3M Company (MMM) Earnings Call Transcript & Summary

Hi. Good morning, and welcome to the Ninth Annual Laguna Conference. I'm Morgan Stanley's electrical equipment and multi-industry analyst, Josh Pokrzywinski. Thanks for joining us today. We're going to have you for the next 3 days talking to some great companies here. With us leading off for, I think, 2 or 3 years in a row now at least, I'm joined by the team from 3M, Monish Patolawala, Executive Vice President and CFO. Also joining me, SVP of Investor Relations, Bruce Jermeland. Before we get started, guys, I do need to read a quick disclosure here, just noting that for important disclosures, please see our website, as such, morganstanley.com/researchdisclosures. And if you have any questions, please reach out to your Morgan Stanley sales representative. I know before we dive in here, Bruce, you have your own comments to make on the disclosure front before we get started.

Yes. Thanks, Josh. It's great to be here with you today. Yes. Before we get going, I'd like to remind everyone to take a moment to read our forward-looking statements. During today's fireside chat, we'll make certain predictive statements that reflect our current views about 3M's future performance and financial results. These statements are based on certain assumptions and expectations of future events and 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. With that, I'll kick it back to you, and you can introduce Monish.

Perfect. Well, Monish, thanks for joining us this morning. As always, a pleasure. Shame, we can't do it with the beach behind us. But we can just imagine, if I knock this down, that there's a palm tree there. Maybe just before we dive into Q&A, if you have any opening remarks, just how you guys are seeing the world, what you're focused on and then we can dive into it. Also want to remind investors, anytime if you want to submit a question to the Q&A portal, I'll be monitoring that as well. We'll leave some time at the end.

Sounds good. Thanks so much for having me and Bruce on the call, and we're glad that we are headlining for 2 to 3 years in a row. As you've seen our results for the first half, we had a pretty good start to the first half. The team delivered strong organic growth, improved margins. We have also had good cash flow. The team has also made decent progress on improving daily management through operating rigor using data and data analytics. But as I've said before, there's a lot we can do in this space and we'll keep doing it. On the long term, when I look at the business, we still feel very bullish about the trends that exist that have come through the pandemic. We are pretty excited about these spaces. We know 3M can win in these spaces. And so we are continuing to invest despite all the uncertainty in our growth, productivity and sustainability goals. And then if we come back to the short term, to your point, a question of what we're seeing in the world, during our earnings update, we had talked about some of the uncertainties that we are seeing in the world. And I think it's starting to play itself out. So we [ were worried ] in July on what it would mean and it's starting to play itself out. All of us are experiencing the semiconductor shortages that are not just linked, I would say, to automotive and electronics, but you're starting to see it impact a lot of industries. The outbreak of the Delta variant continues to impact the world as well as Hurricane Ida has also put more stress now on already stressed supply chains, causing a lot of inflation as well as material availability across -- issues across the globe. So if I take it one notch lower, I'll just start with auto, the semiconductor shortage impacting both auto, electronics. Auto, you're seeing a lot of OEMs are shutting down manufacturing because of the lack of semiconductor chips. Auto, which was expected to be down minus 3% for the second half of the year, auto builds, is now going to be down 6% for the second half. Electronics is getting impacted. So consumer electronics, TVs, are all getting impacted by the chip shortage. But also TVs, we are seeing that factories are being shut down because of the Delta variant in many parts of the world. So that's going to put more pressure on basically what was already going to be a negative year-over-year comp and it's going to make it worse. When I move over to health care, you're seeing uneven recovery in health care. So in certain places, you're seeing procedures remaining as they were. In certain cases, you are seeing procedures starting to come down. We see right now that North American elective procedures will be approximately 90% of pre-pandemic levels. Going into the third quarter, we have thought we would be closer to the 90% to the 95%, but we're going to be at the lower end and even lower depending on where it goes. Respirator demand is pretty much playing out where we thought it was going to be. I would say we should see what happens with the Delta variant and what demand does in the next month or 2 to go. And then when I go to office or return to workplace, again, when we had talked in July, we have said we had started to see the trends move up. As schools are starting to open, offices were starting to open. We are seeing that offices, people have delayed return to workplace in the office, and that's going to impact the office supplies business. Moving over to raw materials. Again, I think the inflation is unprecedented. We are seeing inflation in the same areas I talked about earlier: jobs, raw material, labor and logistics. Raw materials, again, you go down to polypropylene, you talk about resins, that inflation remains. We saw it dip a little bit, it's back up again. And then logistics cost, we read about it, you read about it, you all have written about it, where you're seeing port congestion, you're seeing a lot of pressure on logistics costs. And so when we look at all the inflation and all these metrics that we look at, we had talked about a $0.65 to $0.80 headwind for the year. We see ourselves currently at the higher end of that range as well as we haven't yet factored in the impact of Hurricane Ida because I think people are still just coming off Hurricane Ida, we'll have to figure out what material availability is and we'll see where that goes. And our plan is to update you during our earnings conference in October. Price, we are gaining price. So we have been able to gain price versus the first half, pretty much to what we expected, so price is up. Unfortunately, inflation is higher than we even thought in the third quarter. So despite taking price up, getting to positive, we are seeing inflation outstrip price. So when we come in at earnings, we had told you 50 to 100 basis points of pressure between the net of price raw. Currently, we look at it somewhere between 100 to 150 basis points of pressure in Q3. And then you have also read that for the Combat Arms litigation, the judge has accelerated the number of cases or MDL cases going to trial, so we can continue to spend more legal fees as we get ready for those trials. So when I put all that together, 2 months in, Josh, I would say, our margin rate is somewhere in the 19% to 20%. But again, it's 2 months in. We got a month to go, September is a big month for us, the team's all focused on making sure we are delivering for our customers, reducing the cost where we can, increasing price. But at the same time, we are bullish about the long term. So we're going to continue to invest in growth, productivity and sustainability and we'll keep finding this.

Excellent. So that's a really helpful topical, certainly, intro. Maybe just to kind of dig down into some of those components. Clearly, the supply chain and inflation part is the most topical. I think everyone has kind of braced to get some update from most of the attendees. You guys are sort of famously localized on your production footprint. So maybe talk about, if you had to kind of rank order the pressure points, is it the availability of product? Is it the cost of the product itself? The logistics piece? Which of those has sort of been kind of the biggest issue? Because I think even over the past couple of weeks, we've seen companies say, "There are things that we can't get at any price." It doesn't sound like that's necessarily the case for you. It just costs more. Maybe kind of rank order what some of those pinch points might look like.

Yes, I would just start first by the comment you made that the 3M strategy of being local for local or in region for region has played itself out very well. You saw us -- that benefit has shown up through the pandemic, it continues to show up. So I would say if I had to rank order this, I would say the cost is the biggest issue. We have an amazing relationship with our suppliers. We are working really hard to make sure that there is availability. Because at the end of the day, both the suppliers and us want to make sure that our customers continue to have the product. And that's what we are completely focused on. But that doesn't mean we don't have availability issues, but it's not the biggest item that we talk about. I would say inflation, when you think about raw material and logistics, both are very high. For us, inflation, again, comes from multiple difference. So luckily, we don't have one commodity that has all the inflation. But right now, we are seeing broad-based inflation. So we have seen inflation in the resins world. We've seen it with polypropylene, ethylene, wood pulp. You're seeing inflation in all those areas. We're also seeing labor inflation. You're seeing labor inflation, whether it's outsourced manufacturing goods. Plus, in some cases, even in our own factories, we are seeing some labor inflation. And logistics, the port congestion is so hard. So there, I would say, there is sometimes even the lack of availability of carriers to take the product that's hurting us. So I would say cost is #1. Availability is #2. But we are quite confident that we will work through this. And we are blessed and to have customers who still rely on us for helping us solve their problems, at the same time, making sure that we fulfill our brand promise that we have, which is delivering on time with good quality and helping customers solve their problems.

So I know you guys are in the midst of kind of diving into the organization and trying to unlock that next layer of productivity. You're big users of automation, obviously. Even a quick jaunt through the factory would kind of illuminate that. Anything about your own footprint or CapEx strategy that has evolved through this process? I mean people throw out nearshoring kind of as a bit of a platitude. You guys are already there, so maybe that looks different for you. But anything that has sort of crossed your desk strategy-wise that is evolving as a function of what we're going through right now?

Yes. So I don't think the nearshoring issue is that big an issue. As we've said, we are region for region. We've been there for years, and we'll continue to follow that strategy. At the same time, Josh, we are all about solving customer problems. So the customers are moving to different locations. We are more than happy to move to those locations, too. So we'll play that out the way the customers decide. For us, as we have gone through the pandemic from a CapEx perspective, a couple of things have come into play. I would say, number one is the importance of partnerships and making sure that we are partnering with other OEMs or partnering with people who have solutions that can help us improve our manufacturing. Our cycle time of manufacturing, et cetera, is number one. And you saw that through the pandemic, where we were able to ramp up respirator production very, very quickly. But that's not just because of our own talent, but we were able to partner with some amazing companies as well as we got help from the Department of Defense, et cetera, that allowed us to ramp up these facilities. On the other hand, the other thing that we have talked about, which we talked pre pandemic which was the business transformation, which was before my time, actually has played itself out very well through the pandemic. So that's another thing that we have found. So a piece of it is for those who are not familiar with the change that was made, was the company changed to 4 business reporting units as well as enterprise operations became 1 horizontal pipe that supports the 4. Think about enterprise operations and supply chain in most of the companies. And the benefit of having it all under 1 pipe has not only allowed us to keep our employees safe and has allowed us to rapidly respond to changing demand but has also helped us drive inventory and cash. So that has been a benefit. But the enabler of all of that, Josh, has been digital or data and data analytics. So we have finalized our digital strategy in 4 different buckets, which again has come out through the pandemic. One is digital customer. As we are going through this, we are seeing there's more and more need to have customer intimacy, not just through physical meetings, but also through digital, digital products and offerings. There's a pretty good market out there that can allow us to use 3M data to provide solutions to customers. Digital enterprise, which is more than an ERP, the next 2, which is digital enterprise and digital operations is more than an ERP. And that was the bedrock of the transformation, using data and data analytics that allow us to improve yield and efficiency in our factory. And then of course, from a digital operation perspective [indiscernible] using data, leveraging our ERP, leveraging other cloud solutions that we have to reduce cost of operations. So that's our learning. I would say we are investing in growth. We were historically investing $1.5 billion to $1.7 billion a year. We have upped that in 2021 to $1.8 billion to $2 billion. We currently believe we'll be at the lower end of that $1.8 billion. That's partly driven by just the availability of OEMs on the CapEx side and the availability of material for CapEx. But we are quite bullish about the future. We won't hesitate to invest where we see the growth opportunities and we do see growth opportunities. So you'll hear more from us as we go into 2022 on that front.

Got it. That's helpful. And then just back on the inflation component. Obviously, there's a heavy cocktail of purchasing contracts and hedges and supplier relationships that would say looking at a spot price doesn't necessarily tell the story. When should we expect kind of that convergence of pricing cost, understanding cost probably reads out here inflationary for a few more quarters just as with the tyranny of the math?

Yes. So back to what I said, I think inflation is way outstripping anything that we thought. We are going after price in multiple areas. But we also have got a self-help story. So it's not just price, but we are also looking at dual sourcing, we're looking at improving yields, we are continuing to be cautious on the spending that we do, always to reduce the impact of the inflation. Price was a headwind in the first half of this year or price raws. In Q3, we are seeing price increase come through in the first 2 months. We'll see where we go to the end of the year. But for us, we are making sure that we are following a concerted effort to take price across regions and geographies. We are making sure with the channels that we play in, that we are being fair and working through all those channels. So it's taking a little bit of time. But as I mentioned during the earnings call, we are seeing price go up in Q3 and Q4. And our plan currently is to make sure that, that lands. I think inflation, it will depend on when inflation starts tempering down. And my belief, and I may be wrong, is until we see a demand-supply parity somewhere, I think they're going to continue to see inflation in raw material and in logistics. And then I think port congestion as well as port shutdowns actually don't help. When you get an event or a natural event like Hurricane Ida, it actually makes this situation even worse. But we are confident we'll work through this.

Got it. Yes, I would agree. I don't know if turning the calendar at the end of the year, that the input cost environment cares about that arbitrary time frame. Got it. That's helpful. Maybe kind of flipping over to the demand side of the picture, you mentioned, is pretty solid. In your own guidance though, 2Q kind of looks like a bit of a high watermark. And you talked about some of the industry-level bottlenecks there in transportation, electronics and, obviously, respirators as well. Anything else at the business level that should moderate from 2Q? You touched on kind of the return-to-work stuff maybe not being as heavy, but I don't know if it's necessarily going backwards either. So any other kind of end market walk that we should think about as maybe having had peaked out in 2Q, at least on a near-term basis?

Yes. So I'll just start with the ones you mentioned just for everyone's benefit. I think semiconductor, you're seeing that shortage that's going to impact auto, it's going to impact consumer electronics. Consumer electronics was also going into a heavy comp on a year-over-year basis. So that was expected to be down on a year-over-year basis. TVs and tablets but also expert down saying with phones. On TVs, the new thing we have seen is factories also shutting down because of the Delta variant or lack of raw material. So that was -- that is new. You talked about office supply. So coming into 2Q, we saw point of sale to be pretty strong when people were going back to work as well as back to school. People are delaying the workplace. So we'll see where that goes. We believe consumer -- the home improvement market will remain strong. But just a reminder, they also go into heavy comps on a year-over-year basis. So last year, second half 2020, if my memory is right, the Consumer business was up plus 7% as well as the home cleaning business part of that business also goes to a heavier comp. 3M, in total, actually goes into heavier comps into the second half. So we had pretty good growth last year between 3Q and 4Q. So that's the other one for you to just keep in mind as we think through this. But everything is going to ultimately depend on what happens with the end markets, what happens with elective procedures. Hospitals, as I mentioned, again, is at around 90%. Oral care, Josh, we are close to pre-pandemic levels on oral care. Time will tell what happens there, but we are seeing that play out. And then respirator demand is pretty much following what we said. But again, it's fluid. It changes every day. And depending on what happens with the Delta variant, I think it's going to determine the level of respirator demand.

You mentioned some pretty decent recovery in health care, particularly in oral care, but I think in general, the business has had a solid past couple of quarters. How much of this do you think is sort of catch-up on some of those procedures versus something we can kind of sustain? Now obviously, being at 90% still leaves kind of a category gap to fill. But is there something about the business that has made price recovery easier or price cost or the growth vis-a-vis something like restocking? Anything on the internals that would sort of point to why this business has been stronger and maybe still has some runway ahead of it?

Sure. Listen, health care for us, in general, as a segment is a great segment for us to invest in. We believe 3M is winning that space. The first half, Mojdeh and team did a beautiful job of running the business. It's up 16%. You saw pretty good improvement in margins, good job in driving cash in that business. I would say when you look at the first half, you would say declining COVID hospitalizations clearly allowed hospitals to increase elective procedures. So that is definitely one piece that has helped that business out. It was tempered in the second quarter with the respirator demand that started coming down as the incident of COVIDs are coming down. You are seeing us, as I mentioned, seeing a slowdown or uneven recovery of hospital procedures. In certain parts of the world, you're as low as 70%, 75%. So there's pretty good headroom, in our view, with elective procedures in our Medical Solutions business to keep growing non-respirator demand. I would say the question on this pent-up demand, Josh, I think it's an open debate, but there is a lot of pent-up demand. At least what we are hearing is there's a lot of pent-up demand on elective procedures. I don't know if it's a 2021 issue, but I think this is going to be a 2022 issue and beyond, is to make sure what happens with these elective procedures because not all of these were truly elective. They were elective, but they were time-sensitive at some point in time. So the question is what happens? I think it's going to depend on capacity in the hospitals. It depends on how governments react to spending on health care so it will all play itself out. We would also say what we're seeing. I think hospitals are better right now equipped to deal with the Delta variant. But again, that's pockets are -- good pockets need improvement. So -- but overall, I think as elective procedures go up, our Medical Solutions business is going to continue to benefit from it. Plus the Acelity acquisition that we have done is starting to show its synergies. For example, a week or 2 ago, we were able to put our Bair Hugger product, which is a temperature management system with the Acelity surgical infection prevention product, and we were able to win over $1 million of revenue, because now you're able to show hospitals the end-to-end benefit of two. So that's [ playing its odds ]. So other than elective procedures, we also have new products. We have combined selling opportunities with the Acelity acquisition that is allowing us to keep growing in this space. When I go to oral care, which is the next piece of health care, you saw a pretty good recovery in the first half of 2021. Electives have -- oral care procedures are close to pre-pandemic levels. Again, there are areas that are not. But I would say, in general, they're close to pre-pandemic levels. The channels in that area are pretty close to pre-pandemic levels. HIS business, which is our Health Information Systems business, where we've done the M*Modal acquisition a few years ago, continues to show good growth, but at the same time, they were impacted by the decline in elective procedures because hospitals are not spending money on capital, but we are starting to see that open up. And then biopharma, which comes as a part of our purification business and our food safety business is the other one, continue to -- the food safety was also impacted to some extent, I would say, by the pandemic. But you're seeing us continue to have very strong growth in our biopharma filtration business as the filters are used for biologics as well as vaccine production. We continue to see that growth. So health care, good segment. We believe, long term, continuing to grow. It will grow. It's a GDP-plus kind of business, so it's a great business to be in. Your specific question on price. 2/3 of our health care business is contract-driven, Josh, so it's not as easy to raise prices because there are contracts out there. But that's something we're working with our customers to make sure either when the contracts come to an end or reworking some of the contracts. For 1/3 of it, we do have more flexibility to raise price that we have in that segment.

Got it. That's helpful. And not to belabor auto because, obviously, well documented there on some of the bottlenecks, but I guess, two dynamics. First, any indication from what you guys can see or what your customers are telling you when we start to release that? I mean I think it was supposed to be second half of this year, then first half of next year, now it feels more like second half of next year. Is that sort of best thinking right now? Or is everyone still kind of using Kentucky windage to get to the right answer? I obviously didn't invent that phrase, but I love it, so I'm going to use it a lot this week.

Yes. Well, I have not heard it before, so you educated me on something here. But just I would tell you, when we started the year in auto, people said we would be up 14% for the year. Then we will be up 12%, and it came down. And now I think it's plus 6% if my -- or 8% -- if my memory is right. The second half when we were in June, July, we said we'd be down 3%, that's down 6%. I would say -- and you're also reading that many automakers are shutting their factories right now for the lack of availability of semiconductor. So sitting right now, again, we have to go with all the external metrics that we see, which is IHS, that's what we follow. But in just talking to auto OEMs, talking to multiple other people in the industry, we believe that this is going to go into 2022. I don't think it's a 2021 issue. I think until you see the availability of chips go up and a steady supply of those chips, you're going to have auto OEMs have to go through ups and downs to keep their factories running. So our belief is this is a 2022 recovery.

Now on the other side of that is cars are basically like walking computers now and the chip shortage sort of proves that. 3M's content, I would imagine, goes higher in that more tech-savvy environment. Anything, as we've sort of seen these new EV models come out, even with bottlenecks that you guys can point to, to say what outgrowth could look like versus production or content per vehicle over the past few years that you could point to, to maybe give people that confidence on like, okay, in whatever environment, here's sort of the algorithm that 3M would follow?

Yes. So as you know, Josh, and you've followed the company much longer than I have, 3M has had an amazing space in auto business for decades. We have worked with auto OEM manufacturers to solve their problems, whether it is lightweighting, soundproofing, helping with internal combustions. EV auto electrification is a new front. And again, 3M's ability to bring solutions to the market is forefront. So whether it is new innovative solutions, like terminal management for batteries is an area that we're working on, we believe that even in spaces with soundproofing, using our display technology that is used in consumer electronics that can be used in the auto OEMs, et cetera, all exciting areas that we can continue to point to as areas that will keep growing. Our auto electrification business, give or take, $300 million, has been growing tremendously over the last few quarters. Historically, 3M has, because of its content penetration, outbid or outrun the auto growth percent by 300 to 500 basis points. We'll see where it goes, but we believe that we should be able to continue with all the products that we have, the innovation that we bring, that we should be able to beat auto builds over a period of time. Short run, I think it's -- time is going to tell which factories are open and which is not, and that has an impact because each car has a different content for 3M. But I think long run, we should be able to beat all of it.

Excellent. Just shifting over to the balance sheet. I suspect you don't have any new news for us today or else we'd see a press release. But on the PFAS front, just with the Hoosick Falls settlement, anything that folks should focus on there that would [ suppress in ] or apply elsewhere that would make that unique? I know you guys didn't manufacture there, and there's like this property value component that someone without a legal background, sources over my head a little bit more. But anything that people should key in on there specifically that makes that kind of new news as a settlement relative to what you guys have done thus far?

So you're right, Josh. We didn't have any manufacturing there. And in most of our cases that are out there, we don't have manufacturing. I would say in Hoosick Falls, number one, the settlement was already reserved for when we announced the settlement. So that was part of our reserve. Every case is so different, Josh. There are so many facts and circumstances on each one of these cases. And as Mike has mentioned multiple times before, I would say 3M is driven by corporate responsibility, sound science, full transparency. So as we go through these cases, we'll definitely keep you in the loop. At the same time, I would encourage people to go look at our SEC filings to give you a lot of detail on the state of the cases. So we'll definitely keep everybody updated as things evolve. To your point on capital allocation, Josh, I just thought I'll hit that point, too, before we run out of time. I would just say no change to your point. Our plan always is first step is organic growth, because we just believe that's where you get the best return. You have seen us increase CapEx this year from historical. You have also seen us announce that we're going to invest $1 billion, mixture of CapEx and OpEx over the next few years, over the next 20 years, for us to become carbon-neutral. To increase our sustainability goals, you're going to see us front-run the CapEx side over the next few years. We'll tell you more in 2022, but we'll never feel shy to invest in growth because -- or sustainability, because we believe that gives us the best return. The second one is dividend. I know investors are -- care about the dividend. We know they do, and that's an important priority for us. So that's our second. Third is on the M&A side. We don't see currently an acquisition side of Acelity. But at the same time, we have a lot of activity. We are looking at acquisition targets all the time. And as long as it adds value to shareholders, as long as we believe that it adds value for us and we can add value to the target, we'll be open to it. And then the last priority for us is share buyback. Again, we've done approximately $730 million in the first half. Our plan there is to be active in the second half, depending how all things being equal, because we just feel that the stock is at attractive valuations. So we'll see how this plays out. But the goal for us always is continue to have a strong balance sheet. Our leverage ratio is down to 1.3 net debt to EBITDA versus 1.9 or as high as 2.3 sometime in December 2020. The model generates good cash, and our goal is to continue to have optionality. And I think where we are right now from our net debt-to-EBITDA leverage gives us a lot of optionality strategically [ and finish it ].

Excellent. Well, I see we're out of time. Monish, Bruce, thanks for joining us, as always, and providing a great start to the week here. And thanks to everybody on the line for joining us and for submitting your questions in through the portal. We'll leave it there. Thanks a lot, guys, as always. Be well.

Thanks for having us, Josh, and stay safe.

You too.