Shares of 3M (NYSE: MMM) have broken out of the typical pattern being showcased by virtually every stock in the S&P 500 index composition, where 2021 was shown to be a year of new highs for these stocks, followed by a steady decline to today's consolidation to mark the first half of 2023.
3M's decline began in 2018 despite a lack of financial troubles; the more than 60% decline since 2018's high price of $259.77 per share stems from legal and political issues affecting the company. Today, as these issues keep intensifying, some analysts have pointed to the potential financial impact of a resolution.
What will present a rare buying opportunity for investors seeking exposure to the manufacturing conglomerate sector is the severe underperformance that 3M has undergone relative to other names in the space.
Subsequently, the valuation multiples that these names trade under will give investors another reason to start considering this stock being added to their watchlists. Considering that today's price, hovering around $98.0 and $102.0 per share, represents prices not seen since 2012, the company's current state is severely disconnected from where its valuation should be.
Assessing the Damage
Sell-side analysts are pointing to a potential $20 billion or total cost via lawsuit settlement costs stemming from pollution allegations and military-use earplugs, which seemingly failed to perform their purpose during active service. These two lawsuits, which have come together at once, are estimated to cost 3M $10 billion in pollution-related lawsuits and another $10 to $15 billion related to the faulty earplug issue.
The main concern for investors today, assuming that these costs are realized, is the future of the company's dividend payout as well as its subsequent valuation.
By taking a look at 3M's financials, investors can note that the company's past five-year average free cash flow levels have been $5.1 billion. This is important to remember since realizing these settlement costs would imply leaving the company with no free cash flow for at least four years and forcing management to take on debt or even dilute shareholders by issuing shares to cover the costs of these expenses.
Should these massive capital outflows be realized, the company must postpone its dividend payments, representing around $3.4 to $3.5 billion annually. Considering debt only makes up 52% of 3M's total capital, adding another $20 billion of debt would bring this ratio up to 71% approximately.
The company's current dividend yield of 6.0%, which is proximate to its all-time high of 6.4%, could be taken as a sign of undervaluation. Considering these levels, the typical path to 'normalization 'implies either a dividend payout reduction or a significant stock price advance. While a dividend cut would severely affect the market's perceived value, remembering that these expenses are non-core and non-recurring can provide an unorthodox opportunity to acquire this stock at 'distressed' prices.
Where is the Common Ground
3M stock has underperformed other peers in the sector; companies like Honeywell International (NASDAQ: HON) and MDU Resources Group (NYSE: MDU) have blown past 3M by as much as 35.6% over the past twelve months. The broader markets and select investors are already pricing in the risks of these lawsuits, as 3M's price-to-earnings ratio is sitting well below that of its competitors. A lower P/E ratio would imply that the market is not willing to pay a similar price for 3M's current - and future - underlying earnings while also being willing to pay a higher premium for the earnings coming from competitors.
3M analyst rating points to a 20.6% upside scenario from today's prices and a top-side price target of $155.0 per share to bring on an implied 54.6% rally. Considering the current valuation multiples in the stock being at a decade-low, coupled with the actual stock price trading at the same levels as back then, whatever negative effect may come from these legal issues is not likely to keep hurting the stock price any further.
Honeywell stock sells today for a 26.2x P/E, while MDU resources are going for a lower 11.0x. The focus of the matter is that 3M has proven to be the cheaper alternative in the sector. Despite a dividend cut, the value is present to close the gap between the group's valuation multiples.
