3M's Future Dividend Policy Remains Fuzzy as Health Care Spinoff Draws Near
Continuing our analysis earlier this summer following the first settlement of 3M's multiple legal liabilities, the industrial conglomerate's payout ratio is looking more likely to stretch to uncomfortable levels in the years ahead.
Given this significant settlement and its cash flow implications (annual payouts will consume around 20% of 3M’s free cash flow), we hoped management might use 3M’s late July earnings report to clarify their commitment to the dividend.
Unfortunately, the company remained tight-lipped on whether it intends to keep income investors whole, a decision further complicated by 3M’s plans to spin off its health care segment (25% of profits) in late 2023 or early 2024.
Given our lingering concerns about 3M’s future dividend coverage and management’s unclear support for keeping the full payout intact with the health care spinoff looming, we are downgrading the company’s Dividend Safety Score from Borderline Safe to Unsafe.
Here’s a look at the numbers that make us wonder if a 20% to 40% dividend cut could be in the cards once 3M separates its health care business.
Looking at potential dividend coverage in 2024, assumptions need to be made about how the dividend gets split between health care and 3M, the actual amount of PFAS settlement payments, developments with remaining liabilities, and how much free cash flow each business generates.
Our analysis below assumes the consensus free cash flow estimate for 2024 (~$4.6 billion) is split 25/75 between the health care spinoff and 3M's remaining operations.
After giving the spinoff a 50% payout ratio and having 3M assume the rest of the current dividend, a $1 billion PFAS settlement payment would put 3M's cash flow into a deficit position.
Source: Simply Safe Dividends
And that's looking at a base case scenario that ignores the high likelihood of further PFAS and earplug settlements that could add billions more to 3M's current liabilities.
S&P, which downgraded 3M in June to an A- credit rating with a negative outlook, believes that "the ultimate settlement figure [$12.5 billion paid out over 13 years] regarding PFAS will be much higher."
Barclay's analyst Julian Mitchell provided a more specific and sobering estimate that another $16 billion of potential PFAS liabilities for 3M are yet to be settled.
If the annual settlement payments for PFAS and earplugs rise closer to $2 billion, 3M's cash flow deficit could land closer to $1.5 billion in 2024. Free cash flow is expected to grow around $400 million in 2025, but 3M would still face a large hole for the foreseeable future.
What about using the balance sheet to cover the difference? After all, 3M will likely receive a $7 billion debt-funded dividend payment from the health care spinoff to bolster its cash pile.
Dipping into cash reserves isn't prudent because it would keep 3M's leverage ratio elevated for longer. If we assume remaining PFAS and earplug liabilities total another $10 billion, 3M's 2024 leverage ratio could spike to 3.9x (up from less than 2x in 2022).
Source: Simply Safe Dividends
With high leverage and cash flow struggling to accommodate large dividend and settlement payments, 3M has little financial flexibility to invest in its business or pursue acquisitions.
Cutting the overall dividend by 20% to 40% would provide more breathing room and could be viewed by management as a worthy tradeoff if the cut coincides with a speedier resolution of the firm's remaining legal liabilities.
While the Dividend King could try to ride out a few years of restrained free cash flow in hopes of favorable PFAS and earplug litigation outcomes and material earnings growth, we're not sure 3M's attractive 6% dividend yield is worth the risk.
While this downgrade doesn't imply a dividend cut is inevitable, it does reflect the odds of such are growing.
As we've suggested for more than a year, conservative investors may want to consider alternative investments as 3M's financial position worsens and management's options dwindle.
We'll continue monitoring litigation developments and news surrounding the health care spinoff that could further alter the dividend's outlook, providing updates as needed.
