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Executives

David Meline – Chief Financial Officer

Analysts

3M Co (MMM) The Electrical Products Group 2013 Annual Spring Conference May 20, 2013 2:00 PM ET

Operator

Hi everybody if you guys could take a seat that would be great. We just have our last few presentations of the day. I’m pleased to welcome David Meline, CFO of 3M who has been back to EPG now for few times.

David Meline

Okay. Thank you very much. What I’m going to go through today is primarily what I’m going to cover is some of the key themes that we came out with late last year, which was basically the work we did to develop our sort of next stage plan under the new CEO Inge Thulin. So we spent last year working through that and rolled it towards year end, some of you were there. So I’m going to go through, it's been most of the time kind of touching on those themes and then at the end I’m going to have a couple charts really talking a little bit about what we’re seeing right now in the current year. So with that I will go into this.

All right so how do we create value as a company? 3M of course is all the round innovation and technology supported by our manufacturing capability, very strong global coverage which I’ll talk about today and then obviously, a very strong financial position. If you look at just to recap the results of the business over the last decade, which really provides the foundation for us as we look forward then. The key three metrics that we were tracking against financially over the last decade were those of EPS growth where we had double-digit EPS growth over the decade. Sales growth we delivered 6% annual sales growth of which a little over a half of that was organic revenue growth, and then finally we did 22% average return on invested capital in the period and our operating margins were at least for the last seven years right in that range as well.

If you look at the company as we have configured it and as you would probably know many of you we made some modifications to try to be better aligned to our customer set as part of the changes that we announced last year. Five business segments the biggest about a third of the company is in the industrial space and then more or less equal size businesses in the sectors of healthcare, consumer, safety, graphics and electronics and energy. Turning to some of those key themes that I mentioned, the first of those is in fact innovation should be and will be at the center of our plan going forward. If you look at this measure that we use of how we track the innovation index and how we’re doing in that regard this shows the percent of our revenue that’s coming from products launched within the last five years and so you can see last year about a third of our sales were from products launched within the last five years, which was up nicely from the prior period and we think there is room for opportunity here. So we continue to stretch ourselves to move that index up and we think it's certainly very doable.

One element that we talked about as we rolled out the plan which was a little bit of a change for us was around our investment and R&D overall. And if you look over the last several years at least we've been investing somewhere around 5.5% of revenue, and we had a discussion last year with Inge took over really looked at what was working really well for the company and areas we thought we could potentially do better and one of the areas we had a very deep discussion around was exactly what’s going on this space and one of the results that we’re seeing from our investment and R&D because as I showed in the prior chart we’re seeing a very nice improvement in this innovation index and we could see as we look at the business it's quite obvious to us the link between that level of innovation and our profitability. What was not as clear to us was the link between that innovation index and what was going on with our growth level. And so as we talked through as a group we have realized that was quite interesting, that when you looked where the money was going for investment and R&D and not surprisingly given the tough targets we give to our businesses they of course are prioritizing those developments which they could see revenue and profit coming out within a one to three-year time frame.

And then to the extent there was still some money available putting some money into some of the longer term, higher risk opportunities which our conclusion was we’re probably not doing as much we can in that space, and now that we have a good foundation kind of in that incremental investment area and innovation area, we felt it will be appropriate to put a layer on top of that where we would invest specifically in higher risk, more disruptive technology opportunities that will take longer to pay off. So we basically created to fund centrally more of a venture type of approach here where we’re looking at opportunities. We frame those as ones that would typically require three to seven years before we start to see outcomes from them and by definition disruptive game changing type technology opportunities. So we’re starting down that path right and we have had a couple rounds of funding this year and that will be one of the drivers, the primary driver actually for this increase in R&D investment over the five year period which as we say here by the end of the five year’s we expect the intensity of our spend increase somewhat to around 6% of revenue.

Another area that we looked and made a modification to our medium term planning was around our organic growth and the genesis of this if you may recall we have had a plan over recent years where we were looking to grow at 7% to 8% annually on an organic basis, and of course what we have observed is we weren’t delivering to that commitment. And so we had very specific review during the year is to we wanted to set out a goal that we thought was continued to be aggressive for the company but also something that reflects good likelihood that we could hope to achieve that.

So the way we ended up with a 4% to 6% organic growth goal and it's basically built on the fact that over the decade we grew at about 1.5 times industrial production during the period and we look at the outlooks for industrial production growth over the next five years, all of the wise economist who work for the firms that some of you work for told us that they thought it would be something like 4.5% annually over the five years. We’ve put a little skepticism on that and cut that back to 3 to 4 and concluded that 4% to 6% was a reasonable goal for the company.

The second piece of that what you can see on the right-hand side of the chart, we then bifurcated the growth expectations to give a little bit more granularity which I will now talk about and we expect that in developed markets over that period we should expect to grow 2% to 4% organically and then in the developing markets, we expect to continue to grow bracketing around double digits.

So if you look at what that does for the company’s next in terms of geography over the period then first of all you can see since in the last decade, we've had very good growth in terms of our emerging market presence where we have grown from 21% of our sales in 2003 to 34% of the sales last year we’re in developing markets and we expect that over this next five year period that portion of total sales will continue to rise for the company with an outcome at the end of the period of some 40% to 45% of the business will be in those emerging markets.

Another piece which is we started to share which I think is interesting and insightful as to how the business operates in 3M and quite honestly this came out of a discussion which we were talking about how the model works, and we concluded that with something that would be interesting to share.

So basically what happens for us as we enter countries and emerging and developing markets? Typically what happens in early stage of economic development we will enter with our businesses and our products which are appropriate as they are building out their base infrastructure then as the country matures and develops manufacturing capability we will start to build out the model with manufacturing and safety products and then as it gets more advanced as per capita income goes up as you get a more modern retail trade and the expectations in the healthcare space start to elevate towards more modern requirements, then we typically will build out at that stage or consumer and healthcare businesses.

So very much accompanying the development of these economies and while it doesn’t always develop in precisely that order generally speaking, you can see very typical patterns of development in those economies and obviously we have products that are applicable throughout all of those businesses. So if you look as a good example our most mature of the developed regions is in Latin America and we’re now starting to approach an average of the company with its portfolios, we have been building out these including the later stage of product profiles more recently.

And then this shows us where we’re on that journey in terms of the evolution of our business. So if you look at the left side which is what I mentioned. So 34% in the bottom green is the percent of our sales in developing markets last year, 66% in developed and then if you look at we basically cut out, we carved out consumer and healthcare and then in other you have got electronics, energy industrial, safety and graphics and so what you can see is that 39% of those other sales in industrial infrastructure are in emerging market so again earlier stage development we build out our businesses in developing markets earlier in those segments and you can see only 21% and 22% are the healthcare and the consumer business are in emerging developing market. So basically hence for us we have been, we talk a lot about how we’re driving the footprint in these developing markets in these what we call the domestic businesses and you can see there is a lot of opportunity here for us to fill that out as we’re quite under penetrated in those markets and if you think about this in terms which we talked about here the last couple of years in terms of the fact that today our developing markets profitability is higher and has been over the last decade undeveloped and you think about that evolution, that makes us confident we will continue to enjoy good profitability in developing markets because in particular healthcare is a very profitable business for us, so you can imagine that we see better growth going forward in those segments and they tend to be quite profitable for the company.

So we like the equation that we have got here and we think there is a lot of legs for us going forward certainly in these next five years at least.

Turning now to another key thing for us coming out of the planning process last year. M&A which will continue to be an important compliment to the organic growth activities that we have in the company which is basically the core of our business model. So what we have said is we expect including this year to deploy $1 billion to $2 billion annually towards this use. We’re thinking as to how we deploy that, generally speaking we have concluded, we do better in some of the larger transactions than the average over the last recent years. We’re certainly aligning our thinking to prioritization as we have set out a set of priorities across our businesses and we’re using that as a guideline for us how we think about prioritizing the acquisition space and obviously for us we’re really in interested in businesses that bring incremental technology to the portfolio as well as those that give us a chance to enter into higher growth spaces.

On a couple of examples of exactly that where the two most recent acquisitions that we have done, the first being the Federal Signal Technology. So this is electronic toll collection, very interesting business which is an adjacent safety (ph) for a traffic safety business and if you look at how we’re performing on that business we’re tracking ahead right now on both a sales basis and an EBITDA basis versus our original plan and then the second one there is a paradigm which is a business we acquired last year which is an advance technical ceramics. We have always been in ceramics but they have some expertise in sort of the other half of the ceramic space where we weren’t in and we’re very pleased with the acquisition, this one as well as the Federal Signal is we’re working very hard to integrate. This one is behind sales right now, again the plan with the slowdown and the troop withdrawals are turning in Afghanistan but we’re ahead of the EBITDA plan and we feel good about the overall acquisition. So if you look at in particular we have got last count some 15 divisions who have identified and are working on projects to integrate into their divisional activities, these technologies that the company has which are powder base ceramic technologies which are new for 3M.

Another theme that came out of the work that we did last year was operational excellence and as you would know, as you can imagine company that consistently delivers operating margins above 20% and returns on capital above 20% you can’t do that without a good focus on operational excellent. What’s also true is we really haven't been emphasizing as strongly in recent years perhaps in some prior year, so we felt it was a good time for us to raise this up in terms of the visibility in this area. We use broadly principles of Lean Six Sigma and (inaudible) and in particular what we have indicated to our teams, we’re interested in focusing first and foremost in for the manufacturing supply chain space and if you think about if you’re aware we’re building out right now a global manufacturing footprint and so in a lot of countries they are newly becoming fully integrated businesses not just sales operations but also with R&D and manufacturing. So we think it's quite important to establish early as we’re building out that presence, a good capability to run those operations using Lean Six Sigma principle.

So chief focus for us, second key focus for us is around our acquired businesses. We think there is a good opportunity to aggressively drive using these principles as we integrate those businesses. And then the final and the third area where we are using Lean Six Sigma principles aggressively is we’re building out right now, we’re in the third year of the a seven year ERP deployment which is a broad deployment in SAP across the company globally and as you can see here the two white boxes we’re just concluding this year of the second of two releases as we blue print and design the system and now we’re moving more heavily into the deployment phase and using very heavily principles of value stream mapping and Lean Six Sigma principles as we standardize business processes and data across the enterprise.

So we expect on this to invest about $700 million to $800 million over the period. We do expect to generate about a $0.5 billion of working capital improvements and also profitability improvements as a result of this deployment which will be completed here in 2017.

Turning then to capital allocation, company as you know has a strong record of paying dividends. We have raised dividends 55 year’s consecutively including an 8% increase this year and as part of the roll-out of the plan that we offered late last year we did adjust modestly our thinking in this year where we indicated we will be raising dividends in-line with earnings going forward versus in recent years we have been guiding to an increase somewhere between inflation and earnings growth.

In terms of the other means of returning cash to shareholders being share repurchase, here we indicated in our plan that we expect to see upto 2% annual EPS earnings growth from repurchases where we will deploy now in the next five years upto $15 billion growth cumulatively. Right now in 2013 we’re running up at the high end of the range we have given for this year which was $2 billion to $3 billion we did 800 million gross in the first quarter and I have added here on the bottom left is a chart which also relates to why we as we did plan we could see we would expect a higher level of net share repurchase over the future period from the capital we’re deploying in this area which is basically you can see the bar what happened is until 2006 we were issuing options to our employees to the tune of about 12 million shares annually.

We changed the plan at the end of 2006 so in 2007 we adjusted and remix the plan so that we have been since that time issuing about 7 million shares annually in the form of options and our issues primarily being options and so no surprise of the consequence of that, these are 10 year term grants. So what’s happening now is we’re seeing the balance of unexercised options declining. So at the end of ’06 there were 83 million options that were outstanding and unexercised and at the end of the first quarter that balance had declined to 54 million. And included in that 54 million we saw a very strong level of reissuance in the first quarters, our share price was hitting record levels. We drew down about 17% of the balance just in the first quarter, so the net impact of all that of course is that going forward we expect that our growth repurchases will be closer to the net impact and has been true in the past as we work through this overtime.

So finally just to summarize this piece, we laid out what are the four key financial goals for the company over the next five years. Again you will recognize double digits earnings growth, the organic revenue of 4% to 6% annually continuing to focus on return on invested capital at 20% or higher and then we added a fourth goal which we thought was descriptive of who 3M is which is a 100% free cash flow conversion which is very consistent with how the company has operated in the past.

So turning briefly then to 2013, in the first quarter the company generated 2% organic revenue growth and if you look at the business level, four of our five businesses grew on the first quarter within the range that we expected for them in 2013. The exception to that was our electronics and energy business which declined organically by 2% in the first quarter and our operating margin for the first quarter was 21.6% with again four of our five businesses in this case operating above 21% and E&E in the mid-teens.

And then in terms of what we’re seeing currently basically we expect that global economic growth is going to remain difficult in the first half and we’re anticipating some improvement here in the second half specifically where we expect the changes to occur in the consumer electronics business which threw this first half, we expect it will remain week with a recovery of developing in the second half, we expect the renewable energy business which we have called out as being quite challenged for us that will remain challenging throughout the entire year. The Japanese yen continues to be weak obviously and we adjusted our outlook for the year such that FX will impact the company by about 1.5 points negatively year-over-year versus our original expectation that it would be flat year-over-year and that will impact our EPS by about $0.05 a share negatively in the year and the majority of that we expect in Q2.

So we expect about $0.03 to $0.04 a share negative impact from foreign exchange here in Q2. In terms of the posture of the company as we work through the year we’re obviously continued to remain in the stance which is very much focused on operational excellence and we continue as I talked about to invest in the long term health and the business with a particular emphasis scenarios like R&D, like the CRP system and certainly in this emerging market areas where we’re building out our portfolio.

And then finally as I have already mentioned our share repurchase we’re tracking at the high end of the range that we announced of $2 billion to $3 billion for 2013. So I think I will stop there and maybe we can take some questions.

Question-and-Answer Session

Unidentified Analyst

So Dave it's a nice color there on the end markets, so some of the end market trends but you may be just talk about geography in terms of U.S. and Europe this is China, whatever else. We saw in 1Q that’s what we have seen right now?

David Meline

Yeah I guess what I would say, I mean sort of in totality we don’t see right now any change from the outlook that we set out for all of the regions as we came into the year, so if we refer back to the guidance we gave for the year where we tried to give some indication on region by region growth we think that still looks very good right now. I mean very accurate if you will which is of course like everyone else Western Europe most challenge we had in minus three to positive one for the year, the U.S. in two to five which is consistent with our overall growth for the company, both of those regions we’re operating at the lower end of that range in the first quarter and we don’t see in this first half where we will see a big inflection in any of those areas and then you know we do expect Asia to pick up in the second half and that’s primarily again driven by this inflection we’re expecting in consumer electronics.

Unidentified Analyst

And on that inflection (inaudible) a lot of that will be driven by inventory adjustments I’m assuming. Where else in your portfolio are you seeing inventory headwinds, I mean if you can give color around that the second half (ph).

David Meline

Sure yes. I mean we saw in some of the industrial businesses in some of the area, so for example in Western Europe in the first quarter we saw some slowing and it was quite broad across the region and also across the various of the industrial business and clearly some of that was inventory corrections. We had a very specific area in the industrial space which is some specialty chemicals that we use that service both the renewable energy and the automotive business and that inventory correction in the automotive space is largely run its course. So we see some adjustments there, other than that we obviously have the consumer electronics adjustments of inventory and I would tell you beyond that there is really nothing that we have been able to identify that we would call out.

Unidentified Analyst

A question on optical film, it was interesting a milestone was reached last quarter on the earnings call. There wasn’t a question on optical film.

David Meline

So you decided to bring it up now?

Unidentified Analyst

So I figured just to break the streak I bring it up but it does raise the question that this business has been reduced to about 4% of total revenues and suggestion as it becomes increasingly commoditized with price pressure and you’re whipped by consumer electronics and maybe just make the case for hey this is why it really belongs in the portfolio and there is still an opportunity for innovation going forward.

David Meline

Good question. So yes so first of all the business now is about 4% or 4.5% of both revenue and income for the company so it's kind of a normalized size business, we regulate the business by managing share and profitability so there is lots of opportunity to grow which would generate some hard profitability which we’re not interested in. So we have stabilized the business, it's growing we accept I think this year in mid-single digits and pretty in a reasonably stable in that regard. What continues to be true for us is a couple of things, one is the trend towards the value proposition that we offer with our products in that division towards battery operated devices continues to be very strong. So if you look at the profile of the business, this year it will now shift further to 75% of the sales will be to products whether those be smartphones or tablets, other battery powered devices and that continues to be a very interesting space for us where we have a chance to innovate and add value for our customers. And the other piece that we see which is coming out in parts of the labs that support optical systems is we have got about 18 divisions which depend on those labs for micro-replication technology which is if you think about repeating patterns in materials that create unique features for products that’s what we do with that lab and it's diverse as, there has been disruptive which charges to talk – technology in abrasive so think about sand paper which is no longer crushed rocks but finally shaped, repeated pyramids that we manage.

We’re seeing it increasingly, there is applications in places and healthcare and consumer for micro-application and which is quite surprising. So that is a fundamental typical example of a foundation of technology that we use, it's housed in the optical systems group but it's a resource for the company which continues to generate new and novel solutions for customers in many sectors across the portfolio. So we like the business, we just don’t like it when it's whipping the whole company around and we solved that problem.

Unidentified Analyst

I have a couple of questions, one from the buy side, one for myself if I can do that. For the buy side the question is how much does this 3M do these days in Japan, how much is through domestic consumption versus how much is for the display in graphic segment or are they seeing a pickup in product for domestic consumption in Japan.

David Meline

Right so about 7% of the company in sales are coming out of our 3M Company in Japan. That company has traditionally had quite a heavy biased towards electronics and industrial activities as we have very strong customers traditionally in those spaces in Japan and what happened for us is several years ago as we recognize the trend that was going on with the economy we started reducing our manufacturing footprint in Japan and we also started doing a couple of things with the model one is it still represents in many cases the key spec in for some of the OEMs in particular in the Japanese automotive companies and the Japanese companies that are in the electronic space whereas often the production is taking place in other countries but they operate as the customer interface where they are doing work to specify products so that continues but what we also did is we have been shifting over these last several years and that continues which is the higher focus to what we call the domestic businesses which are consumer and healthcare and so including this year we have got a substantial, a material share of our employees we’re moving across the enterprise into those spaces to bulk up and redeploy resources which is actually working very well and we had in the first quarter I think we grew 7% in healthcare and 7% in consumer businesses which we were quite pleased with because the economy is still quite weak. So that’s kind of how we’re treating that business.

Unidentified Analyst

Okay and I have a second question from investors before mine I just got, this one is -- can I ask about inventories at customers by region, any change in destocking and restocking trends and do you expect this is a sort of key variable for your plan for the year?

David Meline

I would say nothing beyond what we talked about in the presentation and my comments to Nigel (ph).

Unidentified Analyst

And here is mine if I can tweak this in, so I thought your comments about taking a look at R&D and how that’s really driven more maybe margin result as opposed to core growth for results is very interesting and when I looked at that 1.5 times historical growth rate for IPI the breakout between domestic sorry mature markets and fast growing markets my understanding as I recall is that your mature market growth is actually pretty consistent with IPI and most of the growth is really come from (inaudible). So how does that kind of play into how you’re thinking about really, if you’re coming at so much investment and innovation over so many decades its actually kick start that outside of these mature markets.

David Meline

Yes so what I would say if I understand the question, as we looked at this R&D equation as I have articulated where we felt the biggest opportunity for us on the margin was to add this component over long term more disruptive and higher risk developments. If you then overlay that with what’s going on with our overall R&D footprint we have been working very hard over recent years to broaden that footprint globally, so today we have 33 labs globally last year over 50% of new products were launched from -- the development work was led by the International Lab, so and that’s a very significant increase versus even five years ago. So we have seen a very strong development coming in the International Labs and when I say International our second largest lab in the world is now in China so as an example China, India, Brazil building out in Mexico. So we’re building those out, we’re seeing a higher level of innovation coming from those labs but what’s true is as they matured what tends to happen is as you establish the labs in the earlier stage they tend to be more incremental, innovations and applications as opposed to fundamental new technology development.

So what we’re using this incremental innovation fund to do is as we’re taking inputs for new projects and ideas we’re very consciously encouraging projects to come out of those new labs in those countries because we think it's going to be a way for us to also move them more quickly up the curve towards more fundamental innovation breakthroughs if we can encourage that by providing some targeted type funding into some of those best ideas that are coming up.

Unidentified Analyst

If the dollar sustains its strength you guys historically have had this arbitrage with currency and your (inaudible) and so forth and your international profile, so that caused you to somehow engage in some other actions structurally or from hedging perspective to kind of mitigate that what could be that negative impact?

David Meline

Yeah. So actually it fits for us, our view is that over the long term the most robust model for the company is some form of make it where we sell it because that gives us a natural hedge against currency movement, so we have been moving over these years to establish a more broader footprint that’s more naturally immune to currency movements and also with a broader footprint you have the ability to can move production more easily when you have established capabilities around the world.

So you know we view if we see some structural shifts we’re in a better position today than we have been in the past to address that and then secondly we do a rolling hedge program of 50% of our exposures and quite honestly I don’t see any reason that we change that, it's working. We think it gives -- the intent of the program is to give us some visibility on the financial impacts of exchange rate movements and to give us some time than to make those kinds of adjustments to the business as we think they are appropriate.

Unidentified Analyst

David can you just give an update please on the ERP roll out and maybe think about the peak suspending and kind of peaks that one the incremental benefits flow through and then there is a specific number to think about in terms of 14 on a P&L.

David Meline

Yeah. So, if you look at that chart what’s happening is we’re finishing the design phase now and we’re going into a pretty heavy deployment. We will do about 20 countries next year. If you look at the spending pattern we said we will do up to 800 million over the project period and we will be peaking in that spending next year and I think it will be up – we haven’t of course done the full plan but you could think about something around $50 million incrementally versus this year and this year is about more than 50 million, more than last year. So we’re moving to a peak now and I will come back on that as we go through the plan next year.

Unidentified Analyst

Maybe a last question I will ask it, what will it take unless I have got somebody else I’m sorry, so what would it take from a return of capital to shareholders. You guys have obviously step that up right? But as you look forward under what conditions would you see taking that up to an even higher level.

David Meline

I mean what I would say like all things we continuously look at uses, how we’re deploying cash, first and foremost we want to deploy it into the business but with the model we have we clearly have capability to do not only that but to provide significant returns to shareholder. So I would say the circumstance under which it changes is as we update and look at how the business is operating and how we think it will operate and all of the elements of the balance sheet including things like how our pension fund is funded which is frankly looking quite good right now. That will influence our thinking as to returning cash to shareholders and I guess I would say we view this as an important point and to the extent that we can do that while still being confident of our ability to meet our other objectives. We’re interested to be able to do that. No I had the chart here which basically goes through the key points of the plan and really how we create value as a company at 3M and we feel good about the health of the company and our ability to continue to do that going forward. So, thank you very much.

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