3M (MMM) 2006 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the 3M second-quarter 2006 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. (OPERATOR INSTRUCTIONS) As a reminder, this conference is being recorded Tuesday, July 25, 2006.

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

Good morning.

I am Matt Genter, head of Investor Relations for 3M, and welcome to our second-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.

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-Q lists some of the most important risk factors that could cause actual results to differ from our predictions.

Both George Buckley, our Chairman, President and CEO and Pat Campbell our CFO, will make some formal comments on our results and forward outlook, and then we will open it up for Q&A.

Now I would like to turn the program over to George Buckley.

Thank you, Matt, and good morning, everybody.

Clearly this quarter was a tougher one than last one, and I want to get right down to explaining what went on.

Let me begin by stating how disappointed we were in our performance and that no one in this call is more disappointed in it than me.

The rapid impact of the optical films inventory correction clearly accounts for the lion's share of the shortfall this quarter.

You also saw this pattern repeated in the earnings of the many LCD OEM manufacturers that we supply our products to.

We had three things which happened in this optical films business this quarter.

First, sales of monitors where 3M has traditionally had high attachment rates and good margins, sharply declined.

Desktop monitors have matured and are becoming commoditized.

Second, we had a simultaneous inventory correction in the channel for LCD TVs.

And lastly we had a troublesome startup of a new optical film plant that makes the best film product.

The new plant first went live with commercial products at low-volumes in November of last year and helped to service the market as LCD TV production accelerated.

It had difficulty manufacturing consistently excellent film and the new line was shutdown for much of April due to a mechanical failure.

The film line was quickly repaired and has been running since the first of May.

Overall the startup is being challenging and yields are by our standards very low.

It is important to note that the plant has been delivering significant quantities of high-quality film to customers and we are able to screen out film that does not meet specifications prior to shipping.

It is hard to separate all the contributor costs here but we estimate these issues are costing us a couple points of margin in this business.

These plants are very complex and the manufacturing processes to get high yield, consistently high-quality product is very challenging.

This is why it is so hard for us to enter these high-performance optical film markets.

It is not at all unusual for these things to happen during plant startups.

I would state here that even with the yield challenge we have more than enough capacity to meet anticipated customer demand later this year.

This plant was added to increase capacity in anticipation of growth as well as to significantly reduce manufacturing costs, the large format films for LCD TVs.

Longer term as larger formats get more popular, this is an important strategic advantage for 3M.

The dynamics of this rapid change in the consumer electronics field are well known.

We have been heretofore blessed by strong growth in LCD TVs and monitors, driven by early adopter purchases of these products.

In my view we are beginning to see the LCD TV market changing gradually from a pure early adopter mode to the more traditional seasonal cycles seen in other consumer electronic purchases.

The inventory correction that took place in the channel may therefore have been exaggerated by these seasonal pattern changes.

The people unfamiliar with these markets, the sharp falloff seemed unusual and surprising, but let me explain how these markets work.

This is a market where the end product has a life cycle of only 9 to 12 months, and the price of that product is declining by 20 to 25% annually.

So if the retailer and manufacturer do not correct the inventory ASAP if they see excess, perhaps only in one quarter, the end product is potentially obsolete and worth considerably less at retail than it was previously.

Consumer electronics are not like wine.

They do not get better with age.

The environments are relatively low margin for OEM manufacturers of these products is absolutely vital that they do not become the victims of excess inventory.

This all explains why in these kinds of markets inventory corrections can be sharp and disturbing.

Even if you have the best sales and operating planning process possible, precise predictions of volume is hard.

But they are just that, corrections.

And the demand changes can be just as high in the opposite direction, especially if seasonality creeps more vividly into the picture.

It does not signify that somebody in the management of these companies was asleep at the switch.

Things simply change tremendously quickly.

From our perspective it also tells you why it is critical that we continue to invest in order to diversify our offerings.

In the optical systems division and throughout broad 3M portfolio in order to prevent a potentially cyclical business from becoming too large a portion of our revenues and profits.

This is absolutely essential.

We do not know precisely how long it will take for the excess retail inventory to bleed off.

According to display search, channel inventory for LCD TVs is dropping rapidly.

The correction at our end of the channel will continue for a little while longer.

It began to accelerate rapidly for us in mid-June, and I think that it will likely persist into the middle of the third quarter.

Another unknown right now is where the mix of optical film margins will eventually settle out.

Pricing pressure in this industry is enormous.

While I expect margins to remain attractive and to additionally offset some of the downward price pressure with ongoing cost improvements, given the poor state of the monitor market the reality is that we will be somewhat lower in mix than in the past.

Nevertheless, despite all of what I've said this optical films business continues to be a jewel in 3M's crown and provides a high growth opportunity for the future.

3M's capability remains unmatched in this category; both our technology and our manufacturing.

And despite the onset of seasonality going forward, we believe the second quarter will be the low point in the year.

Revenues will again increase in the third and fourth quarters in anticipation of the holiday buying season.

I can assure you that the issues are in our control, specifically things like the scale up of the new multilayer film manufacturing line to increase capacity are being addressed immediately and forcibly.

They will be resolved as quickly as possible.

I mentioned in our May meeting in New York that we significantly underinvested in our core.

This type compounds the transition issues we face both in cost and targeted growth rates, and finding the right balance in this transition requires a lot of finesse and care.

Internally we are working on new ways to stretch our capital dollars much further than was once the case so we don't induce a glut of capital spending coming forward.

Unfortunately under investing in the past has created some challenges in the present; putting aside the aforementioned optical issues manufacturing costs in the second quarter increased in a handful of divisions, and in many cases we can point to under capacity as the root cause.

For example, in our roofing granules business we are short of capacity in facilities that serve the still hurricane torn areas of the Southern United States.

We are still supplying our customers but we must do so from farther away locations, and we are contractually obligated to pay the huge extra freight bills to get the rock to their shingle manufacturing sites.

Nor are we allowed to pass through the cost of raw materials as copper used to color granules.

Copper has tripled in cost this past 12 months or so.

These two factors alone cost this business several hundred basis points of operating margin in Q2.

Moving now to SG&A, investment spending also increased this quarter.

This would not have been a visible problem for us but for the optical issues I mentioned earlier.

Our enthusiasm to invest in sales growth contributed to this increase, and we overshot our targeted spending mark.

But because this increase was self-generated it can also be self-directed and is being corrected as we speak.

We also saw continued trend upwards in inventory that began back in late 2004 that has to be bled off over the next few quarters.

We did this to attack some full-service issues.

These service issues are a function of very long and convoluted supply chains we built over our long history and over the next few years we will gradually unravel that puzzle and change the supply chain footprint to better reflect our customers' service needs.

This inventory challenge was exacerbated in the second quarter by the shortfall in optical system sales but also by the sluggishness we saw in visual systems, automotive and diaper tape sales.

Which I will mention again in a few minutes.

Even as we make necessary corrections, the enthusiasm for growth that we shared with you earlier in the year has not waned one iota.

Emerging growth mindset at 3M continues to gain momentum and will continue to dominate our plans and our path going forward.

The company makes the kind of change in emphasis that we've been making to encourage growth; it is always a challenge to get the early balance right.

Investments in new products and supporting channel investment always happen a little before the sales growth and earnings improvement can be measured.

Overall, if you exclude for a moment the shortfall in optical film sales, our growth rate would be well within our targeted range for the quarter.

I can assure you that our growth plan is gaining momentum.

And the trick here will be to avoid getting distracted by short-term events and not losing our focus on growth.

We achieved this growth despite significant quarterly contractions in some sizable noncore businesses.

For example, sales in our visual systems business were down 18% year-on-year, and revenues declined by 8% in our diaper tape business.

This latter case is a classic example of a business which did not invest in its own future and suffered the consequences.

We are now busily inventing our way out of this problem, but again it takes extra time and money to do it.

The fact is that progress is evident in each main element of our growth plan, expanding the core, growing through strategic acquisitions, building new businesses and in international growth.

Let me take a moment to provide you with some examples.

The number of our large core divisions showed double-digit local currency sales growth in the quarter.

Examples include dental, at 17% growth, commercial graph graphics at 14%, electronic markets materials division at 13%, electrical markets division at 11%, construction and home improvement at 10% and occupational health and environmental safety, which is the home to our market leading family of respiratory products, at 10%.

And our traffic and safety systems division, another large core business, was just shy of double-digit growth.

I think we could have had even greater sales in some of these divisions if we had had the necessary capacity.

We made significant progress in the quarter toward building new businesses to capitalize on emerging opportunities in high growth markets.

For example our track and trace initiative is nicely taking shape.

We just put in place a leader, with experiencing building businesses at [ES] to pull together the existing assets within 3M and to identify potential acquisitions to fill in the gaps in our offerings.

Turning to acquisitions, we have announced 8 so far this year, and most recent and largest is the purchase of Security Printing and Systems Ltd. in the UK, which is a very exciting and potentially very valuable asset.

Security Printing has supplied passports to the UK Government for more than 40 years.

But for us the addition of RFID components embedded in electronic passports will bolster both our track and trace and overall border and civil security capabilities.

They also have superb security and secure ID card capabilities and we intend to expand and grow this business significantly internationally as part of our track and trace initiative.

This is the first of several acquisitions in this area that I expect you will see.

The fourth element of our growth agenda, international, continued to demonstrate both progress in its potential, optical film sales dragged Asia's results down a bit, and therefore international down in total.

But as we discussed, this is a short-term situation.

I call your attention to performance in several key countries.

In the quarter China boasted local currency growth of 27%;

India was up 47% and Poland grew 24%.

Russia posted local currency growth of 22% and Turkey, 34%.

Overall there is no doubt whatsoever that our growth agenda is advancing and delivering real results.

The near-term difficulties in optical in no way diminish my confidence and optimism in 3M's prospects.

Our top line guidance remains 5.5 to 8% which is in the neighborhood of two times IPI.

Realizing that economic conditions wax and wane, 2x appears to be a good growth target for 3M.

Now I will turn the call over to Pat who will walk you through the financial details of our second quarter results.

Thanks, George, and good morning everyone.

Please turn to slide number 2.

Second quarter sales were $5.7 billion, up 7.5% versus last year.

Organic local currency growth was 4.6% and acquisitions mainly CUNO, added 2.6% to the top-line growth.

Three of our six businesses grew in line with our expectations, primarily Health Care, Safety Security Protection and Electro and Communications.

On a geographic basis organic local currency sales were up 6.5% in Asia-Pacific, about 5% in the U.S. and 3% in Europe.

As we mentioned on last quarter's conference call, second quarter sales growth was negatively impacted by approximately one percentage point due to the timing of this year's Easter holiday.

Reported second quarter operating income was $1.2 billion, a decline of 5.5% year-on-year.

This percentage does not tell the entire story, however, as 4.3% of this decline was due to higher stock option expense and 3.9% was due to a combination of special items, which I will explain in detail in a moment.

Adjusting for these items, year-on-year operating income was up 2.7%.

Operating income margins were 21.5%, including a -1.6% margin impact from stock option expenses.

Putting these adjustments aside this was the first time in over four years that we did not expand operating margins year-on-year, and we missed our earnings guidance which I am very disappointed in.

Second quarter net, second quarter earnings per share were $1.15, up almost 20% year-on-year.

Special items this quarter added a net $0.10 to earnings per share while last year's second quarter results included a $0.10 penalty.

Again I will explain these items in detail in a moment.

Also included in this result is $0.07 of stock option expense in the second quarter compared to $0.04 for the same quarter last year.

Let me be clear.

The second-quarter increase in option expense is not a function of granting more options to employees.

Rather, as we discussed on last quarter's conference call, the increase was largely due to a requirement under FAS 123(R) to immediately expense stock options upon grant paid for those employees who were considered retirement eligible.

A 3M employee is considered to be retirement eligible, upon reaching age 55 with five years of service. 25% of this year's grant award was to these employees.

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

The accounting rules do not allow restatement for the retirement eligible impact.

The second quarter the specific costs associated with this pool of employees was $55 million pretax or $0.05 a share.

I know many of you are interested in a status update on our efforts to seek strategic alternatives for the pharmaceutical business.

But there's not much to report yet, an offering memorandum went out during the quarter.

We have received initial bids and due diligence is underway.

Please turn to slide number 3 for a recap of our sales performance.

As I mentioned, worldwide sales increased 7.5% versus last year's second quarter.

Volumes increased 7.4% with organic volumes up 4.8% and acquisitions adding 2.6% to growth.

Selling prices and foreign exchange impacts basically offset one another in the quarter.

In the United States sales improved 8.4% versus last year's second quarter.

Organic growth in the quarter was 4.9%, with volumes up 3.1% and selling prices adding 1.8%.

All six businesses had positive growth in the quarter.

Acquisitions added 3.5% to U.S. growth in the second quarter.

Sales in our international operations were up 6.9% in U.S. dollar terms.

Local currency sales were up 6.3%, their organic volumes increasing 6% and selling prices decreasing 1.6%.

International selling prices were down about as expected, impacted by our businesses that serve the consumer electronics industry.

International sales were impacted by the slowdown in the LCD industry, as our optical film sales are recorded where our customers reside in the Asia-Pacific region.

Acquisitions added almost two points of additional growth and foreign currency translation increased second-quarter sales by about a half a point.

Organic local currency growth was 6.5% in Asia-Pacific, but Japan down 1% and the rest of the region up 11%.

Acquisitions added 2.2% of additional growth in the quarter.

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

Europe delivered 4.9% local currency growth in the quarter, including acquisition related growth of 1.8%.

As we mentioned on last quarter's conference call, second-quarter growth in Europe was temperate due to the timing of the Easter holiday.

Since Easter was in the second quarter this year compared with the first quarter last year, local currency growth in Europe was held back due to the fewer billing days in the second quarter.

We estimate the impact on Europe's second-quarter local currency growth was about four percentage points.

Importantly, European organic local currency growth over the last two quarters has averaged over 5%, an encouraging sign compared to recent years.

And finally, local currency growth was just shy of 4% in Latin America.

Excluding the impact of the decline in our CRT real projection business in Mexico and the move of a sizable flexible circuit customer from Puerto Rico to Singapore, Latin America organic local currency sales increased 10.3%.

Acquisitions added an additional two points of growth in the quarter.

As we discussed in last quarter's call, and included in our first quarter 10-Q I would like to take a moment to explain the earnings impact of special items.

On slide 4 we have provided a detailed earnings analysis of second quarter special items in both '06 and '05.

Through this quarter special items impacted SG&A expense.

First, we entered into an agreement in principle during the second quarter to resolve the antitrust class action involving direct purchasers of transparent tape that as previously disclosed had been scheduled to start trial at the end of May.

The settlement is conditioned on court approval, which will be sought promptly upon execution of final settlement agreements and is expected to be granted later this year.

Second, during the quarter we incurred expenses associated with our efforts in seeking strategic alternatives to our pharmaceutical business.

These costs included items such as professional fees, along with the retention bonuses for key employees during this transition period.

The combination of these two items negatively impacted earnings per share by $0.04.

Also affecting this year's second quarter was $105 million of positive adjustment related to the resolution of the U.S. tax audit through 2001, the substantial resolution of audits in certain European countries and adjustments to tax accruals for all other open years.

These tax adjustments amounted to $0.14 per share benefit.

The Company will complete the preparation and filing of our 2005 federal income tax return in the third quarter; as part of this process the Company anticipates it will report a positive adjustment to its provision for U.S. income taxes in 2005.

Since the amounts are uncertain at this point in time our forward guidance today will exclude any such adjustments.

George will address our guidance later on the call.

As you may recall, in last year's second quarter we announced our intent to reinvest $1.7 billion of foreign earnings back in the United States pursuant to the provisions of the American Jobs Creation Act of 2004.

This Act provided the Company the opportunity to tax effectively repatriate foreign earnings for U.S. qualifying investments specified in the domestic reinvestment.

As a consequence in the second quarter of 2005 we reported a nonrecurring charge of $0.10 per share.

In total, special items in this year's second quarter resulted in an earnings per share benefit of $0.10 per share versus a charge of $0.10 per share in last year's second quarter.

Including all the special items in both periods, second-quarter 2006 earnings per share were $1.15 versus $0.96 in the second quarter of 2005.

As mentioned, option expense was $0.07 in the second quarter this year versus $0.04 in last year's comparable quarter.

On slide number 5 we compare our second-quarter P&L versus last year's comparable quarter.

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

Therefore, all numbers shown will reflect this as well as excluding special items.

As I previously mentioned, sales were up 7.5% year-over-year.

Second quarter gross margins were 50.1%, down 70 basis points year-on-year.

The combination of lower than anticipated sales volumes higher than expected startup costs for a new multilayer LCD film facility, along with supply chain inefficiencies and a handful of businesses that are capacity constrained, hold much of the increase.

These businesses, including roofing granules, medical supplies and respiratory products remain (inaudible).

In addition, 30 basis points of the gross margin decrease was attributable to the difference in stock option expense year-on-year.

SG&A expense was 22.4% of sales, up 1.1 percentage points versus the comparable quarter last year.

The increase is largely due to the combination of higher advertising and merchandising investments, along with hiring additional sales reps to ensure better global market coverage in many of our businesses.

Obviously these investments are aimed directly at higher revenue growth.

Finally, 40 basis points of the SG&A increase was attributable to the stock option expense year-on-year difference.

R&D expense increased 10.3% year-on-year or 6.2% to sales.

Operating margins were 21.5%, including 160 basis point drag for the expensing of stock options.

Second quarter net interest expense was $11 million versus $3 million last year.

With an increase in interest expense due to higher interest rates and a decrease in our interest income due to lower cash balances.

3M's tax rate for the second quarter excluding special items was 32.5%, similar to recent quarters.

Putting aside 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, 2005.

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

Including the special items in this quarter our tax rate was 23.3%.

Net income was $808 million, down 2.6% and earnings per share decreased about 1%.

Second quarter results include $56 million after-tax due to stock option expense or $0.07 per share versus $22 million after-tax and $0.04 in last year's second quarter.

The sequential quarterly P&L comparison is found on slide number 6.

Remember that the first quarter was an all-time record operating margin for the Company.

Sales were up 1.7% versus the first quarter as four of our six businesses build positive sequential growth.

Health Care, Electro and Communications, Consumer and Office and Safety Security and Protection.

Operating income declined 10.5% sequentially.

Half of which was due to the difference in stock option expense; for the remainder primarily related to the decline in optical films.

On a sequential basis, net income and earnings per share both declined by approximately 10%.

Stock option expense was $0.07 per share in the second quarter versus $0.02 in the first quarter.

Slide 7 shows our year-to-date performance.

With half of the year behind us, I felt it was important to reflect on our performance todate versus last year.

Please remember that while the quarter did not meet our expectations, this is an outstanding business.

Margins in our (indiscernible) well in excess of 20%.

First, sales were up almost 8% for this first six months with organic local currency growth up 6.4%, acquisitions added an additional 2.4% of growth.

Operationally we are performing at levels very similar to last year.

Year-to-date we have been able to leverage the top-line growth in a 9.4% EPS growth excluding special items in each year.

On a year-to-date comparative basis stock options had a negligible impact.

Let me turn to slide 8 where I will recap our second-quarter segment results.

Our Industrial and Transportation business delivered local currency growth of 11%.

Including 7.9% growth from acquisitions, primarily CUNO.

We acquired CUNO in August of 2005.

This is a world-class liquid filtration company with a long history of double-digit top-line growth and very attractive operating margins.

It is a great addition to our portfolio.

Operating income in the second quarter was $321 million, up about 3% including a -3.2% year impact year-over-year due to the expensing of stock options.

We built positive local currency sales growth versus last year's second quarter in all businesses with the exception of personal care.

However, growth was below our expectation in three key businesses.

Automotive aftermarket, industrial adhesives and tapes as well as the automotive OEM business which George referred to, which continues to be impacted by softness in the U.S. auto industry.

As we have mentioned in past quarters, and as George referred to earlier, sales in our personal care diaper tape business continued to decline year-on-year, which reduce overall industrial and transportation sales and operating income growth by 0.8% and 1.4%, respectively.

This business is working relentlessly to invent new solutions for its customers to recover volume loss over the past year or so.

They will be more competitive in this space but it will take us some time.

Health Care sales were $1 billion in the second quarter.

Organic local currency growth was 3.3% with acquisitions adding an additional 80 basis points of growth.

Growth was led by our dental and medical supply businesses, two solid 3M franchises that offer some of the strongest brands in the respective industries.

Excluding our pharmaceutical business, which is approximately 20% of Health Care, second-quarter local currency growth was greater than 7%.

Geographically Health Care's revenue was strongest in North America.

Operating income in the quarter was down 5%.

Adjusting for stock options and pharmaceuticals, operating income would have been flat for the quarter.

Health Care was adversely impacted in the quarter by operational issues in both medical and orthodontics associated with product startups and supply chains.

The underlying fundamentals in Health Care remain very strong.

The aging population along with emerging economies are rapidly adopting Western Health Care practices making this business an important platform for future growth.

We are investing in sales and marketing capabilities in this business in our core strength areas, such as infection prevention, wound care, dental and orthodontic product systems and others.

Moving on, the Display and Graphics business posted local currency sales growth of 6.5% with an operating income decline of approximately 13%, including the 3.3% reduction income due to stock options.

As George mentioned, commercial graphics delivered strong double-digit local currency growth in the second quarter, with strong end market penetration and differentiated products that offer superior value to customers.

The traffic safety systems maintained the momentum from the last three quarters with near double-digit currency, local currency growth.

Optical film sales volumes increased at double-digit rates in the second quarter; however as George mentioned, sales growth was below our expectations.

We estimate that the impact from the overall LCD industry slowdown and inventory correction in the second quarter along with the mix impact from the weakness in the monitor segment, accounted for approximately two-thirds of the shortfall in optical film operating income versus our expectations.

The remainder of the shortfall was due to manufacturing startup costs previously mentioned by George.

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

Excluding the negative impact of the CRT rear projection lens business, total D&G local currency sales would have been up 8.1%.

Consumer and Office posted organic local currency growth of 4.4% in the quarter with an additional 20 basis points of growth coming from acquisitions.

Growth was led by our businesses serving the retail do-it-yourself channel, boosted by outstanding brands such as Scotch Blue masking tape and Filtrete home filters.

We also posted solid growth in the retail office superstores and in commercial office channel.

On a geographic basis revenue growth was strongest in the United States while growth outside the U.S. remains a bigger challenge, particularly Western Europe.

The second-quarter operating income was $121 million, down 11% year-on-year.

Options hurt income growth by about 4 percentage points.

During the second quarter we increased our advertising and merchandising investment in Consumer and Office to support the recent launch of a national advertising campaign for Post-it Picture Paper.

Along with other products such as Scotch Blue masking tape, Scotch-Brite home cleaning products and Nexcare brand bandages.

While these investments impacted the growth rate in operating income this quarter, it is a vital step in supporting both new and existing products for our retail customer mix.

Our visual systems business which offers primarily analog overhead and electronic projectors and film continued to experience declines which [reduced] second quarter Consumer and Office, sales and operating income by 1.1 and 1.6%, respectively.

We anticipate that operating income in the third quarter will grow at double-digit rates for the Consumer and Office businesses.

Local currency growth in our Safety, Security and Protection Services business was up 8.3%, $653 million.

Growth in the business continues to be driven by strong global demand for personal safety products, especially respiratory protection.

We continue to invest in additional respiratory capacity, such as our recent announcement of a new respirator manufacturing facility in Korea which will serve the Asia-Pacific region.

Operating income was $145 million in the second quarter, down 1.6% versus last year's second quarter, including a 3.7% negative impact from stock options.

Gross margins declined both year-on-year and sequentially in this business, with a majority of the impact due to roofing granule business which George described in his opening comments.

Finally, our Electro and Communications business posted sales of $632 million, organic local currency growth was 5.3%, driven by strong global demand for our specialty adhesives, boards and tapes for the electronics market.

Along with the electrical products for insulating, testing and sensing.

Acquisitions contributed another 80 basis points to growth in the quarter.

Operating income was $123 million, up 7% year-on-year and including a negative 4.3% impact from stock options.

Electro Communications has performed consistently well over the last several quarters.

Please turn to slide number 9 where I will review a few balance sheet and cash flow metrics.

Networking capital turns were 5.2, down 0.2 turns sequentially and down 0.4 turns versus the second-quarter 2005.

The sequential change is partially due to normal seasonal increases in certain businesses.

For example, we built inventory in Consumer and Office in anticipation of the big back to school season.

Optical film business is building inventory in preparation for accelerating demand for LCD TVs during this year's holiday season.

And finally, in Traffic Safety and Systems where sales are skewed towards the warmer months of the summer, we also built inventory to prepare for this peak season.

Capital expenditures were $261 million, an increase of $44 million year-on-year and $77 million sequentially.

Todate we have spent $451 million of our expected $1.1 billion capital expenditure plan in 2006.

Second quarter acceleration is demand driven as these investments are largely supporting growing businesses.

We have recently announced additional capital investments for optical films in Poland, respiratory protection products in Korea and customer centers in China and Russia, among others.

We also have improved capacity conditions for medical supplies, Filtrete filters, Scotch Blue painters tape and roofing granules just to name a few.

Second quarter free cash flow was $539 million which was lower than last year due in large part to second-quarter 2006 tax payments of approximately $500 million versus $270 million in last year's second quarter.

Also, as I just mentioned, we are continuing to invest in CapEx and working capital in anticipation of increasing demand.

We paid $348 million in dividends for our shareholders in the second quarter.

Stock repurchases were $527 million during the quarter, up from first quarter's $251 million.

Weighted average diluted shares outstanding were 770.4 million down 2% from last year.

And finally our debt to capital ratio was 19% at the end of the second quarter.

Now I will turn the call back to George who will address our expectations moving forward.

Please turn to slide number 10.

Thank you, Pat.

The longer-term outlook for the rest of the year looks okay for now.

We have cost-saving actions in place to inoculate ourselves against the remaining short-term challenges of the LCD film situation.

I do see early signs of uncertainty creeping into the U.S. economy, and of course into the global picture.

On costs we have seen disappointing price gouging from some suppliers and increases in other commodity and transportation costs, and this has crept into our factory costs.

This has cost us overall 60 basis points in the year-over-year quarter.

For the next six months we will be using our superb Lean Six Sigma capabilities to gradually get this back out of the cost base.

As for our guidance going forward, for the third quarter we expect organic local currency sales growth of 4 to 8%.

I set the bottom end 4% number to allow for any residual bleed-off in LCD oriented inventory with acquisitions adding about an additional 1.5 percentage of growth to this picture.

Third quarter earnings per share are expected to be in the range of 1.10 to 1.15, including $0.04 per share impact from stock option expensing. 2005 third-quarter earnings per share restated to reflect stock option expensing of $0.02 per share was $1.08.

For the 2006 calendar year our guidance remains unchanged versus our July 7th press release.

We expect full year 2006 earnings per share to be within the range of $4.55 to $4.65, including a $0.17 impact from option expensing in 2006 and $0.14 option cost in 2005.

Also included in this estimate are the previously mentioned net gains from special items of $0.10 per share in the second quarter of 2006.

Organic local currency growth is expected to be 5.5 to 8% for the year with acquisitions adding approximately 2 percentage points of additional growth.

As Pat mentioned earlier, we may have further positive tax adjustments in the third quarter.

The amount of which is unknown at this point.

We also incurred additional restructuring charges or other expenses associated with evaluating strategic options for our pharmaceuticals business.

Neither of these items are included in our third-quarter or full-year guidance.

Let me just say in conclusion that 3M is a superb Company, and we will manage these short-term challenges vigorously.

Having led the Company for a little over six months I am coming to know the superb character and capabilities of 3M's people.

We don't like getting buffeted by things outside our control, but we do know how to handle them.

Whatever adjustments may be made the underlying fundamentals of 3M, combined with its culture of innovation give me tremendous confidence in our ability to grow and deliver superior returns over the long haul.

That concludes our formal comments.

Also joining Pat, Matt and myself is Jim Stake, Executive Vice President of Display and Graphics.

We would be happy to take any of your questions.

Thanks, everybody.

(OPERATOR INSTRUCTIONS) Mike Judd, Greenwich Consultants.

Good morning.

A question about your comments about wanting to diversify the portfolio and obviously you are working on the pharmaceutical business.

That would actually be sort of the opposite approach, but could, should we be expecting a larger size acquisition?

Could you give us some sense -- you've been making a lot of small acquisitions, but given the rate that you are making of these small acquisitions it is kind of hard to move the needle.

Let me pick up that one, please.

On the Pharma acquisition, Pharma divestiture, obviously that was an issue of taking something out of the Company that was non-core.

That in many respects did not have the same kind of steady investment profile that we traditionally associate with 3M, so that was clearly the decision why that took place.

On my comments on optical film, I do believe that it is prudent to find ways to leverage and diversify that portfolio into more applications.

So we are not seen as dependent on some of these electronic swings that we saw in this quarter.

So that is kind of the answer to that question, Mike.

And the last piece of the puzzle, I think the predominant number of acquisitions that we are likely to do is always going to be these kind of tuck in sorts of things.

But if the right value accretive, long-term opportunity came along we would consider it, but we don't have any in our sights at the moment.

Just a quick follow-up to your segment results, which is slide number 8, I see you adjusted the Health Care operating income number but you didn't make any changes to the Consumer and Office number.

In order to get to sort of the clean EBIT numbers should an adjustment be made to that segment?

Mike, the reason we adjusted Health Care from the, what is published in the press release, is to back out the special item related to the professional fees and retention related to the work we've got going on in pharmaceuticals.

So effectively we are trying to get that chart to match with our results excluding special items.

There were no special items within consumer office.

The tape settlement, where was that basically -- where should that be incorporated?

That actually appears in the corporate segment.

Got it.

Okay.

Thanks.

Stephen Tusa, JPMorgan.

Just a philosophical question for George.

I know that the timing of the preannouncement, as well as some of the results that we've seen today, which is a couple weeks after that and really the businesses even outside of Display and Graphics were a little bit of a disappointment.

You come to 3M, are you happy with your visibility on the businesses, and do you feel you are getting the right counsel from maybe the finance side of the house as far as expectations in setting those expectations?

Are there any -- is there investment that is needed there or any kind of changes that are necessary to get maybe a little bit of a better view on what you guys can do given this is probably not the way you wanted to start by raising in your first quarter with the company and then missing pretty dramatically in your second?

Let me try to answer your question, Steve.

We have pretty good forces inside 3M for forecasting.

We have great SNLP processes as a general rule.

We do a quarterly financial review of each business, actually right down to each division.

That, by the way, is new news, it is not something which happened prior to my arrival here.

We did the big business, the sector level review but we didn't do individual division reviews, so that is new news.

So I'm reasonably comfortable with those sorts of things.

I think there are two factors, though, that I would comment on.

The first is in these optical businesses, Steve, when you get a situation where your largest customers cancel your orders a week before the end of the quarter, it is very difficult to be able to predict that kind of event, and you get buffeted by that and there is nothing we as a company or even in the Display and Graphics business can do anything about that kind of activity.

In the other pieces of the business we always knew it was going to be a bit of a delicate balance, Steve.

Where we needed to make investments and particularly in advertising and merchandising, but also in the R&D and you saw the R&D.

That was up 10%, that was nice.

You saw those up, you should see that as an indicator of something pretty positive for the future.

It is always a delicate balance, Steve, to put that money out on the counter and spend it because the results always come a little later.

So at some level you are always going to see this kind of pattern.

Of course it was coincident with the optical film's issue, and it would probably have been a relatively positive story of investment had it not been for the setback in the optical film's industry.

So at some level, Steve, we've got to make those investments if we're going to drive growth, and they are always a bit delicate and sometimes even awkward in their timing.

Great.

Thanks a lot.

Jeff Cianci, UBS.

Maybe just for Pat on the margin question, actually George mentioned you had some of this under your control, and I am just kind of wondering how much you need to spend.

Can you quantify any kind of increase in R&D and SG&A that would be a goal of the Company?

And what the return on that investment, how quick we would expect it.

Am I hearing between the lines here that '06 is the spending year and '07 we restore that margin?

Maybe elaborate a little.

I'll take it then George can pipe in if he wants.

Let's face it we have to balance a number of pieces of the business.

We've got to balance the top-line performance and bottom line to really judge how much money you can really invest back in the business.

We have committed to you and all shareholders that we are after getting more top-line growth but at the same time also indicated that we want to continue to maintain at the income level, EPS level a low double-digit growth rate.

So it's going to be a balancing act between those two that will determine exactly how much money you can flow in.

The higher our top-line growth rate is, the more money we can invest back in the business and get it to grow faster.

So there is not a precise number that is fixed in nature relative to how much that spending will be because we've got to run the business on a balance basis.

It's not a matter of let's just go invest all this money and next year we will reap the rewards.

We have to run it in a very balanced approach.

Let me chip in another couple of comments, Jeff, please.

Thanks.

Conceptually what you want to try to do is to invest first in those businesses that have got to the faster product cycle time because that's where you get the earlier bop.

We also have this other thing that we've wrestled with, Jeff, which is in many of the places we don't have capacity.

So even if we were to spend money in advertising and merchandising, or feet on the street we wouldn't be able to do anything to respond to those increased sales anyway.

So we've got a little bit of a balancing act between where we are at capacity, clearly waiting until we solve the capacity issue so we can drive growth; trying where we can to drive growth in faster cycle businesses where we do have capacity.

And some of our electrical businesses by the way meet that criteria, and recognizing the underlying theme, Jeff, that when you are out of capacity in many places and can't always respond to the growth or if you respond it ends up being inefficient because you're running lines inefficiently and paying overtime or outsourcing at lower margins, those sorts of factors that come together.

It is an interesting -- it's going to be an interesting balancing act in this first year, Jeff, until we get through the situation where we're seeing more capacity come on stream.

Thank you for that insight; if I can just add your sales growth is certainly not bad at all versus your peers if whoever you want to call your peers.

And maybe I will give you an opportunity to comment on the one that is lagging, Health Care.

Clearly the drugs are going away but I am just kind of wondering underlying are these markets not as growthy perhaps as other parts of the Company?

And does this require an internal solution or an external solution for the Health Care growth rate?

I am trying to make sure I understand what you're looking at because back to pharmaceuticals, the growth rate was 7% for the quarter, which is a good growth rate vis-a-vis our own portfolio, and of course we wanted to do more.

Of course, you will find other healthcare companies out there that are more in medical devices and so forth that may have higher growth rates.

But both our dental orthodontics franchise and our medical franchises we feel very, very good about the potential of both of those.

So would 7% be a good goal for you then; you are satisfied with that?

No, no, no.

That's where we're at today.

We want to get both of those up, and I think Brad referred to those in his May presentation as well.

I think, Jeff, it would have been an interesting -- perhaps an interestingly different discussion had we not had the challenges in optical films.

The growth rates may have been above our targeted rates.

So it would have been a pretty encouraging call, I think, in that context, but thank you for offering tat your kind of perspective.

Good point.

Thank you.

John Inch, Merrill Lynch.

Thanks.

So I want to understand, of the original $1.14 to $1.17 guidance, how much is optical films shortfall, both production and lower volumes?

What is that on an EPS basis?

John, I'll try to address it this way.

If we had met our optical film expectations for the quarter, we would have been basically at the bottom end of our guidance range of $1.14.

Okay, so that is about $0.09, right?

And I think George, you said there was about 2 points of margin miss associated with the production line inefficiencies.

Did you mean on Display and Graphics, or did you mean on Film?

I meant in opticals, films, John.

So that is like what, $0.01 to $0.02?

I would say that is probably a reasonable range, John.

I guess my question is, you mentioned that the optical films line was down mostly or through most of April.

You raised guidance in May.

Did you presume that some other piece of the portfolio was going to make up the $0.01 to $0.02, or did you just not have the information in hand in terms of what the drag was going to be?

No, our expectation, John, was when we gave you guidance in the second quarter that optical would deliver collectively on their plan, maybe not on each one of the pieces, but it was our expectation that they would deliver the numbers that I just quoted for you.

I think, John, you know when these things go down, you start them up, the process is really our -- we've got to take you guys down there sometime and let you see them.

But they are very, very challenging manufacturing processes, and I think if we could get you to see it with your own eyes, you'd really understand just how difficult it really is.

So you never know just after startup just how difficult it may or may not be.

Things may run very well and you're a hero, and things may run less well and you're not so much of a hero.

But I want to (indiscernible) one other thing which I said at the end of my remarks, John, and that was factory material costs right across 3M cost us something like 60 basis points of margin in the year-over-year quarter.

So some of the import material challenges we face really did cause us some consternation, and that is not just optical, John.

It is broad based.

Okay, that's fair.

I guess someone could conjecture, though, that that variability should have been contemplated when you provided guidance.

Let me back up.

We gave guidance in April, not May.

I'm sorry, Pat, I was referencing the May 2nd analyst meeting.

We didn't really give any view on short-term in that meeting.

Okay.

No, that's fair.

(indiscernible) operational issues, John, we talked about long-term strategy.

We never talked about the quarter.

That was never a subject of that meeting.

No, that's a fair point.

Just one other quick one then.

The $49 million of special items in SG&A, does most of that fall into healthcare if we are trying to adjust margins, or does it go into somewhere else?

There is only 9 of the 49 that actually goes into a business.

The other 40 goes into the corporate sector, so it is -- you just have to adjust Health Care by the 9, John.

Okay.

Thank you.

(OPERATOR INSTRUCTIONS).

John Roberts, Buckingham.

George, in your opening comments you talked about softness in several non-core areas, and you talked about diaper tape which I assume is non-core; visual systems which I assume is non-core.

It included automotive when you talked about the three.

Did you mean to include that as a non-core or did you (multiple speakers)because it was down?

No I did not mean to include that non-core, not at all.

And a follow-up on the optical films area, is there a simple explanation why the manufacturing doesn't scale well to larger format?

And if it is more complex to make in larger format, why is it lower margin?

Well, the fact it is actually -- you just answered your own question because it is more complex that is why you have lower margin.

What happens, John, if you imagine a sort of an 80 in. wide piece of material and you've got to try to get a 68 in. wide pieces and 12 in. wide pieces, so you're cutting this out almost like a patchwork quilt when you are actually converting this kind of stuff.

So if you have a move up in large format films what tends to happen is the yields go down, and therefore the net manufacturing costs go up.

If you have a preponderance of your sales in much smaller pieces so now we are cutting out 4x4 pieces instead of 68x48 pieces, you can imagine if you have any defects in that film across its width or along its length that you can cut around those so you end up overall with better yields.

So that is the dynamic that you are following.

We have some very, very precise manufacturing processes, John, that actually spot and mark optical blemishes in the films, and then when the film is eventually converted we keep sort of a roadmap of those, very, very complex electronic roadmap of where they are across the film and along the length of the film.

And then we that record is run on a computer and we cut around those blemishes.

So you can see that depending on the mix of low versus high larger format cutouts, you can end up with yields going down generally as you move up in size.

Why can't you price to at least maintain margin given your marketshare?

If these are so hard to make, competitive issues should be less.

I think it all depends a lot on who is out there competing with you and what margins they are prepared to tolerate.

Because you're always on the one hand -- obviously the best place to -- best time to get any improved margin is when you first start selling these sorts of things and we traditionally do do that.

But over time pricing pressure pushes that down, and the balancing act that we've nearly always in the past managed to perform well and didn't perform well in this quarter was, as we saw price decreases we pulled back up in margin because we were able to get costs out of the manufacturing process by all sorts of different ways.

So it is all about the competitive dynamic that you see out there John, that doesn't necessarily always allow you to put prices where you think.

Thank you.

Bob Cornell, Lehman Brothers.

Good morning everybody.

Continuing on optical film, you mentioned that the volumes not or sales I think you said were up double-digit.

Where you talking revenue sales dollars or units?

And what I am really looking for is units and then price in the quarter.

Bob, volume was double-digit.

If you looked at total revenue it would be more of a single digit number.

We were expecting, of course, a double-digit revenue growth in that business.

So units were up 10 to 12 and pricing down 10 type of thing?

Is that ballpark?

I'd say pricing we've been looking at price on a quarter basis -- we give price reductions twice a year.

This happened to be the quarter that we entered a price reduction that has been running on an every six-month basis 5 to 6%.

Here we are in the middle of July.

How about a status report on the inventory issue?

Where you are in terms of the inventory work off globally in that channel?

In that channel?

In optical film, yes.

George mentioned that in his comments there is a -- and you really have to look at it -- if you look at manufacturer by manufacturer you have quite a different story.

We see that the inventory is coming off, but we also believe that we may see the recovery from our own supply chain a little bit later in the quarter than when they may actually start to.

We don't have a supply chain issue in optical film, do you?

It is the issue that we saw it later when the inventory correction hit, Bob, we saw it a little bit later.

Therefore I think we're going to see it a little bit later coming back a little bit in some of the manufacturers.

It looks like and Jim Stake can speak to this, it looks the Korean manufacturer's inventory seem to be in better control right now than some of the Taiwanese manufacturers, some of the Taiwanese manufacturing.

Here is what I am getting at, I mean you have a third-quarter expectation that is well above the second quarter just reported; that you mentioned that were it not for optical film you would have been at the low end of guidance, so I am trying to gauge here we are sort of the end of July, how visible the third quarter is in optical film relative to the guidance you just gave.

Maybe Jim can jump on and reference that.

Well, Bob, it is visible with -- we don't really know how long the correction is going to take when the ramp up is going to start back up.

Right now we're expecting it will be probably mid quarter by the time that we see volumes starting to ramp back up.

So you haven't seen it yet?

Have not seen the ramp up yet for us.

The other question is where are the yields on the new line right now relative to -- I mean right now as in last week?

Let me sort of clarify one thing.

Just hopefully these pictures are difficult to get visibly when you are speaking over a phone.

When there are inventory corrections in the retail channel obviously the retail see them first.

The ordering pattern for the retailers comes a little bit -- from the set manufacturers comes a little bit later than that.

The ordering for the raw material for the panel parts comes yet later than that, and electronic components and films comes yet later than that.

So what tends to happen in the dynamic here is the guys further back up the supply chain see the impact later in the cycle, and by the way, they suffer longer in the cycle before they come out.

That is kind of the dynamics.

Let me also give you some data on what I have been told this week by Andy Wong who runs the Optical Systems Division.

Andy says that inventories, this is now in the manufacturers this is now in the TV set manufacturers, exceeded two months of supply at their peak.

Typically the industry likes to run somewhere between three and four weeks of supply, and what Andy told me on Monday is that numbers were down -- this is inventory numbers now -- were down in the two to three weeks.

So at their level, Bob, the inventory is being bled off.

Now as Pat rightly pointed out, that varies from manufacturer to manufacturer.

The Japanese maybe different than the Koreans, and the Koreans different than the Chinese and the Chinese different than the Taiwanese.

So I'm giving you some kind of blended numbers.

So that is at least is encouraging in that piece of the supply channel the inventory is bleeding off.

But just because of the first dynamic which I explained to you, it is more likely that we will see a recovery a little later which is what we try to do in the way that we have arranged our forecast; we've anticipated that, and built right into our forecast.

Now while you're on -- what did Andy say about the yields on the new manufacturing process?

Jim, why don't you pick up the question on yields, please?

This is Jim Stake.

Without giving you specific details on yields numbers I guess what I would let you know we have basically two production lines for our multilayer optical films.

In the factory indicator the original line is running exceptionally well right now.

We are shipping virtually everything we make on the line and the quality yields and the subsidiaries are extremely high, as well.

As George mentioned, the yields vary a lot based on the type of products you're producing.

So for handheld devices and monitors and notebooks the yields tend to be quite high; when you get into large size televisions because of the part fit yields tend to be quite low.

But the new line indicator is actually running very well this week.

We've had some ups and downs.

We've had a lot of waste.

I guess at times we've been having yields down as low as 10%, but at this moment it is running very, very well.

Like what, what is well?

I guess you could say in terms of jumbos being made, right now we are shipping the vast majority of jumbos being made to Asia for converting.

What is the yields on the original lines for comparison purposes?

There are all kinds of factors that come into yields because when you're on a film line the absolute theoretical yield on a film line based on the way the film is made, maybe only in the 60% range.

So that is sometimes the very best you can do unless you are --

Is that original line doing close to that?

No, it is not at that level.

There is still a lot of upside on yields, and I guess that is the way -- we're looking at this.

The yields on this particular process because it is so technically challenging, and I think I pointed out in New York the size of the defects we're talking about are so incredibly small that they can't even be detected by the eye, and they are about half the thickness of a human hair.

And I think because of that challenge the yields on multilayer optical film will probably never get all the way up to that entitlement level of 60-some percent.

But the way of I look at is is just a huge upside for us as we improve the process.

So imagine for a minute, Bob, you've got three factors going on here.

Imagine yourself making a gigantic roll of saran wrap and you take the saran wrap and you grab the edges with these testers and you stretch it in a lateral direction, so the film which is against the edges where the film is made is useless, so you have to cut all of that off.

So when Jim said there is a theoretical yield number it is because you have to cut those edges off where you grab a hold of them that you lose that particular piece of yield.

And there is a second issue.

Moving manufactured the film with blemishes that will impede or impair the optical performance of the film and you've got to cut around those issues and it depends a lot on what the fit, the size of products that you are making as to precisely what yield you would get in that particular issue.

So you've got this really three factors, the fit, the blemishes and this side that you slit off the saran wrap, shall we call it, sorry my colleagues in the optical business are going to get me into some hot water shortly with my visuals.

But that is basically what is going on, Bob, and that is why these things are so complex, but focus on what Jim told you.

The blemishes that we detect electronically are less than the size of a human hair.

You cannot see them with your eye, but the unfortunate thing is that the precision of -- depending on what kind of film it is, whether it is a multilayer film or whether it is an optically imprinted film like that, you can actually see it when you illuminate it from behind.

And so these are very challenging manufacturing processes, Bob, and.

Let me jump in with the next question.

I was surprised when you noted in the press release that the margins on the big film for LCD TVS is going to be less than monitor film.

I would have thought and the world would have thought that because of the new technology and the size of the film the inability of the competition entered that market, that the margins in film for LCD TVS, big ones, would be better than monitor film.

And is that right in the long term or wrong?

I think George answered this question previously, maybe slightly different.

That is that you always have to keep your eye on what alternatives of TV manufacturers have, not just competing necessarily always (multiple speakers) film for the same product.

There are other indirect replacement opportunities that TV manufacturers have.

So our product has to remain price competitive in the overall scheme of what they are after.

And we're absolutely convinced that our film gives the best performance characteristics from both viewing, as well as brightness, but is not necessarily the only choice that they have.

So we have to remain competitive otherwise there would be no business there.

So it is a delicate balance that Andy and the team have to run.

Final question, sorry, built into the guidance you just gave for the third quarter, what is the expectation for optical film in terms of top-line and margin?

Basically it will be maybe slightly better than the second quarter is the way that I would say at this point in time, Bob.

But with margins very similar, Bob.

Margins similar to this quarter?

Yes.

Okay.

Thanks.

And they were at a low point.

Okay.

Thank you.

Jack Kelly, Goldman Sachs.

George you had indicated that margins in displaying graphics or maybe just LCD film don't get back to where they were historically, so I just wanted to see if you could elaborate on that a bit.

Typically Display and Graphics was 32 to 33% operating margin.

You indicated this was probably the low point; second or third quarter would be low point.

We are at 26 and change.

Pricing is a little tougher.

Can we get back up to the high 20s or what kind of -- what were you kind of thinking about when you made that comment?

What I was thinking about was as much about the mix, Jack, as anything else.

If you think about all of the products that get made with our films, one of the real strong points, certainly the early market when it was built was in monitors and notebooks and primarily monitors.

We had fabulous attachment rates and good margins in those businesses.

What essentially happened is all the time, Jack, the prices of those products have fallen, and as Pat was speaking really in his comments about competition earlier, you compete with lower performing films in some cases.

As these products have become more and more commoditized, more and more manufacturers have said you know, what, I don't need that for our engine in my Chevrolet.

I can only get the price of a Chevrolet, I am not buying Ferrari engines.

So attachment rates fell, Jack, and the earnings contribution of those components fell.

And when you blend it into what is happening into LCD TVS they as a general rule have been lower margins for us and really for everybody as far as I know.

And so you have a situation were you have monitors falling in margins, really falling attachment rates I should say earnings contribution, and you have LCD TVS growing relatively rapidly that have lower margins.

Now there will come in time in terms of pure earnings contribution where the gain from LCD TV growth will overcome the contraction in earnings compression from monitors.

And so it's that kind of blend issue, that mix issue that I was really speaking about, Jack, when I made the comments that I did.

So 26 is the low point, 32 to 33 we probably don't go back to, so the reality is somewhere in between.

Yes, I think it is, I think what is going to happen now, Jack, is there are some other subtleties that have gone on.

Of course you can never actually finally determine with precision exactly what contributes to what.

But we have a lot of people working on getting this new film line back up to snuff, up and running first and then getting its yields up to the level that we're accustomed to.

And we spent a lot of time, a lot of money, a lot of our people who ordinarily would be focusing on other cost reduction efforts are working on that.

So the unknown here is how much might we have got?

It is a question you could ask me but it is an answer I can't give you because I don't know it.

Is what have we suffered in overall margin penalty because we weren't able to dedicate resources on continuing cost reduction versus getting lines back up and running and stable.

And so that is a long way of saying I think what will happen is we get this particular issue behind us, this particular manufacturing issue behind us.

Those assets will get reapplied, and we may see some creep back up in margins.

I don't want to say I'm confident, but I am hopeful that we will see -- I mean logically I can convince myself that we will see some improvements in margins in those products from the bottom that we've seen in this quarter.

Jim, just coming back to when the market gets in balance again with regard to the inventory situation, it seemed like in the past you all thought that from a revenue standpoint the LCD market or sales for you guys could grow 20% plus, and that would be after price degradation of maybe 12 or 13%.

Do those numbers still look like they make sense, again maybe to the latter part of this year?

I don't know if we want to speculate on exact numbers for optical, but there will definitely be double-digit volume growth that will more than offset the price change.

I don't know if I want to --.

That is about all you did in the second quarter, though it sounds like.

If you look at the dynamics of the situation right now there is, as George said, there is about three weeks of excess inventory in the system overall.

Those customers of ours who have controlled their inventories better than others are ramping up, so we are shipping -- we are growing with those customers; those that have not managed inventories so well our sales are below where we would like them to be.

I guess we would expect the inventory to resolve itself during the third quarter.

I can't say if that is going to the middle of August or into September but it will certainly resolve itself kind of day by day as the third quarter goes on.

And I think we will see a significant ramp up on LCD televisions as we've seen in the past.

If you look at the big build is usually August, September, October and even into November and early December.

So we'll see strong growth.

I just don't want to commit to an exact number because the inventory situation is a little bit hard to predict.

I know I realize that.

I am just saying once the inventory situation clears whether it is three weeks or six weeks, what are you looking forward to in terms of the growth rate in terms of volume and dollar volume growth and unit volume growth for that business?

I guess why don't we -- the other thing that is a little hard to predict is the monitor to televisions which --.

But I guess if you just assume like 10 to 12% price down, you would expect to see 15 to 20% total growth for the business.

Got it.

Thank you.

Jack, one last comment I'd like to make if I can, please, I speculated in my remarks that we are seeing some creeping seasonality; we're seeing a creeping in.

And I would just like to stress to you that it is unknown for us, but we may have seen some seasonality creeping in that exaggerated the issue of the inventory correction.

And it may well be if all goes to plan if the inventory bleeds off and the US economy stays sufficiently robust, I think we may see a flip in the opposite direction in the fourth quarter if our belief that seasonality is now creeping in.

So what is likely to happen is you are going to bleed that inventory off, it was exaggerated in the second quarter the down, you're going to bleed it off to a good piece of the third quarter, and it may well then significantly excise in the fourth.

That would be the pattern that you would expect if our speculation or our hypothesis that the seasonality is now becoming more of a factor.

Good.

Thank you.

Mark Gulley, Soleil Securities.

Yes, as I'm listening to this call I am trying to connect some dots here with respect to the LCD film story, and I must confess I am fairly confused.

First of all I would have thought that TVS at least would be a much more demanding application, both in terms of the customers and in terms of the performance of your film.

Now we find out that the most demanding application seems to have the lowest margins.

You built a large facility which appears to have dis-economies of scale with respect to making that product.

And of course all the growth, much of the growth in this business is going to come from TVS.

So it sounds like there is a huge secular shift that you're talking about for the first time today in the outlook for this business.

Am I being too pessimistic?

Thanks for the question.

Let me -- I think it speaks to some of the earlier questions that I would like to speak to.

The first one is on what Pat was talking about earlier;

I think when you look at LCD televisions there are certain price points that we have to hit based on the size of the television, based on the quality that the customer is shooting for.

As you know, there are or if they are willing to sacrifice quality, if they are willing to build in a lot more lamps, etc., there are alternatives to using our product.

So I think price point has to be realistic, number one.

Secondly, is the part fit yield issue that George mentioned, when you -- as these televisions get larger and larger to get perfect pieces of film becomes harder and harder.

And the third one is the physical requirements of the large LCD televisions require more anti-warping kind of performing.

So you need to laminate our film onto other materials which of course adds cost, as well both in materials and labor over in Asia.

I think that is why the margins on large LCD televisions at the moment are lower than what we've seen historically on monitors where let's say when LCD televisions were first launched and they tended to be like super monitors, they tended to be not so huge and they tended to be high-performance monitors that used [Debev].

I think that is why the margins are lower in the television segment.

The other think I think we're seeing is I mentioned when LCD TVS first were introduced they were on the smaller side, and they were all positioned to be rather premium products.

I think as that has evolved they have migrated to much, much larger sizes.

And at the same time they have segmented the marketing to let's say the really high-performance products, the midrange and the really low end.

And I think the really low end can't afford our product today.

So we're really focusing on the midrange and the premium segment of the television market.

I hope that helps to explain it.

A little bit but George it doesn't sound like you're being rewarded for bringing great 3M technology to this business.

I am still confused.

The biggest piece of the growth of this business you are going to have the lowest margins; you're not getting rewarded.

What gives?

The other thing I would mention --.

Mark, just a comment; a lot of this is a relative discussion as to what the margins are here.

The TV business is still an absolutely superb business to go after.

The other thing I wanted to point out a little bit was on when we get into the discussion on this new capacity that we're putting in Decatur, this was not just about installing new capacity.

It was also trying to get at a much more cost-effective operation as well that the new facility we are putting in as once we get it up and running, should have a much better cost position than the prior one.

That helps.

That has been part of the strategy all along is it wasn't just putting more capacity of the same in.

We knew we had to also get a step change in the cost performance, as well, to compete in a much lower priced down market.

So that has been part of the strategy; why it is so important for us to get that facility up and running here as fast as possible.

That line is designed for 2x the speed and 2x the width.

So in a single facility you can pump out significantly more products, so you're really getting some leverage on the volume.

And of course if we can at all manufacturers working on this stuff, focus will always have to be yield because that is another significant issue on how to drive net manufactured costs in these products.

So to the extent the second line is more or less dedicated towards the TV side, do you see a point at which the lower costs offered by that facility both in terms of speed and width, will allow you to offset the margin pressure that Jim alluded to earlier in terms of extra lamination and things like that?

That clearly is the goal, Mark.

That was the design goal, clearly.

Any idea how long it will take to achieve that goal?

I think it is going to be months, but Mark, there's no real way of knowing with precision.

That it the reality.

Thanks for that detail.

I appreciate it.

David Begleiter, Deutsche Bank.

A question for Jim.

Jim, have you said how much lower the margins are on the LCD TVs versus a TV monitor and notebooks?

No, I have not.

Any just sense of, is it a 1000 basis points lower or is it more or less?

I will try to jump in and help Jim out here.

We haven't, and part of it is that -- and I think as George and Jim have both described, is the fundamental difference -- of course the products are different as well, but the fundamental difference in the margins between monitors, handhelds and notebooks and TVs is really the yield side of it.

The pricing, per se, is a little bit differently, so the key determinant there is for us to get our manufacturing yields up.

They will determine what the margin spread is primarily in that market.

So it is really a yield related -- it is a cost issue as compared necessarily is there that big a difference in the pricing market.

That's very helpful.

And Jim, one more thing on the notebooks and monitors as you have seen commodization of those products, have you given up additional share on the low end to other competitors?

It's a good question.

On monitors, it is really more of a shift in technology in the panel.

They have gone to very low cost monitors as George mentioned, I think he used the word commoditization, and they switched to sort of a low end technology for LCD panels that allows more light to pass through.

So I think the need for higher types of films and monitors has become less.

There is still going to be a premium segment of monitors where our films will find good applications.

So I would say we have not really lost share to competitive enhancement films, but we've lost attachment rate because of changes in the panel technology on monitors.

On notebooks I think you are familiar with the key competitive alternative there we have seen for some time is turning film, which is a different take on Prizm films.

We had lost a little share to turning films over time.

That has been stabilized, that was stabilized more or less six months ago, and we have not really lost more share on notebooks.

And last thing what is the mix shift mix breakdown between films for LCD TVs and the rest of a portfolio?

How much is it for business now LCD TVs?

That has really grown very quickly, and if you look at the latest figures in 2006 it is more or less 30% of the total sales dollars today LCD TVs.

That would equate to square feet of your film being produced as well or sold?

I don't have that figure handy.

That would be a larger percentage going into TVs than what I just gave you.

So just to be clear your business now is about 30% LCD TVs?

For film?

That's about right, yes.

Thank you very much.

Dmitry Silversteyn, Longbow Research.

A lot of my questions have been answered.

Can I go back for a little bit, if you look at all the issues that are facing the company whether you're talking about the inventory corrections or plant problems in the optical films, you have declining sales in diaper tapes and rear projection CRTs.

You've mentioned an overall slowing down in some of the economic sectors that you are exposed to, under capacity in other sectors.

And with all of that you are still looking at acquisitions, you are still looking outwardly a lot to try to generate some business growth.

Do you feel there is too much on your plate right now that you should be concentrating on getting the internal things fixed before looking outward, or trying to get your capacity expanded before you go after extra business?

Or can this all be done at the same time?

Is there enough infrastructure in place for you to keep tabs on the progress in all of these areas?

Excellent question, Dmitry, but the reality is the answer to the question is, yes.

The answer to the question is yes because different people do these different things.

The focus on factory comes from factory people.

The focus on market development comes from business development people and M&A, and the new product comes from other parts of the Company.

So it appears to us that we readily have the capacity to handle a number of spinning plates at one time, but thank you for the question, but it's probably not the concern that you think it is.

Jeffrey Sprague, Citigroup.

Good morning, everyone.

Just kind of getting back to kind of managing the changes in the demand flow of the business, given that you are at the back of the chain, thinking retail demand to OEM to panel to you guys, I understand if somebody canceled the last week of the quarter, but you would have thought through point-of-sale information and things like that that you wouldn't have been so surprised.

And I am just wondering if you could give us a little bit of color on how you actually measure the market.

And as a follow-up to that, I believe you said, although maybe I got it wrong, that you are actually now building inventories in your film business in preparation for the second half.

So in essence, you're not waiting for the demand pull from the OEM; you've decided to go ahead and start building in anticipation of that.

It sounds like there could be some risk there, too.

So if you could address that whole range of questions of staying in sync with what the demand is.

Thanks, Jeff.

This is Jim again.

I would say first of all we are building some inventories in anticipation of the LCD TV ramp up that we expect.

So that's true, not a huge amount, but we are building some.

We do a lot of monitoring of the markets.

We do retail monitoring mainly in the U.S., and that is probably one of the weaknesses we have.

The LCD market as you know is a very global market and the LCD TV market is larger in Europe than it is in the U.S. and larger -- it started in Japan, so we need to probably improve our retail market knowledge outside of the U.S.

But we study the market in the U.S.

We subscribe to the same types of reports you do and get the details on panel inventory.

But the problem is in the end we are kind of dependent on our customers and we are there to serve them.

And if they are -- they want to order our products and they want to ship within the next couple of days, we need to be there to service them and that is the final metric.

We have to be there, and that is kind of what happened that we were receiving information that they were still going to be looking for films and in June, it just dried up and they ended up canceling some orders and you know the story.

This issue of kind of attachment rates on large screen LCD TVs, basically engineering a non film solution, do you -- where is really the pinch point on that?

Is the OEM backward integrating into those type of applications, or is someone stepping up in the supply chain and really pushing that alternative approach?

Well, it is probably both, but I would say that on the television side the reason I am so confident in television is that I think brand will always matter, and I think quality will matter in television.

It is much more than it has in monitors.

I don't think people really think about what brand of monitor they have on their desk, but they do care about what brand of television they have, and they do care about the quality of the picture they have on the television.

So we have seen a segmentation, as I said, and in the low-end there are televisions out there that have known 3M films inside but in the midrange and the high-end, they definitely see the value of our films.

And our goal and our goal has always been to maximize attachment rates and to maximize operating income dollars in economic profit dollars, and that is what we will continue to do.

And then just I think George in his intro mentioned mechanical failure, Jim.

Is that part of the problem, or is that just when it rains it pours type of dynamic that just further mucked up the quarter?

Is this mechanical issue related to the yield issue and everything else that's going on in the business?

No, it was really definitely when it rains it pours kinds of issue because we were already seeing some challenges with the quality with these particles and with the tiny defects that I described earlier.

And then we had a very unexpected mechanical failure, and it was not easy to repair.

It took about two weeks of extremely intensive work to repair the mechanical damage, let's say, and then another two weeks to really fine-tune all the control systems and take a lot of preventative actions to prevent that from ever happening again.

So that was a surprise, a nasty surprise.

But we're definitely through that and now we're focused much more on the film quality issue.

Another thing that didn't come out earlier, I think we've already demonstrated with this new piece of equipment it was built for LCD television.

We've already demonstrated that it can produce better film in terms of flatness, in terms of color uniformity.

So we are really confident that we will get the yields up, get the cost right and end up with a superior product for television.

And then just two quick follow-ups for Pat.

I think, Pat, if the settlements in corporate if we adjust out of that corporate, it is a diminimus number in the quarter.

That's right.

What's going on there?

Normally we run give or take 15, $20 million there.

It does adjust on a quarter by quarter basis.

So there really wasn't anything that unusual that you got to look at, Jeff, in the quarter.

But I assume there must be some little gains or something going on in there, right?

No.

There's not.

There is nothing, there is a lot of onesy, twosy things that get reported there.

Sometimes it is plus five, sometimes it is a minus five.

Nothing material.

And then just on free cash flow, Pat, you mentioned the tax payment issue in the quarter, and there was some talk around inventory, obviously impacting the numbers.

But what is the look on free cash flow in the second half of the year?

And I don't know if you can give us any early thought on how these things kind of play out as you get into '07.

On a long-term basis there is no reason for me not to believe that our free cash flow will somewhat mirror our net income.

You do have quarterly movement because of tax payments and the like.

And when inventory gets built or depleted, but on a long-term basis I really don't see too much of a difference there.

Now longer-term it is our desire we've got to get our inventories back down.

We're going to struggle here a little bit as we get some of our supply chains fixed.

But long-term our objective is we've got to get our working capital and specifically in this case inventories, back down, but it's going to take us a while to achieve those levels.

Thanks a lot.

Tony Boase, A. G. Edwards.

Thanks, and thanks for extending the length of this call this morning.

You know my question I guess goes to the long-term growth of your optical film business.

And as you said this morning, 30% of sales are derived from LCD TVs, and therefore a 70% is derived from notebooks and monitors, primarily.

If those are potentially shrinking in dollar value or in sales, not only due to price declines, but also de-contenting.

Won't it take a while before you can really get back to a sustainable double-digit sales growth in optical films, given your current mix and the amount of time it will take for the film business to really kind of outweigh the effects of what is going on in monitors in particular, but also probably to a certain degree in notebooks?

I think it's a very good point, Tony.

If you look at our business we have four main segments; television, monitors, notebooks and handhelds.

I think you probably forgot to mention handhelds but for us in particular that is a very, very important segment.

So we see growth in the handhelds; we see notebooks holding steady, and actually if you think about some of the dynamics in the industry, people are shifting away from monitors into notebooks which is a good thing for us.

I think other people are shifting from monitors kind of into an all-purpose monitor television, which is also probably a good thing for us.

So we see a lot of strength in notebooks, in handhelds and in TVs.

I think you have a good point on the short-term view because we are in sort of a period of adjustment right here where we have the combination of the inventory adjustment, you have the monitor de-contenting, and you have the end of the year push on TVs.

So it is going to be a little bit difficult to predict between now and the end of the year, but I feel confident we will see good growth from TVs, good growth from handhelds.

I just can't really give you a very firm number on top-line, and as far as sustainability, none of the fundamentals have really shifted that much for us in terms of the fundamental strengths of the business.

I think we just have to keep focused on attachment rates and on the yields and getting our costs down and making sure we're on every LCD display we can get our hands on.

And just to clarify what would monitors represent as a percentage or as an end market for your optical film business?

It shifted quite a bit over the years.

If you go back to when I first started in this job in 2002 monitors were about 45% of the total business; in 2006 we are talking more around 20%, so there has been a significant shift over time and that has accelerated in the past year I would say.

Monitors really hit the wall from an inventory standpoint in second quarter.

And lastly, Jim, I wonder if you could draw any parallels between this current inventory correction and I suppose the one that we experienced a couple years ago.

And it struck me that maybe the last inventory correction from a couple years ago, took three quarters maybe to really sort itself out, and it sounds like your expectations are for something that is resolved in a much shorter length of time.

I think that's right.

I think the previous dip that I didn't really personally live through, the one that back in the '01, '02 timeframe if I remember correctly was more challenging than this one.

I think if you talk to Andy Wong who George mentioned, I think he sees this inventory correction as being a little shallower than ones he's seen in the past.

Thanks for your time.

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 comments.

Thank you everybody.

While the second quarter was disappointing I can assure you all the actions are in place to drive growth at the same time address as quickly as possible our manufacturing challenges.

We're both optimistic and energized about the second half of the year, and working very hard to meet our commitments to stakeholders for the Company.

Thank you everybody for listening.

Do appreciate your time very much.

Thanks, everybody.

That does conclude our conference for today.

You may all disconnect, and thank you for participating.