There are links in this article to news and research for 3M shareholders who need more background on the Combat Arms Earplug Product Liability Multidistrict Litigation (MDL). I will avoid regurgitating those and instead provide my thoughts on the matter from the point of view of a 3M shareholder.

If you are reading this, you are probably a 3M (NYSE: NYSE:MMM ) shareholder like I am. You probably bought shares of this company for similar reasons that I did:

1. You want a stable source of income from a reliable dividend payer. 3M fits the bill; it is a dividend aristocrat that has paid growing dividends for 63 years. What's not to like?

2. It has a huge moat from its 21561 active patents.

3. It boasts of ubiquitous products found across 10 major industries such as automotive, health care, manufacturing, safety, electronics, energy, design and construction, commercial solutions, and more. Most of us probably own 3M products or have used them before.

And if you are still reading this, it is probably because of the 3M Combat Arms Earplug product liability multidistrict litigation (MDL) that is threatening to bankrupt the company (read Forbes update on this), and you are considering one of the following three options:

1. Should I sell my 3M shares, even at a loss, to get back some capital before it goes kaput?

2. Should I hold my 3M shares and hope that it can reach a favorable settlement?

3. Should I buy more shares as poor sentiments have depressed its share price so much that it is literally a "blood in the street" scenario right now?

Well, let's get into it. I will lay out the theses for selling the shares, holding them, or buying more. The decision you make will depend on your risk tolerance and your understanding of the risks (and rewards) involved in being a 3M shareholder.

1. The judge is not exactly a 3M fan after 3M's lawyers complained about how the judge mishandled the docket.

2. 3M lost 10 of the 16 bellwether trials so far, winning just 6, with damages totaling $256 million. Not a good start.

3. 3M's best defense as a government contractor that simply designed and manufactured what the military requested and thus the fault lies with the military and not with the company was tossed out by the same judge.

4. 3M's next best defense to ring-fence the damages to bankruptcy proceedings of Aearo was tossed out by U.S. Bankruptcy Judge Jeffrey J. Graham.

5. As a shareholder, you bought 3M shares to get income from a stable company. 3M is a company with an A+ credit rating that is yielding 4.61% at the time of writing. However, the payout ratio has crept up to 57%; it was only 37% 10 years ago. Plus, although a 4.61% dividend yield is very delectable, it may not be worth the angst over this litigation, which could drag on for years. 3M is supposed to be your SWAN (sleep well at night) stock and not one that you need to worry about. If it is a Dividend Aristocrat that you want, maybe something like Walgreens Boots Alliance (NASDAQ: WBA), which offers 5.31% dividend yield at a safer payout ratio of 35.37% is a better choice.

6. This is not the only major litigation 3M is facing. In 2010, the state of Minnesota sued 3M for PFAS contamination which polluted east metro groundwater. This class of chemicals is found in non-stick pans, water-resistant clothes, food packaging, and firefighting foam. Nicknamed “forever chemicals”, PFAS does not break down in the environment and they accumulate in the human body. Numerous studies link PFAS exposure with cancer, thyroid problems, and developmental issues in children. 3M closed that case in 2018 with an $850 million settlement, the third largest natural resource recovery in the country's history. That however did not end the lawsuits. 3M, together with the Chemours Company and DuPont were charged in 2019 by US lawmakers over PFAS contamination. Now, even the European Union could be taking issue with 3M over PFAS pollution from their factory in Belgium.

1. You Believe That This Earplug Lawsuit Is Without Merit.

The lawsuit basically states that 3M manufactured faulty earplugs that did not protect servicemen, resulting in them suffering from hearing loss and tinnitus. Tinnitus happens to be one of the most common clinical conditions in the United States. All kinds of loud noises can lay the foundation for this medical condition. According to the Centers for Disease Control and Prevention (CDC), repeated exposure to loud noises over time can cause hearing loss.

Sources of Loud Noises ((CDC))

The risk of damaging your hearing from noise increases with the sound intensity, not the loudness of the sound. If you need to raise your voice to be heard at an arm’s length, the noise level in the environment is likely above 85 dB in sound intensity and could damage your hearing over time

The following table lists daily activities that produce sounds exceeding 80 decibels.

Daily activities exceeding 80 DB ((CDC))

A 2007 research done in Idaho National Laboratory showed that the Combat Earplug was effective in protecting the users while allowing them to hear soft noises nearby. The author concluded with the following:

The Combat Arms earplug provides conservative protection from impulse noise generated by small arms fired in training scenarios. The indoor impulse noise generated by firearms using blanks is above 140 dB and requires hearing protection in accordance with MIL-STD-1474D. Foam earplugs or standard earmuffs do not allow the SPO to hear effectively, not only enemy activity, but also the coordinating commands or signals from leadership or fellow SPOs during the FOF exercises. Using the Combat Arms earplug on FOF exercises provides a balance between realistic training and employee protection.

I am no lawyer, but I would think that for the plaintiffs to prove that their hearing issues arose purely as a result of using the Combat earplug is a challenge.

Besides, tinnitus is not just one of the most common clinical conditions in the United States, it is also the leading diagnosed condition in the military, and that should not come as a surprise. The loudness of a gunshot is up there in the 140-decibel range, after all.

According to this 2009 New Yorker article by Jerome Groopman:

In 2006, the V.A. reportedly spent five hundred and thirty-nine million dollars on payments to veterans with tinnitus. A survey of more than a hundred and forty-one thousand Army active-duty, reserve, and Guard members who were examined in audiology clinics from April, 2003, through March, 2004, showed that tinnitus accounted for more than thirty per cent of post-deployment-related diagnoses. The study, from the U.S. Army Center for Health Promotion and Preventive Medicine, concluded, “There were not adequate supplies of earplugs to fit all deploying soldiers.

There was also failure of an Army medical readiness automation system . . . to provide unit commanders with information regarding troops having adequate hearing protection. . . .

Finally, there is evidence . . . that soldiers having blast injuries may not have been referred to audiology for adequate evaluation and treatment.” As with body armor and protective shielding on Humvees, the Pentagon had failed to anticipate the kind of hearing-protection devices that were needed. Even soldiers who were provided with earplugs were given insufficient instruction in their use; mistakenly believing that the earplugs could interfere with low-frequency sounds, like whispered commands during search-and-destroy operations, many chose not to use them.

Neither 3M nor Aearo ever claimed that these earplugs will "prevent hearing loss", as described by Another Mountain's Rock Investing's article that issued a "Sell" rating. 3M's and Aearo's product claims are less expansive, simply claiming that:

Testing by the military, 3M, and Aearo, as well as independent labs and other organizations, confirmed that the CAEv2 product decreased noise as intended at every frequency .

The company's statement reinforced this stance with the following:

Hearing loss unfortunately has always been a potential side effect for individuals serving in the military... The CAEv2 product was designed to mitigate against those risks , and it worked as intended.

Published research data from the Idaho National Laboratory report also supports the company's claim that the product "decreased noise". The graph below, taken from the report, showed that when an M-16 was fired indoors there was a reduction in noise roughly between 12 decibels (left ear) to 20 decibels (right ear) when the earplugs were used correctly. That outcome, good as it was, hardly prevents hearing loss.

Hearing Protection Evaluation for the Combat Arms Earplug at Idaho National Laboratory (Research paper)

Take that research outcome together with CDC's information that sounds above 120 decibels still causes "pain and ear injury", all I see is transparency from the company when it comes to this particular product. 3M never claimed that their product can prevent hearing loss.

Therefore, if this medical condition is one that is common, one that can be caused by numerous sources of loud noises totally unrelated to gunshots or exploding shells, and can be a result of incorrect usage of the earplug device in the first place, making a claim that the device is defective is not a guaranteed winning strategy.

There is a likelihood that plaintiffs will settle because the alternative is to have the court case drag out over years through the courts (like the PFAS case between the state of Minnesota and 3M that dragged on for 9 years), and a victory is uncertain. Yes, of the current 16 bellwether cases, plaintiffs have prevailed in 10 of the 16 bellwether trials to reach a jury, winning a combined $265 million in damages. But 3M did win six defense verdicts, and managed to get the other eight bellwether cases dismissed before trial, proving the point that a win is not guaranteed. 3M further showed its willingness to resolve the legitimate claims quickly through the Chapter 11 process and committed to adding $1 billion to a trust dedicated to this purpose.

2. You Aren't Fazed By The $100 billion In Damages Headline.

The headline-grabbing "$100 billion" in damages is just that - headline-grabbing. It was a figure given by one "expert witness", a litigation consultant hired by the plaintiffs' attorneys, who extrapolated the $100 billion figure based on the damages granted by juries thus far and considering the 230,000 cases that are pending hearings. This same (biased) expert also acknowledged that the sample is small and that a judge may conclude that $100 billion is not realistic.

3M's own experts estimated that a much smaller sum of $1 billion would be sufficient amount to fund the trust, and that figure is based on the analysis by an experienced estimator of claims, an economic consulting firm, Bates White.

If that is also your conclusion, then 3M could very well survive this incident, scarred, $1 billion poorer but alive and kicking to keep those dividends coming for many more decades.

3. 3M Is A Hold But Not A Buy (Yet) At Current Valuation

Although 3M's share price has corrected sharply at the time of writing, it is still not exactly at a blood-in-the-street valuation.

Using a conservation DCF valuation approach, the shares are overvalued.

The first-year growth rates above were assumed in order to reach different ranges from the earnings guidance as well as consensus analysts' projections of adjusted earnings per share. For instance, in Scenario 1 (normal case), I assume a 2.8% growth rate of the 2021 adjusted earnings per share of $10.12 in order to arrive at the consensus FactSet analysts estimate of $10.40 by the end of 2022, and the 5% growth was forward earnings growth estimates provided by SPGI analysts. In Scenario 3, the worst case scenario, I assumed a 0% growth rate to factor in the company needing to set aside even more of their earnings to pay for litigation costs and settlements, which will negate any benefit from earnings growth.

In that conservative calculation, I derived a fair value of $122.07 per share. At the other end of the spectrum, we have Morningstar analyst Joshua Aguilar's fair value estimate of 3M's shares at $183 per share mainly due to management guiding lower for the rest of the year by a full percentage point and on low reported organic growth.

Average these two estimates, I get a fair value of $152.54. With the shares trading at $127.30 at the time of writing on 29 August, I would not be selling my 3M shares.

Using different valuation methods, 3M shares could be considered relatively cheap now.

3M shares typically traded at an average PE of around 19-20 over the past 20 years. Its 5-year average PE is 19.59 and it is trading at a PE of 13.06 now. Analysts still forecast a 5.76% adjusted earnings growth rate for 3M and if the stock were to re-rate to a PE of 15, there is a potential upside of 19.14% to $163.49 excluding dividends, and 23.55% including dividends by the end of 2023.

The situation is similar from a PS perspective. 3M typically trades at a PS of 2.96. Its 5-year average PS is 3.27 and it is now trading at a PS of 2.11. If 3M's PS were to be re-rated back to its normal 2.96 by 2023, it could return 35.16% including dividends, and the share price appreciating to $185.57.

I became a 3M shareholder because it serves as a regular and steady dividend payer in my portfolio. There are just a handful of companies that can boast of paying and raising dividends for 63 consecutive years.

The current litigations are definitely casting a pall over this. If these concerns are not giving you peace of mind (as outlined in the "6 Reasons to Sell" segment above), selling is definitely your prerogative.

If you have full confidence in 3M and think that it is a great deal at the current valuation based on PE and PS, you can also consider buying 3M shares.

Personally, I intend to hold my 3M shares. 3M is just like Altria (NYSE: MO) and Johnson and Johnson (NYSE: JNJ) in the sense that these companies face litigations all the time. It is part-and-parcel of being a shareholder of such companies. I can't very well be selling shares of companies I own every time they face a class action suit.

3M's role in my portfolio is a dividend payer, and so long as it keeps doing that, and so long as it remains profitable, it can stay right there. And 3M is a profitable company that generated $7.45 billion of net operating cash flow in 2021 and has $2.98 billion in cash and $14.51 billion in current assets as of June 2022. And according to Seeking Alpha's Dividend Grades and Profitability Grade, 3M performs remarkably.

The company has also set aside $1.2 billion in preparation to settle with the plaintiffs, amounting to $1.66 of adjusted earnings of litigation-related expenses. At the low end of the earnings guidance, estimates for adjusted earnings per share for 2022 are $10.30. That means in the event that the actual compensation figure exceeds this original $1.2 billion allocated, the company has sufficient earnings to pony up to the tune of $6 billion before it has to dip into its cash and cash equivalents. Management is fully prepared to handle this situation and to take responsibility to support valid claims.

After assessing the situation, I have confidence that this venerable company is capable of tiding over this crisis which explains my rationale for holding my shares.

However, I am not a buyer at the current prices as the risk and reward are not sufficiently favorable. To me, it is not a blood-in-the-street situation yet. A potential 23.55% to 34.16% upside is not enough reward considering the unclear outlook facing 3M currently.

However, if the share price drops below $100, I will be a buyer. At that price, 3M would be trading at a PE of just 9.7, a level unheard of other than during the depths of the Great Recession from 2008 to 2009. At that price level of under $100, the potential upside is 49% or more. And that will be a blood-in-the-street moment that I want to capitalize on.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of MMM, MO, JNJ either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.