3M (MMM) 2010 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the 3M second quarter earnings conference call.

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

Afterwards, we'll conduct a question-and-answer session .

(Operator Instructions).

As a reminder, this conference is being recorded Thursday, July 22nd, 2010.

I would now like to turn the call over to Matt Ginter, Vice President of Investor Relations at

Good morning, everyone, and welcome to our second quarter business review.

For those of you that attended our investor meeting in Kentucky last month, we hope you found it helpful in understanding our Company further.

Also as I've mentioned on the past two calls, please mark your calendars for the morning of Tuesday, December 7th, when we'll host our annual out look meeting in New York City.

Complete details regarding timing and location will be available very soon.

Before we begin, take a moment, please, to read the forward-looking statement on slide number two.

During today's conference call, we'll make certain predictive statements that reflect our current views about our future performance and financial results.

We base these statements on certain assumptions and expectations of future events that are subjects to risks and uncertainties.

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

Let's begin the review.

I'll turn the program over to George.

And please turn to slide number three.

Thank you very much, Matt.

Good morning, everybody and thanks for joining us on our second quarter call.

As you have seen, it was another outstanding quarter for us in both revenue and earnings as we essentially repeated and built upon the success patterns of recent quarters.

In fact, sales of $6.7 billion matched our previous all time corporate record set in 2008.

And coming off the depths of the recent recession, I think this is a remarkable achievement by 3M's people only one year after such a terrible economic contraction.

We once again delivered tremendous organic volume growth; 18% this time.

Nearly twice the rate of global IPI.

While it's difficult to determine accurately the exact sources of growth, the strong economy was certainly a factor and as we explained last quarter, we continue to take market share and create new markets with a high level of new product vitality.

It's opening many old and many new customer doors for us.

As we've done throughout the downturn, we continue to invest in and build for the future.

In Q2, we took a major step forward increasing advertising and promotions by nearly 30%, mostly in consumer, and increased R&D spending by 13%.

I think this speaks directly to the strength of the 3M model in that we were able to generate very high quality results even as we invest and build for future success.

Second quarter record operating income was $1.6 billion, up 34% on last year.

I'm especially pleased at our margin performance at 23.7% with all businesses achieving 22% or better margins.

The corresponding EPS at $1.54 per share is a 38% increase year-over-year.

Now, let me take you quickly through the business highlights.

Please turn to slide number four.

In our largest business, industrial and transportation, sales were up 23% and leveraging was outstanding with profits up 66%.

Within that segment, our newest division, renewable energy was up 73% in sales coming off a 72% increase in the first quarter.

FYI, we built a brand new [calking] line for this business in Singapore last September which very quickly sold out.

So we'll be expanding capacity again in the months to come.

Also of note, is that our automotive OEM sales were also up nearly 50%.

This compares to global auto bills in the mid 20% and the abrasives, our oldest business, was up an impressive 28%.

Healthcare sales rose 5% in dollars or about 6% in local currency terms.

H1N1 was about a point drag on healthcare growth.

The stars in healthcare were drug delivery systems which is creating double-digit growth largely from new products.

Dental care sales were up 7% in local currency, and our core skin and wound care business grew at a similar rate.

Healthcare profits increased in line with sales, reflecting increased investment levels.

Even work with those investments margins, were a very spiffy 31%.

Display and graphics continued on its impressive growth and profit trajectory with a 30% sales jump and profits up 69%.

Optical systems, again, led the way with a 64% sales increase, driven almost entirely by new products.

Our technology is in the sweet spot of need as LCD TVs migrate to LED back lines.

Another star was our commercial graphics business.

In 2009 it was impacted greatly by the downturn and is now on an upswing with second quarter sales up 22% year on year and 12% sequentially.

This is especially encouraging more generally since in our experience commercial graphics is usually a proxy for business renewal and advertising expense.

Consumer office sales rose 10% with organic growth accounting for over half the increase.

Acquisitions were also a significant driver with the addition of Ace Bandages in the retail healthcare space and A-One in the Asian retail [level] market.

Consumer office is another investment story as we're adding sales and marketing resources, especially internationally in addition to the [ad/merch] investments I mentioned earlier.

Profits rose 7% with margins at a healthy 22%; very good for consumer business in these unusual times.

Safety, security and protection services grew sales 10%, a great result even as H1N1 related respirator sales naturally tapered off as that crisis passed.

We estimated that H1N1 added about $18 million in sales for the second quarter results.

In comparison a year ago, H1N1 sales totaled $50 million.

So the drag on Q2 growth for the total Company was about 0.6%.

Security systems posted growth of over 30% on both industrial mineral products, and building and commercial services drove double digit sales increases.

Profits in [SSPS] rose 9% and margins were maintained off at 23%.

Last but certainly not least, electronic communication sales rose 32% while profits rose a whopping 150% and margins approached 23%.

Consumer electronics is the story here as our business that is serving the electronic market grew over 60%.

Using logic chip set sales in the proxy, the industry was up 34%.

You might logically ask why we're growing so much faster than the market.

The answer, again, is new products, like our [Opticare adhesives] and new market share, as increasingly 3M components are being specified into a number of leading electronic handheld devices.

Growth wasn't limited to electronics though, as electro markets division, which is the utility MRO construction oriented division, sales grew by 17% year-over-year and nearly 10% sequentially.

In summary, with another terrific quarter with some real eye popping results.

Some of us though have said as a practical matter, investors are not interested today in anybody's second quarter news or their results, only what they see as a very uncertain future.

We certainly understand and sympathize with the basis of that view.

In that vein, let me try to answer two principle questions for you today.

The first is, what are we seeing in economies around the world that might indicate where these markets are headed in the coming quarters.

And the second question is, what progress is 3M making toward our goal of more or less doubling our national organic growth rate.

Hopefully, we're going to target north of 7% growth if IPI is within its normal historical balance of 3% to 3.5%.

Let's remind ourselves that with the second quarter now behind us, we have seen the end of arithmeticly easier year-over-year growth comparisons.

It's now going to get a lot harder for everyone, not just 3M, from here on in.

We made that simple observation at the beginning of the year on our fourth quarter '09 conference call, but it seems to have been misunderstood here and there.

We were never speaking about the innate growth capability of the Company, only a simple exercise in year-over-year arithmetic.

Turning to the world economies, the [pen at] of the end market demand, you're seeing has remained very positive overall.

Some of the things you would expect to see happening have some interesting positive twists and turns.

Asia and Latin America will be no surprise to you in that they remain very strong.

Before anybody infers that this was just the law of averages working across several months and many countries, let me give you a little bit of extra data.

China as a proxy for Asia rose 51% in the quarter and 45% in the month of June.

And Korea grew 68% in the quarter.

Brazil was a comparable 50% in the quarter and 42% in June.

Europe was quite strong for us also with local currency growth coming in at 11% for the quarter and 11% in June as well.

For context, please remember that the recovery had already begun for us in June of 2009.

There was some mild softness in Spain and Greece with sales flat for the quarter as you would expect.

But we see no signs of contagions in our numbers.

A few small eastern European countries fitted that same pattern.

The sales in June showed good recovering trends.

FYI, Greece, Spain and Portugal combined make up only 1.5% of our total sales and are, therefore, not a large factor for us.

Emerging markets as a whole showed gains of 38%.

You can see now why we have such a focus on our international strategy when you consider that emerging markets now account for fully one-third of all 3M sales.

It was a mere five years ago that emerging markets comprised only one-quarter of our sales off a significantly smaller base.

For the quarter, the big European economy is running two different speed lanes.

Germany was in the Audubon style super fast league at more than 20% local currency growth in the quarter and 27% in June, which more than made up for any slowness elsewhere in Europe.

Germany's IPI in the second quarter was estimated to be 9% so we grew at about 3X the market in Germany.

Italy, France and the UK were all in the cruise lane at about 5% to 6%.

If you imagine that what happens in these countries from here on in, will be highly variable from market to market, affected by a combination of the presence, or lack of, local stimulus funds, foreign exchange rates, China especially is impacted here, and whether their markets are local consumer led or more export oriented and what rates they're recovering at.

We really don't have the time to go over each of them one by one.

For export-led manufacturing economies like Germany, Japan, China, Korea and Taiwan, all appear to remain robust at this time.

Overall, we remain cautiously optimistic and think the risks of a second economic collapse is small.

That said, as stimulus funds run out, we must expect the collected end market demand in those economies to taper off, accentuated by the more challenging arithmetic of year-over-year comparisons.

Underlying market growth is slowly increasing in most markets, but perhaps not at the same rate as stimulus funds could dry up, depending on local policy execution.

The US is trying to feather in that change to avoid a sharp decline in demand.

The outcome is that there will be possibly a period of slower growth, beginning in end markets later this year, perhaps late Q3 or early Q4.

This isn't a double dip per se, it's just a soft spot and very normal as economic growth takes a breather for a while and adjusts to new circumstances, such as higher interest rates, lower stimulus or commodity inflation.

All are very normal in my view.

We get one in every recovery.

I think the fact here to note is that companies that innovate well can beat this trap.

The unknown factor, while it's very hard to assess with any precision, is the longer term impact of debt levels in Europe.

If all the nations in Europe address this problem systematically and simultaneously, then growth will inevitably ease.

Reports suggest this factor could reduce [euro zone] GDP by 1% to 1.5%.

In my experience, [custom] social programs are always less successful than their well-intentionally plans.

In my mind, as long as the [break did not go audibly hard], slow economic growth is certainly better than sovereign debt defaults and bodes well for future -- a better future as default risks fall.

As long as we as a Company keep innovating and differentiating, this mild slowing is not necessarily negative for 3M.

After all, we surely can comfortably overcome a small 1% GDP reduction in a few countries.

It's the relative competitive advantage that counts.

I maintain my view that even if you shake the bottle, the cream always comes back to the top of the milk.

In the US, the key to improved long-term growth remains unemployment investments.

Candidly speaking, if the US Government wanted to help the situation, it would be finding ways to encourage investment in manufacturing and not adding more entitlement programs.

In my view, prosperity is the best way to ensure security in any nation and for any company.

US employment is moving forward a bit, even if it is at [snail] like pace.

Productivity for us and many other companies is outpacing both inflation and GDP growth.

And that means two things.

One, margin trends will be good.

And, two, apart from new technology areas, overall hiring will likely be low.

For those companies who have the capability to differentiate, innovate and thoughtfully invest in new as well as core markets, I think the environment can be pretty good.

And in a perverse twist of irony, it offers real competitive advantage to innovators like 3M.

This is simply a process of the [dowardy] in economics at work.

Turning to 3M's growth capability, we've seen trends for three or four quarters which suggest that we might be close to cracking the growth code.

In the past, we were close to the tipping point, that we've long been in search of.

When do we know this for certain?

I feel a little bit like an economist now by saying that to be definitive, we need more data.

Q3 and Q4 are going to be very important in the quest as the world economy cools a bit and any inventory transients, to the extent that they ever existed, die down.

It's at this point that the share and market creation data will be much clearer.

But tipping point or not, all in all we seem to be making meaningful progress towards our long-term growth objective.

I think this is completely logical to believe that as our NPVI number goes up, we should expect it to translate into more growth either through market creation or share gain.

If two doesn't, then why bother?

What is unknown and probably unknowable is whether the share gains we've made are sustainable or just a one time function of economic recovery.

The other important factor is the improving implicit quality of the products under the umbrella of that NPVI number with more platform products being released than ever and a greater percentage of longer lived products.

The overall trend is very positive, and we plan to show you more of the data behind it in our annual update in December.

To summarize, our microeconomic views have played out more or less as we expected, confirming our plan was and still is the right plan.

To speak candidly, we believe we can deliver superior performance whatever economic scenario unfolds, good or bad and we're not afraid of it.

We've clearly demonstrated our ability to generate growth and leverage earnings while always keeping our eyes and investments on the longer time prize of much higher growth.

What is clear is that we have tremendous momentum in our favor, with 18% organic volume growth in Q2, which is well in excess of market growth.

For three quarters in a row now, we have generated net growth of about 8% to 9% above the market.

We all know how fickle these things can be, but this is clearly much more than a one quarter flash in the pan adjustment.

In fact, we have outpaced economic growth by a large margin for nearly a year.

If we can do this again in the next couple of quarters, I think we should all conclude the growth point has been proven.

I can't, however, promise you a [monotonically] increasing pattern.

The road to growth often has a few bumps on it.

We also have to closely watch demand and have the confidence to invest in capacity just a little bit ahead of it.

Otherwise we'll stifle growth as capacity, not demand, becomes the new short point.

3M's people have proven we can simultaneously do acquisitions, invest heavily in the long-term, drive R&D productivity and service low parts [we're in currently] without margin collapse.

If the growth point gets proven in the next couple of quarters and if I were in your shoes, I would soon be asking the next question, how much more money can you put to work and repeat the trick.

With that, let me address our outlook for the year.

Please turn to chart number five.

With a strong second quarter behind us and with great forward momentum, we're raising our full year 2010 expectations for the third consecutive quarter.

We now believe that organic sales volumes will come in between 13% and 15% for the year versus a prior forecast of 10% to 12%.

We also expect that earnings per share will fall somewhere within the bound of $5.65 and $5.80 on an adjusted basis versus a prior expectation of $5.40 to $5.60.

We anticipate that operating margins will be above 22.5% for the year, half a point higher than our previously expected numbers.

Our tax rating sharecount estimates are unchanged versus last quarter.

I hope this color helps you.

And I'll now turn over the call to Pat who will explain our second quarter results in more detail.

Thanks, George, and good morning, everyone.

Please turn to slide number six.

On a year-over-year basis, sales rose 18% in the second quarter to $6.7 billion and importantly equal to previous peak sales level from the second quarter of 2008.

Growth was led by Asia Pacific at 42% and Latin America at 23%.

We saw a tremendous growth in our -- some sales to some of our large and important businesses and industries, including 61% in electronics and 49% in automotive OEM.

As George mentioned, we grew much faster than the underlying market in both of these cases.

As in the first quarter, organic volumes drove up our results in the second.

Organic volumes rose 18% worldwide, with increases of 38% in Asia Pacific, 22% in Latin America, 11% in Europe and 9% in the United States.

Acquisitions at our 70 basis points of growth versus the second quarter of 2009, primarily is attributable to the recent purchases of Ace Products, home of one of the great consumer healthcare brands and A-One Labels, the second largest retail and office label producer in the world.

Both of these transactions are on track to deliver in 2010 and well beyond.

Selling prices declined 60 basis points in the quarter, about in line with our plan entering the year.

The decline was largely due to normal price down trends within our electronics businesses.

Gross profit grew 20% year on year and gross margins rose just over a point to 49%.

Strong volume growth certainly boosted gross margins and in fact, utilization rates were very good in the quarter.

We also experienced carryover benefits from restructuring actions undertaken in 2009.

These gains more than offset some modest pricing headwinds, both in terms of selling prices which declined 60 basis points and raw materials which increased just over 3% year on year on a gross basis.

We fully anticipated this in our plan for the year.

Looking ahead, we expect raw materials to be a slight headwind again in the third quarter, but costs are likely to flatten out in the fourth.

Finally, we saw significant improvements in yield, waste, speed and productivity, driven heavily by 3M's many lean six sigma teams around the globe.

SG&A costs increased 9% which included a 15% increase in sales and marketing investments.

We continue to invest in advertising and promotion, which is up nearly 30% on a year on year basis, as well as sales reps and new marketing talent, particularly in high growth developing economies.

R&D investments rose $41 million or 13% to $350 million for the quarter.

And once again, general and administration costs remained under very good cost control.

Operating income rose 34% to $1.6 billion, a record for any second quarter in 3M's history.

And margins surged nearly three points to 23.7%.

The second quarter tax rate was 26.6%, down about four points on a year on year basis, due to a lower international tax rate, along with the resolution of a number of US Federal tax audits.

We continue to expect full year tax rate to be about 28% or lower which would imply a 29% rate in the back half of the year with the third quarter slightly higher than the fourth.

On a GAAP reported basis, we generated record second quarter earnings of $1.54 per share, up 38% year on year.

Please turn to slide seven for a look at our sequential P&L results.

Sales rose 6% sequentially, despite approximately 2% -- points of currency pressure so in fact, underlying volumes rose nicely versus the first quarter.

Sequential growth is broad based as five of our six businesses posted improvements and the other, namely healthcare generated sales that were about the same level as Q1.

The Company overall continues to improve and expand quarter by quarter.

At a sub segment level, there were many sequential sales highlights, but I'll hit just a few of them.

Optical films posted impressive quarter on quarter growth of nearly 30% as customer production levels rose in anticipation of a good year of sales for LCD TVs and other electronic devices.

Other notable increases include traffic safety systems, industrial tapes and adhesives and automotive after market solutions.

Our retail DIY business also posted very impressive sequential sales gains, boosted by a continuous flow of great new products such as the new generation Scotch blue painters tape and filtering home furnace filters.

Gross profit increased in line with sales and gross margins were a solid 49%.

Factory throughput in the second quarter was similar to Q1 levels and raw materials nudged slightly higher on a sequential basis, but we managed to match Q1's gross margin percent regardless.

Gross profit was boosted by ongoing productivity efforts which continue to play a critical role in our future strategy.

Future growth investment demands continuous improvement throughout our businesses.

SG&A and R&D investments both rose 2% sequentially.

Recall that stock option expense is highest in the first quarter, commensurate with when we grant options to our employees.

Adjusting for this, SG&A and R&D both increased over 5% on a sequential basis.

Operating income increased 10% versus Q1 and incremental profits rose 40%.

Operating margins were up nearly a full point versus the first quarter to 23.7%.

Net income and earnings per share increased 20% and 19% respectively.

Now let's turn to the balance sheet and cash flow.

Please turn to slide number eight.

Free cash flow for the first six months of 2010 was $1.9 billion, a year on year increase of over 10% and we converted 92% of net income to free cash flow over the period.

Slightly lower capital expenditures accounted for most of the difference.

We anticipate that capital investments will begin to accelerate in the second half of 2010 as a number of our key product lines are at or near full capacity.

We expect to invest approximately $1 billion on CapEx in 2010 and early forecasts indicate that 2011 could be up 25% to 30%.

These additional investments are mostly for growth related investments.

For the full year 2010, we're forecasting that free cash flow conversion will be right around 100%.

Acquisition activity was light in the first half of the year, but we expect to increase our acquisition activity in the second half with a number of good opportunities in the hopper.

Net working capital turns were 5.4 at quarter end, an improvement versus 5.3 last quarter and 4.81 one year ago.

Accounts receivable turns were 7.2 versus 6.61 a year ago as receivable balances are up only 8% year on year versus an 18% sales increase, so receivables are in very good shape.

Inventories rose 15% year on year, again less than the rate of sales growth and turns were 4.4 in June versus 4.3 one year ago.

We certainly are not satisfied at these inventory levels, but considering the rapid ramp up in demand over the past two quarters, along with tight supply in some raw materials, it was good to see continued forward progress in our turns.

Overall, our working capital is in good shape and we're well positioned for future growth.

Cash return to shareholders totaled $748 million in the second quarter, roughly double the amount paid in both the first quarter of 2010 and the second quarter of 2009.

We resumed share repurchases in Q2 after a few quarters without and we expect to continue buying additional shares during the remaining of the year.

To quickly summarize, the second quarter was another very good one for 3M.

We drove strong growth and outstanding bottomline leverage, even with significant investments to continue driving higher future growth.

We raised our earnings and guidance from a previous level to $5.40 to $5.60 to $5.65 to $5.80 per share and we expect that organic sales volume growth will be in the range of 13% to 15% for the whole year, three points higher than our previous expectation.

Operating margins will be north of 22.5% for the year and we're anticipating a tax rate at or below 28%, assuming no change of course to current tax laws.

Finally, our balance sheet is in great shape.

It puts us in a strong position, given uncertainly about the shape of the recovery.

Regardless of how the economy shakes out, we'll remained focused on outrunning our competitors and delivering superior financial results.

That concludes the formal portion of today's conference call so let's begin the Q&A.

(Operator Instructions).

Our first question comes from the line of Scott Davis from Morgan Stanley.

Please proceed.

Thanks.

Good morning, guys.

Good morning, Scott.

Good morning, Scott.

Across the board things were obviously very strong, I think with the exception of healthcare which is supposed to somewhat cover comps because that business was pretty strong last year.

My question is what are you seeing in that business because it was a little slow (inaudible)?

Is there across the board some destocking going on?

In dental, is there just -- is it just a function of tougher comps?

Just a little bit more color is what I'm asking.

Let me take it and George can add on.

Actually they performed at basically their historical growth rate, give or take a point.

You do have to recall that they did have some favorable impact of H1N1 in the second quarter last year, Scott, probably to the tune of a point, point and a half of sales that didn't repeat here in the second quarter.

But we feel very, very positive about the progress of that business.

And a lot of it is that they did not fall off as much nearly as many of the other businesses.

Our oral care business, as George said, was up 10% so we had very good results there.

We really have no concerns within our healthcare business relative to the growth.

The two businesses that we saw -- maintained -- they compressed a little bit, Scott, but maintained normal performance was the consumer office business and healthcare.

And you are just really seeing small dents from them last year and comparable smaller growth this year so it's really arithmetic issue.

It just measures the stability in the business rather than anything to worry about.

Okay.

That's what I figured, but thought I would ask.

The other thing price down 0.6%, I think that's first quarter we've seen price turn negative.

I know obviously you've got some -- displaying graphics is always a negative price curve.

Is there any other reason why prices came down?

Because most of your main commodities, I believe, in the first half of the year were probably a little bit higher.

There is no particular reason, Scott.

As you point out, the electronics is the fundamental -- the structural piece of the price down.

I think it's fair to say that if you ask the question, did we give up some price to maintain volume and so forth, when you look at our volume levels, I think it would be fair to say that there is probably some price, okay, that we're trading off to get some volume.

But that's not a big concern for us.

The businesses who have material cost increases are well aware of it and they manage the relative position of price to cost very well as you can see in our overall margin results.

I think, Scott, there is some pricing opportunities that we might be able to grab now.

Also when you think about the very high mix of electronic oriented sales, it distorts the net pricing picture.

So, again, I don't think there is anything for you to be concerned about.

But it looks like there might be a little bit of opportunity here and there.

Okay.

And just quickly, I just wanted to get a sense -- I know it's early in the year to start talking about pension, but just to try to make sure we get our models right for next year.

If we had to mark the market where we're at with discount rates, where do you think that would be for next year?

Scott, let me, first of all, try to address the broader issue.

We have a very, very solid balance sheet so I don't lay awake at night worrying about our pension plan from a funding status.

You asked the question more around an EPS.

I think it's important that you, as well as investors, make sure that we differentiate between EPS and what the cash flow impact is going to be for a number of us who face a little bit of a headwind situation.

But let me just try to table set where we're at.

Going into the year, we had a carryover amortization issue of probably in the order of about $200 million.

If you use tailend of last year's assumptions and for our US plan that would have been an 8.5% ROA and a 5.7% discount rate, that effectively left us in a situation that going into 2011, assuming those results effectively we had about a $200 million headwind.

If you then look forward and I'm not going to give you a specific number, but I'll give you some sensitivity so you can look at -- because obviously, we only measured this come year end.

It's one of these things where you only measure one point in time during the year.

But for every 25-basis point change in the discount rate, it impacts our earnings -- our pretax by about $28 million and every point of return on assets is about $6 million.

Hopefully that helps you.

From a modeling standpoint, you could look at your own set of assumptions.

It's a course here, at the end of the second quarter, we're in an environment where discount rates have really come down very significantly.

I would not look at that as a realistic point from a funding perspective because I think most of us would probably believe that interest rates are going to have to ratchet up in the future.

It's just a matter of when we start to see that happen.

And I think we're all hoping, of course, that the equity markets have a little more of a back half rally to it.

I think we would all like to see that.

I agree with that.

Thanks, guys.

Thanks, Scott.

Our next question comes from the line of Steven Winoker from Sanford Bernstein.

Please proceed with your question.

Good morning.

Good morning.

The first question around -- again, you talked a lot about, again, breaking out that top line core volume growth and talked about what it implied and what must be share gains and new product discussions, et cetera.

But how are you still seeing that restocking part of it playing out?

As you now reflect back on the quarter, what is your sense of total restocking?

I know you just talked about dental a little bit, but just total restocking across the business?

Steve, it's really not that high to be frank with you.

We poll our people here and they really save us just not a lot.

In fact, if you look at the census bureau data, it shows that there is a little bit more maybe destocking than there was restocking net-net.

I don't think that's a big factor.

We tried to calculate what the impact was in the first quarter because we had some monster numbers and we cranked in three to the number.

It might have been a little high.

I don't think it's a big factor at all, Steve.

Maybe it's 1% if you want to put a number on the total list quarter, certainly not more than 2%.

It's certainly less than last quarter.

I don't think that is what is driving it, Steve.

It seems to be when you look at the market growth and you subtract all of the other things you know, you're left with this 8% or 9% of growth that you can only attribute to either share gain or new market creation.

And that has been the pattern that has existed for three or four quarters now.

Of course, you can well understand we try to do our level best to repeat it.

It does seem that the new product growth model seems to be working, Steve, and I don't think that it's -- a big piece of this is being driven by restocking.

Remember, a lot of the channels that we have no stocking.

Automotive has no stocking points.

Electronics has no stocking points.

It's not -- we don't really send a lot through channels that do.

I don't think it's a big deal, Steve.

For the second half of the year, as you look to that organic growth number that you've described, again, that is still dependent mostly on new product introductions and market share gains versus the cyclical rebound?

Is that fair to say?

Yes.

Steve, I would say that we're not anticipating that -- I'll call it the restocking side, okay, is the reason for the back half growth.

It really is our fundamental performance in the back half of the year.

Just add to George's comment as he says, there is always -- it's a little bit of a tricky question on restocking because when you're selling to OEMs and electronics and auto and the like is -- we don't think there is restocking going on, of course, until the point in time that obviously they overbill.

Then in some point in time, they may have excess inventory and they have to adjust production schedules down.

But it's very interesting that a lot of supply chains across the globe are very, very tight today just to meet existing schedules.

I don't think there is a lot of -- there has been a lot of room for people necessarily to build a lot more inventory back into the system.

Plus, let's face it, coming out of the recession, people are more and more cautious about a little bit of last minute ordering still and they are waiting until -- actually trying to tighten up the supply chains even more and pushing some of that back into the suppliers.

Steve, there is another phenomena that we've heard about and that is in the electronics area, that is some double ordering.

Because the supply chains are so tight, so lean and some customers are worried about being able to get products, we do hear some occasional tales of double ordering.

And of course, in the end it's he who has the service (inaudible) inventory that is going to get the business.

You have some risk conditions that exist in some of the businesses so I'm with Pat.

I think it's not a big factor as we see it at the moment.

Could you maybe expand on the incremental margins in consumer and office and safety over the last quarter?

Just struck me on the incremental side, a bit low.

But just peeling that apart a little bit.

Yes.

And in both of those businesses, you just have to be a little cautious, Steve, because of the sell in to distribution and when we promote products.

Generally speaking in the first quarter and a consumer specifically, we don't spend a lot of money in average sales and promotion, but that starts to kick up here in Q2 and then through the rest of the year.

If you look at the margins in that business though, you just -- I still think that we're leading margins in about any consumer business.

I look at that business really more from a standpoint of, are we investing enough in it and really helping the retailers sell through the products that we have.

I think it's more of a timing of expense issue than it really is any incremental -- so if you look at it over a trend basis, Steve, and on an annual basis or longer term basis, they should have similar incremental margins, but you just have to be a little cautious on it quarter by quarter basis.

Only one last piece of color, Steve.

We did decide to fund some projects on more advertising and merchandising, and feet on the street in some of these emerging markets.

It just seemed wonderful opportunities to us.

We did make some of that spending this quarter.

Again, I think you should see -- as long as you understand the reasons for -- behind the question or behind the data, you'll feel more reassured.

Because actually a positive, we're investing in growth, not suffering some price compression or difficulties in the business.

It was completely the opposite.

Great.

Let me hand it off now, but thanks.

Thanks.

And our next question comes from the line of Jeff Sprague from Vertical Research Partners.

Please proceed with your questions.

Thank you.

Good morning, gentleman.

Good morning.

George, back to your maybe closing thought before you tossed it to Pat on if you have cracked the code, how do you deploy capital to further capitalize on it.

Obviously, R&D is lagging sales.

Not really from a lack of wanting to spend R&D, but the sales are just so darn strong.

Yes.

But I wonder if you look at the balance between R&D and capital, how you think things play out going forward.

I think you've done a lot of work untangling the hair ball as you used to call it.

But you do have a lot of product in the pipeline.

Is the growth challenge there actually getting the capital in place to deliver them or do you actually feel like you need to continue to really prime that pump more to drive the top line?

I think it's a great question, Steve.

I really do.

We talk about this -- if you look at that roughly 30%, 31% NPBI number where we're at right now and we really haven't lowered a lot more people into the system.

It's a similar number to what existed when it was in the low twenties or the low eighteens.

We clearly have driven some real good productivity in our R&D.

Now, you say the question, how much more can we get out of productivity and how much do we need to put in real money on spend.

You have to think of a couple of things there.

One is just the basic administration burden in R&D.

Secondly, as Pat makes the point, we still have loads and loads of growth opportunities in emerging markets which is generally less expensive.

My feeling on the R&D is it probably has to go up a little bit if you're going to continue to accelerate that 30%, 31%, up to 40% which is what really is our goal.

On the capitalizing, the growth rates we've been seeing in some of these businesses in optically clear adhesives and optical films, in abrasives, in the renewable energy and those areas, we have really just loaded those factors up.

I think -- I only say it on the call because I think it's a reminder to ourselves as well as investors that there is another piece of this puzzle that we have to have capacity to do it.

I think right now we seem to have got the R&D net-net.

I think we got the R&D thing running pretty well, Jeff.

And here and there we're just going to have to pay increasing amounts of attention to investment in those big businesses.

We have talked to investors about increasing the capital expense of the year, probably taking it up by another $100 million maybe to $120 million, but something of that order in response to the question really that you're asking.

I think we're okay for now.

I think we have the people to execute it, Jeff.

But if you continue to get these growth rates for a long time, clearly we're going to have to put some more people in here and get some more infrastructure to execute it to make sure it is all kept in balance.

That is a high class problem.

Really high class problem to have.

Exactly.

And then I'm just wondering to get in the weeds a little bit on consumer.

The organic growth was a touch lower than I was guessing.

Was there any channel fill from the label initiative or is that more of a back half dynamic?

Did that have any impact on the quarter at all?

Yes, Jeff, first of all, specific on your question on label initiative, very, very small here in the second quarter.

That's going to take a couple quarters to gain some volume traction here.

But the other thing, maybe I should have brought this up with Steve is last year if you recall during the recession period, the retailers were really struggling getting floor traffic.

They actually tried to pull some of their back to school into the second quarter.

One of the things that we did see is fewer back to school sales in the second quarter which we'll see now into the third quarter.

That is purely a timing issue.

Actually I recall that now.

And then just finally on commercial graphics, you're not the first company this earning season that is starting to hint that maybe some of these commercial markets are looking better.

I wonder there if you can parse apart just underlying demand versus your own new product momentum in that market.

You see a genuine turn in demand or do you think it's new products and penetration there?

It's hard to know exactly, Jeff, where it's coming from.

If you look at the reports, you see that some of the markets are still pretty [moribund].

But I think the sales and the distribution are in the distribution there, Jeff, for the most part.

Utility sales, commercial construction sales, those things that you see in the market division, I actually just briefly mentioned in my remarks, we have 17% growth.

I think it's way too early, Jeff, to be suggesting there is some resurgence there.

I'm hard pressed to believe that.

I think it's us getting new products.

And maybe here and there, maybe there is a little bit of restocking.

If there is any restocking anywhere, that's the place in these distribution channels (inaudible).

I don't want to be forecasting any resurgence in that market.

I think it's way too early at this moment.

It does seem that our new product formula is working to the extent (inaudible) in that market.

A lot like the rest of our businesses, the growth rate outside of the US was much higher.

Yes.

In that business than it was inside the US, even though we did see some recovery back in the US as well.

Thank you, guys.

Thanks, Jeff.

Our next question comes from the line of Terry Darling from Goldman Sachs.

Please proceed with your question.

Thanks.

Good morning.

Good morning, Terry.

Good morning, Terry.

Gentlemen, I wonder if you could talk a little bit about the incremental margins in the second half of the year, implied in guidance.

It looks to me if you scope the high end and the low end of the range here, you're more in the mid 20s.

You were 39% in the first half.

And we talk about price cost getting less negative in the back half as you trend through it.

Presumably you're stepping up some investments in that context.

But I wonder if you can just talk a little bit more about the elements that are driving that lower incremental in the back half and what level is conservativeness that you might be building in there.

Shame on you, Terry, for thinking that we're building conservatism in.

Safe assumption here for about a year, right?

Two things to talk about here.

One is we are stepping up our investments in the back half of the year around growth activities.

Those programs take awhile to gain the traction need be.

The FS markets vis-a-vis the first half, will be a little bit more unfavorable the way they are playing out here, based upon the assumptions we had at the end of the quarter.

Now the Euro has bounced back here a little bit.

But the way we do our forecast is really more off of a quarter ending rate.

S FX is a little unfavorable and I think you're looking at it from OI leverage, not an EPS leverage.

Because the other thing you'll see on the EPS side is the tax rate is higher at the back half of the year, but I think you're focusing more on the operating income leverage.

Yes, operating income, yes.

Those would be the factors that I see.

And then the other question always becomes what happens to the fourth quarter.

I feel reasonably good about third quarter volume levels.

Fourth quarter is always a question as to what happens comes December around plant utilization and the like.

Okay.

And then you didn't get all the way into negative territory on that net debt to cap, but you got pretty close.

You did step up the buy back a little bit, but presumably that's just in the context of offsetting the options.

Can you give us an update with regards to where you are and getting a little more aggressive with the balance sheet?

On the repurchase, it was just not an anti-dilution.

It really was our view as to there was some good buying opportunities in the second quarter.

And that will still be our mantra is that if we see good opportunities in the market, we will continue to pursue them.

But I must also say on the other side is that George and I feel a lot better about our acquisition pipeline, okay, as it's materializing here in the second half of the year.

We'll have to balance all of those factors out.

We all know that reinvesting back in this business is the right thing to do.

That's going to be our first and foremost priority.

If you think about the acquisitions we've done and all the rebuilding we've done, we've still managed to maintain good growth rates and great returns, great margins.

It's really why I pose that question.

I posed it for ourselves before anybody posed it for us because I knew it was going to go down that pathway.

And as Pat said, we have a number of quite exciting acquisitions which are close to maturity that we hope to get completed in the second half of the year.

I think you'll be quite impressed with some of them -- some nice technology areas that we're trying to get closed.

I think you'll see this concern that disappear, certainly wain as the year goes on.

And report --

And, Terry, back to Scott's question, companies like us who have a pension legacy issue, probably the reason we do keep a very strong balance sheet is to be able to adjust to, I'll call it shocks in the system.

We feel very good about our flexibility there.

Okay.

Then just lastly, George, I wonder if you can talk about the 25% increase in CapEx in 2011.

Presumably the biggest increments go to where the growth has been highest, but any other color you can put on those initiatives for us?

It's a pretty big increase and obviously you wouldn't be making those if you didn't see any opportunity to continue to grow the business.

But maybe more color there for us.

No, it's a good question, Terry.

There are a lot of places which are getting a little bit tight on capacity.

In particular, it's the renewables energy area, we need more capacity there.

We need more capacity in some of these very, very exotic abrasive grain areas.

We need some more capacity in (inaudible).

The demand for display technology with the things that we make for them is just -- it's just enormous.

They are the areas, but they're not the only areas.

We're seeing good growth in general industrial type usage.

I suppose at some stage we will eventually see some other markets like construction come back.

But as you quite rightly pointed out, Terry, it's focused on those areas where we see the greatest growth.

And even in our optical films business, it's quite remarkable that the guys in optical have done just an absolutely magnificent job of reinventing that business, driving out massive cost, eye popping costs and increasing productivity per square meter by almost 300% percent.

It's really quite remarkable what they've done.

And it looks like -- and you know how that business can be.

But it looks like that business is set for the next year and a half pretty nicely, maybe even a little longer.

And we're probably going to need some more capacity, either to alter some of our capacity and modify some of our capacity that's dedicated to some other places with a little priority or some new capacity in there.

That's where the new demand is going to be.

George, just to follow up on the point on optical because it's interesting.

With that much cost out, do you see that business -- obviously there is still going to be cycles there.

Do you see the volatility in the margin through the cycle as less dramatic?

Though that cost out process, have you fixed the fixed cost mix in that content or how should we think about that?

Yes.

I think you should ask the question and we ask it ourselves, what is the (inaudible)?

The price on these electronics, it comes down and down and down and down.

The ultimate goal of any large consumer electronics company making TVs is to have an empty box on the wall that costs nothing that does everything and that is their ultimate goal.

But if you just look at where the [asymptotes] likely like, look at the cost of material, weigh them, look at the cost of building material, multiply it by some small return and you can make measurements as to where the asymptote is going.

If I was making an educated guess right now, Terry, I think the bottom of this cost reduction cycle for TVs comes within the next three years.

And so I think if we continue to win that battle, so the asymptote gets there.

I think the pricing pressure goes away.

You reap the rewards of all of cost reductions and efficiencies that you've got.

And what happens when you get to the bottom of these cycles, Terry, is you get recounting.

I think this matures into a somewhat slower growth stable margin, good margin, great relationship business that is like many of the businesses in 3M.

We have gone through these transitions.

I think that's the corner of that journey is somewhat close to three years away.

As long as we can keep on winning for around that time, Terry, we're going to be in great shape.

Very interesting.

Thanks very much.

Thank you.

Our next question comes from the line of Bob Cornell of Barclays Capital.

Please proceed with your question.

Yes.

You guys got good job explaining what is going on.

Just a couple of mop up questions.

The analyst day, you mentioned, George, of the incremental growth spending, a third of that would occur in the second quarter.

Did it actually happen or it sounds to me you might have pushed some of the growth spending out to the second half?

I would say to answer for George there, I would say that realistically with the projects that we've got it takes awhile to get people hired and in place and executing.

I would say probably, Bob, it's probably moved a little bit more towards the back half of the year from where we obviously have penciled on paper.

The final question for me, the corporate expense and how it's allocated was, again, an $80 million number which is in line with the first quarter, but way more than I modeled.

What is going on there and what is the outlook for the line item for the year?

Bob, what is in there year on year specifically is I'll call it the finance related losses on our pension plan.

And I think we've modeled it at about $30 million a quarter, I believe, is the year on year impact.

Right.

Some of the other things that are rolling through there is as our earnings go up, we do have higher, I'll call it variable comp around bonus payoffs and so forth and that flows through there as well.

How would you guide that for the balance of the year then?

About $80 million a quarter?

I would say that or slightly less than that, Bob, would probably be my thinking.

Okay.

Thanks.

Great quarter, you guys.

Thanks ,

Thank you.

Yes.

Our next question comes from the line of Stephen Tusa from JPMorgan.

Please proceed with your question.

Good morning.

Good morning, Stephen.

Can you talk about what the third quarter organic growth target is?

We can get an idea of realtime economy, no real restocking, destocking.

Just curious what you are seeing near term.

I don't think we gave you a third quarter guidance number, but good try.

But if you think about -- if you extrapolate the 13 to 15 and you take what we did in the first half, it gives you a back half number if you just do the math as 8 % to 12%.

Okay.

And you look at the comps.

The comps are more difficult in the third quarter than the fourth quarter so I think it's fair to say that the third quarter should be better than the fourth quarter from a reported perspective.

That comp gets about ten points tougher from the third to the fourth from negative five to positive six?

Yes.

But I don't know if it's going to translate directly to that.

The other way I would look at it is -- I look at Q3 to Q2 is another way to think of it.

I think Q3 will be a lot like Q2 from a revenue -- an absolute revenue perspective is maybe the way to look at it, Steve.

Okay.

Okay.

Got you.

And then just on D&G, I know you guys talked about the margin going back to 20%, but you're saying it's more stable at a higher level.

Are you now coming off that 20% target for D&G now?

It's stable within our window of visibility.

Okay.

What we've always said around that business, Steve, is that we understand the nature of playing in the consumer electronics game.

And as long -- as George was explaining, as long as we're winning both on a cost standpoint and a product standpoint, it's a very good business.

But you also have to be aware that that business can change rapidly.

We're trying to bracket our thinking in that business around -- on the down side it can be a 20s margin business.

But when it performs well, it will do very well for us.

And we just want to be fair with everybody to realize that within just the nature of the business is that you can have that range of outcomes.

But of course, what we're focused on is how can we keep the up side going, realizing we have experienced and just the nature of the industry as such at times it can have a tendency to retract.

We're trying to provide you a reasonable bookend for you to think about.

I think with me --

One last question.

I was just going to add something if I can, Steve.

When I was speaking to Terry, I want to be clear that I meant that the stability would come when the asymptote has been reached and the pressure on price.

Always the pressure on price in that industry.

But the 12 -- minus 12, minus 14 will probably translate to minus three, that kind of number.

And what I really mean is not that there is not the possibility of volatility between now and then, it's just when the asymptote has been reached, it's much more likely that this is a more stable, more normal 3M like business going forward.

Okay.

One quick question.

You gave a great bridge last quarter on sequential increases, whether it's merit pay, investment.

Any moving parts going from second to third quarter from a cost perspective that isn't related to volume that we should be aware of?

No.

Other than Terry did ask the question on incremental margins.

When you model it out, it does apply, less than we've been running here in Q1 and Q2.

And really it's around two things.

You have variability around foreign exchange and then you do have our new growth investment centers more backhalf loaded which we probably have 50 -- over $50 million more probably the last half of the year than we do the first half of the year.

Thank you.

Thanks.

Our next question comes from the line of John Roberts from Buckingham Research.

Please proceed with your question.

Good morning, guys.

Good morning.

The strong June volumes that you talked about in Germany and other export led countries, they were actually up more for the average for the quarter.

Is that just because the comps were easier?

Did they bottom late so they had easier comps in June or are they actually accelerating up?

I would have to say they are accelerating up.

Germany as an economy has performed very well.

Export related businesses have performed well.

But of course, remember that in the first half of last year, they did -- they were impacted.

But I think Germany, vis-a-vis the rest of Europe, has outperformed.

And secondly, back to school ordering and consumer and office back to prerecession levels?

Can you maybe just characterize how that feels relative to maybe normal environment rather to last year?

It's a great question.

I'm not quite so sure I can answer that.

My intuition would say, it's not.

With unemployment the way it is and just the sensitivity around consumer spending, I would have a hard time believing that it's the same level that it was back in the prerecession period.

And remember, in the consumer business, we actually started to see that all the way back into '07 which was probably more of when the -- I'll call it the more -- the peak was.

Okay.

Thank you.

Our next question comes from the line of Ajay Kejriwal from FBR Capital Markets.

Please proceed with your question.

Thank you and good morning.

Good morning, Ajay.

Just a question on emerging market.

Nice growth at 38% and you gave nice color by country.

But wondering if you could provide some comments on how much of that 38% is just underlying growth in those markets versus what you're doing on new products and new channels and other initiatives you have and driving growth there.

I don't know the answer off the top of my head, Ajay, but I would say it's at least a 2-1 ratio.

And it may be as much of a 3-1 ratio.

We'll get Matt to give those numbers back to you afterwards.

It's an excellent multiple.

We're doing much, much better in those open markets.

You can take the China market number for example, the 50%-ish with growth of their markets in nearly teens.

We're on a three X or more multiple there.

I gave you -- Germany is obviously not an emerging market, but their IPI for the quarter was around nine.

We put in 20 for the month, 27 in June so between two and three multiple there.

And it's the same in Latin America.

It does seem to be coming from share gain on new market creation.

I think that's the conclusion you have to reach.

I have a tendency to look at it and it's the underlying growth rate of those economies and say whatever we're doing over and above that is really a combination of penetration and gains in new products.

Recall what we said in some meetings is that one of our strategies is to invest heavily in these local technical organizations to develop products that are more closely aligned with market demands.

You start to see that in places like China and Brazil where we have products that are more in tune with local markets.

Then you also have the dynamic in places like China where a lot of electronics are moving to China.

A lot of the new product development that we've got in places like optical and optically adhesives also throw through in places like China and Taiwan.

As you look forward, that multiple versus the underlying economic growth in those counties, how do you feel about that?

As you get tougher comes, I imagine some of that month will get compressed but the 30% looks really robust number.

I think (inaudible) would say that his objective for the emerging markets continues to be in that two and a half, three times the economy growth rates.

Good.

And then on H1N1, that was clearly a headwind for both healthcare and safety in the quarter.

Maybe you can remind us how much of that headwind in the third and fourth quarters was 2Q -- the big tough comp?

Well --

In each of Q3 and Q4 for the Company, the number was about $90 million.

It's the equivalent of about a point and a half of drag on the growth rate for the total Company in each of Q3 and Q4.

Good.

Thank you.

And the great majority of that would be in safety, security and protection.

Good.

Thank you.

Our next question comes from the line of Jason Feldman from UBS.

Please proceed with your question.

Good morning.

Good morning.

Just a little bit of a follow-up on some of the issues.

As the volume has ramped up, have you had issues with your own supply chain?

And the flip side as well, you've mentioned double ordering and electronic and you think you've passed it.

Are there areas where you're really having difficulty keeping up with demand or losing out on business today because of capacity constraints?

In some cases I think we are.

There are some unmet needs, Jason, here and there.

I think that's a fair observation.

Okay.

And there's been a lot of talk about internal investments in R&D.

But specifically on the marketing and advertising and consumer and office and elsewhere, should we think of this as a new run rate or we see continued material increases going forward?

I would say it's a new run rate until we decide that -- they're all obviously paying off and then we decide if we want to take on new investments on top of that.

In absolute dollars, we are ramping up our spending and thus far, we're very confident on our growth projections for those investments.

If they continue to pay off the way we think they will, then obviously we will take a look to see if we should we ramp them up more.

Now, if you look at our ratio of sales, if you take a look at SG&A, I do believe that our SG&A costs will continue -- we will continue to get leverage out of SG&A in total as our revenue expands.

Okay.

Thank you very much.

Thank you.

Our next question comes from the line of Laurence Alexander from Jefferies and Company.

Please proceed with your question.

Good morning.

This is [Amanda Segman] on for Lawrence.

Concerning the consumer electronics end market, is 3M seeing any signs of momentum falling here?

Is that because customers are running into capacity limits?

Amanda, we haven't seen it specifically from our business.

And I think part of this is clouded a little bit because, as George was talking about, double ordering and so forth.

The supply chain has been very, very -- in a fragile state.

I have seen some reports over the last week where there has been some belief that maybe that there is a little bit of a slowing and pull back a little bit.

But thus far, we haven't seen it on our side from a demand perspective yet.

Amanda, the interesting thing about some of this big growth in electronics recently has come from technology changes.

It's come from the movement from CCFL back lit, LCD TVs to LED TVs, driven by brighter pictures, higher refresh rates and much lower energy usage.

You have seen these driven by consumers making the choice to not only get new technology, but getting it at cost savings.

Certainly all of these display, the Smart Phones, smart display devices are all driving a lot of demand, new gaming, 3D cameras, 3D televisions, 3D gaming.

It's coming from new technology and is not necessarily connected directly with consumer sentiment.

Now whether in the end that will fall off, we always expect that it is.

But in our business, we haven't seen anything that would cause -- it doesn't mean there has to be changes here and there, but nothing that we've seen that would cause us any untoward upset.

So far so good.

Okay.

Thanks.

And just moving to the automotive and related after markets, could you provide any further color on trends you're seeing there and the outlook for the back half?

The automotive after market we probably will be more like the current pace of activity.

That doesn't really change that dramatically.

The OEMs though, you'll get into a comp issue here as you get to the back half of the year.

The first half had very, very robust build increases; 25% in the first half auto builds.

That will not continue in the back half of the year as the industry went through the correction last year.

They started to ramp up production in Q3, Q4 last year.

You're going to start to see smaller increases on a year-over-year basis on the auto side.

Thanks.

Thanks, Amanda.

That concludes the question-and-answer portion of our conference call.

I will now turn the call back over to 3M for some closing comments.

Thank you very much, everybody.

I hope you liked the presentations and liked the results.

Very much appreciate you spending time with us, listening and we look forward to talking to you soon.

Thanks a lot, guys.

Ladies and gentlemen, that does conclude the conference call for today.

We thank you for your participation.