3M Company (NYSE:MMM) Morgan Stanley 10th Annual Laguna Conference September 14, 2022 11:45 AM ET
Company Participants
Monish Patolawala – Executive Vice President, Chief Financial and Transformation Officer
Kevin Rhodes – Executive Vice President and Chief Legal Affairs Officer
Conference Call Participants
Joshua Pokrzywinski – Morgan Stanley
Joshua Pokrzywinski
Okay, welcome back, everybody. Joining us next for our next fireside chat is 3M. And we’re pleased to welcome this morning, EVP, Chief Financial and Transformation Officer, Monish Patolawala; Kevin Rhodes, Chief Legal Officer, as well we have Bruce in the front row. He’s not joining us up on stage, but I’m sure he’ll they’ll dart eyes at me if I go off script too much. But really appreciate you guys join this. Monish, if you wouldn’t mind, just kind of set us up with what you guys are seeing out there and what you’re focused on at 3M these days.
Monish Patolawala
Thanks for having us. I have a few opening remarks and then Kevin is going to give a quick update. He’s our chief legal officer. A quick update on our litigation matters.
When I just look at the first half, 3M has continued to make tremendous progress and continue to strengthen the company for the long run. We have continued to work with our customers to make sure that we’ve delivered well for them. We have navigated a pretty difficult supply chain situation.
We’ve been pretty active on the portfolio side. We have announced the spin of our healthcare business. We just closed on September 1 the RMT with our food safety business. I’ll give you a little more detail on that. We’ve been active in acquisition. So, we closed the company called LeanTec in the auto aftermarket space. We have sold a couple of small businesses [indiscernible] floor care business as well as exited our consumer skin care business in Thailand.
At the same time, we’ve continued to invest in growth productivity and sustainability. We have made sure we’ve made progress on our sustainability trends, especially when you think about water and you think about water, air stewardship, as well as plastic reduction. We have worked and addressed the concerns of the Flemish government, the local Flemish government at Zwijndrecht. Our manufacturing facility is back up and running. We are ramping up pretty much as per plan.
And then, at the same time, we have tried to address some of our litigation risk by trying to resolve our Combat Arms litigation quite efficiently and equitably. Kevin’s going to give you a quick update on that.
So, that’s just – as we look at all the macro – at all the [indiscernible] in first half, if I go down to numbers, Josh, for the first half, good growth, 1.4%, but you have to exclude disposable respirators which we have declared coming in that that would be lower as the pandemic slowed down. So, if you exclude disposable respirators and the China COVID impact that happened in the second quarter, our total growth for the first half was nearly 4% growth, EPS at $5.13. We’ve continued in the first half, as I said before, investing in growth products and in sustainability. We have continued to drive margins to drive operating rigor. We were at 21.2% for the first half.
And then, I know we don’t usually give quarterly guidance, Josh, but there’s been some questions where people wanted to know some trends that are going on in Q3. So, I thought I’ll address that in some form if it’s helpful for people.
So, as we reflect on Q3, I would say the revenue trends that we’re seeing are pretty similar to Q2 and pretty much what we thought coming into the quarter. So, I would start with that as the backdrop. And then you’ve got to adjust for some of the special items that have happened.
So, we closed the food safety transaction on September 1. We got $1 billion of cash and we were able to retire 16 million shares approximately. The impact of food safety is approximately $30 million to $35 million a month. So you will not see that revenue that happened in the month of September, and that’s approximately 40% EBITDA [indiscernible]. But you offset with the share buyback. And if you just remember, the share buyback, the way we report dilution or dilute EPS shares because it’s 12 months on average.
So, the impact for Q3 is approximately 2.5 million shares reduction. Because of that, impact on Q4 is 16 million shares, which is all the shares we retired. And for the year, it’s approximately one-third of that because, again, it’s a four month [indiscernible]. So, the impact on EPS is, on the food safety divestiture, approximately $0.01 negative in Q3, but it’s a $0.02 positive in Q4.
And with our Arrow subsidiary that has filed for Chapter 11, we will be deconsolidating that entity for financial reporting purposes. That has an impact of approximately $25 million of revenue in Q3 and a $0.01 headwind to the EPS because we won’t get [indiscernible]. So those are two tactical items.
I would say the other thing that we are seeing when we think about FX, FX continues to be a headwind. I think a lot of companies have talked about headwinds. FX on a year-over-year basis is nearly 5% on revenue impact and $0.10 on EPS. When you look at it sequentially, it is approximately $150 million to $200 million impact on revenue and $0.05 of headwind on EPS sequentially. We’ll see where the dollar goes. I don’t know if it’s just taking what the current spot rate is and looking at where it is.
We’re also working on the exit of our business in Russia. We were suspended in Russia since March. We’ve worked through what the details are, Our plan is to [indiscernible] Q3 and Q4. Most likely there’ll be a charge in Q3. It will be a GAAP charge. Most of it is non-cash, but it won’t have an impact [indiscernible].
The food safety business also will have a gain and that gain will also – which will get booked in the third quarter, but that also will get adjusted for [indiscernible]. And then when I go around the business and I look at all the business profiles, Safety and Industrial, pretty much to what we saw in Q2. Disposable respirators is still down $100 million to $200 million on a year-over-year basis.
Transportation and electronics, we have seen consumer electronics to be much softer than what we thought coming into the quarter. But auto is continuing to remain robust. We have seen IHS build rates to be projecting approximately 20% up in Q3. But you got to remember, you’re coming off a very low comp last year. And then for the first half versus second half, auto build rate as per IHS is on 8% [indiscernible]
Then if I go to health care, health care is pretty much in that 90% to 95% of pre-pandemic levels on elective procedures. What we’re also seeing is that you’ve got global staffing shortages that are impacting the pace of elective procedures. We still believe that, in the long term, these elective procedures would cross 100% of pre-pandemic levels. The question is how those systems settle itself out.
And then on the Consumer side, [indiscernible] and I think we’re watching the different retail channels and the different [indiscernible] results. And at the same time, we keep watching what the inflation means on the Consumer and if Consumer are going to have a difference or not.
So when I put all that together, I would still say, we see good growth overall. We are continuing to drive operating rigor. We are continuing to deliver for our customers. We effectively used the tools [indiscernible] price to offset inflation in the first half. We’re see more inflation than we thought coming into the year, as I said in my earnings call a month and a half ago. We continue to see offsetting effects of price and other actions that we are taking.
And I would say sitting right now, we look at sequential margin improvement. It’s, again, something we talked about. And we are somewhere in that range of 21% to 21.5% for [indiscernible]. And then for the total year, we still continue to see ourselves in that range of guidance that we gave you.
And so, as we look at Q3, in total, you look at the overall macro trends and the long-term growth of macro margin expansion and strong cash, especially our focus on working capital, something that I think we’ll keep working on [indiscernible].
So, with that, I’ll turn it over to Kevin to give you some updates on our litigation.
Kevin Rhodes
Yeah. Thanks, Monish. Josh, thanks for having us today. Happy to be here. Let me start with our Combat Arms, our earplugs litigation. And Monish referenced this, but just to sort of start at the beginning, the reason Arrow filed the Chapter 11 proceeding at the end of July was to bring some certainty and some finality to a litigation process that had been challenging to try to find certainty as part of that process, and there was no end in sight.
So, the goal of that filing is to reach a more efficient and equitable and expeditious resolution. And that would be in the form of some of the tools and processes that are available in the Chapter 11 proceeding, including the formation of a Settlement Trust funded by 3M, and we’ve made a billion dollar commitment to that trust, so that claimants seeking compensation can present their claims to the trust and those entitled to compensation will be compensated from the trust in a way that’s equitable. Claimants with similar types of cases will receive similar compensation in a more efficient and more prompt way than litigating those cases, case by case through the litigation process for years to come.
So there’s been I know a lot of commentary about one of the initial rulings from the bankruptcy court, in which the state of litigation that automatically applies to Arrow as the filing entity, the debtor in the proceeding, whether that stay would be extended to 3M and the bankruptcy court declined to extend the stay of litigation to 3M.
So, let’s put that into context. That’s just one ruling in a very complex process. That was an initial ruling that was procedural in nature as to the extent of the state of litigation that didn’t reach any of the underlying issues in the case. The court did not rely on the ability to reach the goals that I just outlined, to establish the trust, to have claims go against the trust, rather than into litigation, all of those goals are still in front of us and still achievable and we are confident in our legal position and resolute in continuing that process.
Now, to be clear, we think the bankruptcy court ruling was wrong, and we have appealed it. And just yesterday, we heard from the bankruptcy courts that it had certified a review of that decision up to the Seventh Circuit Court of Appeals in Chicago. So that skips a step and goes all the way up to the Seventh Circuit. And we’re pleased we had asked for that. We filed a motion seeking that because we believe that Seventh Circuit and other law and a number of Chapter 11 proceedings supports that the state of litigation should be extended to 3M as a funding entity to put into place the trust and the settlement that will resolve the Chapter 11 proceeding. So, we look forward to presenting our arguments to the Seventh Circuit and our best estimate at this point is maybe four to six months we’ll have a ruling from the Court of Appeals on that decision.
But to be clear, we’re not waiting. The case is not on hold. We’re going to move forward while that appeal is pending and we’re able to do that. And first and foremost, Arrow will be moving in the bankruptcy proceeding to the claims estimation process, which really is the foundation for establishment of the trust and for compensation to claimants who are seeking it from the trust. And Arrow’s estimation and the corresponding funding commitment by 3M $1 billion is based on expert analysis from the claims estimation firm of Bates White, and that firm, and the expert involved. Dr. Charles H. Mullen, has been involved in a number of the leading bankruptcy cases through the years and that work has been reviewed and endorsed by a number of bankruptcy courts. Same analysis here.
What the funding commitment and the claims estimation is based on is an actual review of hearing test data from the claims in the case. So the actual review of alleged hearing loss by the plaintiffs in the case, comparison of that data to generally accepted measurement of hearing loss from – not from a litigation context, but rather from the World Health Organization, from the American Medical Association, further quantify those claimants who would have hearing loss that would be entitled to seek compensation provided that they could prove the other elements of causation and that they used the earplugs and used our earplugs and the like. And so, that’s really the foundation for the process going forward in the bankruptcy court, to establish the funding that will be necessary for the trust.
And just a point to remember, when you hear us talk about claims estimation, the numbers you’ll hear, the analysis that you’ll hear from Arrow and 3M really is based on that analytical review of actual hearing loss data. Other estimates that may be out there are not based on that same kind of analytics. Typically, they may be based on extrapolation from some of the bellwether trial results from the multi district litigation proceedings.
And keep in mind that all of those are on appeal. We have not had an opportunity to present what we believe is all of our legal defenses and a complete evidentiary record in those cases.
And more important, the bellwether case selection process was not entirely random. So there’s a subset of cases that were selected for the bellwether pool that then became the 27 plaintiffs that that had bellwether decisions by way of trial or dismissal. And by the way, 14 of the 27 came away with no compensation and the other 13 had wildly different amounts of compensation. So, that’s why we’re trying to bring more certainty and equity across the claimant pool. But you can’t just extrapolate those results because that was not a representative sample of the claims across the entire docket. So, that’s the claims estimation process that Arrow will be pushing forward through the Chapter 11 proceeding.
At the same time, we’re encouraged. We came into this knowing that many, if not most, Chapter 11 proceedings are resolved through negotiation and a mediation framework is essential to get those negotiations started to make them productive. That’s something that we’ve been asking from the outset of the case. And we’re pleased that the mediation process is now beginning so early in the case and it will commence as early as this week with the first steps and then will continue. And we’re encouraged that as that mediation continues, we’ll have involvement and input from an experienced bankruptcy court, a judge who can talk about how some of the tools and procedures available in the Chapter 11 process can provide the kind of certainty, equity, efficiency that we’ve been talking about to resolve this matter. So, we’re encouraged by this mediation. We look forward to participating in it. It’s something that we have anticipated and have been asking for, and we think it’s the path forward. And we hope all parties will come together to really focus on that as a way to resolve this.
In the MDL proceeding, with that continuing and not being stayed as 3M, I should mention there’s one additional MDL trial currently scheduled that set to begin on October 24. Make no mistake, we wish that the MDL would be stayed because we don’t think further trials on top of the 16 that we’ve already had is not the way to resolve this matter, but rather than the claims estimation and the negotiation that we’re undertaking is and that’s what we’re going to be focused on, but we’ll be prepared to defend that case on October 24 as well.
So maybe just conclude with – that’s it for combat arms for now. Of course, we’ll keep you updated as developments warrant.
Maybe a few comments PFAS. We continue to deal with those matters on multiple fronts, including our environmental stewardship commitments to make sure that our ongoing operations are compliant and using the best available technology to control the impact of our operations. We continue to seek to resolve, as Monish mentioned, issues around our historical manufacturing sites, including Belgium and others. And we’re defending ourselves in the litigation that has arisen and will continue to do so, while looking for opportunities to resolve cases where they make sense. So we continue to seek resolution for matters where that’s achievable. And we think in the right way, while we litigate other matters. And the matter that I know a number of you have asked about is the AFF, that is the aqueous film forming foam that’s used for – was used for firefighting applications that multi district litigation in South Carolina is proceeding. It’s in the pre-trial stages right now. The court currently has set a date of April 1, 2023 for the first of the bellwether trials. That trial is to try to assess the state of the cases in the docket. The first bellwether trial is scheduled for April 1, 2023. And it will be a public water supplier case. So, a case of a public water supplier to be determined, which case the court is reviewing that with allegations about cleanup that’d be necessary for that public water supplier. So, that’s a really brief update on where we are on the PFAS side docket as well.
Joshua Pokrzywinski
That was a great overview by both of you guys. I appreciate that. I do still have some questions left, even though you had a lot of opening remarks. Maybe just to start off, Monish, you gave us kind of a good round up on summary of what you’re seeing in some of the businesses. Maybe kind of approaching it the same way geographically, I think everyone is sort of a little bit shell shocked that Europe is holding in as well as it is. And we’ve heard that from most folks. You guys obviously have a lot of diversity in – or shorter cycle. What are you seeing there in that business? And maybe kind of same observation on China as they ramp back up after lockdowns.
Monish Patolawala
So I’ll start with Europe. As you all know, we’ve been watching it as much as everyone else is. We are in close contact with our customers and suppliers. Just watching how this plays out. There was a lot of discussion around energy and what it means for our customers and our suppliers. We have seen, the last few months, a lot of the customer suppliers are focused on different sources of supply and how do they get sources of supply. At the same time, the last few weeks, I think they’ve moved a lot more into what’s the cost of energy. So you’re seeing spot prices have gone up tremendously in there.
We are also seeing, as many of you will have also seen or follow, a lot of these large end markets are getting impacted by what’s going on in Europe, especially the auto builds are much lower in Europe because of what’s going on there.
At the same time, we have a pretty close partnership with customer suppliers. We making sure that our own factories continue to keep running. And that’s what we’re focused on, is continuing to drive production, keeping our production factories running, but at the same time partnering closely with customers to make sure we’re supplying what they need when they need it.
Joshua Pokrzywinski
Is there any sort of – and I asked this in the last session as well. Is there a sense of urgency on your customers to sort of work down backlog or get as much product out the door while they can since they don’t know the future around are they going to have supply when winter comes?
Monish Patolawala
I would say they’re doing what they need to do to manage their business and we are closely partnering with them. They have been looking at different sources of supply to ensure that their factories keep running and that’s what they’re focused on.
And then I come to China, your question on China, when we came into the second quarter, Josh, we had said that China COVID shutdown will cost us approximately $300 million of revenue. The team did a marvelous job once China opened up to reduce that to $140 million which we had disclosed during earnings. And we had said we see that backlog recovering over the next two quarters. And we’re seeing that pretty much play out. But I think we’ll have to wait and watch what these COVID shutdowns mean, how deep they are and how wide they are. And that will I think definitely again have an impact on supply chains.
What I know is our businesses prioritize where we are investing in China. 50% of our revenue actually gets exported out of China again because it’s used for OEMs who use our product and then that final product gets shipped out. Our healthcare business continues to remain strong in China. And if there is an unfortunate event where things shut down, I know our teams are on the ground there that when they reopen they’ll do the best they can to get the product out for our customers. So we’re seeing pretty much what it’s playing out right now.
Joshua Pokrzywinski
Got it. That’s helpful. You mentioned supply a little bit on the Europe commentary. I think, more broadly for 3M, your supply chain focus would be different than a lot of other folks up here who have a lot of chips content, more kind of direct material conversion. How has that played out? I guess, maybe, didn’t seem like it was as acute as the chip situation. But you guys kind of have this 1000 points of light for input costs, like how would you sort of rate those today in terms of the performance.
So I would say it’s still as volatile as it was. You have seen pockets of improvement, but then you see other pockets slow down. At any point in time, we are working with 100 to 150 suppliers at a point in time, making sure that they have a source of supply. And that material will come in on time to keep our factories running.
I think for everyone to feel better and to make sure the factory is running, you want to make sure you have a sustained improvement in supply chain. And we haven’t yet seen a sustained improvement. So you see areas where it does improve and it gets worse.
But at the end of the day, what we are doing, Josh, right now is our focus is just driving what we can to make sure our customers are taken care of. It has costed us a few points of gross margin because we have to airfreight product as needed to make sure our customer is taken, but in the long run we’ll recover all of that. So I’m not too worried. But I think success will be for the world is to see a sustained improvement in supply chain that will have an impact even on the inflation that the world is seeing.
Joshua Pokrzywinski
Got it that’s helpful. Maybe switching over to transformation. I know it’s a big part of your role. Since the start of the pandemic, which I guess is the start of your own tenure, what are the biggest kind of pieces of evidence of transformation?
Monish Patolawala
Yeah. So, before my time itself, Mike had announced the change in the business model. It was just before the pandemic, where we moved the business to four customer-facing units, which you all know – Safety and Industrial, Transportation, Health Care, and Consumer, all based on different end market behavior. So one’s a distributor based business all the way to a consumer based business.
As a part of that, we also had supply chain, which at 3M we call enterprise operations which includes sourcing and manufacturing and customer service and put that as a horizontal pipe that goes across all of this.
The purpose of that and the theory of that was, when you start seeing things horizontally, you can take better action because you’re doing end to end manufacturing or end to end supply chain.
Through the pandemic, we have actually strengthened that. So, we are able to see more customer trends quicker. And that’s why when we talk about investment in growth where in areas like auto electrification, personal safety, digital, home improvement, and healthcare are all we’ve been able to see very clearly by business unit where they are.
Secondly, using digital as a method, we have been able to look at the horizontal supply chain and I would say applied in two areas. One is starting to look at where inventory is, and where inventory should be to make sure we have the right inventory in places. Now, the pandemic has thrown this off a little bit, but we have the platforms and tools that can do it. And secondly is just making sure we’re using smart factory, digital, whichever word you call it, that allows us to start using data and data analytics to improve yield and efficiency.
So for example, the same tools that were used to increase the output of N95 masks to the pandemic, which was a high acceleration of production, is being used for the volume increase in our filtrate brand from our consumer filters, which is also allowing us get better yield and efficiency. So I would say that’s one layer of one area of transformation. We’ve been very active on the portfolio front. You’ve seen we’ve taken a few transactions because our belief is there’s a better owner, for example, food safety. The combination of food safety and Neogen is a great transaction for the food safety business, but also for Neogen as well as for customers. Because at the end of the day, it is setting up all these businesses for success. And so we’ve been active on the portfolio side.
And we are always, Josh, looking at efficiency when it comes to effectiveness and efficiency of organizational structure, which was also one of the hypothesis of making this change. So those are the three examples of how we’ve been moving ahead on our transformation journey.
Joshua Pokrzywinski
Got it. And then on the priority growth platforms that you guys have spoken about many times, I guess how much of 3M’s growth is really driven by those? And if I were to exclude those, are you happy with the growth on the rest?
Monish Patolawala
We would always love to get more growth. At the end of the day, we want to get growth above the macro. That gives us the best leverage. I’ve said that multiple times. But when I just reflect back and say okay, what are the trends coming out through the pandemic? I’ve already talked about some of those. What the teams are focused is on two things, Josh. One is making sure that the innovation that we’re doing, for example, these priority growth platforms are all helping to drive growth in areas that are all GDP plus growth. Example, biopharma. You know that industry is GDP plus growth. Similarly, look at personal safety, that’s also GDP plus growth. So we are making sure we’re investing in areas – auto electrification, GDP plus. So, that’s one.
And the second, we are saying let’s outperform the markets that we have in our commercial end platforms, whether it’s a [indiscernible], whether it’s in our CSD, business, etc. So when we put all of that together, I look at it and say, the opportunity to grow above the macro in the long run is there because of two big things – commercial intensities that helps us outperform in the markets that we are in with the platforms that we have. And the second is investing in products that have GDP plus growth.
Joshua Pokrzywinski
Thank you. So that’s – the kind of last couple questions I have for Kevin, and we get these a lot. I guess, first, anything around what you guys are experiencing through Combat Arms or PFAS that impacts the healthcare spin? And if that were to be something that would be kind of ruled on later, where does that get decided? And sort of what did they keep in mind when looking at that?
Kevin Rhodes
Thanks, Josh, for the question. The question comes from, there was a lawsuit that was filed earlier this month, seeking to link the two. We’ve been clear that the rationale for the Combat Arms and for the healthcare transaction, we talked about this back on earnings day of July 26 and I’ve talked about it since, they’re different rationale and they’re both intended to address different issues, with the healthcare spin-off directed toward maximizing the value of both companies, 3M and the health care newco, and then the Combat Arms as a way to, as I said, bring more efficiency and equity and certainty as finality to this process. So the lawsuit has been filed to seek to link the two. We think it’s without merit. We’ll be moving to dismiss. And we’re not changing course. We are proceeding as planned with the healthcare spin and anticipate, as we did, because we announced on the day of the announcement, 15, 18 months from the announcement, so that puts us toward the end of next year to complete that process.
Joshua Pokrzywinski
Got it. And then last question, just on Combat Arms, the bankruptcy decision, does that ultimately shorten the amount of time it takes to resolve this or reduce what you think kind of the total liability would be or both? And maybe saying that differently, like, if you were to get rulings against you or the kind of existing ruling upheld, is the risk more in time or cost?
Kevin Rhodes
Well, so to be clear, from the beginning, we’ve emphasized that the Arrow’s Chapter 11 filing is not an effort to avoid any liability that may be arising from this matter. It’s a way to provide more efficiency and determining who may be entitled to compensation in a more equitable way, and faster and more expeditious as compared to each of these claimants taking his or her chance in litigation over the coming years. So, the goal here is to bring more fairness, finality, and certainly to the process.
We’ve also looked at the amount that we think is appropriate to provide that full and fair compensation. And that’s the estimate that I talked about in the billion dollar funding commitment. We’ve made clear that if in the course of negotiations additional funding is needed to provide that finality to the matter, we’re prepared to do that, but we think a billion dollars is the number for the funding.
Question-and-Answer Session
Q –
Joshua Pokrzywinski
Terrific. Thank you both for joining us. Kevin. I know you’re kind of a rare attendance on the conference circuit. It’s immensely helpful given what’s going on strong. So, thank you both for joining us, and we’ll leave it there.
Monish Patolawala
Thanks for having.
Kevin Rhodes
Thanks.
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