3M Company (MMM) — Q2 2018 Earnings Call Transcript

Thank you and good morning, everyone. Welcome to our second quarter 2018 business review. On the call today are Inge Thulin, 3M's Executive Chairman; Mike Roman, our Chief Executive Officer; and Nick Gangestad, our Chief Financial Officer. Inge, Mike and Nick will make some formal comments, and then we'll take your questions. Please note that today's earnings release and slide presentations accompanying this call are posted on our Investor Relations website at 3m.com under the heading Quarterly Earnings. Before we begin, let me remind you of the dates for our upcoming investor events in 2018, found on Slide 2. Please mark your calendars for our Q3 earnings calls on October 23rd. Also, our next Investor Day, which will be held at our headquarters in St. Paul, Minnesota with a welcome reception in the evening of Wednesday, November 14th and a formal presentation program on Thursday, November 15th. More details will be available as we get closer to the events. Please take a moment to read the forward-looking statement on Slide 3. During today's conference call, we will make certain predictive statements that reflect our current views about 3M's future performance and financial results. These statements are based on certain assumptions and expectations of future events that are subject to risks and uncertainties. Item 1A of our most recent Form 10-K lists some of the most important risk factors that could cause actual results to differ from our predictions. Please note that throughout today's presentation, we'll be making references to certain non-GAAP financial measures. Reconciliations of the non-GAAP measures can be found in the appendices of today's presentation and press release. Please turn to Slide 4, and I'll hand off to Inge.

Thank you, Bruce, and good morning, everyone. As you all are aware, Q2 was my last quarter as the CEO and I have now moved on to my new role as Executive Chairman of the 3M Board. Mike Roman is our new CEO, and I am pleased with the orderly transition between me and Mike, which we have worked on for the last year. In a moment, I will turn the call over to Mike and our CFO, Nick Gangestad, and you will see that once again we had a very strong quarter with robust organic growth, margin expansion, EPS growth, and good cash flow. But before doing that, I would like to make a few comments. First, I would like to recognize all of you who have covered, analyzed, and invested in 3M. I have enjoyed our many interactions and I have always appreciated your input along with your integrity and professionalism. I would also like to thank all of our 91,000 3Mers around the world for your contributions and support. Working together, I am pleased at what we have accomplished over the last six years. We enhanced and focused our portfolio and as a result, today, we are far more relevant to our customers and the marketplace. We have strengthened our innovation engine and improved our cost structure and begun to transform 3M for the future. We have reached for our vision of advancing every company, enhancing every home, and improving every life. All of this is reflected in our financial results and in the premium value we have created for our customers and premium returns for our shareholders. At the same time, I am equally confident in our future. The Board of Directors and I have no doubt that Mike is the right person to lead our company as CEO and continue building strengths on strengths. As I look across our enterprise, it’s clear that we have the leadership, market position, and capabilities to continue to build on the fundamental strength of 3M. With that, I will turn the call over to Mike for a summary of our second quarter.

Thanks, Inge, and good morning, everyone. Let me begin by saying that I am honored to serve as the Chief Executive Officer of this incredible enterprise and lead our team into the future. I would like to express my gratitude to Inge for his vision, leadership, and ongoing partnership in his new role as Executive Chairman. Over the last six years, we’ve made great progress in building out the 3M playbook, which has created a tremendous foundation for us. Moving ahead, we are focused on continuing our momentum, generating extraordinary value for our customers and premium returns for our shareholders. Now let’s review our second quarter results, starting on Slide 5. We had a strong quarter highlighted by broad-based organic growth and a double-digit increase in earnings per share, along with record sales and rising margins. Looking at the numbers, total sales were $8.4 billion, an all-time high for 3M. We delivered strong organic growth of 6% with positive growth across all business groups and all geographic areas. Please note that we have an upcoming ERP roll out in the United States, and in anticipation of that deployment, some of our customers decided to accelerate their purchases. We estimate that this added approximately 50 to 100 basis points of growth in the second quarter, all of it in the U.S. results. Moving on to earnings, we posted GAAP earnings of $3.07 per share, up 19% year-on-year. Adjusted earnings were $2.59 per share compared to $2.25 a year ago. This demonstrates that our teams around the world continue to execute well. Underlying margins were strong at 24% with all business groups above 21%. Beyond financial results, we are committed to building 3M for the long run while returning cash to our shareholders. In the second quarter, we invested $468 million in research and development and another $365 million in CapEx. We also returned $2.4 billion to shareholders, including both dividends and share repurchases. Please turn to Slide 6. There is a lot to like this quarter across our entire portfolio.

Thank you, Mike, and good morning everyone. Please turn to Slide 7. Sales grew 5.6% organically in the second quarter. Increases in selling prices contributed 110 basis points to sales growth in the quarter, and were positive across all geographic areas. The net impact of acquisitions and divestitures contributed 80 basis points to sales growth in the quarter. Foreign currency translation increased sales by one percentage point. All-in second quarter sales in U.S. dollars increased 7.4% versus last year. In the U.S., organic growth was 5.6%, led by electronics and energy, safety and graphics, and consumer. EMEA increased 5.8% in Q2, driven by strong growth in West Europe that was led by Electronics and Energy, Industrial, and Safety and Graphics. Asia Pacific delivered 5.5% organic growth, led by Health Care and Safety and Graphics. Organic growth was 12% in both China, Hong Kong, and India, while Japan was down 2%. Finally, Q2 organic growth in Latin America and Canada was 6%, led by Health Care and Safety and Graphics. At a country level, Canada was up high single digits while Mexico and Brazil both delivered mid-single-digit organic growth. Please turn to Slide 8 for the second quarter P&L highlights. Company-wide, second quarter sales were $8.4 billion. Operating income in the second quarter was $2.4 billion, which included a $400 million benefit from the communication markets divestiture gain net of related actions. Second quarter underlying operating margins were 24% excluding the net benefit from the communication markets divestitures.

Looking at the rest of the Industrial portfolio, our industrial adhesives and tapes, auto and aerospace and automotive aftermarket businesses, all delivered mid-single-digit growth in the quarter. On a geographic basis, Industrial’s organic growth was led by a 7% increase in EMEA, followed by mid-single-digit growth in each of the other areas. Industrial delivered second quarter operating income of $724 million. Operating margins were 23% with underlying margins up 180 basis points, excluding the impact of last year's second quarter portfolio and footprint actions.

Let’s take a closer look at the components of our margin performance in the second quarter. Leverage on organic growth improved productivity and lower year-on-year portfolio and footprint actions contributed a combined 290 basis points to margins. Selling price benefits more than offset raw material inflation, adding 30 basis points to operating margins. Foreign currency net of hedging impacts reduced margins by 20 basis points. Lastly, during the second quarter, we settled several respiratory and oral care related lawsuits, which decreased margins by 70 basis points. Let’s now turn to Slide 9 for a closer look at earnings per share. Second quarter GAAP earnings were $3.07 per share, up 19% year-over-year. Underlying earnings were $2.59 per share when adjusting for the communication markets divestiture gain net of related actions.

Inge, you will be missed. You did a fantastic job, as you know, and Mike, big shoes to fill, but I'm sure you'll do great as well. There’s one thing that caught my eye just in the prepared remarks was your ERP rollout comments. Can you tell us, is that in every segment? How big of a deal is this and what’s your confidence level that the pull forward was just 50 to 100 and not something greater than that? Is it possible to have that kind of precision?

We have been focusing on our global business transformation and ERP rollout for several years, and we have nearly completed our deployment in Europe, especially in Western Europe. As we entered 2018, our attention shifted to the U.S. We have a well-structured plan for deployments by region, business, and supply chain operations. Over the next 18 months, we will be deploying in the U.S., following a specific timeline for each business. We already deployed our Health Care business at the end of last year and have gained experience from that. Now, we are working on deploying the remaining businesses in the U.S. during the next 18 months. We have a clear understanding of how the deployment will impact our customers at different times, allowing us to gauge how much of the accelerated sales are related to the ongoing deployment in the U.S.

Scott, the playbook on there really isn't changing. We seek to have natural hedges against currency risk and how we set up the supply chain, and then we layer on top of that some financial hedges. And those financial hedges don't ultimately change the underlying financials over a longer period of time, but we have hedges that we enter into going out one, two, three years to buy time for us to adjust our cost structure, our supply chain in order to end up with a competitive supply chain in a revised FX environment. So in the short term, what we often do especially in emerging markets, we will adjust prices to partially offset the FX impact. And then we will adjust our supply chain adjusting where we’re manufacturing based on FX movements. That tends to take a little longer time though, Scott. And not in a short-term, but we often have to change and re-qualify sources of supply to make that happen.

Inge, congratulations. Thanks, Mike. Look forward to working with you and the team. Just a question on guidance, if I look at income before taxes that you guys have on Slide 22, basically, I think prior outlook was 7.7 to 8.2, and now it’s 7.8 to 7.9. And I think the press release indicates that most of it is just adjusting for missing revenue and earnings from the divestiture, but the composition sort of doesn’t make sense. Can you tell us what the big moving pieces are as we move from 7.7, 8.2 range to 7.8 to 7.9?

Andrew, there’s a few moving pieces there. First of all, as you noted, now that we have divested of our communications markets division, there is some income that that would have been generating in the last seven months of the year that will no longer be generating, and that’s what's encompassed in our adjustment to our EPS guidance for the year. In particular, what you're talking about there is also an impact from net interest expense. So in terms of our earnings bridge that we laid out at the beginning of the year, there are a couple of moving parts in addition to this communication markets adjustment that we announced today. First is, we are buying back more shares, and we originally guided that that would be $0.10 to $0.15 of benefit. We now see ourselves at the high end of that range, so that’s on the positive. We also are borrowing more money, so our net interest expense is going up. So we started the year guiding that net interest expense would be a benefit to our EPS of $0.05 to $0.10. We now think that will be approximately flat for the year.

I would start by emphasizing that our business transformation truly revolves around our customers. In our deployments, we begin with their needs in mind, striving to deliver the best possible outcomes while minimizing disruptions and maximizing benefits associated with our transformation efforts. During our rollout in Europe, we witnessed this firsthand, as we asked customers to adapt significantly in their interactions with us. However, this transition also brought numerous advantages for our collaborations. We experienced similar dynamics in the U.S. when we rolled out deployments and observed some repurchases. I wouldn’t describe growth as adversely affected by our business transformation; rather, it was influenced by other market factors and our portfolio strategies. Additionally, some of our strategic investments also played a role. Our ongoing focus on customer needs is a key aspect of our current efforts in the U.S.

So there’s obviously been a little more noise here with the ERP rollout. But can you give us a little more color on how should we think about your organic sales growth guidance by segment. If we look at your annual guidance and you guys talked about Health Care, at 4 to 6, maybe you’re trending a little below there, but Safety and Graphics is trending way above. So is there a bit of trade-off there? And then the other segments generally in line for the year. Is that how we should think about it?

There are a few points regarding the impact of the ERP go-live and its effects on different segments in the U.S. We primarily see these effects in our Industrial, Safety and Graphics, and Electronics and Energy business groups. The consumer segment isn't significantly affected, nor is our healthcare business. When considering the impacts for the second, third, and fourth quarters, it's mainly those three businesses that are impacted. Regarding our guidance for the year, we still project industrial growth globally, which we initially estimated at 3% to 5%, and we expect it will likely be in the lower half of that range. This aligns with the updated overall company guidance provided in April. We anticipate healthcare growth to be around 4% for the year, while safety and graphics, originally guided at 4% to 6%, is expected to meet or exceed the upper end of that range. The consumer and Electronics and Energy segments are projected to perform solidly within the ranges we initially set.

For the second half, we will continue to prioritize high growth opportunities in Electronics and Energy, such as automotive electrification, data centers, and semiconductor fabrication. Finally, organic growth in Consumer was 4%, which included good performances across our leading brands. We saw continued strength in home improvement, along with a strong start to the back-to-school season. In summary, I am pleased with our performance in the second quarter and I thank our teams for their many contributions. Our playbook is working and we are just getting started. We are well positioned to grow into an even stronger and more successful company.

In terms of the automotive outlook, particularly in your Industrial business, do you have any updated thoughts? Additionally, in the Electronics and Energy sectors, there was a notable split earlier this year where device sell-through was weak, but the CapEx or electronics materials business was robust. How have you observed this trend recently? Are you concerned about the CapEx segment or EMS slowing down due to the current situation with device sell-through?

So starting with the automotive, we continued, as year-to-date through the first half, to see strong growth relative to the build rates globally. So remember we’re managing a global automotive business, focused around key account relationships with the OEMs globally. And we’re seeing continued good performance on our spec-ins and penetration into the marketplace, resulting in good growth, year-to-date relative to the build rates. Some improvement in the build rates in the second quarter with IHS projections showing an increase of over 4%. We are continuing to see a very robust outlook for outgrowing the build rates. If you turn to Electronics and Energy, we continue to see strong growth in what we've been talking about as high growth electronic segments, around automotive electrification, around data centers, semiconductor fabrication, that continues to move forward. The rest of electronics is playing out in line with the way we laid it out at the beginning of the year.

The $0.15 probably mix of restructuring associated with the gain on the communications business. Is that just to the E&E communication segments or is this broader, and maybe just some color in terms of what actions you’re taking with the $0.15?

Nigel, the actions that we’re taking are to address stranded costs that are left after the divestiture of our CMD business. So there’re addressing structural costs that this divestiture is leaving. We started those actions in Q2 and we expect to take more in the second half of the year to offset what could have been a negative impact if we had left those stranded costs in the company going forward.

Just a quick cleanup from me on healthcare and then maybe a bigger picture question for Mike. Health Care U.S. growth has been a little on the soft side year-to-date and in the quarter, perhaps it's dental. But are we observing some hangover from pull forward on sales there from ERP last year in the healthcare business?

Jeff, healthcare in the U.S. where you’re seeing the impact, broadly, we had strong growth and our medical solutions business is leading the way there. We had good growth in the U.S., also in food safety and health information, although oral care was down slightly. The bigger drag in the second quarter was our drug delivery business, which we see opportunities to take that business to a positive growth business as we move ahead. It will continue to be a project-based business, so quarter-to-quarter, it can be lumpy and up and down but we do see opportunities. To wrap up, we had a strong performance in the second quarter, led by broad-based organic growth, expanded margins and a double-digit increase in earnings per share. We are executing our playbook and are positioned to deliver successful 2018. Thank you again for joining us this morning, and have a good day.