David W. Meline - Senior Vice President and Chief Financial Officer
Matt Ginter - Vice President, Investor Relations
3M Company (MMM) Morgan Stanley Industrials & Autos Conference September 18, 2013 12:10 PM ET
All right, folks. So we’ll pick it back up again with 3M. Very pleased to welcome to the podium CFO, Dave Meline and Matt Ginter.
David W. Meline
Okay, good. So I’ve a presentation. I’ll try to go this through this in a reasonable clip so we have some time for Q&A at the end here. Okay, so you know, read this.
What I am going to do is talk today mostly about a number of key themes that we rolled out, that we developed last year when Inge Thulin took over as CEO. And then at the end I’ll talk about current results and as I said leave some time for questions.
So really starting point for us is really how do we create value as a company. And that’s around leveraging a number of our fundamental strengths. First thing, innovation; around developing new products which will deliver, continue to deliver high margins and return on capital. Secondly, supported by world class manufacturing and process engineering which has enabled us to have very high gross margins over multiple decades, supported by global coverage and also having a strong financial position as a foundation for the company.
If you look, just to set the stage at the company’s performance over the last decade through 2012 we’ve been driving with really three key metrics that we worked towards; the first one being our earnings growth, which we’ve been setting a target of double digit earnings growth which the company delivered over the last decade.
Secondly sales growth; we did 6% annually over the decade, a little more than half of that was organic growth. And then thirdly, targeting to have a good return on invested capital, which for the company averaged 22% over the decade. And then finally we also have as a key attribute of the company good operating margins and over the last decade now we’ve been operating at 20% plus.
We reorganized last year, at the beginning of this year into five business segments which is now better aligned to our customers and end markets. The largest of the segment is our industrial business which is about a third of the company. So what you have in here are some of our core businesses which we call Heartland. Those would include industrial adhesives and tapes, abrasives and automotive aftermarket.
The other four business sectors then are more or less of equal size, give us a very nice diversified mix. And the one I would call out there is healthcare which has been our fastest grower recently and also has the highest margins.
If you look at the core and the first theme for the company certainly would be innovation which is at the center of our plan and really the key advantage that 3M has in the marketplace, where we leverage all of our technologies broadly across the entire company and typically where we have the best successes where we put together multiple technologies into novel combinations that our competitors are unable to replicate.
We measure our performance in this area via the New Product Vitality Index which is shown on the chart and which is the percent of the revenue of the company which is coming from the products launched in the last five years. So you can see that last year was a third of our sales and then up quite nicely from 2008. And if you look today across the company, across our 35 divisions you would see the product portfolio is broadly healthy across all of the different businesses in the company. And it’s our view that there is more opportunity to see this index continue to move higher.
One area that we focused on in terms of innovation is we concluded that there was an opportunity here for us to increase our commitment to innovation and R&D. And basically this came out of a discussion we had last year when Inge took over which was we looked at what’s going very well for the company and we observed that as I’ve already said, the product pipelines were quite healthy, we were feeling good about what’s been going on there. We could see a very good connection between our profitability and margins as well as returns on capital and health of the product portfolio.
But what we also concluded as we looked at it, there was an opportunity for us to up the amount of investment we are doing in more disruptive innovation. And so the reason for that is, we set quite tough targets for our businesses. And as we looked at what was going on we observed that not surprisingly, the bulk of the money that they were allocating to R&D, they would prioritize towards things that delivered shorter term results in terms of revenue and profit. And so it was our conclusion it would be appropriate to increase some of the longer term higher risk investment in R&D.
So we set out a plan for the company to increase our spend here up to 6% of revenue from what’s been running about 5.5% and the specific focus of that incremental investment is towards some of the longer term, more disruptive technology opportunity that we could see.
The second theme that we struck last year was around prioritizing our portfolio of businesses from the top down, which is something that hadn’t been done in recent years. And so what we did is we looked at the characteristics of our businesses and the elements of where we’re most successful and we mapped that here for the different businesses and we then categorized them.
So we have one group, which is we call Heartland businesses, which are large profitable and growing businesses that are well represented around the globe. We have a push forward category, which tend to be more medium sized in some of the faster growing segments and where we think we've got good growth potential for the future.
And then finally, we categorized the group of our business, representing about 8% of the revenue into a review category, strategic review. And the intent here is we’ve been working with each of the leaders in this area to identify how we would improve and fix the businesses or combine them with other businesses to improve their characteristics of performance or harvest or sell them.
So we’ve been going through that process this year. And really the intent here of this categorization is to more sharply drive resource allocation, get the right kinds of leaders in the right positions to enable us to move the company forward.
Another area, a third theme would be around organic growth. Basically the company is an organic innovation business. And this is core to the proposition of the company. And we had 7% to 8% organic growth revenue target which we were observing, we weren’t achieving. So we spent some time to look at what would be an aggressive but achievable goal for the company over the next five years. And what we concluded was, we think 4% to 6% organic revenue growth is a good number for the company, which is basically based on the observation that over the decade we’ve grown at about 1.5 times global industrial production.
And as we looked at the outlook and we concluded okay, 3% to 4% would be reasonable to expect for growth going forward of the economy and industrial production broadly and therefore growing at one and half times that would put us at 4% to 6%.
And then likewise we articulated how we think that growth will occur as between developing in developed markets. So we’ve been growing at double digit rates in developing and we believe that will continue so we put 8% to 12% against that area and 2% to 4% in the developed markets.
So if you look then at how that will cause the revenue profile of the company to evolve, right now last year we were at 34% of our sales were in the developing area and with that growth over the next five years we expect that will increase to 40% to 45% of the total by the end of the five year period.
This chart explains which I think is quite insightful, explains how the model at 3M works in terms of as we grow our business globally. And basically what happens is in the early stages of development of any economy around the world we tend to enter our businesses first which offer products which are relevant to the infrastructure build out of an economy.
So in the early stages of economic development they are putting in things like road, like power lines which we have products that are applicable to those areas. As the economies mature and they develop a manufacturing base we then will add to the portfolio of products applicable to those spaces, so think about adhesives, abrasives out of our industrial and safety businesses.
And then finally as the per capital income rises in these economies, as retailing modernizes as the requirements in the healthcare space become if you will more sophisticated and people have the income to pay for that, then we tend to enter in later stages with the consumer and healthcare offerings to the business.
So it’s a model that we’ve used over decades across these markets and it works very effectively in any market that we’ve entered. If you look then and this I think also captures where we are on that journey. If you look at the company last year 34% of our sales were in developing markets, and then if you look at the split of our five business sectors and we’ve called out here the healthcare and consumer segment, which are the later stage entries, you can see last year respectively 22% and 21% of consumer and healthcare's global sales were in the developing market.
So we are still under penetrated in those segments with a higher level of penetration presently in our core industrial energy and electronics businesses and safety and graphics. So we continue to see the lot of opportunities as we build out and these emerging market presence models.
Another theme, a fourth theme would be around M&A. So while we are fundamentally an organic innovation company we think that M&A is useful component in the core. So we expect to deploy $1 billion to $2 billion annually towards M&A. We link that now to the portfolio prioritization I talked about. And here the targets really are to increase our relevance in the particular segments or with the particular customer set sometimes acquiring for technology, sometimes for local brand.
So we have obviously a variety of different businesses and we use acquisitions to fill gaps in those business portfolios.
A couple of recent transactions we did last year, one is Federal Signal Technologies, which is in the electronic toll collection space; very interesting business and a nice adjacency for our traffic safety business. The business is performing very well. We are ahead on our sales and our EBITDA goals versus the original plan. So we like the business. It’s going well.
A second acquisition we did last year was the Ceradyne company which is an advanced ceramics company which complemented, we already had quite a big presence in the ceramics space. But they had some technology capability in ceramics that is complementary to our core. So right now we’re integrating that business.
We’re a little bit behind on sales right now but we’re ahead on the EBITDA targets for the business. And I think importantly for us, 15 of our 35 divisions have got projects with Ceradyne, which are integrating the ceramics technologies that they have into their own portfolios in combination with technologies we already have.
Finally, operational excellence is another theme that we rolled out last year. Any company that consistently delivers operating margins above 20% and returns on capital above 20% has by definition a good focus on this area. But we decided it was an opportune time for us to raise the emphasis here.
So we’ve done that and in particular, using Lean Six Sigma approaches, which again are very well established in the company, but we’re using the opportunity to really raise the visibility there.
Just quickly then, we’re rolling out ERP system based on SAP. We’re in the third year of this business transformation for the company where we’re standardizing business processes across the globe in a very broad single instance implementation. We expect to invest over the seven year period, $700 million to $800 million in the project with some significant benefits in terms of the efficiency and profitability going forward.
In terms of track record on returning cash to shareholders, certainly we have a model that delivers very strong cash flow and we have a good record of paying out dividends now. We’ve increased the dividend 55 years consecutively, including an 8% increase this year and we expect going forward to raise dividends in line with our earnings growth.
We also indicated this year that over the five year period we expect to deploy $7.5 billion to $15 billion toward share repurchases over the next five years versus $7 billion over the prior five, which would then translate into about a 2% annual growth in EPS from lower share count. And this year, well, actually in July, we raised our buyback plan for 2013 to 3.5 billion to 4.5 billion from original guidance of 2 billion to 3 billion.
So a number of reasons for us to do that. Basically we see the businesses operating very well right now. We see trends in the market such that our pension funding requirements, we expected would decline but we’re seeing that actually accelerating that decline. Thirdly, we didn’t close any acquisitions here in the first half. And then finally, we concluded that we think our balance sheet, capital structure is sufficiently strong and we don’t see a reason for it to get any stronger. So as a consequence of all of those factors, we decided to raise our buyback here this year, which we have indicated would be $3.5 billion to $4.5 billion.
So just in summary, we have four key financial objectives for the five year period: continuing double digit earnings growth; organic revenue 4% to 6%; maintain our record on return on invested capital of 20 plus; and 100% free cash flow conversion.
First half performance, we had strong results in a slow growth economy, we had $15 billion of sales and a little over 2% organic growth, 2% earnings growth over the first half with a 22% margin. And we continue frankly to invest here in the future to enable us to maintain that kind of a record.
So with that I think I will stop and entertain some questions.
Okay. Thanks David. Take a seat.
David W. Meline
Great. So I thought maybe a couple of short term questions and then we will get back to big picture. But everyone in this room is interested in what do you see in your markets, given that you’ve got such a broad portfolio, quite short cycle, so maybe describe the current trade environment.
David W. Meline
Yeah. So if you look at the growth of the business, as I said we had 2% growth on organic revenue basis in the first half. We expect for the year to have 2% to 5% in total with the fact that we do expect to pick up in growth here in the second half, in particular in our electronics business which has being running around negative 2% in the first half.
So we do see some better performance and growth in the second half. If we look right now the electronics business is improving as we had expected. We obviously have better visibility on the third quarter and that’s coming along as we expected and then ultimately the fourth quarter performance will be driven by end market demand and basically pull through the holiday season which we really can’t predict at this point.
But I would say very much along the lines and consistent with what we previously expected.
So the unit is ramping up as you expected. And how much of that is easy comes with the genuine pick-up acceleration in demand?
David W. Meline
Yeah if you look at the consumer electronics business we see a real pick up there. We did have some softening last year in the fourth quarter but the third quarter means it's about real revenue growth as opposed to the comp getting particularly easier. Fourth quarter I think the comp then gets a little bit…
Right, and geographies anything…?
David W. Meline
Geographies, we expect 2% to 5% growth in the U.S. for the year. We had a little bit under 2% in the first half. So we see some improvement there coming in the second half. Asia has been a mix story for us this year. We had basically 2% growth in each of the first two quarters. But within Asia we saw improvements occurring through the first half in Japan which started out very weak and then has being improving and that continues.
And in the case of China's it’s been very much an up and down, a bumpy story, and I would say we feel okay about China but I would also say it’s not we don’t see something unusual in terms of dramatic growth pick up happening right now.
Okay, so it sounds like very much the same as we saw in 3Q.
David W. Meline
I think so.
And then raw materials and currencies, you have seen a lot of volatility in emerging market currencies but I am assuming that given where the euro is, the Pound I am assuming that currencies are pretty much tracking to your plan.
David W. Meline
Yes we had originally and this year we’d expected to have the effects of currency to be flat on our results for the year, with the strengthening of the dollar we’ve updated that now to be a negative 2% impact on revenue and will have a negative impact on earnings for the year and we’ll have to update that here in October as we see how we finish the quarter.
Okay and then finally raw materials. You’ve seen a sort of pickup in some of your in some of the petrochem, polyethylene type input cost means but broadly speaking what you are seeing on the costs?
David W. Meline
Yeah we think and so again for raw materials for the year we had started the year expecting it to be roughly flat, the impact on our results year-over-year. We now think that we’ll have positive $0.05 to $0.10 per share improvement in profitability due to a lower raw material cost which in the second quarter were down 2% year-on-year.
And we because as you’ve just described because we do see some firming of some of the raw material pricing as well as the year-over-year comparison for us we expect that impact of raw materials to dissipate through the second half.
Okay and pricing?
David W. Meline
And pricing similarly we’d expected to see -- we had a positive half point addition to pricing in the first half and we see we don’t have a lot of pricing actions going on other than in areas where we’ve seen the need to offset the weaker currency and higher inflation in particular in Latin America where we’ve taken some specific pricing actions.
But we expect to again from that 0.5% point we would be at that level or modestly declining again in part because of the comparisons to last year.
Great, well we'll see if some questions from the audience, any in here, yes over here?
Just -- on your classification of some or some of the products as Heartland pushed towards the review areas, are they spread evenly across the five segments or are there some areas where, without necessarilygoing to which is which, but…
David W. Meline
Yes, no it’s good question. Yes, if you look at starting with Heartland, which is 5 of the 35 divisions, represents I think a third of our sales….
Third of our global sales.
David W. Meline
Yes. And those five divisions, three of them are in the industrial space, so abrasives, automotive aftermarket and industrial adhesives and tapes. One of them is in the electronics and energy segment, which is our electrical markets division and then the fifth is in our personal safety business, which is our safety and graphics.
So those are spread across three of our five sectors. If you look at we haven’t named the names in the other segments but what I would say is if you look at for example our healthcare business, which is growing very nicely right now several of the divisions in that segment have very good growth prospects. They are kind of medium sized in terms of their size.
So we’re still building out as I showed the global portfolio. So no surprise you see a number of those in the push forward category. And then if you look at strategic review, I would say it’s really spread across all of the – everybody’s got something to work on is what I’d say.
Strategic review of businesses, can you talk about the economics of divestment of the business, you obviously -- you’re a big integrated company and possibly…
David W. Meline
No that’s right. The fact is divestment is hard given our model because if you look at the model, it’s very much a model of leveraging technologies across the enterprise. So technologies are freely shared across all of the businesses. It's a model we’re manufacturing assets, it’s not typical within even a production line let alone a factory to have multiple divisions that are taking product off a single production line.
And our global distribution network is really a virtual -- each business and each country has their set of divisions inside. So the process of divestment is generally quite difficult because of that high level of integration. But on the other hand we think it’s appropriate for us to look at the portfolio, to look at our businesses and to challenge ourselves if there is a business where we think there is potentially a better owner than 3M to, I mean all things are possible.
And we have one small business we sold recently which is the -- was in the fishing line and rod segment. So it's possible to do that. And we expect we will have some sales. But I think correctly, it’s not as if it’s a portfolio of disintegrated companies that you can easily mix and match.
So Inge has been in the chair now for 12 months…
David W. Meline
18 months, yes. Wow, 18 months, what’s changing, how in terms of the three or four big initiatives…?
David W. Meline
That’s a good question, yes a number of things. So Inge Thulin who’s been with the company a little over 30 years comes with a very strong international background. He is a Swedish national, spent seven years, most recently before he was COO building out the international business. So he brings a lot of depth of knowledge and capability to the chair after having had two outside CEOs who led the company.
So with his depth of knowledge of the company, a few things are changing. One is Inge brings a very strong sense, he calls it tempo which is around the pace at which we make decisions and we drive the expectations as to how we drive the business at a faster pace.
Secondly, he has a very strong readiness and a view that leading it from the corporate level, this whole discussion that we have about prioritization is a change for the company. It’s not insignificant, the implications of resource allocation that we’re driving from the corporate level. So certainly that is something that’s notably impacting in a positive way for the company.
I would say innovation, his interest in looking at new disruptive innovation opportunities, some people have been surprised at his focus there, but I think it’s a very good opportunity to build on strength for us.
And then finally, this ERP system, we’re standardizing business processes across the globe, which we think will be a key enabler for the next level of efficiency and growth for the company going forward. So lots going on.
Okay. The long term target of 4% to 6% organic growth, obviously that’s tied to global IP. So is that kind of like 3M today, so the way 3M is kind of configure it or does that bake in some of the benefits from the increase in R&D, some of commercialization or could actually go higher?
David W. Meline
Yes. So when we set out those goals the four goals including the growth goal, what we wanted to describe was really who we are and how we create value as a company. So, strong margins, double digit earnings growth, 100% free cash flow conversion. And the 4% to 6% growth goal, which describes the company that we have today, because we wanted to, we felt it would be appropriate to set what would be an aggressive growth goal for the company. And the 4% to 6% on organic basis is higher than we’ve grown over the last decade. But also as something that would be -- that we could aspire to truly achieve.
So yes, so there are conditions if we do our job well that we could see growth improve from there. But we thought let’s get a goal that we feel confident of delivering on and we go from there. So, that’s what we did.
Okay. We’re running a bit long here but one more question, obviously you have upsized the buyback to $3.5 billion to $4 billion, is that kind of the new norm for 3M going forward?
David W. Meline
Yes. So at the end of the year we’ll rollout the updated guidance in terms of not only what we expect to perform to next year but also to comment on how we’re tracking against those five year goals we set out for ourselves.
In the case of buyback, obviously, we said $7.5 billion to $15 billion for the five year period. And therefore, if you take the midpoint of that range at $4 billion, we’re tracking at the high end of that range. So what we’re going to do now and we’re just going through the update as we speak is look at sources and uses, demands on the business and we’ll have to them make a decision as to each of those indicators including buyback.
One more question. So you’ve been hunkering down for last couple of years, so managing through this environment, is now the time to press the button of growth?
David W. Meline
We’ve been focused very strongly on putting in place the foundation to improve our growth profile. And as hopefully you understand from what I presented we feel very good about the health of the businesses broadly.
So yes, we continue to invest, both in terms of people, in terms of building out the global portfolio, and if you look at capital investment, again this year we have record levels of capital investment, which would indicate that we do feel good about our chance to grow going forward.
All right David, let’s leave at that. Thank you very much. Thanks Matt.
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