My long-time readers know that I have pointed my shotgun at candidates with likely coming dividend cuts. I even made two Weeklies out of this topic, as I am still convinced that dividend cuts will be one of the mega trends of this decade, and a fairly underestimated one! There are several companies where I am seeing massive operating and financial issues. In this latest episode, I am targeting again the famous industrial conglomerate and inventor of post-it stickers, 3M.
Summary and key takeaways from today’s Weekly
– The warning signs are all there. I have had 3M on my radar for a dividend cut since last year.
– By simply looking at some hard facts and figures together with adding up a few numbers, you will see why I am convinced that many novice dividend investors will be negatively surprised.
– It is rather a question of when, not if. Management should be honest.
For me, there’s barely such a clear and obvious case for a coming dividend cut around the corner like this one – especially among “dividend kings” and blue chip companies that are said to be the most stable and reliable dividend payers.
Under normal conditions this is even true.
If you have read my articles about dividend cuts (three of my five most popular articles; see here, here and here), then you will likely know my position concerning these dividend titles – for me, they are only a look into the past, however, a very dangerous one. I even wrote that these titles will become worthless. But, it’s not what those who invest in good belief and practice “buy and hold and pray” like to hear.
As we had falling interest rates between 1980 and 2021, with the extreme being zero or near zero after the Financial Crisis of 2008–2009, now there is a completely different environment.
Many, especially younger investors don’t seem to have fully understood this. While the broad sentiment is tilted towards a coming pivot, meaning rate cuts again, I would never place my bets solely on this assumption. It is only a guess. Guessing is not investing and certainly not with high odds in your favor.
But what if rate cuts do not come or later than expected?
At least in the case of the FED, they have openly communicated and repeatedly said that “higher for longer” shall be expected. Interest rates are already higher than many, even professionals, have thought would be possible. I can remember voices saying that interest rates will not rise again during our lifetimes, because there’s too much debt.
Guess what happened?
This point – interest rates or to make it more vivid, the cost of debt – is what concerns me. Many companies seemingly also were convinced to never again see higher interest rates (or at least until a new management comes). Is it any wonder that many balance sheets are now over-levered?
Once during the 2010s, an advantage, now it is becoming a burden.
What you need to know is that interest rates only slowly bite into a company’s finances if the debt has been spread wisely and wide into the future.
3M (ISIN: US88579Y1010, Ticker: MMM) has been a member of the Dow Jones Industrials Index since 1976, next month it will be 47 years. It has been paying a dividend for an uninterrupted period of more than 100 years (see here on its webpage). 3M also managed to increase its dividend for a consecutive 64 years.
It is a dividend king – but I think the crown will fall off its head, soon. The hikes since 2020 have been really meager and only symbolic. Plus, we are now at a point where it will be really hard to even sustain the current payout. It’s not gut feeling, it’s looking at the numbers without emotions.
Today’s Weekly is an update to the dividend safety of 3M – it does not look good.
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Don’t confuse a value investor with a garbage hunter
You definitely don’t want to get caught on the wrong foot with your investments.
What pundits from the dividend (growth) investing crowd are advising novice investors to do is to look at the dividend history of a company to assess the safety of the payout.
In their mind, the longer a dividend has been paid or even raised, the safer it is.
To cite such a source:
Are All Dividend Kings Good Investments?
source: Dividendstocks.com (see here)
It’s true that a dividend can increase an investor’s total return. However, it’s possible for a dividend king to be overvalued or undervalued. […]
The bottom line for investors is that dividend kings are ideal choices for an investor whose primary consideration is reliable income. But if you’re looking for capital appreciation and/or the largest dividend payout, there may be better options than dividend kings.
For me, the question has not been answered.
First of all, from how I understand it, dividend investors don’t care about price appreciation as long as their cash flows come in. Second, no single word about the necessity of having sound finances. Third, 3M now has a dividend yield of more than 6% – but they say that “the largest payout” is not to be found among those kings.
To prevent unexpected problems or at least greatly reduce the risks, you need to examine the financial well-being of your investments.
Usually, unnaturally high looking dividend yields where you otherwise would not expect to find them among quality-companies, in many cases are a warning sign, not a ringing bell to load up the truck.
It doesn’t matter how long a company has been paying out dividends or how many consecutive years the payout has been increased – you need to assess the status quo and determine whether the dividend is safe, using current figures, not what happened in the past.
For me, it is absolutely foolish and amateurish to extrapolate the past into the future.
What if things – the playing ground – changes?
My prime example for how quickly things can get sour is the one of V.F. Corp (ISIN: US9182041080, Ticker: VFC; I wrote about it here).
To sum up, it was a highly praised stock because it paid and increased its dividend year after year. Then, finally, in December 2022, the management hiked the payout for the 50th time in a row – VFC became a dividend king. However, already long before, the balance sheet was pretty weak due to too much debt. So was free cash flow generation.
The stock has been nose-diving all along since mid-2021.
Although I am not a technician or chart analyst – there seems to be a certain element of truth in it that such a chart does not show a healthy development.
Anyway, it was only a matter of time until a cut would come. It took just two months.
If you had looked into the company’s finances, you would’ve been able to see big risks – at the minimum. Below, you can see a slide from my presentation deck from my webinar about “Why stock picking is becoming important again”. The framed fields at the centre-bottom show that in three of the last five quarters, the company generated less free cash flow than it spent on its dividend.
At the same time, all the painful way down for the stock and its holders, the never-ending perseverance slogans came out nearly on a weekly basis, trying to motivate to buy the dip – first at a dividend yield below 5%, later even above 7%.
But what if you buy the dip and it keeps dipping?
Then came the cut of 41.2% – in addition to the losses the stock generated, depending on when bought. Again, this is not investing or analysis. It is stupidity or lying to oneself and in most cases avoidable as this did not happen suddenly over night.
You could have observed it months and quarters in advance!
As clear as it is now in hindsight, unfortunately, I did not predict this cut.
I simply did not have the company on my radar, despite having dismissed it as a potential investment a few years ago for my former employer who liked the stock simply due to past memories, paired with an “easy to understand business” and wanted me to “find” an investment thesis.
However, there was none.
What I did predict accurately in my article from September was the coming dividend cut of Intel (ISIN: US4581401001, Ticker: INTC). After paying a dividend for more than 30 years and holding it stable during the dotcom bust as well as the Great Recession, now was the time to face the truth.
I also think that the signs cannot be any clearer than they are in the case of 3M – a dividend king with 64 dividend increases in a row. Let’s have a look at it again and update on what has happened over the last weeks and months.
Why 3M will be forced to finally cut its dividend
As said above, I don’t really like to look at charts to form an investment thesis.
But like in the case of V.F. Corp, I think the following picture is already telling more than thousand words about the condition of 3M which many are still seeing as a high-quality company – mainly because it has raised its dividend 64x in a row every year:
Measured by eye, the share price did nothing between 2013 and now. If you want to be evil, you could even say since 2007. But it dropped by more than 50% since its all-time high in 2018!
All this without counting dividends. But is this a good excuse?
There’s absolutely no denying that something is not working properly at 3M. And sooner or later – I am expecting sooner – the consequences will be seen.
But what is it?
As I have written in my older articles, 3M is a cyclical company. This is not problematic per se. However, it is not really helpful in the currently stressed economic environment, either, as you cannot be sure that results will stay stable.
The issue is that the management made several important mistakes.
You should be aware that 3M hasn’t grown its operating cash flows over the last ten years! While sales at least grew by 10% or 3 bn. USD over the same period (which is not much, and this number contains 10 bn. USD gross spent on acquisitions), operating and free cash flow are still where they came from.
Goodwill (immaterial “value” and premium paid on acquisitions) in the books rose by 5.5 bn. USD – a sign of expensive deals and much overpaying!
Not only did nothing happen effectively and operationally, but you can already see that money was thrown out the window.
At the same time, the dividend has been increased on a yearly basis, from 2.50 USD per share to 6.00 USD per share. Share count decreased by 20% – which sounds great – but the management spent around 32 bn. USD on these buybacks!
To put this number into perspective: The current market cap is just 54 bn. USD.
And guess what, the majority was spent in a pro-cyclical way, meaning when the share price and the valuation were high, meaning destroying shareholder value. At the top around 2017 / 2018, 3M’s stock had an earnings multiple of close to 30x and the dividend yield fell below 2%.
You should not be surprised to hear that they are currently not buying back any shares due to the lack of cash flow.
Another important figure to have in mind is net debt. Over the last ten years, it went up by 10x! Yes, that is no typo – from 1.3 bn. USD to 13 bn. USD. This is more than 4x the current free cash flow, i.e. not low.
The current dividend costs 3M in total 3.3 bn. USD per year.
There is a positive gap of 0.5–0.7 bn. USD between this yearly payout and the generated free cash flow which was exactly 4 bn. USD over the last twelve months and 3.8 bn. USD in the year 2022.
Now come the three buts, two of them BIG buts.
First, we don’t know how the cyclical business develops. Results can rise or fall. I don’t want to speculate, hence I am leaving it with this – just keep it in mind.
Second, and here it is getting interesting, is the high debt load that must be refinanced.
Short-term debt, i.e. due over the next twelve months, is 3 bn. USD. Although cash on hand is 3.8 bn. USD and certain parts of outstanding receivables and inventories likely will be converted into cash, it is unlikely that 3M will pay down this whole amount.
3.3 bn. USD in dividends are waiting to get paid out.
With refinancing in a higher interest rate environment comes a higher cost of debt.
This will put pressure on results and cash flows, effectively lowering what is left over after the dividend (and assuming results don’t fall due to lower results from a weaker economy).
Below you can see that more or less every year parts of total debt are due.
Overall, 3M issued its debt on a cheap basis, meaning at low interest rates. But please also look at the floating rate notes where interest rates reach up to more than 6%. This does not have to end here and the bonds that get refinanced will likely double or even triple in interest rates.
As if this weren’t enough to a close race, now comes the third problem that I view as the final nail in the coffin. A few weeks ago, it was announced that 3M achieved a settlement to resolve claims about drinking water pollution with its “forever chemicals” (see here).
In a first reaction, the stock went up by 5%, but later closed the day unchanged. Usually, uncertainty is what puts pressure on an asset.
Investors hate insecurity. But sometimes the truth tastes more bitter.
So, was the settlement the final relief because the uncertainty is gone, now?
Unlikely, because 3M agreed to pay a penalty between 10.5–12.5 bn. USD, starting next year and until 2036. Even though I read that analyst expected a higher penalty:
This is shocking news and nothing to celebrate!
A quick calculation and you will notice that 0.9–1 bn. USD every year will flow out between 2024–2036. This is money that the company does not have – and especially not after the dividend, should it be paid. It could work out if interest rates fall to zero again and the economy grows like crazy – however, I would not rely on both…
Maybe you have also noticed that they wrote “[…] resolve a portion of […]” – is there more to come?
Even assuming this was it, the lower-end number of 10.5 bn. USD is a damage of around 20% of the company’s equity valuation, i.e. market cap! With the next earnings release, 3M will write it down as a non-cash charge. These are shocking figures. It seems as if this wasn’t realized by many.
There seem to be people that prefer to be fooled directly and openly.
What I found funny is that management in a simple press release (not formal SEC filing) said:
“This is an important step forward for 3M, […]
Press Release, 22 June 2023 (see here)
The strength and stability of 3M’s business model and strong free cash flow capability, together with proven capital markets access, provide financial flexibility to deploy capital to meet its cash flow needs under this agreement and other contractual commitments and obligations.”
What financial flexibility are they talking about?
The company is highly indebted with 4x its free cash flow and it will be forced to refinance its already existing high debt load. An effective debt repayment, the penalty over the next twelve years and simultaneously keeping the dividend (not to mention, raising) is hardly possible under the current circumstances.
But even if, which is hard to believe, “capital market access” means more debt to come – but as said, this thing is already highly leveraged. What interest rate will they pay on more debt? What about the credit rating?
Even if this is all put aside: more debt means a higher enterprise value or lower equity value – stocks of highly indebted companies almost always have very low valuation multiples. 3M currently has a market cap to free cash flow of 13x – this is already pretty much. With more debt, you should prepare for 8–10x – based on a lower cash flow due to the coming penalty.
The Wall Street Journal came out of the bush, too, speculating about a coming dividend cut.
I cannot repeat and stress it often enough: Don’t be fooled by this useless “dividend king” title. The crying will be big after the cut, but the facts have been lying on the table for months. It is simply adding up some numbers without showing emotions and falling in love with an under-water investment, hoping that it reverses back to zero.
If you’re still in doubt whether the dividend is safe or not, 3M is also facing legal claims and likely penalties due to the damage its hearing-protection / ear-plug equipment caused to the military.
Here, better put aside another few billions, at least mentally.
What’s the timetable now? In around two weeks, 3M should announce its results. You will see the 10 bn. USD one-time charge. The dividend in the past years has been announced in early to mid August, i.e. one or two weeks later.
I think they will keep it for now, because there is no immediate danger.
The next potential raise would be due in February. It will be hard even to sustain the dividend if management starts to be honest.
Under normal circumstances, over the next 12–18 months, the dividend should be cut meaningfully. I estimate some 20% at the minimum, because this would save around 0.6 bn. USD per year they will need for higher cost of debt and the penalty payments. But also 40–50% are not unrealistic to create enough breathing room.
If management were honest, they would cut it now. But I think they will at some time start pitching and discussing a “competitive dividend” and “reassess an appropriate capital return program” or the likes. This is also what Intel did.
Hopefully, they won’t fool investors longer enough.
Conclusion
The warning signs are all there. I have had 3M on my radar for a dividend cut since last year.
By simply looking at some hard facts and figures together with adding up a few numbers, you will see why I am convinced that many novice dividend investors will be negatively surprised.
It is rather a question of when, not if. Management should be honest.
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