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3M Company (NYSE:MMM)

Q3 2009 Earnings Call Transcript

October 22, 2009 9:00 am ET

Executives

Matt Ginter – VP, IR

George Buckley – Chairman, President and CEO

Pat Campbell – SVP and CFO

Analysts

Deane Dray – FBR Capital Markets

Shannon O'Callaghan – Barclays Capital

Scott Davis – Morgan Stanley

Laurence Alexander – Jefferies

Jeff Sprague – Citi Investment Research

John Inch – Merrill Lynch

Steven Winoker – Sanford Bernstein

John Roberts – Buckingham Research

Steve Tusa – J.P. Morgan

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the 3M third quarter 2009 earnings conference call. During the presentation, all participants will be in a listen-only mode. Afterwards, you will be invited to participate in the question-and-answer session. (Operator instructions) As a reminder, this conference is being recorded, Thursday, October 22, 2009.

We would now like to turn the call over to Matt Ginter, Vice President of Investor Relations for 3M.

Matt Ginter

Thank you. Good morning everyone and welcome to our third quarter 2009 business review. Joining me on today’s call are George Buckley, 3M Chairman, President and Chief Executive Officer; and Pat Campbell, Senior Vice President and Chief Financial Officer.

Today’s call will summarize our financial results for the third quarter. A power point presentation will accompany today’s conference call, which you can access on 3M’s Investor Relations website at 3M.com. Today’s slide presentation and the audio replay will be archived on our website for an extended period of time for your convenience.

As I mentioned last quarter, our next investor meeting is scheduled for December 8 from 8 AM to approximately noun at the Grand Hyatt Hotel in New York City. We sent out an invitation earlier this month and many of you have already RSVP. If you have not responded to date, please do so, and if you did not receive the invitation, please contact my office and we will give it out to you right away.

Before we begin today, please take a moment to read the forward-looking statement on slide two. During today’s conference call, we will make certain predictive statements that reflect our current views about our future performance and financial results. These statements are based on certain assumptions and expectations of future events that are subject to risk and uncertainties. Item 1A of our most recent Form 10-K and 10-Q lists some of the most important risk factors that could cause actual results to differ from our predictions.

So let’s begin today’s review. Please turn to slide number three. And I will turn the program over to George.

George Buckley

Thank you, Matt, and good morning everybody, and thank you very much for listening to our third quarter call. For 3M, the third quarter was marked by continued execution of our plan, tight control of our spending, while retaining the sharp focus we’ve had on cash generation as we simultaneously drove sales and market share everywhere that we could.

I almost give you my second quarter remarks here again, because Q3 was really all about continued execution of the plan, rather than any radical new pathway or strategy. So while we significantly overachieved relative to external expectations and were certainly hugely encouraged by our progress there, do please keep in mind that organic sales volumes are down 7.1% year-over-year.

Sequentially, however, third-quarter sales increased by an impressive 8.3% over Q2 and as I’ve mentioned last quarter, the second derivative of sales with respect to time also continues to improve. We remain encouraged by our ability to operate well and to maintain good margins and generate huge amounts of cash in these times. And I confess that the rate of sequential grow is surprisingly pleasant.

We achieved a free cash flow conversion of 163% this quarter, and 145% year-to-date. So there is no question that it was a strong quarter delivered by hard slog by the good people of 3M. Pat will detail the quarter for you in a moment, including several factors which helped us again. And for example, demand for optical films continued strong as it did in Q2, especially films for LCD TVs.

We also achieved good growth in renewable energy, health care, automotive after-market and aerospace to name but a few. As you would have expected, demand for respiratory products used to prevent the spread of H1N1 virus remained strong. So, investing an additional $20 million or so over and above the 20 million I told you about last quarter, to add yet more flexible capacity to our respiratory lineup this time in Singapore.

We will probably also add a small top-up capacity here in the United States that will cost about another $5 million. This is in addition to the recent capacity adds that we made in the United Kingdom. Preferential purchasing of eco-TVs versus other alternatives and related electronic products has been strong and will probably remain good in the foreseeable future. Obviously sell-through at Christmas will be the determining factor on Q1 in Q2 optical film demand.

Gross margin and inventory improvements show that our control of our factories remains absolutely superb. Raw material costs and solid price carryover from last year have also helped. While it might not be quite so positive next year, at this stage of our planning, we don't expect to see wholesale changes in impact.

Our approach on these factors by the way is always to manage the price inflation gap. We therefore remain committed to our operating and financial plan, which obviously again helped us greatly in the third quarter. As we expected, the cost reductions from recent restructuring and other actions gained further traction in the quarter, and we anticipate those benefits continuing through the rest of the year and on into 2010.

It is easy to forget how tough it has been this past 12 months, and to reflect on the huge changes that have occurred in banking, manufacturing, automotive, retail and the nation's balance sheet. The downturn has been a vicious lesson for all of us, but I cannot say enough about how well 3M people have responded.

We do appear to be gaining share in many places, but with such volatile swings in demand you can imagine it is hard to know accurately how much. Regardless of trick [ph], we need to pull off; we will be keeping it when things return to normal if and when they return to normal and certain to continue this progress well into 2010.

In short, the 3M team is really executing well, and our plan remains the right one for the times, and I will address the outlook after Pat’s comments. So I will turn the call over now to Pat.

Pat Campbell

Thanks George and good morning everyone. Please turn to slide number four. Third quarter GAAP reported earnings were $1.35 per share versus last year’s $1.41 per share. Excluding special items, this quarter's earnings were $1.37 per share, which was slightly below last year's $1.42, and above our internal expectations entering the quarter.

As most of you know, we have been aggressively restructuring the company since early last year, and we continue this effort in the most recent quarter. We announced the reduction of approximately 200 positions in Q3, with the majority of those occurring in Western Europe and to a lesser extent here in the United States.

The related pre-tax net restructuring charge totaled $26 million in the quarter or about $0.02 per share. Next, I will recap the third-quarter sales growth, please turn to slide five. There were some encouraging data points in our third-quarter sales figure, but to be clear we are still operating in a weak and uncertain economy, even as the recession has been determined to be technically over.

First, sales to the consumer electronics industry remain good coming off an improved second quarter with particularly good results in our optical film business. Secondly, demand remained strong for respiratory protection products due to the outbreak of the H1N1 virus. We are the global leader in disposable respirators with market share capacity that far outpaces our nearest competitor.

The respiratory factories have been running 24 hours a day, seven days a week since May of this year to keep up with demand, but we have been unable to significantly reduce our backorder volume levels. The good news on sales was not limited to these two markets. In fact, we posted sequential sales improvements in each of our six business segments in the third quarter, with Electro and Communications, Display and Graphics, and Industrial and Transportation all increasing double digits.

On a global basis, sales grew sequentially in all major geographic regions. On a worldwide basis, sales declined 5.6%, a substantial improvement from the 15% decline we posted in Q2 and the 21% decline in Q1 for the business continues to improve quarter by quarter.

Organic sales volumes were down 7.1% year-on-year, which is a bit better than our expectation entering the quarter of negative 8 to a negative 13%. And also better than the Global Insight estimate for worldwide IPI of 8.5%. Demand declined and many major industries appear to have bottomed at this point, and inventory reductions have either waned or expected to do so in the fourth quarter or early in 2010.

So our sales growth should continue to equal or exceed IPI for the immediate future. Selling prices remain positive, rising 2% year-on-year and acquisitions added an additional 1.8 percentage points to growth. Finally, currency impacts reduced third quarter sales by 2.3%. Sales in local currency declined 3.3% year-on-year including acquisitions.

Local currency sales rose by 5.5% in Display and Graphics and 4.7% in our Health Care segment. But declined by 2% in Safety, Security and Protection Services, 4.8% in Consumer and Office, 6.4% in Industrial and Transportation, and 15.3% in Electro and Communications.

Looking at this year's sales change by geographic region, organic volumes turned positive in Asia-Pacific at a plus 2.6%, the first such increase in this region since the first quarter of 2008. Organic volumes in Europe declined 7.9% as positive growth in Safety, Security and Protection Services related to H1N1 demand and Health Care was more than offset by declines in the other four segments.

US organic volumes were down 12.4% and the combined Latin America and Canada region declined 9% versus last year’s third quarter. There was no surprise on our selling price performance this quarter. Selling prices increase year-on-year in all regions with the exception of Asia Pacific, where prices declined typically year-on-year due to heavy mix of consumer electronics.

Prices rose 10% in the combined Latin America and Canada region largely due to currency as we routinely rise prices in Latin America, when the value of these currencies fall against the US dollar.

Now please turn to slide six, where I will review the key elements of the third-quarter income statement. For the second quarter, we posted very strong and improving operating margins with this quarter coming in at 24.3%. So our ongoing and intense focus on operational excellence continues to deliver strong results despite these tough economic conditions.

Third-quarter gross margin improved 110 basis points to 49.2%, a very good result considering year-on-year volume declines. Selling prices increased 2% also help adding over a full point of gross margin. Finally, raw materials were again positive versus the prior year declining about 3% in Q3.

We have aggressively reduced structural manufacturing costs in many of our businesses over the past year to help mitigate more production levels and these actions were really paying off. As a percent of sales, third-quarter SG&A and R&D spending were both in line with the prior year. As has been the case throughout 2009, we are maintaining firm control over our discretionary spending, particularly as it relates to back-office activities, while doing all we can to maintain our investments in key growth programs.

Also recall that we changed our policy on employee vacation use, which also reduced year-on-year SG&A costs. In short, employees with previously back [ph] vacations are required to use it up during 2009 and 2010. This effectively reduces the back vacation accrual and lowers the expense in the income statement.

Operating income was $1.5 billion, right in line with last year, and as I mentioned operating margins were 24.3%. Net interest expense increased $23 million, driven primarily by lower yields on cash deposits.

The tax rate for the third quarter was in line with our expectations at 32.2%. We were expecting some variability in the quarterly rate during the second half of 2009 due to the resolution of several years of tax audits. We continue to expect that our tax rate for the full year will be between 30.5% and 31%.

Net income was just under $1 billion for the quarter, which was right in line with last year's results. As I mentioned, ahead of our prior expectations due to slightly improved market conditions, a more favorable currency, and continued strong cost discipline.

As I've discussed with many of you in the past few quarters, year-on-year comps are important, but in this environment it is equally important to look at the business results sequentially.

Please turn to slide seven. Sales increased almost $0.5 million versus the second quarter, virtually all due to volume. All six business segments in all geographies posted sequential sales growth as economies around the world continued to improve. Sequential sales growth was led by Electro and Communications at 12.1%, Display and Graphics at 10.8%; Industrial and Transportation at 10.1%.

And on a geographic basis, sequential sales growth was strongest in Asia-Pacific driven by our optical films and industrial-related businesses. In the sales and marketing area, we typically accelerate advertising and promotion efforts in the back half of the year just for our customers’ commercial programs during the back-to-school and holiday seasons, and this year is no different.

Third-quarter advertising and merchandising spending, for example, was up 14% sequentially, which we fully expect to drive growth once end-market conditions improve. Investments in R&D increased by $29 million sequentially, an increase of nearly 10%, primarily impacted by some specific one-off technology investments made in our oral care business during Q3.

We continue to maintain investments in other high-growth businesses such as renewable energy and water purification, just to name a few. Finally, we expanded our operating margin or operating income by 16.4% sequentially within incremental leverage of 45%. Margins improved by 1.7 percentage points to 24.3%.

Please turn to slide eight, where I will recap a few balance sheet and cash flow highlights for the quarter. Heading into 2009, in the face of such a significant economic collapse, we set very aggressive cash flow targets for each of our businesses, and our leaders in the teams have responded with great results.

Third-quarter free cash flow was $1.6 billion, up $769 million versus last year's third quarter. This represents a 97% year-on-year increase. The improvement was driven by many factors, most notably by lower capital expenditures, improving net working capital, lower tax payments and also reduced cash pension contributions.

Net working capital declined by $415 million year-on-year with inventory down $443 million and accounts receivable down $125 million. Inventories again were a bright spot as we drove a 0.4 churn improvement versus September 2008 levels, a very good result considering that third-quarter organic volumes declined by over 7%.

Third-quarter free cash flow conversion was 163%. Year-to-date cash flow increased 36% and we converted 145% of net income. Net debt was $1.7 billion at September month-end, a reduction of $1.1 billion from June levels and one-half of the level that we had September of last year.

Looking into the fourth quarter, our cash conversion rate will decline and likely be less than 100% as we will be making some additional cash pension contributions, but for the full-year 2009, we expect that the full free cash flow conversion will remain in excess of 100%.

We paid $361 million in dividends to common shareholders in the third quarter, and consistent with recent quarters our share buyback program remains on hold. Overall, our balance sheet is very healthy and continues to improve. The majority of our long-term debt balance does not mature until 2011 or later, and we have very good access to capital.

We're well positioned to fund organic growth investments and also take advantage of acquisition opportunities as they surface. Again, our first priority is to grow the business while maintaining our premium credit rating. So that wraps up the balance sheet and cash flow.

So let us quickly review the performance of our business units. Please turn to slide number nine. With several quarters running, our Health Care business has generated strong results despite a tough economy. In this quarter, they delivered more of the same. These end-markets generally grow faster and are more stable than many of our industrial and electronics markets. So this business is a great stabilizing factor in our portfolio.

Third-quarter sales in Health Care were $1.1 billion, up 4.7% in local currency terms. Currency reduced third-quarter sales by 3.1%. It is intriguing to see very broad-based year-on-year growth in Health Care’s third-quarter results. Local currency sales expanded at double-digit rate and infection prevention products, and a mid-single digit clip [ph] in the skin and wound care area. In addition, oral care, food safety and health information service businesses drove positive local currency sales growth in the third quarter.

Sales in the drug delivery systems declined by 5% in local currency terms as this business continued to work through challenging comparisons coming off a very strong 2008.

On a geographic basis, all regions posted positive local currency sales growth in Health Care led by Asia Pacific and Latin America. Operating profit was $340 million, an increase of 12% and margins were 31.5%. Sales mix continues to be a positive factor on margins in this business, and of course the Health Care leadership team continues to drive outstanding productivity. What is perhaps most impressive about these results is that we are simultaneously and aggressively investing in expanding our Health Care business for the future.

For example, we are funding important R&D efforts in oral health care such as digital dentistry in mini implants, and also our drug delivery systems business recently announced the opening of the new laboratory site in Singapore. This lab will develop products in both innovation and transdermal drug delivery solutions, and will serve far more customers and patients throughout the Asia-Pacific region.

The investment in this new lab compliments our already well-established lab network besides in both the United States and the UK. Similar investment examples exist elsewhere in the health care portfolio and new product momentum just continues to get better.

Please turn to slide 10 for quarterly details of our Consumer and Office business. Our Consumer and Office team posted very good third-quarter results in the face of continued tough economic headwinds. Quarterly sales were $923 million, operating income was $227 million, and margins continued to improve. Remember that margins in Consumer and Office tend to peak in the third quarter of each year, driven by seasonally high sales and factory throughput.

Total sales declined 6.6% in Consumer and Office, with almost 2% of the decline contributed to the stronger US dollar. Organic sales declined 7.6%, which was partially offset by nearly 3 points in the acquired growth in the quarter. Also, recall last quarter that we mentioned that we saw earlier than expected back-to-school orders begin in late June as retailers attempted to drive more customers to their stores earlier. We estimate that this earlier ordering negatively impacted year-on-year sales growth by approximately 2% versus last year's third quarter.

On the organic front, our businesses are doing a great job of driving a steady flow of new products and aggressively driving penetration in order to combat a number of tough headwinds at the moment. Overall weak consumer spending and a mixed back-to-school season really hurt our customers in the mass retail channel. In addition, slow housing starts and poor existing home sales impacted our do-it-yourself channel.

And finally, high unemployment levels amongst white-collar workers remains a challenge in the office, retail and wholesale channels. Regardless, we continue to drive innovation to promote more growth. For example, Filtrete our leading family of filters for forced air heating systems in homes and buildings continues to gain additional distribution. You may have also noticed that we ramped up our advertising during Q3 for many of our products including Filtrete, as well as our new label product line.

Local currency sales grew year-on-year in both our home care business and in consumer health care, where growth was boosted by two recent acquisitions. The first was Futuro, a leading supplier of braces, supports and compression hosiery, and the second was ACE brands, an iconic branded business we purchased from Becton, Dickinson in July of this year. These deals when combined with our existing organically grown product portfolio are helping us to drive additional growth particularly in the retailed drug store channels.

On regional basis, sales in the local currencies increased in both Latin America and in Asia-Pacific, while sales declined in the United States and Europe. All in all, the story in Consumer and Office was fairly similar to recent quarters. Despite the challenging market conditions, our leaders in Consumer and Office business continue to deliver really fine results.

Now let's review the Display and Graphics business. So please turn to slide 11. Display and Graphics had a good third-quarter. Sales were $896 million or 5.5% in local currency, including 2.5 points of growth from acquisitions. Currency impacts reduced sales by 1%. So on a total of dollar sales basis sales improved by 4.5% year-on-year. Operating profits rose 12% to $204 million.

In our optical film business, the positive momentum that began in the second quarter continued right into the third. Two factors were possibly impacting results in this business. First, there has been a noticeable pickup in demand for flat-panel televisions, coming off of aggressive inventory clients in late 2008 in the first quarter of 2009, and our films are an important performance enabler for those high demanding electronic devices.

Second, we are driving outstanding new product momentum in optical films as well. Recent 3M film technology breakthroughs effectively improved the energy efficiency of LCD panels. Put simply, 3M multi-layer optical films can fundamentally alter the design of a flat-panel device by requiring fewer light bulbs in the back panel of an LCD screen.

Sales of these (inaudible) to pick up in the second quarter and that momentum accelerated further into the third quarter. Third-quarter sales in optical systems increased 26% versus last year's third quarter and were up 27% sequentially. Optical will remain an intensively competitive business going forward and our OEM customers will continue to aggressively drive cost reductions, price pressure will remain intense. Therefore, we must respond with aggressive cost reduction and productivity improvements.

Importantly, this productivity will enable our ongoing R&D investment in optical as our customers will continue to demand technical solutions to solve their ongoing problems. And we will be there obviously to help them. Moving to traffic safety systems, local currency sales rose at a mid-single-digit rate in the quarter. Acquisitions were the primary factors for this growth, namely our December 2000 acquisition of FAAB-Fabricauto, a leading manufacturer of French license plates.

On an organic basis, sales declined year-on-year as governments and municipalities are facing difficult budget conditions. Unfortunately, the highly anticipated US fiscal stimulus bill has not helped the highway construction industry as much as we had hoped. While sales and commercial graphics were down year-on-year, we did see modest sequential sales improvement as the advertising market slowly recovered from the recession.

Now please turn to slide 12 where I will review our Safety, Security and Protection Services business. Sales in this business were $864 million in the quarter, down 6.1% year-on-year. Sales declined 2% in local currency and currency impact reduced sales by 4.1%. Despite these sales declines profits rose an impressive 10% to $236 million. In the face of economic uncertainty, we kept a very close watch on expenses in the third quarter and our factories ran very efficiently.

As was the case in the second quarter, there were some very positive sales influences in the business in the third quarter as well as some challenges. Certainly, the ongoing weak industrial and housing markets remained a drag on sales in many areas such as personal protection [ph], roofing granules, commercial cleaning supplies, and manufacturing latest sales of personal protection equipment. This was no surprise to us.

At the same time, the surge in orders for 3Ms leading respiratory protection solutions that began in the second quarter continued right on through the third. This was directly related to the outbreak of the H1N1 virus, and we estimate that the x factor added an incremental $80 million to third-quarter sales in our SS and PS business. Considering H1N1 related sales in other 3M businesses such as health care and consumer, the number was probably closer to $100 million.

Our factories have been running flat out since May of this year to keep up with demand and we see backorders well beyond the end of the year. As a matter-of-fact, we recently approved two new manufacturing investments to produce respirators in Singapore and to add some more capacity in the US, which George mentioned. Please turn to slide number 13 for a look at our largest business, Industrial and Transportation. As many of you know that there is one business at 3M that is most correlated with general industrial production, this is it.

So the leadership team here has to stay on top of their game day in and day out and their track record in terms of profitability and return on capital is one of the absolute best amongst large industrial companies. This most recent quarter was no exception. Industrial and Transportation generated $403 million of operating profit in the third quarter and margins were an impressive 21.2%, despite sales declines of 8.6%. On a sequential basis, the results were very encouraging.

Sales and profits rose 10% and 23% respectively, and incremental margins topped 40% as factory utilization continued to improve and we are leveraging a much reduced structural manufacturing cost base. Consistent with what we saw in the second quarter, it appears that general industrial activity is stabilizing and showing a slight upward trend. In fact, almost every division within industrial and transportation poses a positive sequential sales growth with the strongest growth in automotive OEM and in the industrial tapes and adhesives.

On a year-over-year basis, we drove positive local currency growth in a number of industrial and transportation businesses led by renewable energy, automotive aftermarket, and aerospace and aircraft maintenance. Not surprisingly, local currency sales declined year-on-year in those businesses supporting a number of large industrial markets such as automotive OEM appliances and the like.

Industrial and Transportation has introduced an impressive array of game changing new products resulting from R&D investments made over the last 3 to 4 years. In the tapes area, we've launched new products that protect Windows from permanent graffiti damage on buses, trains and other transit areas. We have also introduced a number of tapes that bond and seal solar panels. In our Energy and Advanced Materials business we continue to bring value to customers through unique glass microspheres and improved insulation and buoyancy properties in the deep sea, oil, and gas industries. And finally our abrasive business recently introduced a revolutionary ceramic mineral adhesive technology that has the ability to remove metal more quickly and generate less heat while sanding resulting in a longer-lasting abrasive product.

Early indications from customers have been very, very positive. Investments such as these in our core technologies in exciting new growth markets supported by outstanding operational discipline remain fundamental to Industrial and Transportation continued success.

Please turn to slide 14 where I will summarize results for Electro and Communications business. Throughout 2009 end market declines have been more severe in this business particularly in telecommunications and in commercial construction. So the year-on-year accounts remain very challenging. Sales were $617 million in the third quarter, down 16.5% year-on-year and operating profits declined 26% to $117 million.

Local currency sales declines were fairly broad-based, declined 15.3% in aggregate and currency impact reduced sales by just under a point. Faced with such difficulty end market conditions the Electro and Communications team remains focused on driving operational efficiency and cost reductions as evidenced by their nearly 20% operating margin in the quarter.

Despite the obvious sudden market challenges there is a ray of hope here. Sequential trends were favorable for the second consecutive quarter as sales and profits rose 12% and 59% respectively in the third quarter led by our consumer electronics related businesses that sell high-tech products and solutions in the smart phones, mobile handheld, hard disk drive, and semi conductor markets.

Similar to industrial and transportation things are stabilizing in the Electro and Communications as well. That concludes my review of our third-quarter numbers. Now I will turn it back to George, who will describe our outlook for the rest of the year. George?

George Buckley

Thank you very much Pat. Before we answer your questions, I'd like to address our outlook for the rest of year. We are certainly glad for the positive sales outcome this quarter. We all know that the hardest time to forecast sales accurately is a turning point in demand. That is where the inflection points, or inflection points saw significant changes, or even in some cases reversals in gradient. As we might say, changes in the first derivative.

You recall that we said last quarter that the US economy or at least those collective segments where 3M plays seems to have reached bottom at the end of the second quarter. So that's where you see the changes of gradient. So to be fair to everyone, I don't think forecasting is going to be much easier anytime soon, and I hope you will bear with us as we try to identify the underlying trends and patterns that will help us get better insight into where the world economy is going.

I think 3M’s capability of execution in difficult times is now beyond anybody's reasonable doubt. So the continued $64,000 question on everybody's mind is where is the economy going? Whenever I get excited about our progress, we have seen huge progress in new products in market penetration. I do remind myself of King’s View [ph], which I quoted to you last quarter in that there can be no sustainable recovery without natural improvements in aggregate end-market demand.

The question remains where will it come from. First, some people who will be wondering have similar packages led to this improved performance. The short answer to that question is no. On stimulus packages some countries seem to have done it well like China for example. Conversely some like the United States and the United Kingdom have done it badly and some like Germany and Italy have not really done anything at all.

So as far as we can sell as Pat said while a lot of the money has been spent a little stimulus money is yet let into the US economy at large. The Cash for Clunkers program was successful at spurring short-term demand and driving down dealer inventories but it did not seem to be very successful in improving underlying demand.

Here and there stimulus money may have replaced state spending that would otherwise have been cut but there has been little or no net volume increase to speak of so far as we can see. Perhaps more will bleed through later, but for now it's not the de facto in the US demand equation [ph] for us. In contrast, we did see measurable impacts from stimulus money in China as to some degree in Japan. It was targeted mainly at locally made products in retail consumption, and the impact was almost immediate in its effects on demand for cars and electronics.

That helped quite a bit locally and China seems to be growing significantly again. I will go with this topic in more detail at our December update, but the key to the puzzle of what happens next year seems to be unemployment levels. There are many things to be cautious and worried about, but there have also been many positive things happening and achieving a fully balanced (inaudible) when we update you in December.

So while significant economic challenges remain to be overcome about [ph] the economy, I think this is where our continued R&D spending comes in. We know instinctively that doing this will eventually make a difference, and ironically the longer recession goes on the more advantage I think that we gain from it. Share gains should more certainly be possible and become a real growth differentiator for 3M, and we've already begun to step on the gas a bit more on R&D as Pat mentioned earlier.

As I told you last quarter it's hard to forecast a precise shape of the recovery and even harder to describe it verbally here on the phone. But our expectations are for a flattish but short economic bottom, then some fast restocking, which we saw some in the third quarter. This will be followed by a flat spot as I call it or plateau as end market demand and wholesale demand coming to equilibrium. And after that the earnings recovery will just gradually fall economic activity upwards.

That flat spot if it comes maybe get in the late fourth quarter and is what gives us the continued note of caution and conservatism. So, in light of these realities, we're sticking with the fundamentals of the plan and forecast, generate cash to both our customers and their business to drive sales plus R&D. What the third quarter continues to emphasize is the underlying strength of the 3M business model, its diversity combined with discipline and how it provides a great platform for cash generation and performance even in the most challenging conditions like we're seeing.

So we are going to maintain that discipline going forward even as we make plans to selectively increase our growth investments in the fourth quarter and beyond. So with the third quarter complete, we now believe that organic sales volumes will continue to improve and for the full year will come in between minus 9.5% and minus 10.5%, and that EPS will come in somewhere in the band of $4.50 and $4.55, both are material improvements versus our prior outlook.

In conclusion, we're going to stay focused on cash generation and new investments in growth platforms as the best way for 3M to emerge an even stronger company than it was going into this recession. It's not too soon to remind ourselves that our ultimate objective is consistently higher growth and we haven't deviated from that, and we're taking the necessary steps to make sure that it happens.

Again we are hardened by the power of our business model and by the professionalism and dedication of our people around the world, and we are more and more convinced than ever that 3M is a superior and profitable investment. And with that I'd like to turn the call over to your questions. Thank you very much for listening everyone.

Question-and-Answer Session

Operator

(Operator instructions). Our first question will come from the line of Deane Dray with FBR Capital Markets.

Deane Dray – FBR Capital Markets

Thank you. Good morning everyone.

George Buckley

Good morning, Deane.

Pat Campbell

Good morning, Deane.

Deane Dray – FBR Capital Markets

Hi, George, my first question was going to be to update us on the expected recovery path but I think your closing remarks really honed right in on expectations there and you've had a pretty hard hand, so I think that's – I won't pursue that further, I think that's pretty clear on your expectations. So instead I would like to focus a bit here on what you call the x factor in the respiratory mask and just give us a sense, the last update was 40% of capacity being added, looks like you've done a little bit more than that, but can you size for us the back order, and is there risk in over expansion here and chasing this demand and might you consider licensing out the product and just give us a sense of how you are managing this high quality problem.

George Buckley

Sure. Thanks Deane. The capacity we added was probably closer to 30% rather than 40 so that gives you kind of a sizing of where we've gone. As for the high quality problem of outsourcing, the practical matter is, Deane, nobody has any capacity. So there is nobody to buy from. So the challenge at one level is not to disappoint big customers and very large and very powerful customers like governments, so we chose to make these relatively small incremental investments.

And I do think that H1N1 may – we could be proven wrong, but I think it may have changed people and government's attitude to these quite virulent viruses, so we don't think – because of what we spend, where we spend it, and how we structured it, sort of flexible, shutdownable ,overcapacity that this will be a big challenge. And it is of course a chance Deane for us to gain market share, continued influence with our customers. So we think on balance it is the right thing to do.

Deane Dray – FBR Capital Markets

And just to clarify I know you don't break out margins by particular products but just when you look at this incremental revenue coming through, how does this compare to the margins for the segment?

Pat Campbell

I would say, Dean, Pat here, it is similar. Every one of these tenders are different, okay, but on average it's not all that different from you know the business as a whole.

Deane Dray – FBR Capital Markets

Great, thank you.

George Buckley

Thanks, Deane.

Operator

Our next question will come from Shannon O'Callaghan with Barclays Capital. Please proceed.

Shannon O'Callaghan – Barclays Capital

Good morning guys.

George Buckley

Good morning Shannon.

Shannon O'Callaghan – Barclays Capital

You know George just a question on how you are thinking about the trade-off between the margins and investments at this point, I mean your focus has always been really more on ramping the investment, trying to accelerate the growth of the company, I mean with the margins coming in a strong as they are, I mean you are ticking up R&D a little which is nice to see, why not put the pedal down a little more and how are you thinking about that trade-off as you look out the next couple of years?

George Buckley

Well as always you know the thing in life Shannon you know this, it is what we call here internally the baby bath strategy, not too hot, not too cold, not too soft, not too hard, and we could certainly do what you suggest, but I think we always have to keep in mind the stability that we offer to our investors. So we will certainly tick up our investments machine, absolutely no question about it, and we have already gone through our planning process and we have lots of great ideas, and that is one of the really nice things that really happened to us.

If you go back not that many years, we had a lot of money and not maybe as many ideas as we have today, now we have lots of ideas and plenty of capability. So I think that you'll be pleasantly surprised next year as we step on the gas to invest in a number of different places in healthcare we talked about right in the past, but in industrial, in renewable energy, a lot of really really good ideas are coming through, Shannon. And I think you'll be pleasantly surprised.

But in the end Pat and I will always try to find that sort of balance point so we don't bang the pendulum from one side to the other because in the end when you do that you end up with inefficiencies and we tend to take a view in our company of, it is always better to have funding and R&D a little bit tight than a little bit loose and that is probably the way that we will follow our pathway next year. But I think you can look forward with encouragement and anticipation to what we plan to do.

Shannon O'Callaghan – Barclays Capital

Okay, thanks. As you see the sequential volumes picking up here nicely, how are you thinking about overall employment at 3M? I mean in terms of increasing people's hours as a first step and actually bring in people back, I mean are you hitting that soon, how do you think that plays out?

George Buckley

Well I don't think we are past that, because you know we've got – at least this year, we do have some added capacity, because we had people on, a lot of people on layoff, a lot of people have been on forced vacations, so we still have some already good internal capacity to respond to those things. It is an excellent question, but it is why we manage the business in a way that we did. Rather than laying people off and then struggling with a recovery, we said no, we need to do furloughs, we need to mandatory vacations, those sort of things. Because if a bigger vacation accrues, that's really I think helped us in preparing for the future.

But there is another side to the question and that is the quality of people that are available out there. And we certainly will step on the gas little bit here in investing people that will help us with e-commerce, with some of the electronic products and software opportunities that are emerging. We will almost certainly – I mean the plan is in construction right now, accelerate investments in – I won't be too specific but you'll be able to figure them out very quickly, some overseas markets that provide big opportunities.

But I think we're going to try to do it as best as we can without a lot of wholesale hiring apart from the kind of cherry pickers data that I think we have got from some great manufacturing industries in this country in particular, we will do that. But we're going to try to do it steadily and without again banging the pendulum to the other side.

Operator

Our next question will come from Scott Davis with Morgan Stanley. Please proceed.

Scott Davis – Morgan Stanley

Hi, good morning guys.

George Buckley

Good morning Scott.

Pat Campbell

Hi Scott.

Scott Davis – Morgan Stanley

It looks like you have several billion dollars of cash now on the balance sheet which is kind of a high-class problem I suppose. You know any particular reason, I mean I guess, one, can give us some context of the size of the pension contribution that you're looking at for 4Q? And then two, when does it make sense, you know what is holding you back I guess from taking a look at share buybacks again, is it just uncertain market environment or potential acquisitions that you think you have out there that could potentially be a cash cow in the next year?

Pat Campbell

Scott, we really do have short memories, don't we, as to a year ago we're kind of facing you know kind of concerned about bank failures and everything else, so we've got to let a little bit of time here past that. To answer your question on pensions, we are probably looking in the order of magnitude of $300 million to $500 million in the fourth quarter is what we're looking at contributing at this stage. Of course, we look at how the fourth quarter develops and where rates move and so forth. That would probably be the order of magnitude that we're looking at.

Scott Davis – Morgan Stanley

Okay. The second question and I don't want to take away from other people who may have heard this correctly, but safety security and protection, it wasn't clear to me, it looks like if you're doing apples to apples on H1N1 that sales would have been down about 15% where were the weakest points there?

Pat Campbell

Well, the weakest, even within the I will call it the personal protection that is related to industrial activity, that business is down. As we mentioned, corrosion protection which is heavily driven really kind of by oil price, and of course now with oil prices kind of going up, you know that business may see a little bit of a rebound here. Industrial minerals was down a little bit and also our commercial care business was also down. So those are very industrial kind of related economic related businesses so they were all you know down. And so as the overall economy improves, process SPS [ph], we should see a gradual improvement in the growth rate outside of the H1N1 piece.

Operator

Our next question will come from Laurence Alexander with Jefferies.

Laurence Alexander – Jefferies

Good morning.

George Buckley

Good morning.

Laurence Alexander – Jefferies

Wanted to follow-up on the – you commented a few times on market share gain and specifically for auto aftermarket but also more broadly how much of a tailwind do you think you can get from market share gains in the early part of the cycle and then how sustainable do you think that will be?

George Buckley

You know Lawrence I think we thought about it across the company, there clearly are going to be some better gains in some areas than others. China offers vast opportunities for share gains in automotive aftermarket and that will be one of the investments that we make next year, I'm pretty sure about that. But overall, you know, you try to assess what can you really get market share, I think it is possible to get in the half to one point of market share a year for the entire company, that would be the kind of target range that we would be thinking about.

And you know we've continued to spend on R&D, Lawrence, and we have maintained our investment, we've tried to make sure that we didn't run out of capacity where those opportunities lay, and you have to imagine if you are in our shoes now, it is time to make that pay, and that is basically the attitude that we are taking, and I think we are doing it. As I mentioned in my remarks, it is quite difficult to make measurements of these things, because in many industries, the data isn't there. So you end up making – end up making some kind of educated guesses. But it is going to be a push for us next year, Lawrence.

Laurence Alexander – Jefferies

And lastly just briefly on pensions, what is the endgame, I mean are you aiming to finally get the pension plans to the point where you can immunize them? Or is it is just going to be sort of moving to sort of year by year just to maintain within the statutory limits?

Pat Campbell

Well of course we have significant international plans (inaudible) you have to kind of look at them on a plan by plan basis. Generally speaking, we would like to keep it about fully funded situation. If the opportunity ever arose, if they give us the opportunity, okay, to immunize ourselves, okay, that is something that we would strongly, strongly look at.

Laurence Alexander – Jefferies

Thank you.

George Buckley

Thanks Lawrence.

Operator

Our next question will come from Jeff Sprague with Citi Investment Research. Please go ahead.

Jeff Sprague – Citi Investment Research

Thank you. Good morning everyone.

George Buckley

Good morning, Jeff.

Jeff Sprague – Citi Investment Research

Good morning. I just wonder if you could help us kind of piece together kind of the restructuring variances and towards some degree this idea of the way you've managed cost out on the way down with vacation and furlough and things like that. I mean the gist of my question is, you know what kind of carry over benefit do we have know into 2010, good old fashioned restructuring versus maybe the stuff that creeps back in on kind of undoing some of the more kind of near term things kind of in the heat of the moment?

Pat Campbell

Jeff, I'll take a stab at this. This is Pat. On the vacation side, we have got about another year to go there, 2009 and 2010 and that of course the issue that will be what happens in 2011 and that runs order of magnitude $100 million in both 2009 and 2010, a little bit heavier maybe in 2009. On a restructuring basis, based on what we have watched and announced, we probably have something north of $100 million benefit going into 2010.

Jeff Sprague – Citi Investment Research

Great. And so just to be clear on the pension, I mean I am sorry on the vacation, it is not an incremental 100 more in 2010, it's just stays at kind of where we were…

Pat Campbell

Let me just to be clear for everybody, when we went into the situation, we had a call it a accrual balance of about $200 million for earned vacation okay that had outside the current year. So effectively we will be drawing that balances down over a two-year period, so it comes out about $100 million down in 2009 and another hundred million down in 2010 is the way it works.

Jeff Sprague – Citi Investment Research

Okay. And Pat or George, can you give us a little more color on just the price environment overall, you know it looks like you've got that big Latin benefit you attributed to FX but now we are going the other way on the real and other things, I don't know if this is other currencies we should be worrying about there. But I would assume that your near kind of positive cost variances on a year-over-year basis, so it would – just kind of tie together the price versus cost dynamic as we look forward the next couple of quarters?

Pat Campbell

Yes, sure. First of all, to a large degree, most of our pricing will start to anniversary as we get into the fourth quarter, so our reported price will start to diminish. There is still some pricing going on in Latin American markets, you know you bring up Brazil, but Venezuela is also very a large sizable business for us as well. So there still will be some positive price related to some currency moves. If you look at, as George said in his comments, on a longer-term basis, we have really tried to kind of manage price cost spread.

I think it would be fair to say that in today's world, we have – our teams have done a marvelous job going after price, and input costs as we mentioned are probably down about 3% here in this quarter. So we have got a favorable gap there. But on a long-term basis, we will look at trying to manage those together. And if I really think on a more going forward basis, I think from a planning assumption standpoint, generally you think of it being kind of a loss is the way that you think of the model going forward.

Jeff Sprague – Citi Investment Research

I'm sorry. Just if I could sneak one more in, having put or planning to put this pension contribution in Q4, if you tie that up with where your returns are now and what you're looking at on discount rate, can you give us some back of envelope on pension headwind for next year?

Pat Campbell

Yes I can. Again, I will probably give you some more in December, Jeff, when we meet. Of course, we won't know the final answer until the year closes, but right now, if I had to kind of draw a kind of a snap a line, we are probably about $300 million of headwind next year or $0.03 a share, and that is about $100 million more than they we gave you, last time we gave you a number, which I think was in the April timeframe. And that is exclusively related to the change in the discount rate. Interest rates have – at least corporate rates have come down pretty significantly, so it is really on the discount rate side is where that movement has occurred, it's not really been on the return side.

Jeff Sprague – Citi Investment Research

Yes. Thank you very much.

Pat Campbell

Thanks Jeff.

Operator

Our next question will come from John Inch with Merrill Lynch. Please go ahead.

John Inch – Merrill Lynch

Thank you, good morning.

George Buckley

Good morning John.

John Inch – Merrill Lynch

Good morning guys. So other than optical, were there any of your businesses sort of as the quarter progressed or segments or whatever facing price pressures that incrementally got worse, and any incrementally facing price benefit, I'm just sort of kind of thinking of the mix between all your various moving parts here?

George Buckley

John, I would say that nothing significant to call out.

John Inch – Merrill Lynch

George, when you talk about market share gains, are there obvious areas. I mean obviously you have got all new products in the pipeline that you are launching, but are there segments or areas, as we look back over the course of the recession where you feel you have made meaningfully significant inroads with respect to share gains?

George Buckley

Well I think there are two that immediately come to mind, John, almost as respirators, we have done extraordinarily well, but we did add capacity early. We were able to capitalize on those investments in particular given that the plant that we are building in Korea, we were headed again there. The extensions in the UK and now these new ones that I just talked about, so I think in that area, John, we would have done well.

In the optical area, I don't think there is any doubt either there because we see the reported attachment rates that we have in those businesses, and also picking back up again quite substantially. So we're clearly gaining share in that area. In the renewable energy, John, while that business is still small (inaudible) footprint is getting put down the. We're building a new plant in Singapore for film for that business, and as soon as that capacity comes on stream, we will able to gain share there as well.

We obviously gain share partly through acquisitions in the automotive aftermarket, so I think those things will continue, John. We have some marvelous products in abrasives. If we see you in December, we thought of bringing along some either good graphics or maybe even movies, you would think that it was not possible to add or make any more inventions in abrasives, but it is just – look, we should take people's time on the call to give you the detail, but absolutely marvelous.

So I think in a fairly broad front, John, we're going to be able to gain share. You're always going to be careful not to be too optimistic about how you can gain it because other people have to give it up and they don't always do that willingly, but I think we're going to do well or share gain because of the investments in innovation and is certainly – and in some cases investments in capacity. So I think we can continue down the path way very strongly, John.

John Inch – Merrill Lynch

Thanks, George. Just…

George Buckley

John, the other thing, and I'm not going to – I won't give you exactly specifics, I will give you more of a dull comment. The other thing that happened of course is with the economic conditions, there are a number of suppliers that are not the healthiest today. And a lot of large multinationals reviewed their supply base during these kind of times, so we spent a lot of time with big customers during these kind of times, it doesn't show on our results today. But I think as business returns, I think you'll see that we will be treated I think with additional volume, just because they know what is we are going to be around, and two, obviously, our innovation, so I think we will pick up some as the economy returns here.

John Inch – Merrill Lynch

Okay. Just one more. On healthcare with US going through this big debate, can you guys remind us how much of your healthcare business runs through US hospitals? And if that business is not going to be subject to some form of managed pricing pressure over the course of the coming years?

George Buckley

John, let we try to answer it maybe a little bit differently. I'm not maybe you guys can see if they can figure out the hospital numbers, but here is how I think of that business. About half of it is in the US and there are certain elements of that business that to some degree may actually benefit a little bit okay from some of the efforts. You know take our health information systems business, they may actually benefit. So as we looked at the various rounds of debate that is going on around healthcare, of course we don't necessarily like any kind of taxation that is put on the healthcare industry, but what we're looking at under the various scenarios right now is something that we think is kind of a manageable expense for us. There is a piece that is on, will be on the medical side, there could be piece that you know leaks over into the oral care side, okay, as well, but as we thought about it and looked at it, of course none of us like to have any kind of call it penalty, but the reality is we think within the size of our business, it is a pretty manageable thing at this point in time.

John Inch – Merrill Lynch

Great, thank you.

George Buckley

Thanks John.

Operator

Our next question will come from David Begleiter with Deutsche Bank.

George Buckley

David, are you there?

Operator

David, your line is open.

Pat Campbell

Why don't we go on, we will come back to David right after.

Operator

Our next question will come from Steven Winoker with Sanford Bernstein.

Steven Winoker – Sanford Bernstein

Good morning.

George Buckley

Good morning Steve.

Steven Winoker – Sanford Bernstein

Just a quick question on CapEx first, it is down 37% roughly year on year and cash from ops is up 15%, and historical rate is I have got around a billion and a half spending last year on a full-year basis, so how are you thinking about accepting, pushing the accelerator down on that part of the question?

Pat Campbell

I will start, okay, and then – Georgia and I were kind of debating, okay, where this is kind of going to end up. He's got a big smile on his face, Steve. And in part, Steve, obviously what we're trying to judge is as George talked about , we just kind of completed our planning process, and we – there are some really good ideas inside the company. So we're trying to settle down on that number. As I would have probably told you a quarter ago, I would have probably said that number was going to be kind of flat, okay, which I still think is going to be flat to maybe up a little is kind of how I would, is how I would put it, Steve.

George Buckley

Steve, we have got a lot of these – the big projects are kind of coming to completion, so that carry over from 2008 into 2009 would have been much bigger than the carryover from 2009 into 2010. So even though it sounds impressive, they are flat to a little bit up. In point of fact, there is significant new elbowroom has been created by the completion of earlier products in that roughly 900 million or so that was spent this year. So it is going to create some capacity chances for us.

And then obviously what Pat and I will do is, and are doing as we speak with David's help, are going over each of these projects, the most important ones, the ones that seems to have the best returns, are the ones that have the greatest strategic capability, and probably will end up allocating a little bit more to those, temp it to some degree by some strong demand in one or two areas like respirators, like optical films, that will again color that mix. But again I think overall, it will give us a little bit of elbowroom, more than we had last year to start now allocating some of that money to grow, and we may top it up with just a little bit to make sure that we are not leaving any really good opportunities on the table.

Steven Winoker – Sanford Bernstein

But you're basically looking there for a CapEx, these run rates are closer to normalized, a little bit better than what you used to run historically as you're going through all the major capacity changes in the supply chain effort.

George Buckley

Yes. We still got some of those things to complete, Steve, but I think that – I mean if you think you know the normal run rate within $100 million plus or minus where we are today, I think you'd probably find that's how we're run for sometime.

Steven Winoker – Sanford Bernstein

And just a business unit question, consumer and office, the organic local currency sales were down from what I can tell 7.5% versus 4.3% in the second and 3% in the first, is the only business where I saw organic local currency sales before acquisition and currency, can you once again jus clarify a little bit what that…

George Buckley

Steve, maybe this will answer part of your question. On the second quarter call, I tried to remind everybody (inaudible) there is a little bit of movement in back-to-school shipments that win in the second quarter, okay, that normally was in the third quarter. There is about two points of growth. So the second quarter actually benefited by about two points of growth that normally was a third quarter activity. So if you kind of move two points of growth between Q2 and Q3, I think you get back to something I think that is more of a normal trend.

Steven Winoker – Sanford Bernstein

Okay. And then the last question, sort of another spin on the I think the pricing and margin question that have been asked three times, which is when I look over 40 years of gross margins and operating margins, the peak margins that I can find are sort of 51 and 25% respectively, and you are pretty much just about there now. So as you think about all of these investments and changes in drivers in organic growth, is there a new level that you're driving towards as you think about it in terms of sustaining, you talked about pricing, you talk about the cost cuts that you doing, how are you guys kind of debating and thinking about that looking over a little longer term?

Pat Campbell

Steve, our margins really – we don't have a strategy, okay, that says that our margins ought to be x, and then kind of drive everything off of it. It is kind of an outcome talking of all the individual pieces that we put in place and the great work of the business. And I do think that 3M has a very, very unique business model and capability which is the reason why these margins are so high and so sustainable and we would talk to you some more about that in the December meeting when we think about it.

But I mean the reality is we have improved our business and kind of your observations, we have improved our business to the point where of course our peak margins are now better than they have historically been. And of course if you look at history and we have been in different businesses at different times, so it is never really the same company. But the reality is we have done that, which actually provides a great platform for George and I to think about, you know where do you grow, okay.

There is a lot of good opportunities we have to grow the business and with the incremental margins that we have in many cases, any growth we get just actually makes the results better, better when you drive growth. So even with the acquisitions we have made and some of the strategies we have made on going further down the (inaudible) and so forth, we have been able to kind of hold our margin structure together, which I think shows the power of the underlying capability of the company. So we will continue to drive growth. We are really lucky at obviously how do we drive shareholder value in this company, it is really getting more top line growth. It is not by squeezing more margin out of it.

George Buckley

So we'd be happy if these numbers stay, these margins stayed reasonably in this band and the leverage, if we do the operating leverage we get, Steve, we can just use that as fuel to stroke the growth fire, that is kind of the way that were thinking about this. And we have done quite about in this particular recession, we have done quite a bit of in-sourcing, stuff that actually historically we outsourced, maybe we outsourced it 10 years ago, it seemed to have a good value proposition at that time, now doesn't make sense, and we are bringing that stuff back inside, I think maybe a 150 million in sales this year or so. We're bringing that inside and getting it better process. So all of that is helping to leverage our gross margin and actually shorten our supply chain as well. So there seems to be an awful lot more juice in this lemon yet that we can use but our intention is to use that juice to fund more growth not necessarily fund more margin.

Pat Campbell

Yes, one other thing I guess I would like to maybe point out is also I know your question was really kind of on a operating margin basis, but I don't want to lose the reality that we have also been able to significantly get our tax rate down as well. So if you look at it on a net margin basis, we have been able to make some very good strides on our tax rate over time as well. So when you look at it on a net basis. And then the other thing we don't talk about but the other thing that is safer to us was really looking at our overall ROIC as well. So we have got some objectives that make sure that our returns remain in the 20% plus category, so it's both margins and returns is what we focus on.

Steven Winoker – Sanford Bernstein

Thank you.

Operator

Our next question will come from John Roberts with Buckingham Research.

John Roberts – Buckingham Research

Good morning guys.

George Buckley

Good morning John.

John Roberts – Buckingham Research

When you look below the aggregate sales at the individual customer order patterns, have they firmed up in terms of frequency and in terms of average order size, things like that to give you a little bit more confidence and predictability than you had earlier?

Pat Campbell

I would say on the margin okay maybe it's slightly better but I can't send – we are not back okay to where we were a couple of years ago from a kind of demand planning standpoint.

John Roberts – Buckingham Research

I'm not talking about the aggregate percent, I think before that I had less confidence because they were coming in infrequent basis and smaller amounts.

Pat Campbell

I wouldn't say it is. Any time you start back up, okay, I think it starts to improve, but I still think it'll be fair to say that we're seeing smaller orders than we used to see, okay, and they are kind of in the more sporadic nature. I do think customers will continue to be very cash flow conscious as they recover here. So I think that is going to have a impact in supply chain really across all industries as this thing recovers, I think there is going to be a little bit more of a hand to mouth view for a while here.

George Buckley

I mean they are going to be more cautious John, you expect people to be more cautious, and they may or may not be restricted by credit, but both of those factors if they really will come together and probably you just asked which is probably for a time here, we will have more small orders, more frequent smaller orders. We have done well in responding to that and hopefully that settles down and accelerates to return to more should I say more normal ordering patterns as volume builds. Let's hope that is the case.

John Roberts – Buckingham Research

Thank you.

Operator

Our next question will come from Steve Tusa with J.P. Morgan.

Steve Tusa – J.P. Morgan

Good morning.

George Buckley

Good morning Steve.

Pat Campbell

Good morning Steve.

Steve Tusa – J.P. Morgan

So just a commodity cost benefit I'm not sure you guys give that number, sorry if I missed it?

Pat Campbell

Well in the third quarter we said that our input costs was down about 3%.

Steve Tusa – J.P. Morgan

Okay. When I look at the guidance, just trying to kind of get my hands around the seasonality here, so when you look at the fourth quarter EPS at the high-end, it looks like it's going to be about 26% of the annual number. And when you look at the implied margin at the high-end of around 20.5, you know that is down more than your kind of normal 150 bps decline from 3Q to 4Q and is jumping back quickly to the EPS comment with 26% of the year in the fourth quarter.

That is kind of normal seasonality, but that would seem relatively conservative to me in the context of how this year has played out given that 1Q was so horrible and it looks like you still have a lot of tailwinds going for you in 3Q and 4Q. So I guess the bottom line is you know can you guys maybe discuss the seasonality dynamics here in the third and fourth quarter? It doesn't seem to make like it should be normal or maybe there are reasons why it should, could you just talk about that?

Pat Campbell

Steve, I'm surprised this waited till the last, that this is the last question to come up. It is an interesting question.

Steve Tusa – J.P. Morgan

I can't help that.

Pat Campbell

No that is fine. You couldn't. I guess your observation's true. If you look at the top line guidance, I guess if you kind of do the math, I think you'll probably see that we have probably taken our top line expectation probably down a little bit from our normal seasonality. And to be honest with you, that is a little bit of a just a plan around – we don't know what is going to exactly transpire; I feel pretty good about October, but the wild card for me is December. I really don't exactly know how December is going to play out.

December could either you know continue on kind of a steady trend basis here or could be a complete collapse, so we've kind of obviously you know probably hedged our bets a little bit when we looked at our fourth-quarter expectations, and so don't read anything you know more to it than just maybe a hesitation we've got into kind of operate in the kind of an uncertain world here. I just don't know where really December is going to fall out. But if I look at our margins probably for the fourth quarter, they will come down off the third quarter. They won't be at least to my expectations in the 20s, okay; they will probably be in maybe 22 or so, Steve, is the way I would think of it.

Steve Tusa – J.P. Morgan

Okay, so you're basically – there is normal seasonality, there is upside to the range is what you're saying.

Pat Campbell

I would say there probably is, Steve.

George Buckley

What we will also do, Steve, the other thing we're trying to keep some flexibility open here is depending on how the fourth quarter goes and how the Christmas season goes, doing it the way that Pat has suggested it, will allow us to have a little bit of money in the back pocket to drive, to increase that (inaudible) some other R&D program. It looks like we might be able to pull ahead. So it'll give us that flexibility if we so wish based within the numbers that we told you.

Steve Tusa – J.P. Morgan

And then just a question for the H1N1 stuff, is there any way to give us what the bottom line impact is, I mean how far and if you're not comfortable doing that, I mean either above or below average margins?

Pat Campbell

Steve, I would think from a modeling standpoint, just put a minute in average incremental margins, okay, because and I think it really, you almost look at the thing more from a gross margin perspective, Steve. You know there is not, there is not much infrastructure costs (inaudible) SG&A cost or R&D costs required, okay, to solve these additional mass, so it is more of a incremental gross margin business. But to some degree, some of the tenders are very, very competitive, okay, so to some degree, you have to discount a little bit off of that. So if you were to kind of bracket some points between a normal operating margin, our gross margin would be kind of a decent way to think of it.

Steve Tusa – J.P. Morgan

That's a good range. Thank you.

Pat Campbell

Thanks, as well, Steve.

Operator

That concludes the question-and-answer portion of our conference. At this time, we will turn the call back over to 3M for some closing remarks.

George Buckley

Well, thank you very much, everyone. We appreciate very much the time that you spent with us, especially in these busy times. So thank you very much and we look forward to seeing you and talking to you in the beginning of December. Thanks a lot, everyone.

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