3M (MMM 0.10%)
Q3 2022 Earnings Call
Oct 25, 2022, 9:00 a.m. ET

Table of Contents for 3M Q3 2022 Earnings Call:

• Overview of Prepared Remarks
• In-Depth Questions and Answers
• List of Call Participants

Key Insights from Prepared Remarks:

Operator

Welcome to the 3M third quarter earnings conference call. [Operator instructions] Please be advised that this conference call is being recorded on Tuesday, October 25, 2022. I would now like to pass the call to Bruce Jermeland, senior vice president of investor relations at 3M.

Bruce Jermeland — Senior Vice President, Investor Relations

Thank you, and good morning, everyone. We are pleased to welcome you to our third-quarter earnings conference call. Joining me today are Mike Roman, 3M’s chairman and chief executive officer, and Monish Patolawala, our chief financial and transformation officer. Mike and Monish will deliver some detailed comments, after which we will open the floor to your questions. For your convenience, today’s earnings release and the accompanying slide presentation are available on the homepage of our Investor Relations website at 3m.com.

Please direct your attention to Slide 2. I urge you to take a moment to review the forward-looking statement. During today’s call, we will be making various predictive statements reflecting our current outlook on 3M’s future performance and financial results. These statements are based on specific assumptions and expectations regarding future events that may involve risks and uncertainties.

For detailed risk factors that may impact our projections, please refer to Item 1A of our most recent Form 10-K. Additionally, throughout today’s presentation, we will reference certain non-GAAP financial measures. Reconciliation of these non-GAAP measures is available in the appendix of these slides and in the attachments accompanying today’s press release. With that, I will now turn the call over to Mike.

Mike?

Mike Roman — Chairman and Chief Executive Officer

Thank you, Bruce. Good morning, everyone, and I appreciate you joining us today. We are steadfast in executing our strategic initiatives aimed at delivering value to our customers, positioning 3M for sustainable long-term growth, and effectively managing our ongoing legal matters. Our team achieved organic growth of over 2%, exceeding 3% when excluding the decline in disposable respirator sales, with adjusted margins reaching 21.5%, an adjusted EPS of $2.69, and generating $1.4 billion in adjusted free cash flow.

Despite a softening global economic outlook, our businesses remain committed to innovation and are actively seizing opportunities. The transportation and electronics sectors experienced 3% organic growth, while safety and industrial, consumer, and healthcare each grew at 2%. All business groups reported margins exceeding 21%, with significant margin improvements particularly in safety and industrial, as well as transportation and electronics. Regionally, organic growth was notably led by the Asia-Pacific (APAC) region, which grew by 3%, with China showing an impressive 8% increase due to backlog recovery following the COVID-related lockdowns experienced earlier in the year.

In the Americas, growth was recorded at 2%, while the U.S. market remained flat compared to a robust 6% growth in Q3 of the previous year. The EMEA region reported flat growth as we navigate the ongoing geopolitical challenges affecting Europe. Simultaneously, we implemented operational enhancements to tackle inflationary pressures and supply chain disruptions.

We are committed to delivering strong pricing strategies, managing costs, and reducing inventory backlogs while maintaining an unwavering focus on customer service. A prime example of our initiatives is the recent establishment of a new shipping consolidation center in South Carolina, which has successfully shortened average export cycle times to Asia by one to two weeks. While some of these strategic actions have had a near-term impact on our margins, we remain resolute in prioritizing customer satisfaction. Looking ahead, we perceive a significant opportunity to lower the cost of goods sold and working capital as global supply chains improve, particularly by leveraging innovative data analytics to enhance productivity within our manufacturing facilities.

Regarding our guidance, we are updating our full-year expectations to align with our performance over the first nine months of the year, coupled with the strengthening of the U.S. dollar and ongoing macroeconomic uncertainties. Specifically, for organic growth, we are revising the upper range to reflect a 1.5% to 2% forecast, down from our previous expectation of 1.5% to 3.5%. We anticipate an adjusted EPS in the range of $10.10 to $10.35, slightly lowered from the previous range of $10.30 to $10.80.

We are also adjusting our forecast for adjusted free cash flow conversion to a range of 85% to 95%, down from the prior range of 90% to 100%. To fortify 3M for future growth, we are persisting in our investments aimed at enhancing productivity and sustainability. For instance, while we anticipate short-term softness in the consumer electronics sector, we are channeling investments into electronic segments witnessing robust growth, including innovative solutions for automotive displays and augmented reality. Furthermore, we have recently launched new thermal management solutions designed to enhance electric vehicle battery performance, a crucial component of our commitment to promoting sustainable vehicle designs.

Earlier this month, we also introduced a new posted app for Microsoft Teams, designed to facilitate collaboration in hybrid work environments as part of our digital transformation strategy. Our commitment to innovation extends to enhancing operational safety, efficiency, and productivity. At our Alexandria, Minnesota facility, we are employing 3M’s disruptive technologies to automate our abrasive belt converting process. This transformation has yielded a remarkable 32% improvement in labor productivity, eliminated nine high-risk tasks, and resulted in annual savings of nearly $1 million. We have several similar initiatives underway across our global operations, driving both safety and operational efficiency.

In terms of sustainability, we have implemented a cutting-edge water filtration system at our facility in Cordoba, Illinois. This initiative ensures that all three of our largest water-consuming sites in the U.S. are equipped with industry-leading filtration technologies, fulfilling our $1 billion sustainability commitment made last year. Concurrently, we are strategically positioning 3M for long-term success by actively managing our portfolio, complementing our organic growth initiatives. Last month, we successfully completed the divestiture of our food safety business, unlocking value and further strengthening our financial position.

We received approximately $1 billion from this divestiture and reduced our outstanding share count by 16 million shares. Additionally, we divested two skincare brands in Southeast Asia earlier this month, allowing us to prioritize other areas of our consumer portfolio. We have also established a dedicated team to facilitate a smooth execution of our healthcare spin-off. We are confident in our strategy to create two world-class public companies with increased focus, thereby enhancing our capacity to drive growth and innovation.

Before I hand the call over to Monish, I want to provide an update on our ongoing litigation matters, which remain a top priority for us. Regarding Combat Arms, the Aearo Technologies Chapter 11 proceedings are currently active and progressing. We believe this is the most effective path toward resolving claims in an equitable, efficient, prompt, and conclusive manner. That continues to be our objective—a resolution that is fair and provides certainty for all parties involved.

Aearo is actively participating in a confidential mediation process aimed at achieving a comprehensive settlement, and 3M is fully supporting those efforts. Furthermore, Aearo has appealed the bankruptcy court’s decision in August, which denied the extension of the litigation stay for 3M, and the Seventh Circuit has agreed to hear the appeal. In the multidistrict litigation (MDL), the next trial is scheduled for February of next year. We are also actively managing PFAS litigation.

Earlier this month, we reached a settlement with the city of Gadsden, Alabama, related to carpet manufacturing. The first ALF MDL trial is now slated for June of 2023. In summary, we remain committed to delivering exceptional value to our customers in an uncertain environment. I express my gratitude to our employees for their dedication and contributions, especially as we navigate significant transitions and position 3M for future success.

We will maintain our focus on driving growth, enhancing operational execution, and delivering greater value for our customers and shareholders. I will now pass the call to Monish for further insights on the quarter. Monish?

Monish Patolawala — Chief Financial and Transformation Officer

Thank you, Mike, and good morning to everyone. Please refer to Slide 4. Overall, the 3M team has delivered third-quarter sales and operating margins that align closely with my earlier comments made at a mid-September conference. However, there have been some fluctuations, particularly as demand in consumer and consumer electronics declined progressively over the quarter, while demand in industrial end markets has remained stable.

For the third quarter, total sales reached $8.6 billion, reflecting a decrease of 3.6% compared to the previous year. This decline was influenced by a 5.1% headwind, translating to a loss of $450 million due to foreign currency translation, along with a negative impact of 50 basis points or $50 million from the divestiture of our food safety segment, coupled with the deconsolidation of Aearo Technologies. On an organic basis, third-quarter sales increased by 2% year-over-year, despite an anticipated decline in disposable respirator demand, which negatively affected organic sales by approximately $130 million, accounting for 1.4 percentage points. Excluding this decline, Q3 organic sales growth was 3.4%.

On an adjusted basis, third-quarter operating income stood at $1.9 billion, with operating margins reaching 21.5%, marking an increase of 40 basis points year-over-year and 50 basis points sequentially. Adjusted earnings for the quarter were reported at $2.69, compared to $2.58 last year. Turning to the key contributors impacting third-quarter operating margins and year-over-year performance, you may recall that during our Investor Day in February, we unveiled our operational framework and principles focusing on daily management, data democratization, transparency, and accountability.

We have made significant progress in consistently applying this framework. By embracing these principles and implementing self-help strategies, our team executed effectively during the quarter despite navigating a challenging macro and geopolitical landscape. We have concentrated on serving our customers while driving additional initiatives, including recovering our sales backlog in China following the COVID-related lockdowns earlier this year, implementing appropriate pricing strategies to mitigate ongoing inflation, maintaining stringent spending discipline, and executing targeted productivity measures to adapt our businesses to evolving market demands while promoting simplification. These efforts have more than compensated for various headwinds faced during the quarter, including the decline in disposable respirator sales, which negatively impacted Q3 operating margins by 30 basis points and earnings per share by $0.07.

Moreover, we have encountered incremental softness in end markets, particularly within consumer electronics, alongside challenges in oral care and consumer retail in the U.S. driven by persistent inflationary pressures that are dampening consumer spending. Global supply chain challenges and raw material constraints have also posed significant challenges. Additionally, geopolitical factors, especially in Russia, negatively impacted revenue by approximately $50 million and earnings per share by $0.03 year-over-year.

In total, our operational framework and self-help initiatives yielded a net benefit to operating margins of 2.9 percentage points and an increase of $0.41 to earnings per share. Moving on to raw material and logistics inflation, as I have mentioned over the past several quarters, inflationary pressures remain pronounced and widespread. Consequently, we continue to face year-over-year headwinds with a Q3 cost increase of approximately $225 million, representing a negative impact of 2.6 percentage points on operating margins and $0.31 on earnings per share.

Our full-year estimate for raw materials and logistics inflation remains unchanged at approximately $750 million to $850 million. As previously stated, we are committed to offsetting this through strategic pricing actions. The strength of the U.S. dollar has continued to exert pressure on total revenue, resulting in a negative impact of 5% from foreign currency translation.

As a result, we experienced a positive effect of 10 basis points on margins but incurred a headwind of $0.12 on earnings per share. As Mike mentioned earlier, we have been actively managing our portfolio. On September 1, we completed the divestiture of our food safety segment, resulting in approximately $1 billion in proceeds, and we reduced our outstanding share count by 16 million through an exchange offer. However, we lost one month of sales and income from food safety during the quarter.

Consequently, the loss of sales and income from food safety, along with the deconsolidation of Aearo Technologies, resulted in a year-over-year headwind of $0.02 on earnings per share this quarter. Lastly, other financial items contributed a net increase of $0.15 per share year-on-year, primarily driven by benefits from a reduced share count and a lower-than-expected tax rate. The lower adjusted tax rate for the third quarter was largely the outcome of favorable resolutions from prior-year audit settlements and favorable geographic income distribution. For the full year, we now expect our adjusted tax rate to fall within the range of 17.5% to 18.5%, down from the previous expectation of 18.5% to 19.5%.

Please refer to Slide 5. Our third-quarter adjusted free cash flow amounted to $1.4 billion with a conversion rate of 88%, reflecting an improvement from our first-half performance as we continue to enhance working capital efficiency, including improved inventory levels while also increasing capital expenditures for growth and sustainability initiatives. We remain focused on improving working capital as we navigate a dynamic supply chain environment. Despite ongoing challenges, we are witnessing benefits from our efforts as we leverage data and analytics to reduce inventory levels through refined demand planning and optimized customer payment terms.

We expect to continue realizing benefits from these actions as we move forward. Capital expenditures for the quarter totaled $435 million, bringing the year-to-date total to $1.2 billion, representing a 19% increase year-over-year as we continue to invest in growth, productivity, and sustainability. Based on our assessment of supply chain conditions and project timelines, we now anticipate full-year capital expenditure investments in the range of $1.75 billion to $1.85 billion. During the quarter, we returned $1 billion to our shareholders through a combination of cash dividends totaling $850 million and share repurchases amounting to $155 million.

On a year-to-date basis, we have returned $3.5 billion to shareholders, including $2.6 billion in dividends and $900 million in share repurchases. Additionally, we reduced our outstanding share count by 16 million shares through an exchange offer associated with the food safety divestiture. Both dividends and share repurchases remain integral components of our capital allocation strategy. We continue to view the current stock value as an attractive opportunity and have resumed share repurchase activities following the food safety divestiture.

Maintaining a strong balance sheet and capital structure remains a top priority for 3M, as it provides us the flexibility to invest in the business organically, pursue strategic mergers and acquisitions, and return cash to shareholders while effectively managing legal challenges. As of the end of Q3, our net debt stood at $12.1 billion, down 3% year-over-year and over 30% since 2019. Please refer to Slide 7 for an overview of our business group’s performance for Q3. I will begin with our Safety and Industrial business, which recorded sales of $2.9 billion, reflecting a 1.7% organic growth compared to last year’s third quarter.

This performance included a year-on-year headwind of approximately $130 million due to the ongoing decline in demand for disposable respirators. Excluding the impact of disposable respirators, Safety and Industrial achieved Q3 organic growth exceeding 6%, driven by broad-based performance and backlog recovery in China following the April and May COVID-related lockdowns. Our personal safety segment saw a low double-digit decline organically, primarily attributed to reduced demand for COVID-related disposable respirators. Analyzing the remainder of the safety and industrial portfolio, organic growth was led by double-digit increases in both automotive aftermarket and roofing granules. Electrical markets and abrasives experienced high single-digit growth, while closure and masking systems, as well as industrial adhesives and tapes, delivered mid-single-digit growth. Operationally, the Safety and Industrial team executed exceptionally well during the third quarter, achieving adjusted operating income of $673 million, an increase of 8% compared to last year, and a sequential rise of 7% over Q2. Adjusted operating margins reached 23.2%, up 2.5 percentage points as the team effectively managed inflation through strategic pricing and operational efficiencies while maintaining strong spending discipline.

The safety and industrial business group remains committed to investing for the future, including digital platforms such as Repair Stack for connected automotive body shops and sustainable solutions such as thermal barriers for automotive electrification. Moving to the transportation and electronics sector, which achieved sales of $2.2 billion, reflecting a 3% organic growth compared to the previous year. This overall growth was bolstered by the recovery of COVID-related backlogs in the Greater China region, though it was partially offset by increased weakness in consumer electronics demand and ongoing constraints within the semiconductor supply chain. Our electronics-related business experienced a mid-single-digit organic decline, primarily attributed to decreases in consumer electronics, especially smartphones, tablets, and TVs.

These declines were somewhat mitigated by sustained strong demand for our solutions in the semiconductor, factory automation, and automotive end markets. Organic sales in our auto OEM business rose by 21% year-over-year compared to an estimated 27% increase in car and light truck productions. Notably, we outperformed last year’s Q3 production rate by nearly 20 percentage points, benefiting from a channel inventory build that was unwound in Q4 of the previous year. In the remainder of the transportation and electronics sector, commercial solutions experienced high single-digit organic growth, while advanced materials saw mid-single-digit growth, and transportation safety posted a low single-digit decline. Despite the prevailing fluidity in end markets, the transportation and electronics team delivered strong operational performance. Q3 operating income climbed 9% to $474 million, with operating margins at 21.2%, an increase of 2.5 percentage points year-over-year. The operating margins benefited from effective pricing strategies as we navigated inflationary pressures while exercising strong spending discipline.

The transportation and electronics business group is proactively investing to address some of the most pressing challenges in the market while also executing strategies for future growth. For instance, in Q3, we inaugurated a new battery component testing lab to capitalize on the accelerating opportunities in automotive electrification. Turning to our healthcare segment, which generated Q3 sales of $2.1 billion with organic growth of 1.7% compared to last year’s strong 8% growth. Our medical solutions, food safety, separation and purification, and health information systems businesses all recorded low single-digit organic growth.

While we did experience organic growth in separation and purification year-over-year, the biopharma sector in the U.S. faced declines due to last year’s robust demand for COVID therapeutics. In the third quarter, elective medical procedure volumes were approximately 90% of pre-COVID levels, reflecting a dip in July followed by a gradual ramp-up throughout the quarter. Fourth-quarter procedure volumes are currently projected to be between 90% and 95% of pre-COVID levels as labor shortages continue to affect the recovery pace.

Oral care witnessed a mid-single-digit decline compared to last year’s low double-digit growth. The ongoing inflationary pressures are impacting consumer spending on discretionary oral care and orthodontic procedures. The healthcare segment’s third-quarter operating income amounted to $452 million, marking an 11% decline year-over-year. Operating margins were reported at 21.8%, down 1.7 percentage points, with adjusted EBITDA margins exceeding 29%.

Year-over-year operating margins were affected by increased raw material and logistics costs, coupled with manufacturing productivity challenges. These impacts were partially offset by strategic pricing measures and disciplined spending. The healthcare business group is committed to delivering innovative solutions, including investments in the launch of the 3M Filltech matrix, which introduces a novel approach to dental restorations, simplifying procedures and allowing for greater preservation of natural tooth structure. Additionally, we have made capital investments to support capacity expansions in the separation and purification and medical solutions sectors.

Finally, our consumer business recorded third-quarter sales of $1.4 billion, reflecting a 1.5% year-over-year organic growth compared to last year’s 8% growth. Year-over-year growth in the third quarter was primarily driven by consumer health and safety, which posted mid-single-digit organic growth, alongside stationery and office products, as well as home care, which both experienced low single-digit growth. Home improvement growth declined by low single digits organically compared to last year’s strong results but witnessed a mid-teens sequential increase. The back-to-school season was softer than anticipated, as consumer spending continues to be influenced by ongoing inflationary pressures, alongside retailers aggressively managing elevated inventory levels.

Looking ahead, we expect these impacts to persist throughout the upcoming holiday season. The consumer segment’s third-quarter operating income was $299 million, reflecting a 3% decline relative to the previous year, with operating margins at 21.3%, slightly down year-over-year. Operating margins in the consumer business benefited from strategic pricing actions, disciplined spending, and restructuring efforts. However, these benefits were more than offset by rising raw material, logistics, outsourced manufacturing costs, and challenges in manufacturing productivity.

The consumer business group is actively pursuing future growth opportunities, including the expansion of our command platform to assist consumers with hanging, organizing, and decorating in even more creative ways. Please refer to Slide 9 for an overview of our 2022 outlook. The macroeconomic environment remains uncertain, with mixed trends and signals across various geographies and end markets. While we are actively addressing these challenges and implementing strategic actions, we are updating our full-year guidance to reflect our year-to-date performance, alongside the strengthening U.S. dollar and the fluid nature of the current economic environment.

Our updated 2022 full-year outlook anticipates organic growth in the range of 1.5% to 2%, compared to the prior range of 1.5% to 3.5%. Adjusted earnings are now expected to fall within the range