3M (MMM) 2006 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the 3M first quarter 2006 earnings release 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. [OPERATOR INSTRUCTIONS] As a reminder, this conference is being recorded, Friday, April 21, 2006.

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

Good morning.

I'm Mark Colin, Director of Investor Relations for 3M, and welcome to our first quarter 2006 business review.

Before we begin, I have a few brief announcements.

As in prior quarters, today's discussion will follow a series of PowerPoint slides, which are currently available on our Investor Relations Website.

Looking ahead, our 2006 second quarter earnings conference call will take place Tuesday, July 25.

Please mark your calendars accordingly.

During today's conference call, 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, that are subject to risks and uncertainties.

Item 1A of our most recent Form 10-K lists some of the most important risk factors that could cause actual results to differ from our predictions.

Also, as we discussed in our 2005 10-K, effective January 1, we combined our Industrial & Transportation businesses into one business.

This new business leverages common markets and customers, as well as common channels, technologies, manufacturing base, and selling processes.

In addition, during the first quarter, the Personal Care and related products Division within the Health Care segment, transferred to the combined Industrial & Transportation segment.

And finally, beginning in 2006, we adopted the expensing of stock options and have elected to restate prior periods.

Our comparisons and historical information included in our press release, and also provided via Form 8-K published earlier this week, have been adjusted for these realignments.

George Buckley, 3M's Chief Executive Officer, and Pat Campbell, our CFO, will handle the formal comments of today's call, and then we will open it up for Q&A.

And now I would like to turn the program over to Pat.

Thanks, Mark.

And good morning, everyone.

Let's begin with some key highlights from the first quarter.

Please turn to Slide number two.

This was an outstanding quarter for 3M.

Sales reached an all-time high of $5.6 billion, up 8.3% over the first quarter of 2005.

In local currency terms, we generated sales growth of 10.4%, including 2.3% from acquisitions, primarily CUNO.

Our organic local currency growth of 8.1% in the first quarter was the highest since the second quarter of 2000.

The real highlight this quarter, from both a business segment and geographic perspective, was the breadth of this outstanding performance.

All six of our businesses delivered strong local currencies sales growth, ranging from Health Care which was up 4.9%, to Safety & Security, which experienced a local currency growth of over 15%.

On a geographic basis, organic local currency sales growth was 12% in Asia-Pacific, 7.9% in Europe, and 7.4% in the U.S.

The timing of the Easter holiday had a favorable impact in the quarter of approximately 1% on our overall growth rate.

And this is not just the sales growth story.

We had an outstanding quarter on the income side as well.

Operating income in the first quarter was 1.4 billion, up 18.8%.

Four of our six businesses, posted double-digit operating increases and this was 3M's 17th consecutive quarter of year-over-year earnings and margin expansion.

Reported EPS came in at $1.17, up over 20%.

Included in this result is $0.02 of option expense for the first quarter of 2006, compared to $0.06 in the first quarter of 2005.

The year-on-year decrease in option expense this quarter is the result of a change in our option vesting period from one year to three years starting with our May 2005, option grant.

Another highlight this quarter was our Board's action in February authorizing a dividend increase of 9.5%.

This marks the 48th consecutive year of annual dividend increases for 3M.

As we commented in our press release on April 4, we are pursuing strategic alternatives for our branded pharmaceutical business.

This business has been very successful.

However, its investment and risk profiles are different than most of the other 3M businesses, and frankly we feel that the best way to maximize value, is to combine it with a dedicated pharmaceutical company.

We've engaged Goldman Sachs to lead the process for us.

As you can tell from these results, we're off to a great start in 2006.

Our performance this quarter gives us tremendous confidence in the ability of our teams around the world to drive accelerated growth, which continue to achieve superior financial results.

On Slide 3, we recap our first quarter sales performance on a geographic basis.

As I previously mentioned, worldwide sales in dollar terms increased 8.3% versus last year's first quarter.

Volumes increased 10.4%.

With core volumes up 8.1%, and acquisitions adding 2.3% to growth.

Selling prices in the quarter were flat, while year-on-year currency and translation, reduced reported results by 2.1 percentage points.

In the United States, sales improved 10.8% versus last year's first quarter.

Organic local currency growth in the quarter was 7.4%, with volume up 5.3%, and selling prices adding 2.1%.

This is the highest organic local currency sales growth in the U.S. since the first quarter of 2000.

U.S. organic growth was strong across the portfolio, as five of our six businesses delivered double-digit organic local currency growth.

Acquisitions added 3.4% to growth in the U.S. in the first quarter.

Sales in our international operations were up 6.8% in U.S. dollar terms.

Local currency sales were up 10.3%, with organic volumes increasing 9.8%, and selling prices decreasing 120 basis points.

Acquisitions added 1.7% of additional growth.

International selling prices continued to be negatively impacted by our businesses that serve the consumer electronics industry.

However, our total revenue growth in our consumer-related businesses, Consumer electronics-related businesses remained very strong.

Currency translation reduced first quarter sales by 3.5 percentage points.

Organic local currency growth was 12% in Asia-Pacific, with Japan up almost 3%, and the rest of the region up 18%.

Acquisitions added 1.8 points of additional growth in the quarter.

All six of our businesses posted positive local currency growth in Asia-Pacific during the quarter.

Europe delivered 7.9% local currency growth, it's best results since Q2 of 2000.

Acquisitions added an additional 1.6% to growth in Europe in the first quarter.

Since Easter is in the second quarter this year compared to the first quarter last year, first quarter local currency growth in Europe benefited from additional billing days.

We estimate the Easter benefit to Europe, it's first quarter local currency growth to be about 4 percentage points.

And finally, we posted 1.2% organic local currency growth in the combined Latin America and Canada.

Excluding the impact of the decline in our CRT rear projection lens business in Mexico, and the move of a flex circuit customer from Puerto Rico to Singapore, the Latin America/Canada regions organic local currency increased 5.2%, led by Consumer & Office, Health Care, and Industrial & Transportation businesses.

The CUNO acquisition added an additional 1.7% to growth in the quarter.

On Slide number 4, we compare our first quarter P&L versus last year's comparable quarter.

Again, note that we elected to restate prior periods for expensing of stock options.

Therefore all numbers shown from this point on will reflect this restatement.

As I previously mentioned, sales were up a strong 8.3% year-over-year.

Gross margins were 51.4%, up 70 basis points from last year's first quarter.

This improvement was a result of a continued focus on driving productivity in our factories, along with volume and mix benefits, which more than stayed ahead of inflationary pressures.

SG&A expense was 21.1% of sales, down 1.1 percentage points.

Despite our investing rather aggressively in areas where there is a clear line-of-sight to revenue growth.

Namely, advertising, promotional programs, and feet on the street.

We kept a tight lid on the administrative expenses in the quarter, and lower management stock option expenses accounted for 60 basis points of the year-over-year.

Excluding options expense in both years for R&D, and related expenditures, it increased 4% year-over-year, as we continued to aggressively invest in future growth for the Company.

Operating margins continued to expand finishing at 24.5%.

Lower cash balances and higher interest rates drove up first quarter net interest expense to $14 million, versus 4 million last year. 3M's tax rate for the first quarter was 32.7%, up just slightly from recent quarters.

Aside from the impact of stock options, the tax rate reflects a 30 basis point increase, due to the expiration of the R&D and orphan drug tax credits on December 31 of last year.

In the event the IRS, or the Internal Revenue Code, is amended to reinstate these credits, the corresponding positive impact would be reflected in our tax rate in future quarters.

Quarterly net income increased 16.6% year-on-year, and earnings per share increased 20.6%.

These results included a $17 million after-tax impact, or $0.02 per share due to expensing of stock options this year, this year's first quarter, versus 38 million after tax, or $0.06 per share in last year's first quarter.

We have provided future stock option expense detail in the attachment to this morning's press release, as well as in the 8-K published earlier this week.

The P&L on a sequential basis is on Slide number 5, and reflects solid improvements in all categories.

Sales were up 5.1% versus the fourth quarter last year.

As five of our six businesses drove positive sequential growth.

We leveraged this increase into a 15% operating income improvement.

Operating margins improved by 210 basis points sequentially, driven by a combination of accelerating sales and ongoing productivity.

On a sequential basis, net income and earnings per share increased 15.2%, and 15.8% respectively.

These results include $0.02 per share impact of stock options in each quarter.

Now, if you will turn to Slide number 6, I will review a few balance sheet and cash flow metrics.

Our net working capital turns were down, reflecting higher volumes, and our strategy to improve customer service to drive further growth.

Many of our supply chains are currently constrained, and we are building inventory in some cases to meet anticipated higher demand.

We have approved additional capital expenditures to increase capacity, but it will take a while before this capacity is in place.

Capital expenditures were 190 million in the first quarter.

We expect our capital expenditures to accelerate throughout 2006 to approximately 1.1 billion for the year, which would be a 16% increase year-over-year.

This acceleration is demand-driven, as our capital needs are to a large extent supporting growing businesses, such as optical films, medical products, commercial graphics, Scotch blue masking tape, roofing granules, respiratory protection products, and Filtrete filters to name a few.

And the rapid growth in developing economies, one of 3M's most significant opportunities for sustainable top line growth, is also fueling the need for additional capital over the next several quarters.

First quarter free cash flow, 435 million, was lower than last year's for two primary reasons.

First, as I just mentioned, we invested in working capital in Q1, in anticipation of continued firm sales volumes.

Second, we made higher estimated tax payments to the IRS in the first quarter, versus the same quarter last year.

Primarily related to our record level of dividend repatriation from foreign subsidiaries back to the U.S. during the last half of 2005, including the portion related to the American Jobs Creation Act.

We paid 347 million in dividends to our shareholders in the first quarter.

Our stock repurchase activity during the quarter was low, as we were out of the market for a while, as we were formulating our decision on the pharmaceutical business.

As a result, our share repurchases were 251 million, with a net repurchase of 151 million during the quarter.

Weighted average diluted shares outstanding were 768.6 million, down 22.3% from last year.

Our debt to cap ratio was 19.3% at the end of the quarter.

Please turn now to Slide number 7, where we will examine our results by business segment.

Please note that we have added an additional column to our business results chart this quarter, to reflect the year-on-year percentage operating income impact from expensing of stock options, to help in better understanding our results.

For example, our Industrial & Transportation business operating income growth was 5.5% higher due to the impact of lower stock option expenses in Q1 of 2006, versus Q1 of 2005.

As I mentioned, it grew from a one-year to a three-year vesting period which resulted in a lower option expense in the first quarter of 2006 compared to the first quarter of 2005.

And now, I would like to turn the program over to George to discuss our performance by business.

George?

Thank you very much, Pat.

And good morning, everybody.

Our Industrial & Transportation business delivered a strong quarter, with local currency sales growth of 14%, including 7.5% from the CUNO acquisition.

Operating income in the first quarter was 381 million, or up almost 24%.

Growth in this segment was led by CUNO, complimented by a strong performance in our industrial adhesives & tapes business, and our automotive after-market division, where innovative products, such as our new paint preparation system, driving growth by improving the productivity of our customers.

The CUNO acquisition continues to meet our expectations, with local currency growth of over 14% versus the same quarter last year, when CUNO was an independent company.

So we remain very excited about CUNO's tremendous growth prospects, particularly in emerging markets.

As we've mentioned in some past quarters, our Personal Care diaper tape business sales has been declining, as we lost volume due to our pricing strategy aimed at improving profitability of the business.

I think it is also fair to say that we didn't invent as much as we should have done in this business, too.

We continue to work hard to recover volume over time, by bringing new products to our customers, that we believe will make it more competitive, but this will take a little while.

The sales decline in our Personal Care business negatively impacted Industrial & Transportation segments growth by 1.4% in the quarter.

The Health Care business got off to a good start for the year with sales of 966 million in the quarter, up 4.9% in local currency terms.

Operating income increased almost 10%, 298 million year-on-year.

Excluding our pharmaceuticals business, which is approximately 20% of Health Care, our first quarter local currency sales were up 6.8%, with operating income remaining at about 10%.

Worldwide local currency sales in our Medical & Dental businesses grew at double digit rates in the quarter.

Both in Health Care, was driven by the strength of our infection prevention, wound care products, our leading technology positions in new products, such as Littmann Electronics stethoscopes, and our innovative dental products, such as Lava Crowns and Bridges digital dentistry system.

Geographically, local currency growth in our Health Care business was led by the Asia-Pacific region, where we focused on driving infection prevention and dental platforms into the rapidly growing health care markets in those developing countries.

Also, during the quarter, we announced that we have successfully closed the acquisition of OMNI Oral Pharmaceuticals.

Adding OMNI's preventive expertise, products, and their capability to educate, will enable us to deliver even more value to dental practices while participating in a rapidly growing segment.

We're committed to continue to strengthen and expand our position in the dental industry.

As we commentated in our press release on April 4, relative to our successful branded pharmaceuticals business in today's very competitive pharmaceutical market place, continued success requires broad pipelines of new drugs, significant investments, and a longer term risk/reward business model, that applies to most of 3M's other businesses.

We believe that the best way for this business to grow is to be free to pursue separate strategies under the direction of a dedicated pharmaceutical industry, company, with a business model better suited to maximize it's potential.

We feel that the business is very valuable asset, and there are more opportunities for technology and market synergies for the company, other than 3M.

So as Pat mentioned earlier, we have engaged Goldman Sachs to lead the process for us, and we'll provide further updates to you as warranted as we work our way through the process.

Moving on, Display & Graphics had another outstanding quarter with local currency sales growth up 9% to $915 million.

First quarter operating income was 296 million, up almost 4%.

As in past quarters, sales and operating income in Display & Graphics was dampened by the continuing decline of our CRT rear projection lens business.

Excluding the negative impact of that business, sales and operating income would have been up a very nice 13% and 12.1% respectively.

Actually in the last quarter's record, the ongoing strength of the consumer electronics industry drove demand for our proprietary Optical films and components businesses.

We experienced all-time record first quarter revenues in the film business, as we posted double-digit local currency growth in the quarter.

This business is driven in part by the strength of the rich intellectual property portfolio that we are continually expanding upon.

Focused capital investments is also being deployed by accelerated commercialization of the next generation of reflective polarizer films, and meet the long-term costs and performance requirements of the growing LCD TV market.

Pricing in our LCD films business remained at a similar rate from last quarter, as a result of normal industry pricing pressure.

Commercial Graphics delivered strong local currency growth in the first quarter, with strong end market penetration, and differentiated products that offer superior value to customers.

And finally, Traffic Safety Systems continued the momentum from the second half of last year, with continued focus on innovative new products, such as diamond grade reflective traffic signs.

Consumer & Office's organic local currency sales growth of 8.1% was broad-based across the portfolio.

The acquisition of [Interramal], a Polish manufacturer of home care products, added an additional 30 basis points of growth in the quarter.

Operating income in Consumer & Office was $136 million, up over 19%.

In Consumer & Office, we continued to penetrate our large key accounts with new products, with unique functionality, along with customer inspired design.

Our Consumer & Office team has developed a strong track record of introducing innovative new products, such as the recent launch of Post-It picture paper, which is being supported by a national advertising campaign.

Our line of next care consumer health care products was another notable growth driver in the quarter.

Our Visual Systems business, primarily analog overhead and electronic projectors and film, continued to experience a decline, reducing overall Consumer & Office sales by 1.7 in the quarter.

Safety, Security, & Protection Service businesses had an outstanding first quarter.

Both the currency sales increased 15.6% to 631 million.

We continue to invest in additional capacity here, particularly for our respiratory and roofing granules businesses, to support higher end market growth.

Profits globally improved 30.3% year-on-year to $164 million.

Geographically, local currency growth was positive across all regions, led by Europe, Asia-Pacific, and the U.S.

We experienced broad-based growth in Safety Solutions, including respiratory, hearing, eye, and face protection, along with robust demand for our cleaning and protection products for commercial and residential buildings.

For the second consecutive quarter, our Electro & Communications business delivered double-digit organic local currency growth.

Organic local currency growth in the quarter was 10%, with an additional 70 basis points coming from our acquisition of Flexible circuit technology, our ultrasound machines on Siemens.

Electro & Communications leveraged this growth and a continued focus on productivity into a 33.2% improvement in operating income to $127 million.

This result was driven by outstanding growth in consumer electronics, where our products such as form-in-place gaskets, sealing hard disk drive covers, flexible circuits, films, adhesives and tapes, for bonding, protection, and vibration dampening, solve the unique needs of our diverse and global electronics manufacturing customers.

We also had excellent local currency growth in our electro markets business, where we offer a wide array of insulating, testing, and sensing solutions, to the electrical utility and infrastructure industries.

If you would now please turn to Slide 8, where I will discuss our guidance for the second quarter and the remainder of 2006.

Looking ahead to the second quarter, we expect business conditions to be very similar to what we saw this past quarter.

We expect second quarter organic local currency growth of 5 to 8%, with acquisitions adding an approximately, an additional 2.5 points of growth.

The second quarter growth will be negatively impacted by approximately 1%, due to Easter now being in Q2.

Second quarter earnings per share are expected to be in the range of $1.14 to $1.17, including $0.08 per share impact from stock options expensing. 2005 second quarter earnings per share restated to reflect stock option expensing of $0.04 a share were $1.06.

As Pat discussed the last quarter, we will have some lumpiness quarter to quarter in our option expense, particularly in the second quarter, due to the requirement of FAS 123-R, we immediately expensed stock option grants for those employees who are considered retirement eligible.

A 3M employee is considered to be retirement eligible upon reaching age 55 with five years of service.

Approximately 25 to 30% of the annual grant award is to these employees.

Since we grant our employees stock options in the second quarter, the immediate expensing of those options granted to retirement eligible employees, results in higher stock option expenses in the second quarter.

Accounting rules did not allow restatement for the retirement eligible impact.

Building on our strong first quarter performance, we now expect full-year 2006 earnings per share to be within the range of $4.50 to $4.65, including a $0.16 impact from options expensing in 2006, and $0.14 in 2005.

Organic local currency growth is expected to be 5.5 to 8%, with closed acquisitions adding approximately an additional 1.5 points of growth.

During the second quarter, we anticipate that we will likely resolve several outstanding items.

First of all, we expect the favorable completion of a number of worldwide tax audits.

Next, we're schedule for late spring trial of the certified class action brought by direct purchases of 3M transparent tape and invisible tape, this pending in a federal court in Pennsylvania, that was disclosed in our 2005 10-K.

And finally, we may incur restructuring charges or other expenses, in connection with our pharmaceutical business process.

In that these items are not currently estimatable, they are not in our second quarter or full-year guidance.

So, before we begin question and answer, let me summarize our results.

This was another outstanding quarter for 3M, characterized by broad-based growth from our entire portfolio, and continued strong leverage to the bottom line.

Quarterly sales reached an all-time high with local currency growth of over 10%, and we delivered a double-digit net income increase, while also accelerating our investments in the future.

We're off to a very strong start in 2006, which gives me great confidence in the ability of our teams around the world to drive accelerated growth, and achieve superior financial results.

In fact, this confidence in our team is what led us raise both our full year growth and our earnings guidance.

This concludes the formal part of today's call, so let's now begin Q&A.

[OPERATOR INSTRUCTIONS] Please limit your participation to one question and one follow-up.

We will pause for just a moment to compile the Q&A roster.

Your first question is from the line of John Inch with Merrill Lynch.

Please proceed.

Thank you.

Good morning.

Good morning, John.

Good morning.

How much of the build in working capital, based on your improved demand outlook and just concern about supply chain capacities, how much did that drag cash flow in the quarter?

John, I would estimate that that number is in the 100 to 150 million category.

And then Pat, based on sort of the way the quarter played out based on your order book thus far in April, should we be looking for cash flow to improve sequentially here in the second quarter, or do you think it is going to have to take a little bit longer to work itself out?

John, I guess if I step back from it from a second, I think you have to be a little cautious looking at cash flow on a quarter by quarter basis, because there will be a little bit of lumpiness.

But I would expect that we should see an improvement in the second quarter.

Meaning Pat, you mean that the associated drag from working capital, you think abates, or are there other variables that you think are contributing?

Each on the working capital side, if you look at Q4 going into Q1, we have probably our largest step-up.

As we go from Q1 to Q2, I would see a smaller drag for working capital.

Okay.

And then were there obvious areas, Pat, when you looked at your very broad portfolio of where there are some capacity constraints or concerns vis-a-vis supply chain and if were you to sort of parse out the working capital build, is there an obvious sort of one or two businesses that are kind of sopping this up?

John, I would say it is quite broad-based.

Okay.

We see it in almost every one of our six businesses would have some element of some tight capacity.

And just as a follow-up, I think Pat, you mentioned Japan up 3%, a big geographic area for 3M, I mean the economy there has been doing better, would you expect up only 3% to improve over the course of the year, based on what you are seeing in the local market?

John, I would say that when we look at Japan, of course there is a big piece of it that is electronics related, and there is customers moving around there, but I would anticipate that Japan will continue to improve through the back half of the year.

And not from a growth rate perspective but from an absolute sort of volume and business activity level, maybe ex-electronics, do you think Japan is getting better?

I think it is going to get a little better.

You're always a little cautious as the Japan economy improves, there is a tendency at times to enact some taxation that may have the tendency to slow it down a little bit.

We will keep a close eye on it.

But at this point in time, we feel very good about the situation in Japan.

Thank you.

Appreciate it.

Your next question comes from the line of Mike Judd with Greenwich Consultants.

Good morning.

And congratulations on a good quarter.

Thanks, Mike.

Your comments about a potential charge in the second quarter, related to a potential divestiture or sale of the pharma business.

Does that mean to imply that you think that there is a good chance that that transaction could occur in the second quarter, and then as a follow-on to that, I was just wondering if you could, a lot of the acquisitions that you guys have done over the last couple of years have been more of a bolt-on in nature, do you envision, you know, taking the proceeds from this potential divestiture and, you know, perhaps making a larger size acquisition?

If so, you know, what type of business would you be interested in?

Well, I think, Mike, the answer to your question is obviously what we're trying to do is to make sure that when a transaction gets done in pharmaceuticals, that we make sure that there are no stranded costs, shall we say in the business, and that's really the, you know, the point that we're trying to make in the comment in the call.

As far as using the cash, obviously we've not finally decided what we're going to do, but you can well imagine that we're not in the business of weakening our Health Care business, we're in the business of strengthening it.

So that's one possible source of those cash proceeds.

Thank you.

Your next question comes from the line of David Begleiter with Deutsche Bank.

Good morning.

Pat, you gave us the cash flow impact of the inventory build, was there an impact on the income statement by building this out, by building inventories?

Dave, there is a little bit, but I wouldn't, you know, that's not the big driver to the improvement this quarter.

But as you do build inventory, there is a little bit of positive effect, but I also have to say that we're operating somewhere in our facilities to the point where we've got a little bit of inefficiency in some of our operations at the same time.

So I would not look at it as being a big plus for the quarter, but I also wouldn't look at it as necessarily a drag for the future.

So we see this inventory level as something that we see higher volume growth for the businesses, and something that we we'll be able to grow our way into here.

And George, not to steal your thunder from May 2, but in terms of your focus on investments and advertising, promotion, feet on the street and R&D, can you give us a little more color on your thought process about ramping up 3M spending in those areas going forward?

Thank you for the question, but I'm not going to rise fully to the bait.

Let's just say, you will see a very logical presentation.

That focuses on not just investing in the core, but perhaps thinking a little bit more thoughtfully about the core, and placing money in some places that we might not otherwise have done.

I do have a bit of a view without saying too much more, and Pat sort of reflected it in his comments, we have a number of businesses in the core, Dave, that are very, very strong, and really needed more investment and more focus, and I think there is a lot more growth to be freed up in those areas of the business, if we can get the capacity on-stream rapidly.

So that's probably the only tidbit that I am going to let out to you at this moment, but maybe I will say one other thing.

Just as a general comment.

You know, as a person like me comes to a company like 3M, anybody for that matter, even when Pat came here, you go through a process of learning, and what has been extremely pleasantly surprising to me, is the areas of trapped growth in 3M, and I think with a thoughtful and vigorous approach to this, we can do a lot better.

And I am just so enthusiastic.

I genuinely am enthusiastic about the opportunities I see here, so I think you will like what we have got to say in May.

I look forward to it.

Thank you very much.

Your next question comes from the line of Jeffrey Sprague with Citigroup.

Thanks, good morning.

Good morning, Jeff.

It was clear from that last answer we're not going to get too much into the strategics on [laughter]

To your question there, Jeff.

We have an oral pharmaceutical deal that happened in the quarter and this small Polish consumer deal.

Was that kind of stuff in the pipeline, George, is that something that you were engaged in, or it just had its own momentum?

And I honestly don't know a lot about oral pharmaceuticals, but why is that different than the medical pharmaceutical business?

Well, I was involved in it, yes.

It was very early in my tenure, but when the opportunity was presented to me, it looked very possible, or very positive, and gave us access to some new channels, but more importantly, I use this phrase Jeff, of filling out the white space.

When you go to a deal with a dentist or a doctor, or even a customer, what you want to become over time is more important to that customer.

So they can't discount you, and so we will have a policy of filling out some of the white spaces in our services and products to this channel, and that was really what the strategy behind that particular couple of acquisitions was all about.

And I guess for Pat, Pat, I'm not totally square on the options impact.

So options in the quarter was a third of the impact of last year, because of the shift from one-year vest to three-year vest.

Does that mean, as we look out into '07 and '08, your option impact builds to a larger negative number, or do we kind of see, you know, the full scale run rate here?

Well, Jeff, what you will see is a bigger Q2 number.

On the FAS 123-R.

On the R piece of the standard.

And then over time, our stock option expense will build until, you know, we get to kind of a full effect basis, you know, two, three years out.

So we should be thinking $0.50, $0.16 times 3, kind of a full-year impact?

Not at all because effectively you take a big piece of that during that, the grant piece of it, during the R phase of it.

Okay.

And can you just give us a little color on cash taxes for the year, in light of what you said about repatriation?

Well, anybody who has done tax planning realizes it is a highly, it is kind of a difficult area to forecast, because what you're trying to do is to of course maximize timing and so forth.

But we've had a number of favorable years here where we've had, you know, favorable cash flow because of tax timing.

It is a little bit hard to anticipate, but for the year, with what we did in the first quarter, I would say taxes may be, you know, a little more neutral maybe than negative, slightly negative for the whole year.

All right.

Thanks a lot, guys.

Thanks, Jeff.

Your next question comes from the line of Dmitry Silversteyn with Longbow Research.

Good morning.

Congratulations on a very good start to the year.

Thank you.

A couple of questions.

Number one, we're continuing to see the operating margins expanding here quite significantly on a year-over-year basis.

I was just wondering, basically a couple of questions there, first, what is driving that?

Is it price increases as raw materials stabilizing, is it the impact of Six Sigma and other initiatives you have internally?

And then secondly and kind of coming out of that question is, how sustainable is this improvement?

Should we be looking at margin expansion as a characteristic for 2006 and beyond, or are we coming to the end of I would say, above normal margin expansion which later on will be limited to just, you know, your typical volume growth and incremental improvements.

Good question, Dmitry.

I will get into this, George and I will get into this a lot more at the May meeting.

As far as, you know, into the future.

But, if you take kind of a look at here and now and the rest of the year, what we've got is volume is accelerating for us, we have a kind of business that has very, very strong incremental margin capability to it, our gross margins are high, and we have an initiative to basically keep our overhead costs basically flat as volume expands, so that gives us some margin enhancement and our mix is improving.

It is a combination of everything.

It is not just a one-trick pony here.

The reality is we got volume, we're getting mix and getting productivity and oh, by the way, we are investing in the future, as well.

So those areas that are needing the investment, we're investing in the emerging markets, we're putting more money in the consumer and office business, relative to advertising, promotional expenditures, it is kind of the nature of our business, that with the gross margin structure we've got, and the positions we've got in many markets, that we are very, very strong.

So our incremental margin capability in this company is very, very strong, and we expect that we will be able to keep that going in the markets that we're currently serving.

If you add, Dmitry, to that, the international growth, strong international growth that we see, incremental margins in those businesses too are very encouraging, let's say.

Okay.

So as they're getting to critical mass, if you will, there is a pretty good leverage there in terms of profitability?

Yes, we have a little bit of a more of an unusual situation than our OUS.

Our international business is a very, very profitable business.

That is unlike some others who have a tendency to put a lot of investment in, and then really struggle to make money.

Our approach in international thus far has been one that is kind of build your way up, and you're profitable very early on, and then as volume grows, you have got very good leverage in those businesses.

And if I could look at the proportion of our sales, and the relative growth rates, and the relative margins, they help us tremendously.

I understand.

And then, you know, to kind of comply with the moderator's request for just one follow-up question, if you look at some of the sunset businesses that you have, the CRT rear projection lens, the overhead projectors, the commercial media, recording media, and so on, that have been providing some of the headwind to the display and graphics, and to the Consumer & Office businesses, where are we in terms of anniversarying the worst of this impact?

Or is this going to be an ongoing thing?

And is it ever going to come down to where you need to do some write-downs and some, you know, whether it comes in goodwill or asset write-downs, to acknowledge that these businesses are not what they were, you know, two, three years ago?

I guess to answer that question, if you kind of take it piece by piece, the rear projection, the rear lens business within Display & Graphics, that one will start to flatten out here a little bit by mid-year.

At, a lower run rate.

The video business is, I think we're fundamentally out of that, as of next quarter if I'm not mistaken.

And then the overhead projector of the analog business within Consumer, that's still a pretty sizable business.

And we're a big player in that market, and we're trying to do some things from a cost structure standpoint to improve the profitability, but that business will be, you know, on an eroding path, but at this point in time, we don't see any impairment charges for these businesses.

Okay.

All right.

Thank you very much.

That's it.

Your next question comes from the line of Jack Kelly with Goldman Sachs.

Good morning.

Good morning, Jack.

George, you had mentioned in Display & Graphics, X-CPT, I think you mentioned revenues were up 13%, operating income up 12, which doesn't look like, you know, just getting back to the incremental margin discussion, it doesn't look like there was much if any, maybe detrimental margins.

Can you just explain the dynamics there?

Because you mentioned film pricing hadn't really gotten any worse, so that would be one possible reason for it, but just why wasn't there more earnings leverage?

Well, there are a couple of things going on there.

One the most sizable ding in that area was the precision optics.

This is the CRT rear projection lenses.

They were essentially be the lion share of the difference that drove that earnings contribution down to the 3.9 number, or whatever it was exactly.

So there is nothing other, there is not another big story there.

We, you know, we just saw great growth in the films business, and that was really the big, you know, the PO business was the big headwind.

Okay.

And on the film side, any signs of new competition, GE has talked about getting into this business for maybe two years or so, have you seen any further signs or any signs of that happening?

Well, I think the short answer is no.

It is an interesting issue, this one, and one of the things I would just take a minute to explain, one of the things that has so impressed me about 3M, people think about 3M's technology is the big thing that we celebrate, but I will tell you that 3M's manufacturing capability is absolutely superb, and as an engineer when I go to some of these places where we make films, whether it is the [bes] films or the [Dbes] films, the quality level and the precision, the preciseness of the manufacturing processes, and the difficulty to control and to bring out quality products is very, very large.

It is only speculation, to be honest you with Jack, but I think that those people who covet getting into these businesses, because they see success, they see growth, are finding it a lot more difficult to manufacture products at the precision level that 3M does on a relatively routine basis.

It is a lot harder than people think.

And I think that's the reason that we haven't seen those products out there in the marketplace, making any real kind of progress.

One thing to talk about, it's another thing to do it.

You mentioned double-digit growth.

And that represented an acceleration in the first quarter over fourth, with regard to LCD film?

No that was a year-over-year.

If you look at it sequentially, it was pretty well flat in dollar terms, but up in volume.

So the rate of change in the first quarter was the same as the rate of change, first quarter over first quarter, the rate of change is the same as the fourth quarter over fourth?

No, that is not what we're saying.

What we're saying is, that the rate of change, fourth quarter to first quarter, okay, it is basically somewhat flat, okay?

From a revenue standpoint, but we had did have good volume, good volume growth.

But if you look at year-over-year, we continue to have double-digit.

So you have to look at, you know, what the prior year did at the same time.

And as you recall, there was some lumpiness to last year's performance in that business.

That business, by the way, just seems to, it just continues going from strength to strength.

There was a lot of speculation after Christmas that we may see some cooling of the marketplace, but it didn't really happen frankly speaking.

Good.

And then just secondly, on raw material pricing, you gave us some price increases for various reasons, can you just size what has been happening to the cost of raw materials, the raw materials cost index versus what pricing has been doing in the last quarter?

Well, our overall pricing was flat, so any kind of inflationary headwind of course would then be kind of a negative on that calculation.

Our raw material inputs are probably running about 4% this year, which is down somewhat from last year.

So we've been able to manage against that, in you know, other sourcing programs in the non-raw material area to bring down costs, and if I look at probably sourcing in total, we're probably closer to being flat year-on-year, but if you look at the raw material input piece itself, it is probably up about 4%.

So given the flat pricing, if you are saying overall inputs are flat then there should not be any more erosion from the cost side?

No, that's right.

Okay.

Thank you.

Your next question comes from the line of Mark Gulley with Soleil.

Good morning, everybody.

Good morning.

I want to come at this optical films business again.

If I take a look at one of the leaders in the components area here, Corning says about this business, they think that their glass volume could be up 50% this year, and maybe 25% next year.

Are you benefiting from those kinds of volume trends, guys, or are there some disconnects out there in terms of pricing, or continuing de-contenting in terms of desk top monitors, that prevents you from enjoying the 50% volume gains that Corning is talking about?

Let me try to tackle this, and then George can pipe in if he wants.

Don't forget Corning is playing in the LCD TV section of this market, so when we talk about films, we're talking about monitors, handhelds, notebooks, and TVs.

So you won't necessarily see our growth rate being the same as theirs, because the highest growth segment there is on the TV side.

So I don't think there is a disconnect.

It is just that you won't see a one-to-one correlation, because they're playing in a piece of that segment that, you know, that is covered by our Optical film business.

Of course, LCD TVs are growing as a percent of the overall mix, but notebooks, handhelds, and cell phones, and so forth, are still a very big piece of that, a big piece of that picture.

Except the growth rate in the notebooks are more mature.

They're in the teens, for example, where as the LCD and plasma TVs are growing very, very rapidly.

So it is just that their growth segments are concentrated in that one piece, whereas ours is more broadly based.

So are you implying that you're not participating in optical films for TV?

No, no, no.

What we're trying to do is we're trying to do is, if you take Corning's 25% number, we've got participation in that 25%, and another segment that grows at 17, another segment that grows at 16, and a more mature segment that might grow at 5, so when you blend them all together, we are by all means participating in the same things they are, it is just we're spread across a broad spectrum that has a different profile of growth rates.

Maybe I will come back offline, but overall Corning is talking about their overall glass volumes for all sectors being up 50% this year, and 25% next year.

So it is an all-in number.

It reflects their total business.

If I could follow up with a second question with respect to margins, Pat, I wanted to make sure I understood the impact of that right-hand column on your page 7.

So you're saying, for example, that let's take electronic communications, that while you posted a 33% gain in operating income, that gain would have been less by 7 percentage points.

That is correct.

And the reason we did this, Mark, is just so we had transparency as to what the impact is.

Let's say for the second quarter beyond, will that increase, will these benefits to operating income growth decline substantially?

It will flip, in Q2, specifically, you will see it flip the other way, we will actually have a drag in the quarter, because of our piece of the 123 requirement that we will have a bigger drag, because in Q2, we will have $0.08 of stock options in '06, and we have $0.04 in '05 in Q2, so we will kind of flip around next quarter.

I don't know if you can tally up these numbers, but if were you to tally them up, what is the overall margin hit from options, I'm sorry margin benefit from options in the first quarter, and what would be the drag in the second quarter?

Well, the --

I'm thinking in terms of percentages -- I'm thinking now in terms of percentage gain in Op income.

It is about a percent.

It is 1% is the impact in the quarter-over-quarter comparison.

Because we've got 0.4 of a point hit in '06, and we had 1.4 points in '05, relative to stock options on the margin basis, so that's a 1-point differential between the two periods.

So plus 1 swings to at least a negative 1 in the second quarter you're saying?

It will swing, not quite as much, because it is only half of the rate between the two sides, so I guess you can kind of do the math, you know, you got $0.08 in the second quarter, and we had $0.02 here, so it will be about 4 times, 4 times the size on the margin side, and then for the second quarter of '05, it goes from $0.06 this quarter to $0.04, so that actually drops down.

Okay.

Thanks for the help.

Okay.

Your next question comes from the line of Jeff Cianci with UBS.

Couple of quick follow-ups.

One was on the display film.

Is the volume growth greater than the price decline in percentage terms?

Are we coming out ahead there?

I'm sorry, Jeff, are you talking about overall?

What I'm thinking first, optical films.

We're definitely coming out better off overall.

With the volume in that segment, we are definitely ahead of the game, relative to you know, what we have to trade off relative to the pricing.

I just want to clarify based on the last answer.

And if you take pricing, if you take kind of the consumer electronics out of pricing, I want to get a sense for 3M's overall pricing power, it looks like international was tougher pricing, was that because of consumer electronics?

Or how can you break down the ex the perennial electronic price decline, how the company overall pricing power is doing?

Pricing power is doing fine.

We are doing very well.

And again, the negative piece, okay, that actually brings us back to flat is because the consumer electronics piece of the market.

Otherwise we would be up, okay?

We have positive net margins.

In most of the rest of this, our businesses would be positive, okay, if you take the consumer electronics piece out of it.

If I did the price index going backwards, is this on-par with recent quarters, or an acceleration in pricing?

Well, if you go back, if you go back, Jeff, we had more pricing last year, which was a conscious strategy around the much higher raw material inputs that we were seeing going into last year.

So we had, if you look at it on a year by year basis, we had higher pricing last year, and of course we kept that pricing this year, and in many cases, we've added to it.

So we're getting continuous benefit of that.

But last year would have been a little bit of a higher point for us, because we had to, to offset some of the raw material pressures we had.

And finally that difference between U.S. and international pricing is that because consumers -- ?

The consumer electronics piece is almost exclusively in the international numbers.

Okay.

Great.

Thanks.

Good job.

See you in May.

Thanks, Jeff.

Your next question comes from the line of John Roberts with Buckingham.

Good morning, guys.

Good morning, John.

Clarify the Corning comparison earlier, correct me if I'm wrong, but I don't think any of Corning's glass goes into the handheld market.

See, I'm not an expert on Corning, so, so you know, as to how far they penetrate some of the other markets, and what kind of shares they had, I know they're a very big player in the LCD TV market.

I didn't believe they were a big player in the handhelds, but again I'm not the expert to kind of answer exactly what Corning has and they don't have.

We're just trying to draw a little bit of a comparison, and I think their mix is a little more toward the LCD TV side, than what our film business currently is.

And I think anecdotally John, I've heard exactly the same as you, that they are more heavily penetrated in the TV segments, than they are in the handhelds or the phone segments.

You know, as we said earlier, we're doing extraordinarily well in the TV segment, doing just as well as we've always done.

But some of these other segments are more mature, and don't grow quite as fast.

So when you blend them together, depending on the mix of products, clearly you're going to get a different number.

And then secondly, the minority interest line item which is normally driven by Japan, the Sumitomo joint venture, that was 13 million versus 15 a year ago for the 25% that Sumitomo has.

Why is that down?

Is that currency or --?

The biggest impact in Japan right now is the yen.

So effectively, it is the, you know, the translation impact of the Japan result.

What would be that, on a currency adjusted basis?

They would actually be up, I think if you adjusted for currency.

Okay.

But you know, I don't, offhand I don't know the exact number, but I would guess it would be more flattish.

Thank you.

Your next question comes from the line of Bob Cornell with Lehman Brothers.

Good morning, everybody.

Good morning, Bob.

You know, correct me if I'm wrong, if you could reiterate your free cash flow guidance for the year, if you didn't, what is it, please?

Well, I don't have one, Bob.

That's why we didn't give it.

We've given you an earnings forecast.

We have not given you a free cash flow guidance for the year.

The last couple of years, we've been running a little bit over 100% of net income.

So positive conversion.

The last couple of years, you've been specific about that in guidance.

You are just not making that statement this year?

We have not given free cash flow guidance in the earnings calls, as we have Investor Day, Annual Meeting, we've had, you know, kind of given you a feel for what free cash flow will be, and you know, will possibly look at that here in May, but right now, probably our conversion rate will be a little less this year than it has been the last couple of years, because of two primary factors, our taxes will be worse off this year, because we will be probably in more of a payment situation, and then we are as we grow, we do require, you know, receivables grow, and inventories do grow, so that's one of the kind of the offsets here.

And to some degree also depends where they grow, overseas, where you've got the receivables, the numbers tend to be a little bit bigger than they are in the domestic market.

Both of you guys, I mean I know you're going to elaborate on the growth message in May but when you pre-announced this quarter, I think there was a comment in there that said that there was spending on growth that it's been really expanded in the second half of '05, and I think you referenced a little bit of that in the Consumer & Office today and maybe you could expand on that, and George, maybe comment on how you see some of those things going forward?

When we looked, if I back up a little bit, Bob, toward the tail end of last year, it became very obvious to us that the solution that we had to drive in the Company, we had great margins, we had great incremental margins, we had to get some more top line growth, so we had been putting in place a number of both initiatives, headed at every one of our businesses, and including emerging markets, and I think you're starting to see a little bit of that, but we have a lot more to go here, and you will see a lot more of that when we kind of disclose this in the May meeting.

So part of it's programs.

Part of it is also trying to free up some capacity.

So we can actually go after some more volume as well.

And also, on the expense spending side, if you could imagine, Bob, we are aligning our portfolio, so based on some of the decisions we've already seen this announced, we are edging spending down in some areas, and edging spending up in others, when they net out together, they may not show a big difference, but we are taking some very careful strategic positions behind those kind of number of movements.

I will be interested to hear what those are.

Just one other comment, George, when you look at the portfolio, you know, you clearly have made the decision to exit pharma.

And you mentioned the excitement around manufacturing a little while ago.

Could you give us a little broader picture of your view of the portfolio outside the pharma, you know, how you view the business now having had a chance to look at it all strategically?

You mean all of the business or just pharma?

Everything else besides pharma.

You look at pharma and you made that decision.

You've made the comments about manufacturing and core strength, but what about the other of 3M's business, do have you an overview comment there?

Well, we obviously will talk about it more in May.

But you will be interested to see, when we show you how the portfolio is represented, and how it all links together, you don't end up with that many pieces that you want to say goodbye to, but as was mentioned earlier, there are some sunset businesses, there are some other businesses that are being considered, first to decide whether we do or do not keep them in the portfolio, but I do not think you should expect a wholesale nuking of our portfolio.

In fact it is the complete opposite.

We have such good core businesses, and the route to growth here is not just to take away those businesses that have not been growing, it is to invest in those businesses that can, and that's maybe where we've been a little remiss in the past.

But it is a very positive message.

Looking forward to it.

Your next question comes from the line of John McNulty with Credit Suisse.

Good morning, guys.

Just two quick questions.

Europe looks like it is the strongest it's been for you guys in quite a while.

You can give us some color, in terms of the trends you're seeing there, where the strength may be, and if we can expect it to accelerate from these levels, or if we should be really just be looking at this kind of growth going forward?

John, I think you guys have heard me in the past on Europe, and I think you have to look at west versus, you know, the emerging piece of it.

Very, very clear the emerging piece is double-digit growers, and that's where, you know, we're putting a lot of resources in to build up the capability in that part of Europe.

Western Europe has had a very gradual improvement in its growth rate.

We reported, you know, 7% plus for Europe as a total.

And a piece of that is Easter.

So we have to be a little cautious.

The underlying growth rate is more like 4%.

In Europe.

But they're helping.

Europe is starting to help the Company from a growth standpoint.

But I still see, you know, Western Europe as an economy is going to be a relatively lower growth economy, but that doesn't mean that we don't have some other opportunities to try to go after some additional business within Western Europe.

We've got our teams focused on identifying more business opportunities, because I do think we have some more growth potential, but to say it is going to continue to grow from here, I wouldn't, if it does, I would be very happy, but I would also be very happy for the time being if we can get, you know, very solid 4% kind of growth out of the west side, the western part of Europe.

We've seen negative numbers in many courses over the past few years, and to see positive numbers is very encouraging.

I will tell that you that in a couple of big western European country, we've made relatively recent management changes that have been very, very positive, and Pat and I have had a lot of close work with those people, and they absolutely have the bit between their teeth, and are infused about growth.

And now to put it into perspective, I don't think we're going to see the Asia-like growth numbers but I do believe that there is reason for optimism in more growth in Europe, and if we can do the same sorts of things that we're doing in the United States in Europe, then I think Western Europe growth rates will move up a little bit.

But as Pat said, let's not, sort of, get stars in our eyes.

Okay.

That's helpful color.

Second question, would just be on the raw material front you had indicated that your kind of raw material index or so, was up roughly 4% in the first quarter.

With crude prices surging to the mid-70s at this point, I mean what would should we be thinking about for the second quarter, and looking forward?

Well, I can just tell that you we will be very active in discussions with the suppliers, trying to hold the line here.

There are two sides of material for us, though, John.

One is price.

The other is availability.

We have certain commodities that trying to protect availability is more crucial to us, than price is.

And you have to work on price over time.

So it is a delicate balance game.

Crude oil prices going up definitely okay, they are not advantageous to us.

But we've demonstrated over a number of years here, that we've been able to continue to fight back on the total material front, you know, to try to keep costs down as well as improve our margins at the same time.

So I feel pretty comfortable that we have got a good strategy in place.

We can always be a little bit better.

Obviously, I would like to see oil prices down rather than up, and somewhere in the products that we do get are by-products so it will have a little bit of an impact, but I think it is manageable within the guidance that we've given.

And also, to put some more color on it, the total amount of the commodities that we purchase are affected by crude, it is only in the teens of our total purchases.

So it is not 80%, or 50%.

It is a noticeable amount, but it is not a huge amount.

That's great.

That's very helpful.

Thanks a lot.

The next question comes from the line of Dana Richardson with Argus Research.

Good morning.

Congratulations on an excellent quarter.

Thank you.

I just wanted to clarify the issue of stock option expense.

Going forward into 2007, I wasn't sure whether or not you were indicating that it would be more or less than $0.16?

I don't have the number, Dana, with me, but it would be more, okay than $0.16 going into '07.

We have not provided an '07 number yet.

Okay.

I was just interested in the directionality.

But it definitely will go up.

And what exactly, I think you alluded or mentioned this in your prepared remarks, but what was the margin expansion, operating margin expansion, excluding the effect of option expense year-over-year in the quarter?

You said operating margin expansion excluding --

I know you had the 220, 220 basis points --

Basically, you take a point off of that.

So --

Oh, okay, I got it.

As reported we're 220 basis points, you take a point off of that to back options out, so it would be up 120 basis points.

Okay.

And finally, I wanted to ask you, it seems that your increased guidance for local currency organic growth, implies an increase not just due to the fine results you had in this quarter, but also an increase going forward in the rest of the year.

And what gave you the confidence to do that?

Well, having a good quarter helps a lot.

We had very good momentum in the first quarter, and really what helps is it is very broad-based.

It is not one business that is carrying the water for the team.

You know, really everybody is doing it.

We're seeing good growth in all businesses.

And as we look, as far as we can see, which is really relatively a short period from a customer standpoint, we still feel very good about the demand side.

So are you saying that your orders going forward were improved over your previous expectations, or is it more of a macro economic thing?

Dana, I guess two things.

Of course one thing is we look at the macro economic environment.

We look at where our customers are going, and so forth.

And also of course as our performance improves, I think we get a little more momentum.

We've freed up some more growth funding inside of the Company.

We've got some more programs out there.

So I just feel better overall as to where we're headed from a growth standpoint.

As a company, you know, and of course, the economy will be a determinant as to where that goes.

And there are also soft factors, Dana, that is I think an improved psychological feeling, probably because people are more attracted to growth than they are on just squeezing the lemon, and when you see this happening in Western Europe, as well as as well as Japan, when you see it happening in pretty much every business that we own across the board, it lends confidence, I think, that there are better things ahead.

You know, you're always trying to be careful about not setting your expectations so high that you end up being disappointed, but I think Pat and I in looking at this business, and looking at the various segments that were in here, we are very encouraged by what we see for the future.

So you're saying that there has been a psychological reorientation within 3M towards more of a growth focus?

Yes, I think that's true.

And I guess Dana, I will support that, because George's history here is a little shorter than mine, but yes, I think that is fair to say.

We have turned the psychology inside the Company noticeably away from productivity initiatives, which by the way have not gone away, okay?

We are continuing to drive those, but we have spent enough time investing in those that they have become more of the fabric of the Company, so we haven't had to spend as much dedicated resources for that, and we've really turned our attention more so to the growth side, and as George says, you know, growth is far more exciting to work on than productivity is, but the reality is every company is, you need a backbone, you need a balance of both, but we've moved the needle I guess a little bit more right of center, if I could, on the growth side.

And people are --

Okay.

And I think that's very good.

I mean that's what you have said were you going to do and I think that's what everyone was waiting for to you do.

So congratulations again.

Thank you.

Thanks, Dana.

Your next question comes from the line of Steve Tusa with J.P. Morgan.

Good morning.

Good morning.

Just a question on that growth side, I'm wondering, you know, the upside growth that you're seeing and maybe the modest increase for the year, how much of that, you know, you've talked about shifting the mindset, is that kind of, I know we are going to hear a lot more about that in May but how much of you know, kind of the growth that you're seeing this year as a result of that?

Because you know, R&D continues to decline, as a percentage of sales, and you used to be up in kind of the 7%, 6.5, 7% range historically, I'm wondering when we should start to see that move up as a percentage of sales?

Well, let me, and I will let George kind of wrap up because Steve you're the last one here, you know, it is hard to quantify what the specific impact right now is from a growth standpoint.

So it is definitely on the positive side.

Addressing the R&D question, we just have to be careful, growth is more about, it is not just R&D, okay?

Growth is investing in the right places, the right markets, the right businesses, R&D of course is a critical element of developing, you know, products, technologies, for the long term.

But you also have to be cautious that as to just looking at the ratio to sales, I'm not so sure it is always the right level.

We are going to be growing our R&D costs, but as our revenue grows there is a question, does it have to be one for one.

As we develop products, and we get great ideas on the table, if it requires an increase in R&D, we will do that.

But there is a lot of other things that we can invest in as well, to drive growth in the business.

So it is not just a one-dimensional growth story.

There is a number of elements to this.

And one of the things that we're working very hard on right now is the whole supply chain capacity side, to make sure that we really have enough capability to really drive growth going forward, Steve.

So I will turn it over to George.

I will just make a few remarks.

I was just going to say Steve, that it is not only what you spend, it is where you spend it.

And that's something that is a general comment.

I already made a remark earlier that we've done some rebalancing of where we spend.

We're trying to figure out the right way to handle our pharma sale, and the IRN sale that we have been working on.

And so we, there have been sort of shifts between left pocket and right pocket there that don't necessarily show up in the total, but do show up in emphasis.

So some rebalancing.

Just a very quick follow-up, Pat, and you know, you've talked about how you guys didn't really have the right mindset on growth.

Do you feel like in the marketplace that's kind of impacted the, I think market share is a very loose term, but, you know, your kind of share of mind with the customers?

Is there any kind of long term impact from not having the right growth mindset, I guess is the best way to put it?

I guess, Steve, the way I look at it is first of all, what we had to do was to convert inside.

Inside the company to be a little more aggressive on the outside.

I think it will play out very, very positively with our customers, as we become more important, and we get a little more excited about growth.

I think the customers will see this, the same thing.

I was going to add one other thing.

And I didn't quite finish my list of things I was going to outline.

If you are able to do a survey of the people in the R&D organization here, I think you would find a much more positive attitude, a much stronger spring in their step.

We have been preaching the growth mission inside.

We've been preaching the need to continue it with investing in R&D, and the way that we have always done.

We've emphasized to people here, that it is the engine of our growth, it will remain the engine of our growth, and I think this seems to have created a lot of enthusiasm in the R&D community here, and that kind of confidence springs then into ideas and a sense of freedom, and builds momentum, and eventually you get stuff coming out of the other end of the pipe, but just to overlay that, what we got to do is synchronize our ability to produce products or invent products, with our ability to produce products as a result of capacity.

Great.

Thanks a lot.

Looking forward to May.

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, thank you for joining us this morning.

I would like to remind you of our 2006 Investor Day meeting on May 2 at the Waldorf Astoria Hotel in New York City.

Looking ahead, we expect continued strong sales and earnings growth through the rest of 2006.

For the longer term, we see tremendous opportunity for the great people of 3M to transform our many strengths.

Innovative technology and products, broad geographic presence and capability, and established positions in many of our fast-growing end markets.

And to even greater and sustainable growth.

Thank you.

And I look forward to seeing many of you on May 2.

Ladies and gentlemen, that does conclude our conference for today.

You may all disconnect.

And thank you for participating.