3M Company (NYSE:MMM)
Electrical Products Group 2016 Annual Spring Conference
May 16, 2016 09:00 AM ET
Nick Gangestad - SVP and CFO
Unidentified Company Representative
Okay folks, I’d like to get started with the next presentation. From 3M, we have Nick Gangestad, the CFO and these slides are up on the EPG Web site. Thanks. Nick?
Thanks, Dean, and good morning, one. It’s a pleasure to be here with you this morning at EPG. It’s a pleasure, because I get a chance to tell a little bit about the 3M story, and some of the highlights of what we’re working on. Just as a reminder, before I get started, please take a moment to read our statement on forward-looking statements I will be making this morning.
And as I go through the next few minutes I’m going to spend a few time on some of the highlights of what we are working on and 3M. First of all, we see ourselves as having a business portfolio that positions to win. We are continuing to execute on our three key levers that will create efficient growth for 3M. In 3M, we’re also focused on helping our customers win by assisting them in delivering on their promises and 3M is -- we are also enhancing our capital structure and allocation.
It’s a journey that we’ve been on and we’re continuing on and for those of you that were at our Investor Meeting seven weeks ago, you heard how, what our continued progress on that. And we’re doing this, while maintaining a strong track record of returning cash to our shareholders.
This is not a new event or strategy for 3M. We’ve been -- what we’re doing in 2016 and what we plan to do in the next five years we've been building that foundation since 2012 when we first established our vision and our strategies and much of what I'll show next of our 3M playbook.
Our vision is something within 3M that guides us. It guides us and then we complement that with six strategies. Four of those strategies are focused on growth. One of those strategies is focused on how we develop our people, our leaders for the future. And then finally our sixth strategy is focused on operational excellence and how we continue to execute and performance at the level that we have been performing.
This is our entire 3M playbook. On the left-hand side, you see that vision, our strategies. We also have on the left-hand side our code of conduct, as well as the behaviors that we’re developing within 3M for our leader.
On the right-hand side are our three key levers that are enabling us to deliver efficient growth. Those levers are portfolio management, investing in innovation, and business transformation. That playbook has created for us in 3M a successful portfolio. We are made up of five business group, servicing a number of market segments. But behind that we’ve core 3M technologies and capabilities that we together as we support these five business groups in the unique markets within those. That gives us the ability to execute on our strategy for efficient growth, while continuing to invest for the future.
As part of our plan for capital allocation, our first priority is investing in the business. We invest in research and development, we invest in CapEx, we invest in mergers and acquisitions to supplement our organic businesses. We look for places where M&A can make our organic business stronger.
In addition to that, we also have the ability to return significant cash to shareholders. We do that through dividend and through share buyback. On the dividend front, we just are in our 58th year of increasing our dividend year-on-year and we continue to buyback our shares based on the relative value that we see in that -- in our stock valuation.
If I look at our ability to generate return for our shareholders and create value for our customers, much of that comes down to what I show here on this slide, our four fundamental strengths. And I will take a moment to talk about those. Our four fundamental strength that we think allow us over time to deliver value include, first of all, technology. In technology, part of 3M’s strategy is to take technologies and combine them in ways that others can’t, to create solutions for customers. We also take technologies and share them across the markets that we serve.
Manufacturing, that’s our second fundamental strength. We invest in manufacturing capabilities and know-how to be able to produce high-quality products efficiently. Our third fundamental strength is our global capability. We’ve invested and established a network of companies around the world that can execute 3M’s strategy effectively and efficiently.
And then our fourth fundamental strength is our brand. It’s the promise that we made to our customers about the value and the quality that we’re selling and that’s one of our strength that we think delivers value both to our shareholders and to our customers.
3M’s business model is a model that we have developed over decade and its one that grows with whatever geography we’re competing in. It often starts with an investment into a country as that country is working on building infrastructure, and we have a set of technologies and products that are relevant in the infrastructure building part of an economy. Often economies then build to be more focused on manufacturing 3M products are a natural fit as an economy grows to be more manufacturing based.
As the economy continues to grow that’s often more focused on safety 3M products and technologies then provide solution to insist in worker safety. There is often a developing retail market where 3M products and technologies can be commercialized through a retail channel and then finally 3M’s technologies in the healthcare space as that economy continues to develop. We have relevant technology for more advanced economy.
That portfolio and that business model has enabled us to consistently outperform our markets. If I look over the last five years, if I look over the last 15 years, 3M has been able to grow approximately 1.5x faster than the market, a most common metric that we compare ourselves to externally is industrial production growth. Over the last five years, that’s grown 2.3%. 3M’s organic growth has been 3.4%.
Part of our strategy is to be able to grow and grow efficiently. We see it as important that we’re able to grow efficiently and that we don’t see ourselves having to make a trade-off between growth and efficiency.
Seven weeks ago, we laid out our strategy for the next five years through 2020. And during -- in that strategy, we laid out our expectations for growth. We see our business model being able to continue to outperform the markets that we’re participating in at a rate of 1.5x faster than those markets.
We’ve also taken a view that we can perform and grow efficiently over a range of markets growth projection. We’ve a range between 1% and 3% for growth in industrial production index over the next five years.
As I look at our growth capacity and capability over the next five years by business, we’ve a diversity of growth profiles during this timeframe. We see ourselves being able to grow in each of the markets that we’re competing in, but we’re being -- see ourselves as being led by our potential to grow in healthcare.
Coupled with a 2% to 5% organic growth that I just showed, we see based on our strategies for efficient growth that we can grow earnings per share during this time between 8% and 11%. We can do this to our focus on efficient growth, as well as capital allocation strategies over the next five years. We continue to expect a return on invested capital to be approximately 20% and we expect to generate over time an average of 100% free cash flow conversion.
Part of our efficient growth strategy involves our three key levers that we’re investing in. The first is portfolio management. Portfolio management at 3M takes on several dimension. The first is for our portfolio management involve how we align internally our resources, how we invest those and put our resources on to the best opportunities.
It also involves how we deploy capital to mergers and acquisitions. And as I look over the last three years, our deployment for -- into M&A. we’ve been using capital into M&A to supplement and strengthen our core organic businesses. See, five of our most recent deals that we’ve completed within our safety and graphics business, within our industrial business, within our healthcare business.
We also as part of our strategy for portfolio management are looking at businesses that no longer fit within our 3M portfolio or businesses that we think have a more natural owner beyond 3M. On the right, I show here is the four most recent divestitures that we have completed.
Our second key lever that we’re working on is investing in innovation. A few years ago, 3M was investing approximately 5.5% of its revenue in research and development. We are moving that up to 6% of revenue being invested in research and development. And besides that increase in investments, we are also focused on increasing the productivity of our research and development investment.
We’re doing that by enhancing our commercialization effectiveness, and much of our incremental invest in research and development is being invested in disruptive new technologies for the future.
One of the ways we create value through research and development is by taking insights that we gained by working with our customers and we do that through different methodologies to gain that customer intimacy. We combine that with our own technology platforms that we have in 3M.
We’ve 46 technology platform that service many of our -- most of our -- all of our five business group and we combine that with our resolve and intent to invest in those opportunities. And the type of investment can take many dimensions. It can -- it range from expanding and extending our core platforms all the way to investments in new disruptive markets and technologies.
You heard us say this many times, research and development is the heartbeat of 3M. Its one that we’re continuing to invest in. Part of that involve how we position ourselves in our brand. A year-ago, we introduced a new part of our brand promise, 3M science applied to life. How 3M takes science and uses it to create solutions for our customers. We are investing to enhance 3M’s brand around science.
Our third key lever is business transformation. Part of business transformation for us is continuing to deploy our global ERP and we’ve had multiple successful rollout and that will continue in the coming years. Also part of our business transformation effort are now efforts to deliver productivity by optimizing our supply chain footprint and our manufacturing capabilities. Underlying all of this in our strategy for business transformation is, how do we better service our customer? For us, business transformation starts and ends with our customers.
If I go a bit deeper into business transformation, what we see and what we’re doing and what we see coming from it, clearly there is a part of this that is a global set of business processes and an ERP that we’re putting in place, but we’re also as part of this established -- establishing global service centers to service back office operations for much of the world.
We’ve established business service operations that service much of our front-end operations, and we’re also investing in supply chain centers of expertise that will deliver productivity and cost savings in our supply chain. These things in combination by 2020, we see creating $500 million to $700 million of annualized operating income benefit. In addition, we expect by 2020 another $1.5 billion of working capital improvement once fully deployed.
2016 is a 15 year anniversary for Lean Six Sigma in 3M. It become the way we operate, it’s the way we think about our processes, it’s the way we think about process improvements. Lean Six Sigma is our methodology for process optimization and it’s a tool we use and how we develop leaders within the Company. It’s been a strong part of our culture for the last 15 years and it will continue to be a strong part of our culture.
If look more recently at our first quarter, in April, we announced first quarter results with earnings per share of $2.05, up 11%. We had organic growth down approximately 1% as expected. Our operating income margins were 24%, up 130 basis point, and free cash flow was above the level that we normally expect in the first quarter. In total our free cash flow generation in the first quarter was up 20%.We reiterated that our guidance for the year is maintained.
I will summarize, before I turn it over to Q&A by saying our 3M playbook is strong. We are executing that playbook and that playbook is working within 3M. I will now open it up for questions.
Q - Unidentified Analyst
Thanks, Nick. Just want to go back to your comment about increasing the R&D to the 6% level. The commentary -- and Inge has also said this that the idea of increasing the budget, but also more accountability, more commercialization, more disruptive technology, but you’re the CFO, so how do you measure productivity and commercial effectiveness out of the engineering talent, when you already give them like the senior guys get that 15% free time are now on budget at time. So, how do you provide Six Sigma type discipline, and CFO discipline to a process that just doesn’t lend itself that way?
Dean, over the course of many years we've looked at different ways for measuring our return on our research and development investments. And very candidly, Dean, there is a portion of that is a fundamental belief that this is what ultimately drive value. So there is a bit of that space. There is also a science part of this. For us, part of the way we measure this, some of the returns we’re getting, first of all the revenue that we’re generating from that and in the past few years you heard us talk about a new product vitality index about the amount of revenue that we’re generating from new product line ship. That is a secondary metric to us -- for us. It’s something that’s important to us to be monitoring the strength of what our labs are generating and the relevance they’re creating for our customers, but the ultimate measurement of that come through our organic growth. Our ability to grow faster than the markets we’re in. Another financial benefit just to tag on to that Dean is, refreshing our product line also help for decide organic volume growth, also help us in pricing to be extending the value of what we’re creating to keep the product line fresh. Sometimes keeps this out of a price down scenario for products that could become commoditized. So, that’s part of how we look at it. If I go down deeper into it, Dean, each of them has a target that’s set out and we monitor the progress to that. All-in, we’re pleased with the return that we’re getting on that investment. Yes, Scott?
Nick, now that we’re into the middle of May and I’m not sure how comfortable you’re speaking in terms of how things are tracking so far this quarter around the world, but even if you’re not willing to comment on that, I’m trying to get a sense at least that it does look like you guys have lagged in China for the last couple of years versus many of your peers and how do you fix China for your 3M? I mean, you sell a premium product, it’s now 100% clear that China is really geared up for a premium product. I mean, how you really fix it so that you can expand what you’re doing there?
Yes, our operations in China, I think, Scott, to best think about what we’re doing in China right now when I break it into three pieces. First of all, that the electronics portion where we’re selling into the electronics industry much of it for exports, but some of it for domestic consumption within China. That’s we’re in a down cycle for that right now and that’s driving part of our results in China that you’re seeing. If I pull out electronics, we were flat in China in the first quarter. If I then go and look at the other two pieces, I will call it the rest of our export focused to customers within China where we’re selling into industrial setting and that we’ve seen that going sideways to slightly down for -- in the first quarter and for a period of time into 2015. As exports strengthen out of China, we expect our business to strengthen along with that. The third piece that I'll remind you of is our domestic focused portion of our business in China where we’ve been putting more resources as we see a downturn in the electronics and it going sideways in the industrial, things focused on the Chinese consumer. Our healthcare products are consumer products. Things meant for safety or air quality. Things meant for food safety, water quality, those are places where we 3M continue to see strong growth. We are investing in that and we’ve not seen any kind of slowdown, that healthcare in our Chinese operations continue to grow double-digit in the first quarter of 2016. As far as what we’re seeing so far in the second quarter, we’re not seeing anything that deviate from what we said in April when we laid out comments for the total year as well as comment specific to the second quarter, we’re not seeing anything moving off of that.
And Nick, so we know that electronics and energy is going to hold you back a little bit in the short-term, but what can you -- and what needs to happen for 3M to grow 1.5x IPI here over the next couple of years. You need healthcare to grow like it did in the first quarter in the mid single-digit. How important is safety and graphics to the growth as you look forward here? Because we saw a bit of inflection in 1Q, do we need that sort of inflection? I know that was comps, but do we need that sort of growth here to get to 1.5x IPI?
Andy, over the course of this year and if I go even beyond 2016, healthcare we expect to be our growth leader that’s keeping us at that 1.5x or higher. Safety and graphics clearly is something that we see continued opportunities both for organic growth, as well as margin expansion in our safety and graphics business. Consumers, I should have mentioned right along with healthcare. Consumer is a place where we see continued opportunity for 3M products and geographies around the world for 3M -- 3M’s growth -- to be accretive to 3M’s growth. So, those three I’d say in 2016 will be our growth drivers.
Nick, hi. How are you? What do you see -- historically cannibalization of existing products has been a kind of consequence of or an impact in holding back growth in the rest of portfolio. So tremendous innovation, but a lot of it is replacing current product stuff and resulted that in sort of a net growth has been what we’ve seen 1.5x on average, but three big fluctuations year-to-year. How is that changing inside the portfolio? How do you measure it? Where do you think that is going?
A little bit of this goes back to Dean’s first question on research and development and what we’re doing. We have a portion of our research and development budget that is very intentional on extending our product line and refreshing our product line that does relate -- result in some cannibalization. That we see as healthy and part of our portfolio planning that we want that to happen. We don’t want that to become all or a -- the driver of our research and development investment. So, part of our strategy is we do want that refreshments going on within our product line and some cannibalization. As we’ve been incrementally increasing our investment in research and development, that extra spending has been intentionally going to non-incremental investments for new products where we’re investing in longer term, more disruptive technologies that do not cannibalize existing 3M products. Though typically take longer to develop and we have approximately 30 of those that we’ve being investing in, in the last three years. About a third of them we’ve canceled because we get into that and find out it’s not going to work or not be as successful as we thought. We’d had some that are starting to commercialize. I think we’ve said on record that we’ve about $200 million of revenue coming from those incremental investments that we’re making in more disruptive technologies. So, its part of our strategy as we move our R&D investment up to 6% that the proportion that’s going into the incremental product line extension, it comes down and the proportion going into new disruptive technology goes up.
What percentage of that 6% do you think is like [indiscernible]?
I would put it right around 50%, maybe just a little south of 50%.
Thanks. Nick, just a question around M&A and ROIC. So your ROIC target allows for some diminution from current levels of few 100 basis points. Also when you’re taking about M&A, the fact that you highlight healthcare is a very high growth segment for the next five years, so just that will get a, maybe larger than Company average share of M&A capital. So, what -- remind us what sort of targets you’re looking at in terms of ROIC on acquisitions and how attractive M&A looks right now in the context of your own share price moving up in the last few months?
Yes, we haven’t put out a one specific measurement for as a target for return on invested capital from M&A specifically. The 20% long-term objective that we’ve laid out encompasses our return on investments on all of our capital deployment, some to research and development, some to the CapEx, some to M&A. Over time we see M&A starting to approach that 20% return on invested capital, but it’s not a specific target that we have early on. If I use what we’ve acquired in the last three years, we see that generating approximately during the next five-year period a 12% return on invested capital as we look forward on those deals, some are higher than that, some are lower than that, all are exceeding our cost of capital for -- as we invest.
Hey, Nick. Good morning.
So your gross margins in the first quarter were north of 50%, highest gross margins we’ve seen in about a decade. I’m just curious, how are you thinking about the sustainability of above 50%, particularly if we -- if commodities start to reflate again?
Joe, we look at our gross margins and the benefits that we’ve had in the last 24 months from both price and raw materials. That’s been a healthy contributor to our gross margin, but it hasn’t been the only contributor. We’ve been working on enhancing our productivity in our manufacturing space to keep those margins with some upward pressure. As I look forward, in the next few years more of our -- we continue to see margin expansion, gross margin expansion, but not as much of that margin expansion coming from price raw materials. We think what we’ve seen in the last 24 months will not be repeated. Most of our gross margin expansion in the next five years we see coming through our business transformation efforts where we’re on our supply chain, and efficiencies there as well as what we discussed seven weeks ago around our footprint optimization and the efforts that we’re putting into place there. So we still see growth for margin expansion far less of it coming from price raw materials and more of it coming through specific actions we’re taking within 3M to improve our cost competitiveness.
Nick, 3M is mostly material science company, so you’re increasing R&D. So, yet you chose to keep some software businesses and this seems to be a team of theme of this conference. So how does 3M think about, A, attaining scale in software? And, B, as you invest in your software businesses? How do you compare returns on investment sort of apples-to-apples given that your scale is still material science?
Andrew, that’s a top of mind issue for us. We’ve -- we after a thorough analysis of what to do with our healthcare, IT business, we came to the conclusion that the best way to manage this was to keep it in house and that was exploring different alternatives, including sale or spin. Our view in healthcare IT and then if I expand it to your broader question, Andrew, is that this is going to continue to be a growth driver of the economy as well for 3M. So, we’re investing in that. We’re investing in ways that we can optimize what we already have. We are also investing in ways that we can take some of the capabilities we’ve around data management in IT and bring it in combination with material sciences that we have. We are traditionally a material science company. So some of our benchmarks that we use, some of the management techniques that we use, we’re looking at are they still relevant. We tend to look at them and look often with a little bit longer view as we look at the kinds of returns that we expect from those, but they’re not completely separated, from our normal process of how we manage and manage and set expectations for our businesses there.
Hi, Nick. So you commented on 2Q to date so far, kind of check the time, but have you seen any subtle changes at all in customer behavior that you could point to? But the main question is on the 1.5x IPI target, obviously very good to outgrow the market, but if IPI is growing 1% the next five years, not so good, some companies like Danaher, Roper, are acquiring to try and embrace that growth profile over and above industrial end market. So how much pressure is -- from the Board to drive more non-industrial healthcare type acquisitions going forward?
Our strategy is we take a number of technologies we have and try to lever those technologies across multiple business segments. So as we develop and enhance a -- as an example at a heist of technology we look at how we can lever that across industrial or electronics, consumer, healthcare and that core strategy really is not changing. Part of our M&A approach is what are the technologies, what are the products we want to bring in to compliment that. I’d not say that our strategy is just acquiring for growth sake, because the economy is growing slower. Our strategy around M&A is investing in things that complement that organic strategy we already have. That’s been the process in the playbook we’ve been using, that’s really not changing. Can you repeat the behavior …?
Can you repeat the behavior question?
Sorry, any change in behavior at all from customers?
Oh, in -- within the second quarter any changes we’re noting in behavior? Behavior of our customers, really no. We are not seeing anything changing from what we saw in the first quarter.
Nick, over here. If I look at your GDP per capita chart, where you phase across these industries over time, you’ve got infrastructure manufacturing, giving way to safety retail healthcare. The higher end of that chart you’ve grown about 4% organically and the bottom half is declining. I guess, you bottom out at some point on the bottom half of this, but as you’re attacking kind of business transformation, facility rationalization these things, how are you factoring that in and is there a bigger move to kind of reduce the cost face of that lower point and make that more of a margin story and not perhaps that chart more of a growth story at this point, do you think we’ve reached that pivot point?
Across that geographic portfolio I just showed, clearly there is some tendency on the upper right hand side for more growth and slightly less margins and deeper down the end where there is less growth opportunity, there is a natural push for if there are more margin expansion capability. That said, across that entire portfolio we are always looking for how to increase our cost competitiveness. So, across that portfolio even in our highest growth basis, we’re looking for how do we grow that market segment efficiently, why we talk so much within the Company and outside the Company about efficient growth. But on this margin, you’re certainly right that there is a little more focus on the growth side than on the margin side at the higher end of that spectrum.
Nick, for the past couple of year’s currency translation its one way street, and now it looks like it’s becoming a lot more of complex. How do you view it?
How do I view it?
And how do you think it plays out within 3M’s financials over the next year?
Martin, I will expand that over the next couple of years just to give a little broader view. We ultimately -- we’ve two thirds of our revenues outside the United States. We manufacture in our net exporter out of the United States, so we’re exposed both from a revenue standpoint, but also from a cost of goods sold being a net exporter. Part of our strategy over the last couple of years has been using hedging to offset some of that risk. We attempt to hedge approximately 50% of our income statement exposure of 12 months and then on a diminishing scale out through 36 months. That strategy is not changing. We will continue to do that. Our view is with the currency where it is now it will be to 3M advantage as we will get some benefit both on our outright translations, but also on our cost of goods sold through some of our products being sourced out of the U.S will become cheaper in some of our international operations. But just hedging helped us as the dollar strengthens; hedging for a period of time will go against us as the dollar weakens. So while it net helps us, a weaker U.S dollar, the full benefit of that won’t be felt into our income statement until 2017 and 2018.
This is the last question.
Hey Nick, your electronics business has changed a little bit over the years. The Apple supply chain numbers continue to be a bit concerning. Is there any reason why you guys would decouple from that? I think that’s somewhat related to you guys have seen in the last couple of quarters. And then, secondly around automotive, what percentage of your business now is auto? And is -- for some companies its relatively profitable, I mean, every product you guys make is ridiculously profitable, so maybe there is not a big difference, but how lucrative is kind of the auto stuff for you guys?
Yes, first to the electronics side, our strategy electronic is we work with all the OEMs. We are selling to all of them and our strategy is that we take our technology that we’re using across multiple businesses and look for opportunities for how to commercialize those technologies into electronics. And that’s been a successful business model. It does have more volatility than, I will say, the average 3M business. But with those ups and downs it’s been giving us the advantage of some additional leverage on those technologies that we wouldn’t had if we were not to in that business. If I -- and our strategy going forward is not very different from what we’ve been doing in the past with electronics. So we continue to look for how do we take our technologies and find value for our customer, all of our electronics OEM customers. On the automotive side, I think the right number is it’s about 3% of our total revenue. It’s been a portion of our growth, especially in our industrial segment that we’ve been working on how do we continue to increase the amount of 3M content in vehicles? It’s been successful for several years and over the next few years we continue to see 3M technologies becoming more and more relevant within automobile. At our Investor Day seven weeks ago, part of what we talked about is we see vehicles having more and more electronic components in them and our capabilities in both automotive supply as well as electronics, we think plays to 3M’s advantage there.
Unidentified Company Representative
Okay, Nick. Thank you very much.
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