, and a slowing economy led management earlier this year to introduce 2023 adjusted free cash flow guidance that came in about 25% lower than analysts expected last fall.

While 3M's free cash flow projection of approximately $4.5 billion still covers the firm's $3.4 billion annual dividend, it does not include legal costs that reached almost $1 billion last year – cash costs that look poised to continue as court rulings continue to block 3M's attempts to limit its liabilities.

And while these costs will eventually fade, they are stretching 3M's forward-looking free cash flow payout ratio to almost 100%.

Additional headwinds that could challenge 3M's free cash flow outlook include upcoming separation costs tied to this year's planned healthcare equipment spin-off, looming recession risk, and 3M's intention to exit PFAS manufacturing, a business that we estimate has contributed around $100 million a year to free cash flow.

This stretched dividend coverage could become more troublesome if, as it seems increasingly likely, the company has to pay some sizable earplug and PFAS settlements, which analysts estimate could range from $10 billion to $50 billion.

Because these estimates exceed the firm's $3.5 billion cash reserves and annual free cash flow after dividends, 3M would need to finance these potential settlements to some degree by issuing debt.

Based on 3M's reduced earnings outlook for 2023 and assuming $10 billion of debt is needed to settle litigation claims, we estimate the firm's leverage ratio could spike near 3.0x, even after accounting for a one-time cash dividend 3M expects to receive from its healthcare spin-off.
Source: Simply Safe Dividends

This heavier debt load would result in higher interest costs that reduce profits and pressure the firm's recently downgraded A credit rating from S&P.

The timing and magnitude of 3M's liabilities remain fuzzy. But if this scenario materialized, 3M could find itself in a tough position needing to prioritize deleveraging but having relatively little free cash flow available after dividends to put towards debt reduction.

Recognizing these growing risks as 3M's dividend coverage tracks lower than expected, we are downgrading the company's Dividend Safety Score from Safe to Borderline Safe.

That said, 3M's token dividend raise earlier this month suggests management desires to defend 3M's impressive streak of paying uninterrupted dividends for over 100 years.

In the near term, keeping income investors whole will likely require splitting 3M's dividend with the pending healthcare spin-off, which accounts for around 25% of the company's profits.

The bigger test will come whenever 3M resolves its legal liabilities and reassesses the adequacy of its prevailing cash flow generation to meet competing needs for balance sheet strength, business reinvestment, and sustainable dividends for shareholders.

Conservative investors may want to consider alternative investments with fewer headwinds and more promising outlooks, like Air Products – a global industrial gases producer with steadily improving earnings and a clearer path to solid dividend growth.

We replaced 3M with Air Products in our Top 20 Stocks Portfolio last October.

Other potential ideas with higher yields closer to 3M's include Philip Morris International (PM), Pembina Pipeline (PBA), Leggett & Platt (LEG), and International Paper (IP).

There are many moving pieces in 3M's evolving story; we will provide updates as more details emerge.

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