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Executives

Matt Ginter - Manager-Investor Relations

Inge G. Thulin - Chairman, Chief Executive Officer and President

David W. Meline - Chief Financial Officer and Senior Vice President

Analysts

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

Steven E. Winoker - Sanford C. Bernstein & Co., LLC., Research Division

Abhiram Rajendran - Crédit Suisse AG, Research Division

Scott R. Davis - Barclays Capital, Research Division

Deane M. Dray - Citigroup Inc, Research Division

Jeffrey T. Sprague - Vertical Research Partners Inc.

Jason Feldman - UBS Investment Bank, Research Division

Ramanan Sivalingam - Deutsche Bank AG, Research Division

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Nigel Coe - Morgan Stanley, Research Division

Terry Darling - Goldman Sachs Group Inc., Research Division

3M (MMM) Q2 2012 Earnings Call July 26, 2012 9:00 AM ET

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the 3M Second Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded Thursday, July 26, 2012.

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

Matt Ginter

Thank you. Good morning, everyone, and welcome to our Second Quarter Business Review. With me today are Inge Thulin, 3M Chairman, President and Chief Executive Officer; and David Meline, Chief Financial Officer.

Before we begin, I'd like to mention just a few calendar items. We will announce our third quarter earnings on Tuesday, October 23, and our fourth quarter earnings on Thursday, January 24. And as I mentioned back on our April call, we're planning to host our next Investor Day here in the Twin Cities on Thursday, November 8, so please hold this date on your calendars.

Please take a moment to read the forward-looking statement on Slide 2. During today's conference call, we will make certain predictive statements that reflect our current views about our future performance and financial results. We base these statements on certain assumptions and expectations of future events that are subject to risks and uncertainties. Item 1A of our most recent Form 10-K lists some of the most important risk factors that could cause actual results to differ from our predictions.

So let's begin today's review, and I'll turn the program over to Inge. Please turn to Slide #3.

Inge G. Thulin

Thanks, Matt. Good morning, and thank you for joining us on the call today.

As you have seen, Q2 was very similar to our first quarter. We again saw superb operational execution by our team. We continued to grow our earnings, and I'm pleased with our broad-based margins performance. Second quarter EPS was a record $1.66, up nearly 4% year-on-year. We grew operating income nearly 4.5% to $1.7 billion with operating margins of 22.9%, up 1.3% year-on-year. All 6 of our businesses posted margins above 20%, reflecting strong execution across-the-board.

The revenue side was also similar to the first quarter. Sales were $7.5 billion, down 1.9%, including a negative currency impact of more than 4%. Against a continued uncertain macroeconomic backdrop, organic local currency growth was up about 2%, with increases in all of our businesses except those affected by weakness in consumer electronics.

Geographically, the Americas once again led the way, while Asia Pacific was down slightly. Our teams in Western Europe operated with very good discipline in that very challenging environment. In fact, operating margins improved almost 2 points there.

Overall, Q2 demonstrated 3M's ability to deliver against weak segments and regions. But to me, the real story goes well beyond our second quarter performance. We approach 2012 with caution and a conservative plan, a plan we continue to execute with discipline and diligence. Clearly, it was the right plan, and we got a quick start on it. Our plan called for tight control over discretionary spending, and we certainly did so in the first half of the year. Needless to say, that level of cost control will continue for the foreseeable future.

Last but certainly not least, we returned over $1 billion of cash to shareholders through dividends and share repurchases in the quarter.

Now David will take you through the detail of the quarter. David?

David W. Meline

Thank you, Inge. Let's begin by reviewing the income statement. Please turn to Slide #4.

As Inge said, our business operated well in the second quarter as we delivered outstanding profitability in a continued soft economy. We drove excellent factory performance, and costs remained under very good control. Sales declined 1.9% year-on-year, impacted by weak overall economic conditions and also by the stronger U.S. dollar. I will elaborate on sales in just a bit.

Conversely, gross profit dollars increased by 0.7% versus last year's second quarter. SG&A costs declined 3.3% year-on-year, reflecting prudent caution on discretionary spending, and R&D investments increased 1.1%. We continued to invest to support future innovation and technology development.

In total, operating income grew by 4.4%, and operating margins were a solid 22.9%, an increase of 1.3 percentage points year-on-year. Major components of the change in operating margin are detailed on the right side of this chart. Selling prices increased, net of raw material price changes, adding 1.6 percentage points to operating margin. And foreign exchange impacts, net of hedge, added 0.3%. Higher year-on-year pension and OPEB expense hurt operating margins by 0.3%.

Earnings for the quarter were $1.66 per share, an increase of 3.8%. Average diluted shares outstanding declined 3.3% year-on-year to 702.6 million, resulting in a $0.05 positive impact to earnings per share.

The second quarter 2012 tax rate was 30.1%, up 3 percentage points year-on-year, which hurt earnings by $0.07 per share. As a reminder, in the second quarter of 2011 we realized a onetime tax benefit from reorganizing one of our international subsidiaries, a benefit which did not repeat this quarter. During the quarter, we recognized insurance recoveries related to last year's earthquake and tsunami in Japan, which added $0.02 to earnings per share. And finally we absorbed $0.03 of costs in the second quarter related to relocating a portion of our manufacturing operations from Western to Eastern Europe, along with consolidating certain manufacturing and supply chain support activities within Western Europe.

Once again, operating margins improved by 1.3 percent points to 22.9% as our teams are executing very well. Please turn to Slide #5 for a more detailed look at our sales change for the quarter.

Sales for the second quarter were $7.5 billion. Organic local currency growth was 1.9%, driven by higher year-on-year selling prices, and volumes were flat versus last year's second quarter. Acquisitions added 0.5% to sales in the quarter. Foreign exchange impacts reduced sales by 4.3 percentage points as the U.S. dollar strengthened considerably against the euro and other currencies. On a total dollar basis, sales declined by 1.9% year-on-year.

Organic local currency growth in Latin America/Canada was 11.4%, another strong showing by our teams in that part of the world. All 6 of our businesses contributed to the increase, with 3 businesses growing double digits, namely Electro and Communications, Health Care and Safety, Security and Protection Services. Organic sales growth in the United States was 3.6%.

Organic local currency sales declined slightly in Asia Pacific as strong sales in both Health Care and Industrial and Transportation were offset by slower year-on-year demand in the consumer electronics industry. Japan declined 2%, and China was up slightly year-on-year. We expect to see improving growth rates in China in the second half of the year. On an x electronics basis, organic local currency sales growth was 6% in Asia Pacific. We anticipate that our growth rates in consumer electronics will begin to improve in the third quarter and continue into the fourth. This improvement is due in part to easier comparisons as our sales to this market slowed in the second half of 2011. But of course, there are other factors in play such as the timing of customer new product launches.

In EMEA or the combined Europe, Middle East and Africa, second quarter sales declined 1.9% on an organic local currency basis. Regardless, challenges remain in Western Europe as these countries work through their economic and fiscal issues. We remain focused on what we can control such as driving for additional market share and maintaining firm cost discipline.

So now let's dig into our 6 business segments. Please turn to Slide #6.

Industrial and Transportation generated sales of $2.6 billion in the second quarter, an increase of 4% on an organic local currency basis. The growth was very broad-based, led by double-digit increases in both Automotive OEM and aerospace. We also posted good growth in industrial abrasives and in our energy and advanced materials businesses.

On a geographic basis, organic sales in local currencies increased 8% in Latin America/Canada, 7% in Asia Pacific and 5% in the United States, while EMEA declined just slightly in the quarter. Operating income was $614 million, a year-over-year increase of 13%, and margins in the business improved by 2.8 percentage points to a solid 23.4%.

Industrial and Transportation is the largest of our 6 segments and continues to generate significant productivity and profitability.

Now let's move to Health Care. Once again, our Health Care team delivered superb results. Sales were $1.3 billion, and operating income grew 13% to $414 million. Operating margins exceeded 32%. Sales in the second quarter increased more than 5% on an organic local currency basis. All businesses and geographic areas contributed to this growth with particular strength in food safety and Health Information Systems or HIS. Both HIS and food safety are priority investment areas for us, and we were pleased to see another quarter of high growth in these spaces.

HIS also closed the acquisition of CodeRyte in the second quarter. CodeRyte is a leader in clinical natural language processing technology and computer-assisted coding solutions for outpatient providers. It is a great business and an important technology area and a natural adjacency to our core coding and classification technology base. There are early signs of strong synergy between our businesses which will enable further growth for HIS.

Looking geographically, we are pleased with our progress in the emerging markets. These countries naturally seek higher-quality health care, and our investment in these areas are beginning to pay off. In the first half of 2012, organic local currency growth in emerging markets was more than 14% for Health Care led by our skin and wound care and infection prevention businesses. Of particular note this quarter were China and Mexico, each of which exceeded 20% organic growth in local currencies. In developed markets, we posted positive organic local currency growth despite weakness in Europe. This is a testament to the strength of our Health Care portfolio and the quality of our teams.

Profit margins in Health Care were a strong 32.3% in the second quarter. Our factories continue to run very efficiently, discretionary spending is under firm control and the portfolio mix was excellent.

Now let's look at Consumer and Office business. Sales were $1.1 billion this quarter, up 3% on an organic local currency basis, and operating income rose more than 10% to $222 million. Operating margins rose 1.5 percentage points year-on-year to 21%. From an end-market perspective, top line growth was quite good across the mass retail, DIY, grocery and drug channels. This growth more than offset continued weakness in office wholesale and retail which continues to be impacted by high unemployment levels. Acquisitions added nearly 3% to second quarter sales, largely related to the October 2011 purchase of GPI Group. GPI is a French producer of tapes, hooks, insulation and floor protection products for the home improvement channel. Integration is moving along well and the business is on track towards its financial objectives.

On a geographic basis, organic local currency growth was 9% in Latin America/Canada, 5% in Asia Pacific and 4% in the U.S., while EMEA declined 6% during the quarter.

The Safety, Security and Protection Services business also had a good quarter. Sales were just shy of $1 billion in the second quarter and operating income grew 6% year-on-year to $258 million. Operating margins rose 2 full percentage points to 26%.

A number of factors drove the margin improvement, including a net positive impact from price and raw materials, improved factory utilization levels and positive mix. Total organic local currency sales growth for the business was 3%, with significant contributions from the infrastructure protection, personal safety and building and commercial services businesses. Second quarter sales declined year-on-year in the security systems business.

Looking geographically, sales rose more than 20% in Latin America/Canada and 2% in both Asia Pacific and the U.S. Sales declined 4% in EMEA.

Let's take a look at our Display and Graphics segment. Sales in the second quarter were $882 million, down 7% in organic local currency terms. Optical Systems sales fell 20% versus last year's second quarter, largely driven by LCD TV. On a sequential basis, sales improved by 8%. We continued to see good growth in 3M films for battery-powered devices such as smartphones and tablets where 3M's value proposition remains very strong. Also in D&G, architectural markets and commercial graphics continue to grow nicely. Sales in Traffic Safety Systems declined slightly in the quarter on an organic local currency basis.

On an organic local currency basis, sales grew by 9% in the United States and 8% in Latin America/Canada. Sales declined 14% in Asia Pacific, largely electronics related, and 6% in EMEA.

Operating profits in Display and Graphics were $179 million, and margins were 20.3% for the quarter.

Lastly, let's review Electro and Communications. Second quarter sales in this business were $824 million, operating income was $195 million and operating margins increased 60 basis points to an impressive 23.7%. Sales were down year-on-year in our consumer electronics-related businesses. Our 2012 plans in this space called for a challenging first half, which has been the case. We continue to believe that growth will improve in the second half of 2012 due to a combination of improved industry demand and easier year-on-year comps. Organic local currency sales increased in our Electrical Markets business, while telecom supplies business declined a bit.

In geographic terms, Latin America/Canada rose 13% and the U.S. increased 6%, while Asia Pacific and EMEA declined 5% and 8%, respectively.

That concludes my discussion of the business segment results. Please turn to Slide #7.

Free cash flow for the quarter was just over $1 billion, down $125 million year-on-year. This amount includes a voluntary $250 million contribution to our U.S. defined benefit plan. We made a similar-sized voluntary contribution in the first quarter of this year, putting total year-to-date discretionary cash contributions at $500 million. This amount is consistent with our plan for the year. In total, second quarter pension and OPEB contributions totaled $335 million, which was $271 million higher than Q2 of last year. For the full year, we anticipate total contributions of about $1 billion to our pension and OPEB plans, and we remain very well-funded at the moment.

On the positive side, free cash flow benefited from lower working capital investment and higher levels of net income. Capital expenditures were $358 million, up $63 million versus the second quarter of last year, and we remain on track to invest $1.3 billion to $1.5 billion for 2012 in total. Free cash flow conversion was 88% in the quarter versus 100% in last year's second quarter. Adjusting for pension and OPEB contributions, conversion was 117% this quarter versus 105% in Q2 of 2011.

We returned over $1 billion to shareholders in the second quarter including $410 million in cash dividends and $639 million in gross share repurchases. On a final note, during the second quarter, we issued $1.25 billion of long-term debt spread over 5- and 10-year terms at record-low corporate fields.

So that concludes my discussion of our second quarter financial results. Now, Inge will address our forward outlook.

Inge G. Thulin

Thanks, David.

During uncertain times like this, I'm especially appreciative of 3M's business model, a model flexible enough to allow investments to improve the business and yet disciplined enough to deliver earnings and superior margins when economic growth is challenging. We are well known for our culture of innovation, but just as real is our culture of continuous improvements. For example, in the first half of this year, we absorbed restructuring cost of $0.07 per share. Given that most knowledgeable observers see slow or stalled global growth in the second half of the year, we will continue the approach that served us very well in the first half: strong execution and productivity, good cost discipline and continued investments and actions to improve and build our businesses around the world.

We are, in fact, increasing our momentum to move 3M forward. For example, in the quarter we announced the acquisition of Federal Signal Technologies Group. FSTech is focused on electronic toll collection, parking management hardware and software services, key adjacencies to our Traffic Safety Systems business.

On last quarter's call, we talked about the investments in aerospace and in a newly formed business, mining, oil and gas solutions. They both progressed very well this quarter. Aerospace grew 24% and mining, oil and gas at 20%, significantly faster than the market. I look for great things from these businesses as they both operate at the crossroads of advanced technology and megatrends.

As you know, 3M is a true pioneer of international business. Many of our international companies have existed for decades. For example, 3M Brasil dates back to 1946. Over the years, we have developed global capabilities that are second to none. Our newest frontier is sub-Saharan Africa where we just launched an initiative to broaden our presence in this emerging market. In Q2, we announced the formation of a new subsidiary in Nigeria and reactivated our operations in Kenya. We believe sub-Saharan Africa holds long-term opportunity for 3M of more than $0.5 billion. Also in the second quarter, we took steps to establish a stand-alone subsidiary in Saudi Arabia. 3M already does sizable business there, and with a wholly owned subsidiary, we can make a step-change in our growth there. We expect 3M Saudi Arabia to be in full operations on September 1. Here again we see long-term opportunities in the $500 million range.

We took actions this quarter to fully realize opportunities like Africa and Saudi Arabia by increasing the effectiveness of the way we go to market and serve customers. In addition, we just appointed a new vice president for global sales operations to increase sales skills, competence and productivity around the world. The new VP for global sales is an experienced sales professional, a proven leader who has led 3M businesses in Europe and North America with great success. Also, with the increasing importance of digital platforms in the marketplace, we have elevated eTransformation with the appointment of a vice president for this function. The new leader has both the understanding and experience to lead our company-wide efforts, as he has led similar efforts at a number of companies before joining 3M. The objective is to build and scale our e-platform to realize rewards in increased sales, brand presence and productivity.

These 2 appointments, along with a previous appointment of a vice president of global marketing excellence, will significantly increase our sales and marketing horsepower at the center of the company and improve our capability to drive growth and penetration everywhere.

That is a quick summary of some of the ways we are moving the company forward. I now turn to our outlook for the balance of the year. Please turn to Slide 8.

First, my confidence in the company's ongoing performance lead us to a firmer EPS outlook in the range of $6.35 to $6.50 for the year. We do so with full consideration of additional headwinds from currency in the second half. Looking upon sales, we expect organic local currency growth of 2% to 5% for all of 2012. We trimmed the high end of the range by a point based on the first half and our views about global economic activity, going forward. Strong pricing should offset slightly lower volumes, and comps become easier as the year goes on. After the good margin performance in the first half, we are raising the bottom end of the margin range from 21% to 21.5%. And the tax rate remains unchanged.

To me, the second quarter demonstrates that 3M continues to operate very well with alignment, discipline and always with an eye toward opportunity.

Thank you for your attention. We will now take your questions and comments.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Ajay Kejriwal of FBR.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

So you’re getting really impressive pricing here of up nearly 2% in the quarter. So maybe if you can talk about the outlook for the rest of the year, how should we be thinking about pricing? And then also, raw materials, as they moderate, is that a benefit to the spread and margins?

David W. Meline

Sure, Ajay. So what I would say, first on pricing. As you probably recall, we had indicated we'd get somewhere between 0 and 1% on the year, and what we expected given the way prices developed last year is we would see some level of decline as we move through the year. So if you look at the first half, we've been pretty solid and stable there. We did 1.7 in the first quarter and now 1.9 in the second. But again as you look at the trend through the year, we'll see that moderate somewhat. On the other hand, we had said 0 to 1%, and it looks now like we'll probably come closer to 1% for the year than flat. In terms of raw materials, what we're seeing -- like everyone else, we are seeing that the raw materials are certainly softer than they -- we might have expected at this stage. So we had raw material price inflation of 2% in the first quarter. We had indicated we thought we'd come in at 1% to 2% for the year. The second quarter actually now declined, so at -- from that 2% level, we were around flat in the second quarter on raw materials, and we think for the year in total it's most likely we'll be closer to flat than those higher levels. So yes, it's contributing certainly to our margins presently and that we expect to continue at some level through the balance of the year.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

And then on the discretionary spending, Inge, maybe talk a little bit about the initiatives you have put in place. And then you're obviously seeing the benefit on the SG&A rate there. Could you maybe talk about what's the opportunity you see on cost tightening?

Inge G. Thulin

Well, we continue the rest of the year as we started the year, which as I said earlier, we went into the year with a plan that was conservative, and we've been very cautious. So -- and we have some parts of the world, like Western Europe, at the moment where there is challenges relative to economic outlook. So we are managing that very, very tightly. At the same time, when we see opportunities for growth, we invest, and we talked at the last call, specifically around Health Care which is everywhere around the world. And we see very good traction. We also invest in personal safety. We have those 2 new units that we talked about last time in terms of mining, oil and gas and aerospace where we continue to invest when we see the opportunities. But we are, yes, cautious as we go, and specifically, I think big credit should be given to our West European team that are on that the whole time, day by day. So I -- we hope at the time that we can let up, but the important thing here is we have the plan which we now look upon to say it was a good, solid plan we roll into the year on, and we are very pleased on how the team are executing it. And as you saw also in terms of research and development, went up 1.1%, meaning that we are committed to growth for the future in terms of investments. So I think it's a good balance here.

Operator

Our next question comes from the line of Steven Winoker of Sanford Bernstein.

Steven E. Winoker - Sanford C. Bernstein & Co., LLC., Research Division

I actually want to ask you to dig into a little more detail on the pricing question. So Latin America, it looks like it was up 440 basis points on pricing; the U.S, 290; EMEA, 270. This kind of pricing power is -- continues to be extraordinary. And the question I have is, can you give us a better sense for the kind of actual actions you're taking on pricing? Is this -- whether it's material contract, escalators, what are the -- what things are you doing? It's not mix, I know, so what are you doing that's allowing you to get that kind of pricing quarter in, quarter out lately?

David W. Meline

Sure. So Steve, basically, as you know, we've talked about a number of times over the last now a couple of years that the company really started gearing up to make sure that we were adequately recovering our material costs as we moved through last year. And that continued into the first and second quarters here. So 1.7 in the first quarter overall, 1.9 in the second would indicate that we've taken some fairly limited additional increases here in Q2. And not surprisingly, for us at least, we have very good price retention. The products that we offer in these markets around the world, we work very hard to keep them differentiated and fresh, which enables us to maintain our prices and offer things that are attractive to the market. So I wouldn't view it as something different today than we've been experiencing in recent times. Perhaps, just the comps are showing up a little bit more strongly right now.

Steven E. Winoker - Sanford C. Bernstein & Co., LLC., Research Division

Does that explain Latin America particularly?

David W. Meline

Latin America, a certain portion of those products we price in dollars terms. So when you look at a depreciating currency environment, such as Brazil has a 20% decline in currency year-over-year, we do pick up some price on a portion of the products as they're pegged to the dollar.

Steven E. Winoker - Sanford C. Bernstein & Co., LLC., Research Division

Okay, so that's separate from all the currency impacts you call out and you -- okay, got it. And then secondly, when you talk about that second half top line guidance baking in a more conservative view of the economy, it still looks like there is something, like, somewhere around at least low-single-digit and potentially mid- to high-single-digit growth baked in on the organic side. Is that -- I mean, how are you thinking about that for the second half? And because it sounds like you're still -- there's still acceleration here. And you mentioned comps, is it all comps based? Or what are you planning on?

David W. Meline

They certainly -- yes, it's a good question. So if you look at the range for the year, we've got a range of now 2% to 5% for the year in total. We did 2% in the first half. So obviously the scenario in which we'd be at that low end would be such that we would continue on the same path. And the high end, of course, does indicate that we'd have some pick-up. Where do we see that pick-up coming from? Several factors. One, certainly, that's been impacting us, as you know, is the electronics sector which we do see the recovery developing in the second half exactly as we've previously indicated in our planning, so that's contributing to our second half outlook. And then certainly, there's a component of it, which is the comps, which again last year in the second half we had a deterioration. So even with stable revenue, we would see some level of pick-up there.

Steven E. Winoker - Sanford C. Bernstein & Co., LLC., Research Division

The electronics, what gives you confidence that, that could materialize?

David W. Meline

We were seeing -- as we exited the quarter, we're starting to see that turnaround develop in terms of the volume. So it starts with looking at indicators of forward demand, including areas like semiconductor fab and our consumer electronics outlook that we observe and then observing what is in our forward orders. And we see importantly the inflection developing now, as we've exited the second quarter. And again, there's a comp issue that helps that as well.

Matt Ginter

Thanks, Steve.

Operator

Our next question comes from the line of John McNulty of Crédit Suisse.

Abhiram Rajendran - Crédit Suisse AG, Research Division

This is Abhi Rajendran calling in for John. A quick question on pensions. Based on some of the recent pension funding policy changes, I guess, would you opt for some of the funding relief options? And how should we think about your funding requirements looking to 2013?

David W. Meline

Sure. So in terms of our overall pension -- funded position and how we think about pensions, we have a view that the right approach to this is to be targeting a range of funded status, which is a -- quite a healthy one, so somewhere bracketing the 100% funded position. We were in the mid-80% funded status as we ended last year due to declining interest rates. And so we made a decision this year to do this extraordinary additional funding to make sure that we don't vary from our longer-term goals, so hence the additional funding that we've put in this year, which we expect to be $500 million. So point there is to keep the pension fund well-funded. Secondly, as to the change in the funding requirements, that doesn't impact us because that would give relief to companies that are facing mandatory contributions. And of course, based on the way we manage pension funding, we don't face that kind of a situation, so it doesn't have any impact on 3M. If I look into 2013, last year about this time we were expecting to see pension expense requirements actually decline in 2012 and thus not have the additional requirements for also additional funding, but the reality was -- is we saw interest rates decline as we went through the year, so we actually had a pension increase in our expense last year and also our funded status decline which we've been addressing this year. So as I look into next year, what's true is that we would expect from an expense perspective to be stable or see some additional decline. But quite honestly, I'm a little cautious to make a call at this stage, given our experience recently and where interest rates seem to be wanting to go.

Abhiram Rajendran - Crédit Suisse AG, Research Division

Okay. Fair enough. And then a quick follow-up question on the electronics side of the business. Could you talk a little bit about some of the share gains that you're seeing in the semi market and some of the drivers behind this and if there are any regional factors behind the business wins?

Inge G. Thulin

Yes. We are broad based, as you know, in consumer electronic, everything from semiconductor to data storage to smartphones to notebooks to tablets and touch panel. We attempt on moving with the market. And when we looked upon the outlook a quarter ago and then refirm [ph] it -- look upon it now again, they -- basically we can confirm the movements in the market. There's a slight uptick on tablets versus notebooks, but overall, the growth is coming as we're expecting as for the rest of the year. The other thing we see on semiconductors, which is an early indicator: we see that, in fact, continue to improve, which is good. And the other thing is also, if you go back a year ago in comparison, the Thailand flooding is now -- restructuring there is done, meaning we see a positive comparison for us as we move forward.

Operator

Our next question comes from the line of Scott Davis of Barclays.

Scott R. Davis - Barclays Capital, Research Division

Guys, do you have a sense of what your customers are doing with their inventories right now, whether we have kind of passed the de-stock or whether there's another round of de-stock just ahead of us?

Inge G. Thulin

Well, as you can imagine, we are following that very closely. And when we are scanning our many businesses and end markets, it looked like, overall, there is a very good line in between demand and inventories. And so we don't see an issue there. And in fact, I think, since the last recession, almost all company are now managing inventories very, very carefully. So there is not an issue there, as we see it. So inventory versus demand is well under control. So that's our view at this point in time.

David W. Meline

Yes. If I could, the one exception would be we did see that LCD panel inventories have risen to a pretty high level. Not a big factor in the business any longer, Scott. Last quarter, Optical Systems represented now 4% of our total revenue as a company so -- and of course, only about 1/3 of that is in the LCD business. But nonetheless, that's the one area that we observe a build-up of inventory.

Inge G. Thulin

I think that was the only place we saw a small tick-up on the running rate, which is close to 7 weeks, I think.

Scott R. Davis - Barclays Capital, Research Division

Okay. And just as a follow-up on -- I know there's been a lot of questions on margins. But in Europe specifically where it's pretty hard for us to imagine how you could take margins up by a couple of hundred basis points in such a tough environment, I mean, how much of that is a benefit of kind of past restructuring? You talked about discretionary cost and things that are under control, but is there some permanent step-up in that margin rate that we can expect going forward just from past works that you've done there in Europe?

Inge G. Thulin

Yes, well, first of all, let's talk about Western Europe in terms of perspective. We have been on Western Europe for quite some years. And you maybe recall that we made a restructuring probably 2.5 years ago when we made very clear that there is a difference in between Western Europe, Central/East Europe and Middle East/Africa, so we started that very early. And at that time, we also regionalized Western Europe. So I think, first of all, we have to say this is nothing that is coming here as a surprise for us. We were very early into the game in order to make sure we prepared ourself. There is a combination, of course, of benefit of restructuring in terms of when we did a regionalization where we reduced the layers of management and made sure that we continue to have local execution in terms of sales and marketing. But as much as we could, in terms of management and back-office type of consolidating that on a regional base, meaning Nordic, Alpine, Benelux, Iberia, et cetera. So I think that is one of the thing that is now paying off for us. So we're very pleased we were early on that game. Secondly, of course they are now holding very tightly the spending in that part of the world and have a hiring freeze and, in fact, also reduced I think over 300 people here during this year. So it's the combination of all of it. And at the same time, Patrick Deconinck that is leading our West European organization as his team is focusing as much as he can to gain market share in the market and elevate the elements relative to customer interaction. So it's -- I wouldn't like to -- us to look upon Western Europe now like this is one quarter that, yes, everything came through. This has been a longer period of time that we were working a very diligent plan. Yes?

David W. Meline

I would just add, Scott, what's also true is there is a mix effect. If you look at -- one area of the business that grew in the second quarter was Health Care in Europe and that certainly helps our mix.

Operator

Our next question comes from the line of Deane Dray of Citi.

Deane M. Dray - Citigroup Inc, Research Division

Was hoping to start first on the FXTech (sic) [FSTech] acquisition and road-tolling. It seems like this would be a good fit for 3M. Could you just discuss the competitive landscape? You do have some entrenched competitors there. And maybe reflect a bit on what the mix might be in terms of systems and consumables in this business.

Inge G. Thulin

Yes, first of all, this is very much a business into United States, right? So it's United States and U.K. a little bit. And that is, if you look upon the mix for it, it's -- I would say it's 25% of each relative to parking, toll software, cameras and the hardware in terms of tolling, so 25%, 25%, 25%. That is a competitive landscape that we are now taking on, but this is a great move for us because this is an adjacency that is going into TSS for us where we have a global leading position on signing. So it's absolutely perfect for us in terms of making sure that we build out more relevance in that market space for us. And I think, all those components, that we would be ready to integrate them and execute very well. And we will focus in on the pieces that we have the business today, which is United States, to the most portion, and then a smaller piece in U.K. And soon as we've gone on the integration and build it in after that, we will see how we can expand it on a global base. But we have very good base, and that's where we will start. We'll also make sure we integrate it to a very strong division we have in traffic safety system solutions.

Deane M. Dray - Citigroup Inc, Research Division

And then over on the optical film side. A lot of discussion about the next iPhone and the implications of this new, what they call, in-cell technology where they're going to eliminate the touchscreen layer. What are the implications on -- for the optical film content where you -- if you remove that layer, it sounds like they're already getting better display graphics on this. But is there a difference in content potential for 3M?

Inge G. Thulin

Well, as you can imagine, we are working very close with all the companies in these areas, right? And whatever new technology that is coming, we're in the middle of that in order to help and support with solutions. So I would say that we have seen a still big opportunity for us specifically in handheld and smartphones as we move ahead. So I can make sure for you that we're in the middle of it and that probably will be more of upsides for us than anything else broad based in what I call tablet and handhelds.

Deane M. Dray - Citigroup Inc, Research Division

Great. Just last one for me, on the consumer side. Back to school, third quarter, what are you baking in, in terms of assumptions year-over-year? And any comment on the Avery Dennison consumer performance this quarter?

David W. Meline

Yes, in terms of the Consumer and Office business overall, we continue to expect -- we'd set out a range of growth for the year for that business and we don't see any reason why that won't come to pass. Certainly, the retail consumer, as we commented, has been -- it's been relatively tepid, the demand in the space. Our performance, we saw improve from first to second quarter, so we're pleased with that. And certainly, there's indications that some level of improvement in that particular area is going to continue now into the back-to-school period. So don't really know the answer, but I would say, on an overall trend basis, we're confident and feel good with the outlook for the business for the year.

Deane M. Dray - Citigroup Inc, Research Division

And the pending Avery Dennison acquisition?

Inge G. Thulin

Well, nothing new. We still expect to close that in the second half of the year here, and we are still under negotiations. So nothing new. We look upon it positively and we hope that we would be closing it here before the year is over.

Matt Ginter

Thank you, Deane.

Operator

[Operator Instructions] Our next question comes from the line of Jeff Sprague of Vertical Research Partners.

Jeffrey T. Sprague - Vertical Research Partners Inc.

I was wondering if you could share with us, is there anything to kind of glean from the progression of organic sales over the course of the quarter? And there's been some talk of potentially kind of a CapEx strike in the U.S. kind of grinding into year end and all the expected political and fiscal drama. Have you seen any discernible change in trend particularly in the June, July time frame?

David W. Meline

No, actually. If I -- well, first of all, on the second quarter, it was pretty stable through the quarter so we didn't see -- and obviously, we're looking very carefully. We didn't see any indications of a change in trends, and that's true through July now. So some, obviously, individual sectors, individual geographies, one month versus another you can have some ups and downs in an economy like this, but net-net we don't have anything that would cause us to say there's a material change in the outlook, which is how we characterize the second half now. So -- and then in terms of CapEx, not sure -- if you talk about -- as that drives our own demand, we haven't seen again any discernible change. If we look at our own deployment, which is at some level an indicator of longer-term requirements, we continue to get a bottom-up view that says we have demands for capital based on the view of the business that we need to continue to support growth and there's no reason to vary from that. So -- and if you see some sectors like -- our traffic safety had a very good second quarter, which is partly related, if it were, to government funding in that particular case.

Jeffrey T. Sprague - Vertical Research Partners Inc.

And I was wondering, just as a second question, could you elaborate a little bit more on China? The better performance that you're expecting, is it just this ramp in the electronic supply chain that you've already discussed so far here this morning? Or are there other things going on there that are giving you a little bit more confidence into the back half?

Inge G. Thulin

Yes, well, let's first look upon the facts for us. First of all, revenue in the quarter was stable versus Q1, so we had very similar growth rate for the second quarter versus the first quarter. Health Care is growing very fast for us, 20%-plus, and we also saw I&TB show improvement versus Q1, which is a good sign. So when you take out electronics from China, we grew in the quarter 10% organic locally versus 8% in Q1, so we make a step-change relative to growth, generally speaking. And when we look on the rest of the year, we look upon it to be, from a dollar perspective, similar to the first half of the year, but due to the comparison, we see a growth rate accelerating. And as we talked about last time, there's a couple of things that have impacted China for us, which is of course, export specifically to Europe, electronics and then local consumption. And we will look upon it as we move ahead. Electronics will improve and also local consumption. We don't see any improvements relative to the export to Europe. So I think you can look upon it -- that will be similar in terms of overall dollar sales, but improvement relative to percent is due to the comps in electronic. And we also see Health Care improving quite a bit. We are very happy with our Health Care business in China as we speak, growing very, very fast.

Matt Ginter

Thanks, Jeff.

Operator

Our next question comes from the line of Jason Feldman of UBS.

Jason Feldman - UBS Investment Bank, Research Division

Some very nice margin improvement. When you're talking about discretionary cost controls and specifically discretionary component, should this kind of SG&A level be something we should think of as a sustainable run rate? Or is it really just at this level given the uncertainty and some of those cost controls are going to be lifted when hopefully things improve?

David W. Meline

Sure. Yes, I mean, as you know, Jason, we're always trying to balance cost control with investment in the business and growth. Certainly, as we looked at this year coming into '12, we didn't see the opportunity materializing for the kind of growth that we foresee on a long-term basis for the company, and therefore, we set for ourselves a much more conservative plan in terms of our discretionary spending. And as you know, that's what we've been actually marching to. At the same time, that plan, we continue to invest in the business. That investment both in SG&A and R&D is very steady, so it's not as if we're carving out and starving investment in the business over time. So is that sustainable? Is that SG&A margin -- or expense sustainable? I would say I don't view it as extraordinarily constrained right now, to be honest. I mean, we're always working on becoming more efficient. We're always trying to leverage the business as being a larger business on an efficient back office, et cetera. So to me there's nothing that jumps out in terms of that performance in the context of the current economic environment.

Jason Feldman - UBS Investment Bank, Research Division

Okay. I mean, I guess another way of -- I guess I was thinking about it is it -- I mean, you distinguish, I think, very appropriately between the growth investments that you haven't cut back on. In fact, I think, last quarter you talked about accelerating them I think it was $30 million to $50 million for the year, as distinct from these discretionary cost controls. And so I guess the other way is, assuming that you continue to invest in growth whether times are good or times are bad, is there additional kind of non-growth areas where there's still opportunities for kind of incremental cost cuts?

Inge G. Thulin

Well, as I said earlier, we are well known for innovation but we're equally good at continuous improvement and make sure that we constantly look for operational excellence and functional excellence. And I think that’s what is driving us the whole time. So I think it's an important element to make sure that we and you know that we are driving productivity in all functions, specifically in the back office. So that's an opportunity for us. We are not backing off relative to investment for growth in the front and I think that's a very, very important distinction to make. And again, it's not the same cut for every business. It's based on some opportunities where you can see that it's a short-term, mid-term growth opportunity for some businesses, like in this time for Health Care and Consumer and Office. We let them go and in a different level than some other businesses that have a tougher economical environment at the moment, like electronics.

David W. Meline

Well, if -- and if I could just add one other perspective on that. We talked -- Inge talked now about, I think, $60 million, $70 million that we've directed towards some form of consolidation and restructuring through the first half, which is quite honestly very typical of the business which we're constantly working on productivity, we're constantly looking at how we can improve and be competitive. And eventually, hopefully sooner than later, the benefits of, if you will, those investments in terms of getting the business rightsized or in the right kind of posture reaps rewards for the company. And that's something that we've been doing, continuing basis. So I think it's all within the same theme. Obviously, in times like these, you have an extra-sharp focus on the area, but it's something that the company is always doing.

Operator

Our next question comes from the line of David Begleiter of Deutsche Bank.

Ramanan Sivalingam - Deutsche Bank AG, Research Division

This is actually Ram Sivalingam sitting in for David. A quick question on Health Care. Obviously, very strong results here. In terms of margins, what's fair to assume in the back half? It looks like it was a record margin performance on an EBIT basis.

David W. Meline

Sure. So yes, so obviously we're very pleased with the way the business is running. If you look at the quarter, it's a continuation of a story that we've seen for some time now, which is not only very strong margin performance but also, if you look at the growth of the business, quite solid and very broad based. So we're pleased with the way Health Care is running right now. Why is that the case? Well, we're seeing growth in all of our divisions. The factories are running as well as we've ever seen them run. Health Care, like our other businesses, obviously have a close eye on cost. And so in terms of the margins, as I look out, I think it's realistic to expect that we'll probably run it in the 30-plus range here for a period of time into the future, certainly through -- if I look at 2012 in total. And also, we expect to see that in combination with some continuing, steady growth.

Inge G. Thulin

Let me make an additional comment here. First of all, we have a very strong and diverse Health Care portfolio. And if you look upon the growth rate, the emerging market now grew 16% as of late. And the investment we have done there start to pay off due to the fact that the portfolio there is becoming more relevant for those countries. So I think it's important that we are targeting good growth and strong margins in this business, and they are delivering. And as David said, there's many elements there in terms of mix of portfolio, the efficiency in manufacturing, the go-to-market capabilities, but we are still doing those investments, as we have talked about on the other calls. But based on the business model there, I think, for the foreseeable future we should see low 30s as more likely the margins for us, which is very good.

Operator

Our next question comes from the line of Steve Tusa of JPMorgan.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Sorry, was that last question about the Health Care margin?

David W. Meline

That was on Health Care margin, yes.

Inge G. Thulin

Yes, it was the Health Care, yes.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Okay, great. I won’t -- I'll just go back to the transcript. I'm sorry. I missed it. The price cost -- so on the pricing side, just quarter-by-quarter, does that step down gradually over the next couple of quarters to go on, like, basically flat in the fourth quarter? Or how is that -- price is up 2% in the fourth quarter, kind of stepped up a little bit. So is that how we should think about it? Will it be another big quarter in the third quarter and then step down? Maybe you could just give us some visibility around the comps.

David W. Meline

Sure. Yes, Steve. So we're looking for around 1% for the year. And it does imply a step-down. I would treat it as -- we think it'll be a step-by-step move.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Okay. And then the raws, will they be negative in the second half or similarly?

David W. Meline

Yes, so we ran about flat in the first -- in the second quarter, which was certainly an improvement from the first. We think we'll be flat for the year, so that would imply slightly negative in the second half.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Got you. And then just one last question. I mean, we're looking at it year-over-year, obviously very strong improvement. But I guess, sequentially as well, your profit was up $95 million. Your revenue was up, I guess, $50 million sequentially. Was there something that kind of dropped out of the first quarter into the second quarter? Was that ForEx? Maybe you could just give a little bit of color around the sequential bridge.

David W. Meline

Steve, one thing that changes Q2 versus Q1 is we front-end load our stock options expense. We grant options in the first quarter of the year so our stock -- our options expense is the highest in Q1, and that's typically about a $50 million sequential change Q2 versus Q1.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Okay. And that's happened in prior years? Because last year, I mean, you had...

David W. Meline

Yes, it did. Yes, it has.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Okay. Because in the last 2 years, you've had a -- more like a 50% incremental instead of a 200% incremental.

David W. Meline

Right. Yes, I was just going to say, I mean, on your revenue question, we -- if you look back at the way we set out the year, we expected the first half to be as it's been, which is basically pretty flat to the second half of last year. It's turned out to be the case. Certainly, second quarter was negatively impacted on a revenue basis by exchange more than the first quarter, but it's very much in line with the first half-second half type of a situation where the first half would be most modest and some level of recovery in the second half but obviously still something that's quite contained.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Okay. So how much more positive was price cost in the second quarter versus the first quarter?

Matt Ginter

I'll have to follow up, Steve, on that. I'm not sure off the top of my head.

Operator

Our next question comes from the line of Nigel Coe of Morgan Stanley.

Nigel Coe - Morgan Stanley, Research Division

I just want to pick up on the price cost. Sorry to keep on beating this thing to death. But -- so you've got 50 bps good news on price versus your prior subtation [ph]. You've got, it sounds like, about at least 0.5 point on inflation. I'm just wondering, why is the 50 bps low ends raised to the margin levels? It seems that you should be -- I mean, are you sort of more biased to the high end of your 1.5 points -- 50 bps to 1.5 points margin targets? It just seems that if you just put those through the model, 0.5 point seems very achievable.

David W. Meline

Yes, so if you look at the margin plan that we've got in place, what we set out for ourselves this year was to achieve a 1% year-over-year margin increase, which we ran at just slightly short of 21% last year. The midpoint now of the margin guidance for the year is 22%, so I think it reflects correctly our continuing level of confidence that we had that we'd deliver on that plan. If you also consider, I mean, other factors that would be impacting margins in the second half, you certainly have things like the Avery acquisition, which is not yet in there, so that would have some possible impact. And then secondly, we still have a range of growth that varies several points, and that could impact margins. So we think it's a reasonable outlook. What's also true for us is first half and second half, your margin trend, you normally have a weaker second half in margin specifically in the fourth quarter, which is also being reflected in the way we're guiding right now.

Nigel Coe - Morgan Stanley, Research Division

Okay. And if I can just ask it a slightly different way: If sales come in towards the lower end of your range, which seems at this point to be more likely, can you still make the high end of your margin range given the price and more material good news, x Avery Dennison?

David W. Meline

Yes, that's a hard one, Nigel, to exactly connect those dots as to what the other elements of the equation will give us in terms of things like raw material cost and how it flows through. So I would tell you, I couldn't give you a straight answer on that.

Nigel Coe - Morgan Stanley, Research Division

Okay. And if I could just follow up the -- it looks like you've seen about a point out of your volume expectations for the full year. How does that look by segments?

David W. Meline

Repeat that, please?

Nigel Coe - Morgan Stanley, Research Division

Yes. So the 1 point of lower volume for the full year, I mean, how does that look by segment? So are we losing to -- yes.

David W. Meline

Yes, got it. What I'd say is, if you look at -- and again, if -- we gave some full year segment guidance in December and also full year guidance in terms of the regional split for the growth. The way it looks right now is that we're still foreseeing us being very much in those ranges by 6 business sector for the year. The fact is, is by trimming the top end, it's more likely you'll have more of them sort of in the middle than perhaps some being at the top of their range, which was a scenario that we had as we entered into the year. So I think, from a planning perspective, you should think about those ranges still being good on a business sector basis. And then quite honestly, on a geographic basis, the scenario in which the top of that original guidance would have occurred for 3M, would have involved, quite honestly, a stronger Asian performance, which is not materializing. So if you wanted to articulate those ranges by region, we still don't see the ranges being -- we still see them as being good geographically, but that's the -- if you want to identify the differentiating factor, that's what I would say.

Operator

And our last question comes from the line of Terry Darling of Goldman Sachs.

Terry Darling - Goldman Sachs Group Inc., Research Division

Inge, I'm wondering if you might shed a little more light on how your thinking on capital allocation is evolving and maybe describe a little bit how the M&A pipeline looks at this point.

Inge G. Thulin

Yes. I mean, we just have started to work on the plan for next year, so we are just in the middle of that, right? And as you know, I think capital allocation is an important element for us in order to make sure we prioritize the right businesses as we move ahead. And so we are just in the middle of that, and I hope we can share more with you in November as we meet again. In terms of the pipeline for merger and acquisitions, it's solid. It's -- I would say, as we have a bottom-up process there, we have a still, business by business, very solid pipeline. And we take a look upon them one by one as they are moving forward. We -- as you saw, we announced one this last quarter. We have made a commitment to one earlier in the year. So it's still robust and it's part of our growth strategy as a tactic as we move ahead. So first of all, organic growth for us complemented with acquisitions. But the pipeline is healthy and improving and we are now prioritizing it day by day, I would say, in order really to understand how it will fit in strategically for the company as we move ahead. And the target we have given out earlier in terms of spending, we're standing behind that.

David W. Meline

Yes, if I could add on capital allocation, at least as it relates to the current year, again, go back to the fact that we're tracking very much to the plan we laid out for the year from an operating perspective. If you look at kind of the big goal post that we've got on how we allocate capital in the year, we said $1.3 billion to $1.5 billion on CapEx. We still think that's a good range. We said $2 billion to $2.5 billion on buyback, gross. I think we've done here in the first half about 1/2 of that. So I don't see any reason right now to say that there's a dramatic change in our view there, but obviously, we need to be cognizant of intrinsic value of our shares in the market. And then we prefunded -- as I mentioned, we prefunded some debt maturities that are coming up later this year and into 2013, so that was an action we took. And we've got the M&A guidance out there of $1 billion to $2 billion. The announced transactions would indicate deployment of slightly less than the bottom end of the range in the first half, but I think $1 billion to $2 billion is still, from a planning perspective, a good range, recognizing there's -- we can never precisely plan size and timing of those things.

Terry Darling - Goldman Sachs Group Inc., Research Division

And appreciating that the update in November is forthcoming, I'm wondering, though, if you can, Inge, just put any light on what's any of the -- sort of debate that you're having with regards to how the plan going forward could shift at all relative to where it's been in the past and, perhaps specifically within the M&A realm, whether larger acquisitions is something that you're considering in that mix.

Inge G. Thulin

Well, as we have talked earlier, I don't think it's larger by definition. I think it's the prioritization where we have to make sure that we connect them strategically into some of the very important businesses that is coming out from the prioritization process. And then we are in fact making a step-up relative to integration and make sure that we can do that faster and more professionally as we move ahead. It's an ongoing process, as you know, when you look upon your business and evaluate the opportunity based on your base, and that is what -- we are in the middle of talking about this as we speak.

Terry Darling - Goldman Sachs Group Inc., Research Division

Okay. And then just lastly, David, wonder on the raw material -- the improved outlook on raw materials. Other than steel and copper, which are obviously pretty visible to most of us out here or all of us out here, what other key raw materials are driving that lower inflation outlook? And to what degree are some of those raw materials derivatives of U.S. natural gas? And perhaps your -- you've got a longer tail to the benefit of that reduced inflation as we think about again this ongoing question of sustainability of margins into 2013.

David W. Meline

Sure. Yes, I mean, if you look at our key raw material inputs, there's certainly a portion of those that are pegged to the price of oil and natural gas now. You get into this issue of the amount of these derivatives that are coming out of cracking slates, whether they'd be oil versus natural gas. But the answer is -- polypropylene, for -- propylene-based products, which feature in a number -- as inputs to a number of our products, we're seeing softer pricing there at the moment. Certainly, we've seen price trends improve on things like paperboard, which is an important input to our products. And in some of those areas, we also see capacities reacting to put a floor on pricing. Certainly, our experience has been, as demand improves and as the outlook for economic activity improves, we'd be naïve if we thought that prices would stay down. So I think it's going to continue to trend up and down as the market outlook changes.

Operator

That concludes the question-and-answer portion of our conference call. I will now turn the call back over to 3M for some closing comments.

Matt Ginter

Well, thanks, everybody, for joining us today. I know it's a busy earnings day. I think we’ve covered a lot of ground, some very good questions. Appreciate your being with us. And we look forward to continued dialogue going forward. Thanks.

Operator

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line.

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