3M (MMM) 2003 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the 3M second quarter 2003 earnings conference call.

During the presentation, all participants will be in a listen-only mode.

Afterwards, you will be invited to participate in the question and answer session.

At that time, if you have questions, simply press star then the number 1 on your telephone keypad and questions will be taken in the order they are received.

If you would like to withdraw your question, press star then the number 2.

As a reminder, this conference is being recorded, Monday, July 21, 2003.

We would now like the turn the call over to 3M.

Good morning and welcome to our second quarter 2003 business review.

I'm Matt Ginter, Director of Investor Relations for 3M.

Our speaker today will be Pat Campbell, Chief Financial Officer.

Also with us are Ron Nelson, 3M's Controller and Mark Borseth, our Treasurer.

Our third quarter conference call is currently scheduled for Monday, October 20.

Please mark this on your calendars.

As you listen to today's call, you should refer to the accompanying powerpoint slides which you'll find on our Investor Relations website at 3M.com.

During today's presentation, we will make certain predictive statements that reflect our current views and estimates about our future performance and financial results.

These statements are based on certain assumptions and expectations of future events and are subject to risks and uncertainties.

The MD&A section of our most recent form 10-Q lists some of the important risk factors that could cause actual results to differ from our predictions.

With that said, let's begin.

Pat?

Thanks, Matt.

And good morning, everyone.

We will begin with some key highlights from our second quarter.

Please turn to slide number 2.

Second quarter was a very strong one for 3M.

Reported earnings were $1.56 per share, a 32% increase over last year's second quarter and a record for any second quarter in our history.

Excluding special items in the second quarter of last year, earnings per share increased 14.7%.

We have now achieved record quarterly profits in each of the last six quarters.

Sales reached an all-time high at $4.6 billion, a year-on-year increase of over 10% driven by a combination of higher volumes and favorable currency.

This was our second straight record sales quarter and we've now posted year-on-year volume increases for five consecutive quarters.

We achieved positive volume growth in six of our seven business segments and in all major geographic areas, led by Asia Pacific region, at almost 18%.

Operating income improved to $960 million with margins reaching 21%.

On a year-over-year comparative basis, we've now expanded operating margins for six consecutive quarters and free cash flow was $982 million for the quarter, a year-on-year increase of 36%.

Please turn to slide 3 for a recap of our sales results on a geographic basis.

As I mentioned earlier, worldwide sales increased over 10%.

Our second consecutive quarter of a double-digit year-on-year improvement.

Global volumes improved 5.6% driven primarily by organic growth of 3.8%.

Acquisitions completed within the last year added 1.8 percentage points of sales growth during the quarter.

Global selling prices were close to flat year-on-year and currency translation impacts added 4.6% to second quarter sales driven primarily by a continued dollar weakness versus the euro.

Sales were up about 2% in the United States as core volumes improved 40 basis points, while acquisitions added 1.7 points to growth.

Total U.S. volumes improved in five of our seven businesses.

Namely, display and graphics, transportation, healthcare, consumer and office and safety, security and protection services.

U.S. selling prices declined 20 basis points in the quarter.

Our international companies continued to post outstanding sales results.

Sales outside the U.S. improved almost 17% in U.S. dollar terms, the third consecutive quarter of double-digit-plus increases.

Total volume growth was 8.5% led by Asia Pacific where we increased volumes by almost 18%.

As in recent quarters, growth in Asia Pacific was broad based as volumes improved 7% in Japan and 28% in the rest of the region.

All seven of our business segments increased sales in both dollar and volume terms with five of seven segments posting double-digit volume improvements in Asia Pacific.

Volumes increased almost 10% in Latin America, driven by our recent Precision Optics acquisition, which added almost 12 points.

Volumes were up .6% in Europe as positive growth in safety, security and protection services, display and graphics, healthcare and transportation were partially offset by continued tough conditions in telecom and industrial markets.

For international in total, acquisitions added 1.9 points of growth while selling prices were down slightly.

Currency effects boosts the international sales by 8.5%, driven by positive translation of 16% in Europe and 4% in Asia Pacific.

In Latin America, currency reduced sales by 9%.

On slide number 4, we detailed the P&L, starting with a comparison versus last year's second quarter.

The numbers I will discuss exclude special items from 2002.

Gross margins were 49.3% in the quarter, an 80 basis point improvement over the second quarter of last year.

Overall, factory efficiency continues to improve, benefiting from thousands of Six Sigma and other projects aimed at improving throughput, yield and productivity.

In the raw material area, our global sourcing efforts are helping to keep costs relatively flat, despite pricing pressures.

SG&A was 22.3% of sales, up slightly versus last year's second quarter, reflecting our continued investment in growth programs.

In addition to ongoing increases in advertising and merchandising investment, we're also adding feet on the street in some of our fastest growing markets and geographic areas.

We also continued to right-size our organization through targeted reductions in some of our slower growing businesses.

Total operating income increased over 15% year-on-year and margins were 21%, up 100 basis points versus the second quarter of last year.

Second quarter net interest expense was $19 million, up $8 million year-on-year, driven by a combination of higher debt levels and lower interest income.

The tax rate for the quarter was 33%, up 50 basis points versus last year.

We are now forecasting a rate of 33% for the remainder of this year due to costs associated with repatrioting cash from outside the United States.

Year-on-year growth in net income was 14.8% and earnings per share increased 14.7%.

Now let's look at the P&L results on a sequential basis found on slide number 5.

Sales increased over 6% versus the first quarter of 2003, with all seven business segments posting sequential dollar increases.

Currency added about 2 points of sales sequentially, due primarily to the continued dollar weakness versus the euro.

Excluding currency impacts, six of our seven businesses posted positive sequential increases in the second quarter.

We leveraged this sales increase into a 10% sequential operating income improvement.

Operating margins improved 80 basis points sequentially, driven by a combination of higher volumes, ongoing productivity and process improvement as well as favorable currency trends.

On a sequential basis, net income increased 10.6% and earnings per share increased approximately 10%.

Please turn to slide number 6 where we will examine our results by business segment.

Two of our business segments posted double-digit-plus worldwide volume increases in the second quarter and two other segments grew faster than 5%.

Volumes declined in only one of our businesses, electro and communications, which has continued to be heavily impacted by the sluggishness in the telecommunications industry.

In our largest business, healthcare, global volumes increased 5.6% in the second quarter.

We continue to build on our strong and diversified healthcare portfolio, which ranges from medical and dental solutions, to leading edge pharmaceuticals, to software solutions for hospitals among others.

Virtually all of these businesses posted volume improvement this quarter.

Operating income improved over 23% to $263 million.

Moving to industrial, sales were basically flat year-over-year.

Core volumes remain sluggish, especially in the United States and Europe with Asia Pacific continuing to grow.

Second quarter operating profit in industrial was $102 million, down 22%, primarily due to lower production levels in our industrial factories.

Also, we took additional employment reduction actions in the second quarter which will improve our results going forward but nonetheless negatively impacted second quarter profits.

For the first six months of 2003, operating income for industrial was almost flat versus last year.

Volumes increased over 20% in our display and graphics business driven by continued solid growth in 3M optical systems, one of the world's leading suppliers of solutions for the fast-growing display industry, from LCDs to touch-panel systems to project TVs.

Our recent Precision Optics acquisition added 9 points to growth.

Operating profit in display and graphics increased over 40% versus the second quarter of 2002.

Moving to consumer and office, volumes increased 3% year-on-year.

Sales to the consumer retail and do-it-yourself channels were quite strong, but demand in the office channel remained weak due to many companies continued efforts to curtail spending on office supplies in response to the weak economic conditions.

Operating income was basically flat at $108 million, impacted by year-on-year increases in advertising and merchandising, along with additional spending for new product introductions.

Volumes increased 11% in safety, security and protection services, led by strong demand for our respiratory protection products.

As SARS has become less of a concern, respirator demand is moderating somewhat from recent highs, but we anticipate steady, solid growth in the future for this business.

Compared to the same quarter last year, operating income grew over 40% to $131 million.

Electro and communications volumes declined 6.8% in the quarter due to the continued weakness in the telecom industry.

Operating income was $71 million, down 10% year-on-year.

In transportation, volumes grew 7% in the second quarter with positive contributions from both the after market and OEM side of the business.

This leverage of this sales increase into a 19% operating income improvement during the quarter.

Now let's look at some balance sheet and cash flow metrics, please turn to slide number 7.

Networking capital turns were 4.8, an improvement of .6 turns versus one year ago and up .1 turn sequentially.

While we're making steady progress, we're certainly not satisfied with the pace of our improvement.

Our goal remains a minimum of 6 turns by year-end 2004.

Inventories declined slightly year-on-year and were up slightly sequentially.

Currency impacts added $93 million to inventory year-over-year and $56 million on a sequential basis.

Accounts receivable also declined slightly year-on-year, but were up 5% versus last quarter in line with our sequential sales improvement.

Currency impacts also increased accounts receivable by $123 million year-over-year and $69 million on a sequential basis.

Second quarter capital expenditures were $144 million versus $202 million in last year's second quarter and $120 million last quarter.

We continue to improve the efficiency of our capital spending by applying rigorous Six Sigma discipline to maximize utilization of existing assets.

Free cash flow was $982 million, a 36% increase over last year's second quarter, primarily driven by higher net income along with certain tax timing benefits.

We paid $258 million in dividends to our shareholders during the quarter.

Recall that in February of this year, we boosted our quarterly dividend by 6.5% to 66 cents per share, the 45th consecutive annual dividend increase for 3M.

We have now paid a dividend to our shareholders for 86 straight years.

We also bought back $107 million of our own stock during the quarter.

Our total debt to cap ratio was 30% at quarter end, well within our targeted range.

Please turn to our final slide, which is number 8, where we discuss our future outlook.

First, we feel very good about our ability to execute on our plans.

Through this tough economic period, we've become a much more competitive enterprise, due in large part to an outstanding and energized workforce that is committed to success.

Each day, they continue to improve every aspect of 3M.

And, of course, we also face many challenges such as the continued economic uncertainty in many parts of the world.

Possible downstream impacts from last quarter's SARS outbreak as well as an uncertain currency environment, just to name a few.

Considering all these factors, we will continue to plan conservatively in the second half of the year.

But on the heels of our strong second quarter, we are raising our full-year earnings expectations, excluding special items, to a range of $5.90 to $6.05 per share.

On a reported basis, we anticipate 2003 earnings to be between $5.75 and $5.90 per share.

Both ranges assume volume growth of 5 to 7% for the year.

For the third quarter, we expect earnings to be between $1.56 and $1.60 per share with sales volumes anticipated to grow between 5 and 7%.

Before we begin the Q&A, let me quickly summarize.

This was another strong quarter for 3M.

Sales increased over 10% with broad based contributions across the portfolio of businesses.

Operating margins improved to 21% and earnings per share improved almost 15%.

We are on track for a solid 2003.

This concludes the formal part of today's call.

Ron, Mark and Matt are here to help me answer your questions as well.

So let's begin the Q&A.

At this time, I would to remind everyone, in order to ask a question, please press star and the number 1 on your telephone keypad.

If you would like to withdraw your question, press star then the number 2.

If you are on a speaker phone, please pick up your handset before entering your request.

Please limit your participation to one question and one follow-up.

One moment, please, for the first question.

Your first question is from David Begleiter with Deutsche Bank.

Thank you.

Pat, can you discuss a little bit about the strength of the mask business in the quarter?

Especially in Asia?

And what you might be seeing in terms of follow-through orders as SARS does diminish as a health concern heading into the summer/early fall?

Thank you.

Yeah, Dave, it's -- you know, the respiratory products business is, you know, very, very strong for us and you can't just look at Asia as far as the results go.

We've seen, you know, some tail off in orders but when we looked at the quarter by itself, the benefit, of course, was, you know, some to the business, but I would not call it necessarily material to our overall results and we expect, you know, ongoing solid orders.

What were mask sales up in the quarter, year-over-year, Pat?

We're not going to release actual product sales, but it was a strong quarter for us.

Thank you.

Your next question is from Jeff Sprague with Salomon Smith Barney.

Hi, good morning.

A couple of questions on currency.

First, maybe the easier one.

Can you give us a sense of just the currency impact on the bottom line?

And then maybe the more complex one, as you've looked at the dollar depreciation, can you measure -- or do you have any sense of actual true competitive gain in your marketplaces as a result of just kind of the competitive shift in the landscape with the currency?

Okay, Jeff, thanks for the question.

The first part, if you look at year-over-year change, is probably order magnitude of about 8 cents.

If you look at sequentially, probably more like a 4-cent improvement for us.

If you isolate currency by itself, but I think, you know, second part of your question, probably the more relevant one is how does it affect, you know, your competitive position?

There's a bad exporter, you know, obviously it helps us be at this point in time, not seeing a significant change in the marketplace yet and I think it takes a while for currency movements to actually play itself through the, you know, the market environment before competitors either start to feel the benefit or the penalty of a currency move.

So, I think I -- you know, I view this as being kind of a longer term issue for the, you know, for us and the competitors.

And just separate follow-up.

So, you're repatrioting cash, I guess that's taking advantage of a tax window the federal government has made.

Can you give us a sense of, you know, why you're doing that?

I guess I would think you'd want to leave that cash overseas because that's where a lot of the growth focus is?

And maybe some guidance on what happens to the '04 tax rate.

Well, let me kind of try to deal with that.

Most of our cash, I think we reported $974 million of cash at quarter end.

A lot of that is outside the United States.

What we're trying to do is look at a number of, you know, issues or planning that we want relative to the need for cash.

You know, as our cash for the U.S., you know, we have dividend payments out of the U.S., we have pension contributions in the U.S., so forth, is we do have to get that cash back into the U.S. at some point in time if we don't have all the needs for it outside the U.S.

And it's purely a timing issue as to when is the optimal point to bring that cash back into the U.S.

There really is no specific advantage to us in '03 to repatrioting that cash.

So, that's a balancing act that we continue to look at between the economics of it as well as the need to have, you know, cash back into the United States.

Right, thanks a lot.

Your next question is from Stephen Weber with SG Cowen.

Good morning.

A couple of things.

You reported a couple of times, at least obliquely, to some restructuring charges.

Could you size those for us?

And do you think this is going to be kind of ongoing?

Well, Steve, I think all of us have a need to continuously look at our businesses to make sure they're the most productive they can be and, you know, we're, we have a need as everybody else does to, you know, take some actions on a, you know, quarter by quarter month by month basis.

To size it, it wouldn't be, you know, that material to our overall results, it's probably in line with what we have to do on an ongoing basis.

It was targeted at the slower growing areas of the business.

It continues to be industrial, telecom and Europe.

But it wouldn't be, you know, something that is that, you know, that material.

It is material to certain segments, as I mentioned industrial, the order magnitude in industrial probably by $11 million is what we took in the quarter.

Okay.

Associatively, when you go through the segment stuff, there's this corporate and unallocated number, which was for the first half is just shy of $60 million versus a negative of $59 million, versus the negative 24 a year ago.

What's in there, Pat -- I'm sure there's a whole melange of stuff, but is there anything very big in there?

It was particularly big in the first quarter.

Steve, this is Ron Nelson.

You recall in the first quarter we did have some special costs associated with some legal expenses.

But for the most part, on a quarterly basis, that number that's in corporate and unallocated was to your point is a series of items, will be in that range of 15 to $20 million on a quarterly basis.

So, the first quarter, as you point out, did have, you know, somewhat higher due to some special deal, because, you know, legal expenses will be in the 15 to $20 million, normally on a quarterly basis.

Okay, if I could ask one last question, can you give us a status report on the litigation with the implant optic?

No real update from really our last Q filing.

There have been really no activity.

Okay, thank you.

Your next question is from Bob Cornell with Lehman Brothers.

Good morning, everybody.

You know, could you give us some insight into how, you know, the new product, you know, development efforts are doing sort of broadly within the business groups?

So much depends on you getting the organic growth rate up?

And maybe some talk about how the whole 3M acceleration program is working by business unit?

A big topic, but maybe a summary comment?

Yeah, we could spend the next 30 minutes going through this if you guys want, but I don't think we can do that.

The acceleration activity continues to make progress.

We continue to get more and more traction out of the acceleration program that we are working on.

You know, that entails both how do we improve the idea generation phase of our activity as well as our commercialization activity as well from a corporate standpoint on how we prioritize resources across our business opportunities.

But, you know, we've seen -- I think it was five quarters in a row of growth now in the business, the last two quarters have been, you know, better.

And we just see, you know, piece by piece improvement in our overall organic growth capability.

You know, the nature of our business, Bob, as you're well aware, is we don't have huge volumes per given product.

So, we need to have, you know, a fair amount of individual products that do well in our portfolio.

That's what we're seeing with our broad-based improvement here.

I know it's a big question, we can talk more about it offline.

You reported organic growth in this quarter of 3.8%, you're targeting, what, 5 to 7 in the third quarter?

Yeah, we're, total, total growth, okay, is 5 to 7.

That's not just organic.

Okay.

And if you look at the last two quarters, there's probably about 2 points of acquisition within that number.

Okay, thanks, sounds good.

Your next question is from Michael Regan with CSFB.

Good morning.

Pat, can you give us what the actual D&A number was for the quarter?

The actual D&A number. 230 something, I guess Ron has that.

The depreciation and software amortization was $230 million and then another $11 million associated with the intangibles for a total of $241 million in the quarter of depreciation and amortization.

And just to be sure that we're on the same page, that's up from 234 in the first quarter?

That's correct.

Much of that certainly currency related.

Gotcha.

Pat, if we look at EBITDA margins to just understand what's going on in the base business, they were up about 20 basis points versus the 100 basis points of EBITDA -- of EBIT margin improvement, so, not as much leverage on the EBITDA line, so, a lot of the leverage coming from D&A.

Can you give us some sense on a manufacturing basis what's impacting that?

You're obviously making lots of moves and getting lots of traction in terms of raw materials and Six Sigma kinds of things.

What are you giving it up in?

Is it all in price or is it just lack of volume leverage?

Mike, I'll be honest with you, I'm not 100% tracking with your analysis because we just talked about D&As being up sequentially.

I'm talking year-over-year, Pat.

D&A EBITDA margins were 20 basis points better, 26 2 versus 26, versus EBITDA margins that were 100 basis points better.

So, your EBIT margin was up 100 basis points, your EBITDA was up only 20 basis points.

Yeah.

Just trying to get a sense of despite the good gains you're making in raw material, cost containment and great things you're doing with Six Sigma, where do you think you're giving up a lot of that leverage?

Is it all in price or is it a lack of volume leverage right now?

You know, let me -- I think your number excludes R&D, okay?

Which we had a leverage improvement about 40 basis points.

We're still actually spending more year-over-year so we're getting, you know, good leverage out of our R&D capability, which I think is part of the operational improvements of the business.

But all in all price is down a little bit.

You know, of course, we get a little bit of volume, but good factory productivity.

We are spending some more money on, you know, ad merchants and so forth, that is going to pay us, you know, dividends down the road.

You know, I look at it as 21% operating income margins, you know, were up a point which is, you know, good growth, 15%, you know, bottom line growth operating income versus, you know, 10% top line.

So, then again all in all, I think that's a good leverage ratio.

Okay, thank you.

Your next question is from Don MacDougall with JP Morgan.

Good morning, Pat.

Good morning.

Impressive quarter.

I wanted to ask for a little more color on SARS, specifically, you know, how it impacted the Asian business and, you know, how we ought to think about any tail on that impact that we might see.

Well, Don, that's kind of a tough question because I don't know how you encapsulate all the impacts of SARS.

One of the benefits, of course, we had, was we were not in the businesses that were primarily affected by SARS, you know, from a, you know, a hotel/travel perspective.

It did have some impact as you, of course, people weren't traveling and therefore, you know, you didn't get a chance to meet customers as much as you'd like and so forth.

So, all in all, you know, it probably had some, you know, minor impact on our business.

I guess the question is, you know, does it have a longer term tail?

We don't necessarily see it at this point in time.

I think it really speaks to the diversity of our portfolio businesses and you look at -- as well as in our subsidiary structures, we run most of our subsidiaries with local management teams and, you know, a few cases a, you know, somebody maybe from the U.S. or another part of the world at the top.

So, as compared to some other companies who basically their challenge was, you know, getting their management team out of the country, ours were really there operating.

So, we didn't see as big an impact and, of course, we had the luxury of having a business in our mask business that, you know, was a direct beneficiary of the, you know, of the outbreak, but that's not, you know, good for everybody else.

So, you know, all in all, you know, it's tough to read.

I think we have to kind of take a longer term look at this to see if it does have some longer term tail to it, but we haven't seen it at this point in time.

Well, it certainly wasn't apparent in the volumes that you put up in Asia.

The real question was, you know, given how good the volume performance was with SARS, you know, does it get better from here?

Does, you know, is there some kind of lag on that effect?

But it doesn't sound like you think so.

I think, Don, it's just hard to read, you know, exactly what's going to play out.

You read some publications where they say there's going to be some downstream, you know, impact of it.

You know, we continue to, you know, focus on this day in and day out, just, you know, try to expand our business, but we didn't see a, you know, probably the magnitude that, you know, a lot of other companies did.

Okay, next question for you, Pat, just looking at the industrial segment and the operating income on, you know, pretty much flat sales with the first quarter.

Could you give us a little more color as to what happened to the margins there?

What drove that sequential decrease?

It was the one business that was the tough one for us here in the quarter.

I already mentioned that we took about $11 million relative to some further employment reductions in that business, which kind of speaks to the nature of it.

We're not getting the kind of vote that we need out of the U.S. or Europe, Asia still continues to expand for us there.

We had to take some further production reductions here in the second quarter versus how we were running in the first quarter to get our inventories where we need to be, as well, because we're, of course, balancing our inventory objective, our working capital plans and, you know, where we need to be to run the business, but industrial continues to be an area that we have to focus on to get our costs in line with, you know, where we see that industry.

Okay.

Final question for you, just on electronics and communications.

You know, down a little bit relative to what -- where I was thinking.

Could you give us a little color on any segmentation there?

Is that just all telecom?

Are there any bright spots within that business mix?

Well, the telecom piece of reduction, I think we're down 6.8% in total volumes, I think telecom was down about 13 to 15% is the telecom piece of that.

So, the rest of it, you know, we -- it's kind of spotty, but we didn't see that much erosion in the rest of the overall business there.

Thank you, Pat.

Your next question is from John Roberts with Buckingham Research.

Good morning, guys.

Good morning.

It looked like the projection TV business that you bought from Corning had a little over $50 million in revenues, if I used that, you know, the 9 percentage points that you say for acquisition there.

I thought if you annualized that, that's just over $200 million.

I thought that business was running at 260 when you acquired it?

It's a good question, John.

Your numbers are right, I think the number is really 56, if I recall, the exact number for the quarter.

That business does have some seasonality to it.

It's more back-end loaded.

Pretty much around holiday sales.

Okay.

Plus there was some inventory corrections that we, you know, had here in the first part of the year.

The business is going very well, integration is working very well between Precision Optics and the rest of 3M, the team is really working hard at growing that business, but we did see a little bit of falloff in, you know, back to Don's question on China, some of the projection TV sales in China actually were hurt in the second quarter because people weren't out shopping.

So, you know, that's one of the negatives of SARS.

But all in all, we feel very good about this business and we expect the third and fourth quarter to be at higher sales levels than the first half of the year.

And then secondly, the acquisition environment seems like it's heating up a little bit broadly across industry here.

Are you seeing any change in the level of your activity?

Our activity continues to accelerate, we're looking at more and more -- yields nothing, you know, nothing to report.

We've got our system very productive now.

We've continuously look at a number of options but we have not changed our philosophy on, you know, kind of deals that we want to make.

So, it's just more stuff coming in the funnel and you're able to process it a little quicker here?

Yeah, that's right.

Okay.

Thank you.

Your next question is from Robert Ottenstein with Morgan Stanley.

Pat, a couple of questions.

First, CAPEX is running well below guidance.

Any new thoughts in terms of where the CAPEX number is likely to come out this year?

Well, the good news here is the team continues to aggressively work at increasing the productivity of our facilities and so forth.

My best estimate right now, Robert, would be in a range of 750 to 800 for the year, realizing that's quite a bit above the run rate because the run rate because the run rate would be 264 through the first half of the year.

But we continuously look at our needs there.

I mentioned last quarter that we probably have some investment coming at us in our display, our optical systems business, the back half of the year.

But that's about the only thing from a, you know, a significant standpoint.

Would you say that that range is a good one for '04 or do you see it ticking up?

I, you know, we just -- one of these things as you look closer to it, and you start to look at it project by project you decide you need to do it now or not.

I think as a longer term guidance, I still believe the $900 million that we've given you in the past is the right view of what we need to spend on a going-forward basis.

Okay.

And then on the safety/security protection, that -- the operating income was up 42%.

Can you give us a little bit of feel on that?

And then just, you know, back on the whole mask thing, I know you don't want to talk about individual items, not a good habit, but, you know, this was a -- you know, an exceptional quarter and I really think it would be helpful to give us a little bit of sense so that we have an idea of, you know, the ongoing business there as opposed to particular blips.

I don't know if you can revisit that and then go through the 42% increase on the operating income, you know, what's driving an increase of that order of magnitude.

Well, the operating income improvement was primarily around respiratory products.

And that's probably about as far as I will go to give you anymore specifics on that.

But, you know, that's where the volume -- most of the earnings growth was, but we are seeing, you know, volume improvements in a couple of our businesses within that business segment and the focus on why we reorganize to create safety, security and protection is to get broader growth across that portfolio of businesses.

The second quarter definitely was more impacted because of the SARS outbreak and so forth.

But that should be a growth business for us going forward, not to the magnitude that we had in the quarter.

So, you know, you can say that that business ought to be growing at, you know, 8% give or take anyway.

So, you can, you know, take a look at what the growth rate was versus, you know, where we ended up in the second quarter.

But I don't, you know, I don't want you to think that's just a one-time, you know, one-time event relative to the growth at 11%, you know, maybe it comes back down closer to 8% or so, but --

Well, in the quarter, "X" masks, would volume growth have been more or less than 5%?

Well, you take mask out, well, that's a little bit unfair because that's a big piece of this whole business and it's pretty hard to say what mask sales would have been, you know, absent the SARS event.

There is no way we'll ever know what the real impact is other than looking at a longer term trend projection.

So, I'm not going to go there, Robert.

Okay, and then R&D as a percent of sales, I know it increased on an absolute dollar basis, as a percent of sales, I think, was near a low, or the lowest I've seen for a while.

Can you give us a sense, you told us in terms of CAPEX that $900 million was a long-time good kind of number for CAPEX to keep growing.

What do you see as the long-term R&D either on an absolute basis or as a percent of sales that you need to achieve your growth objectives?

Well, let me -- I'd rather talk about in absolute terms rather than a percent to sales because one of the things that's happening with the weakening dollar, obviously our top line is benefiting, a lot of our R&D is spent in the U.S., so, that percent to sales becomes a little bit of a tough measurement, okay, when you kind of look at it that way.

I'd rather look at it as we spent about $1.1 billion per year in R&D and related activities.

That's what we think is necessary to get us to the organic growth rate that we've talked about in the past.

So, we're not changing that view.

Our spending in the quarter was consistent with that plan.

So, I'd be a little cautious on the percent because I think the best thing to focus there is on the absolute dollars of spending and if we, by the way, if we come up with -- through the acceleration process even better, you know, projects, Jim and I, you know, will further fund R&D.

But at this point in time, we feel that's about the right level of spending for the business.

Great, thanks a lot, Pat.

Your next question is from John Inch with Merrill Lynch.

Thanks, good morning, Pat.

Good morning, John.

I want to go back to the industrial.

If you exclude the $11 million of restructuring, it's 13.5% margins, which would still be down fairly materially year-over-year and sequentially.

I'm wondering if you could give us, I mean, I heard your answer, I'm just wondering if you could get a little bit more color as to where and why there's weakness in the business right now?

Did things, I mean is it U.S. versus overseas?

Maybe it's just a little bit more in terms of where you're actually seeing things and where, you know, the quarter ended?

Like what's your outlook for the business?

Well, John, let me try again on this, but U.S. and Europe top industrial business right now, you know, overall economy is not, you know, not expending as quickly.

Business is moving out of the U.S., western Europe, to Asia, lower cost markets.

That's driving somewhat of a relocation of resources in business as you look forward, but the way I have a tendency to look at it is really the full first half.

The first half, our results are about flat year-over-year, but a relatively good first quarter, second quarter fell off here a little bit.

A lot of that has to do with when we produce, we had more production here in the first quarter than we did in the second quarter so we didn't have as much throughput here in the second quarter.

Took some inventories down in the second quarter, reflecting where we see the business needs are here in the near-term.

So, I look at it as being more of a -- somewhat of a correction, but I don't want to mislead you, this is a tough business.

No, I appreciate the answer.

Just as a follow-up, Pat, if you take the mid point of your guidance, $1.58 in the third quarter and $5.98 for the range ex special items.

It implies $1.42 for the fourth quarter, which would only be up 10% and actually below the consensus.

Is there something about the fourth quarter that you're seeing that perhaps we should be aware of?

Or are you just being cautious as we head toward the end of the year?

It's probably more of the latter.

I don't see anything in the fourth quarter that is materially off our current, you know, performance trend.

That's another quarter further off, so think of it from that perspective.

Okay.

Great, thank you.

Your next question is from Jeff Cianci with UBS.

Hey, Pat.

For the leverage question in a round-about way, you're saying the industrial economy is weak, EC, telecom weak, but, of course, you're raising guidance, implying the growth business is strong.

So, what leverage are we loosing?

I'm trying to narrow down, you have a 5% to 7% range for volume outlook, right?

I assume that includes 2% acquisitions?

That's correct.

So, you're underlying saying, you know, pick the mid point, 6, mine is 4%.

And longer term, if I recall, you wanted kind of a 6 plus 2.

In other words, are we losing 2% of sales due to this cyclical weakness?

Is that a fair way to look at it?

I don't know if it's 2 or not, that's the way, you know, the math works out.

You know, the economic situation still remains somewhat cloudy, cloudy here.

And I think the overall economic growth isn't what we had thought, you know, going into the year.

It's down probably a couple of points for what we thought it would be, specifically around the U.S. and Europe.

Europe's a lot slower than we thought.

Right.

Going into the year and the U.S. is not performing at the rate that we had thought.

The -- of course, Asia is running probably a little bit better than we thought.

So, you know, net-net we're still down some.

I think the important thing, though, is we've got some growth momentum behind us, we've got five good quarters now of growth.

We've shown we've got, you know, leverage capability in the bottom line but you know, your map is right and your observation is correct.

Obviously something better than you thought offset that.

You know, you went in with economic expectations not being fulfilled.

Can you zero in on, is it top line growth in the growth sectors, in the non-industrial, non-[EMC]?

Is it the cost side?

What's better that's getting you, not only meet your guidance, but raise your guidance?

It's hard to say that top's better because I just kind of explained that net-net we're still down.

I meant in the non-industrial businesses.

Well, I'd say our optical business is probably running a little bit stronger --

Stronger than you had thought.

Than we had thought.

But the other thing is the currency markets are more favorable than when we talked to you in the past.

That gives us a little bit of flexibility in the business here, as well.

But all in all, you know, the business is running very, very well.

You know, Six Sigma is really, you know, continues to expand its capability as well as the other initiatives.

Sourcing has helped us really fight against some price increases.

E-productivity gains are improving and our indirect program keeps running well for us.

So, we continue to focus on the basics of the business, improve the way we do things and drive, you know, cost out of the underlying structure of the business.

So, if we don't get the top line, we still have to kind of work to give you what we've promised you on the bottom line.

Thank you, and very last question.

E&C comps start to get easier, I presume, you know, if I look back the last year second half, would you expect, you know, just kind of run rate by the fourth quarter with the volumes?

Jeff, I have to tell you, this is one that who knows where the bottom of this is, but you're absolutely right, the comps become easier as we get to the back end of this year.

I keep saying it can't be, you know, the year-over-year can't be like what it was last year, but things aren't necessarily exactly --

Okay.

But the comps will be easier.

As you [INAUDIBLE] that seasonality, does it feel like it's worsening?

Is the order pattern, second half slowing?

I would say the order pattern still remains very spotty.

Spotty.

Okay.

Thanks for your answers, Pat.

Your next question is from Mark Gulley with Banc of America.

Good morning, guys.

Good morning.

Pat, I wanted to be sure I heard you right on the impact of currency in the quarter.

I think you said 8 cents a share?

That's -- that's the --

On earnings.

That's the year-over-year comparison.

Right.

If I do my math right, I hope I've done this correctly, that implies that your constant currency earnings growth was about 9%, the weakest it's been since maybe the tail-end of 2001.

Am I doing that right?

I'm sorry, run that through me one more time, the 9%.

I think as your constant currency earnings growth, in other words, if I exclude the currency impact from this year's numbers or last year's whichever you prefer.

The year-over-year gain in cost of currency earnings is around 9%.

Did I do that about right?

Yes, your math is correct.

Okay.

Can you give us a feel for the impact of currency, I know you do some hedging here so you have some visibility.

The impact of currency for the balance of the year on earnings per share?

Oh, I think we're looking at the current rates it would be about 6 cents a quarter for the third and fourth quarter.

I think it's 12 cents for the second half is what we're looking at.

Okay, that's what's baked into your, let's call it $6.00 guidance, then.

Mark, let me kind of raise an issue.

We don't run the business exclusively on, okay, it's 8 cents of currency.

We look at what we do we have to generate relative to cash flow in the business and so forth.

If currency is a friend of ours, that gives us an opportunity to do some of the restructuring that we kind of talked about here in the second quarter.

So, you know, it's -- the 8 cents is a good number analytically, but as we look at the business, we have to be able to run in both good and bad times around currency.

So, think of it as -- I wouldn't take it as being we're falling off from, you know, our growth -- our EPS growth expectations, I just -- it's a portfolio of external issues that we're trying to manage via growth or currency.

And we're trying to manage it really as, you know, as an enterprise and not by, you know, line item.

Okay, point taken.

And then lastly on cash flow, clearly the tax timing had had a big impact on your cash flow.

Can you kind of isolate that for us so I can reconcile to the, whatever you showed as your free cash flow number?

And is there more taxes, more of this benefit coming balance of the year?

Yeah, Mark, think of the number in the 160/170 range, that's order of magnitude.

Uh-huh.

That would be deferred, you know, beyond the quarter.

Right.

And then balance of the year?

Balance of the year it won't be as favorable as it was the first half of the year.

We actually end up with some tax payments at the back end of the year.

That's helpful.

Thanks, Pat.

Your next question is from Dmitri Silverstein with Longbow Research.

Good morning, gentlemen.

Good morning.

Most of my questions have been answered, but a couple of questions still.

In your consumer and office business, you mentioned that consumer was continuing to be relatively strong while office is slowing down.

Is that -- the negative mix coming from that, is that what accounts for lower operating income even as there was a slight improvement in volumes?

Well, Dmitri, really what affected us is, you get a little bit of mix, but the big issue is our ad merch is up, we're investing in future sales opportunities in that business.

Third and fourth quarter is the big business in the U.S. for that business and, you know, we're getting ready for that.

Okay, so there were some investments as well as -- excuse me -- as mix shift and it was mostly the investments.

Is that correct?

And when you use the word investments, investments in consumer are as much ad merch, advertising merchandising as they are R&D.

I understand that.

And your transportation business has been trailing pretty well in the first half of the year.

Do you see any impacts from slower car builds or any other external circumstances that may prevent this type of growth in the second half?

Or should we expect mid to high single digit growth on constant currency basis?

Well, if anybody can tell me for sure what the car build in the third and fourth quarter by manufacturer are would probably help us out in that I came from that industry.

But the good thing about our transportation business, we've got a very broad-based transportation business.

We've got a big piece in the after-market piece as well as the that are tied to the OEMs, which is a good portfolio of businesses as well as we've got, you know a couple of good businesses in there relative to aerospace as well as marine.

So, you know, it's a good portfolio.

If there's, you know, a correction here in auto builds -- third quarter auto builds should be pretty well known at this point in time, absent current negotiations.

The negotiations can take any place relative to how that affects production, but usually the third quarter production schedule is pretty well firmed up right now.

So, I guess what I'm hearing is barring any unforeseen events, this is a sustainable type of growth.

Yes, it is.

Okay.

Excellent.

And one final question.

On the industrial businesses, I understand that they're slow across geographies, maybe with the exception of Asia.

Are there any specific businesses that are stronger or weaker than the overall industrial segment?

Is there a light at the end of the tunnel in any of your industrial businesses right now?

Well, I think there's a light at the end of the tunnel for our whole industrial business, it's just a matter of, you know, getting us where we need to go.

And when you look at our industrial business, we still -- our industrial business is a very attractive business, good margins, good return on invested capital.

Our focus is how do we make it better?

So, even though we've got a tough comparable period here, we -- you know, I feel very good about our industrial business that we've got here.

There is always pockets in any given quarter that run, you know, better than the others, but it's a tough place to sell into.

It's very cost-down or price-down driven and, you know, we've got to get our costs where we need to go to get our volume and margins.

Okay.

Okay.

Thank you.

Your last question is from Jack Kelly with Goldman Sachs.

Hey, Pat, I get to bat up cleanup today.

What happened?

Were you asleep this morning?

It was a tough day!

In terms of consumer and office, again, similar to a question was raised about industrial a couple of times.

You had some pretty good volume leverage, you know, up 3%, you know, operating income flat.

You kind of talked a little bit about promotion, et cetera and that office was a little bit weaker due to white collar unemployment, but can you just give us a little more flavor for that?

And then maybe how much the promotions penalized the quarter?

Is it an ongoing thing in the third quarter and how it might map out over the next two quarters or so?

Jack, I would expect consumer to be better in the third quarter than it was the second quarter reflecting our -- some of the spending that we've got going on.

The U.S. consumer business is probably running better than say Europe, Europe is.

Asia is improving for us a little bit, but Asia was also affected, of course, because of the SARS in the second quarter.

So, I think, you know, we got a very solid business, you know, with great brands on the consumer side.

There is one business in there that continues to be somewhat of a drag on us and it's some of our visual products that is effectively being, you know, from a current economic standpoint, not performing as well.

But all in all we got a great, you know, great business, great franchise there and I would say third and fourth quarter, you know, back, actually in a -- in a bottom line growth mode.

So, the leverage for the group is coming, you're not betting on anything happening in office, you're saying things just going to, less spending and better unit volume in consumer in the third and fourth is kind of the story?

I'd say that's a fair assessment, Jack.

Okay, good.

Thanks.

Okay.

That concludes the question and answer portion of our conference.

At this time, we will turn the call back over to 3M for some closing remarks.

Okay.

Again, thanks for joining us this morning.

We had a very solid quarter, represents another step in our quest to deliver a sustainable long-term value for shareholders versus -- be it both improved top line growth, productivity and cash flow.

Thanks again for your continued interest and we'll talk to you again at the third quarter call.

Thank you, ladies and gentlemen for your participation.

This concludes today's conference.

You may now disconnect at any time.