3M Company

Ladies and gentlemen, thank you for standing by. Welcome to the 3M Fourth Quarter Earnings Conference Call. During the presentation, all participants will be in the listen-only mode. Afterwards, we will conduct a question and answer session. At that time, if you have a question, please press the one followed by the four on your telephone keypad. It is recommended that you use a landline phone if you're going to register for a question. As a reminder, this conference is being recorded Tuesday, January 29th, 2019. I would now like to turn the call over to Bruce Germiland, Director of Investor Relations at 3M.

Thank you and good morning, everyone. Welcome to our Fourth Quarter 2018 Business Review. With me today are Mike Roman, 3M's Chief Executive Officer, and Nick Gangsted, our Chief Financial Officer. Mike and Nick will make some formal comments and then we'll take your questions. Please note that today's earnings release and slide presentation accompanying this call are posted on our Investor Relations website at 3M.com under the heading Quarterly Earnings. Please turn to slide two. Before we begin, let me remind you of the dates for our 2019 Quarterly Earnings Conference Calls, which will be held on April 25th, July 25th, and October 24th. Please take a moment to read the forward-looking statement on slide three. During today's conference call, we will 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 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. Finally, please note that throughout today's presentation, we'll be making references to certain non-GAAP financial measures. Reconciliation of the non-GAAP measures can be found in the appendix of today's presentation and press release. Please turn to slide four, and I'll hand it off to Mike. Mike? Thank you, Bruce.

Good morning, everyone,

and

thank you for joining us. I will open with a brief summary of our fourth quarter, and later in the call, I will come back to discuss our full-year performance along with our outlook for 2019. 3M executed well in the fourth quarter, with results that were in line with our expectations. We delivered organic growth across all business groups and geographic areas, along with a double-digit increase in both cash flow and adjusted earnings. Looking at the numbers, total sales in the quarter were $7.9 billion. We posted organic growth of 3%, which is on top of 6% growth in last year's fourth quarter. Growth was led by our health care business group, which grew 5% organically, along with electronics and energy, which grew 4%. With respect to EPS, our team delivered adjusted earnings of $2.31 per share, up 10% year over year. This includes a 2-cent net benefit from a divestiture, which Nick will cover in more detail. The strength of our value model is in enabling us to consistently generate premium margins and healthy cash flow. Margins in the quarter were more than 22%, with all of our business groups above 21%. Cash flow increased by 23% year over year, with a conversion rate of 128%. Finally, in the fourth quarter, we returned $2.1 billion to our shareholders, through both dividends and share repurchases. That concludes my opening comments. I will now turn the call over to Nick, who will take us through the details of the quarter.

Nick. Thank you, Mike, and good morning, everyone. Please turn to slide five. Organic sales growth in the fourth quarter was 3%, with volumes up 160 basis points, and selling prices up 140 basis points. The communication markets divestiture reduced sales by 1.3 percentage points, while foreign currency translation was an additional 2.3 percentage point headwind to sales. All in, fourth quarter sales in U.S. dollars declined 60 basis points versus last year. Geographically, the U.S. grew .4% organically, with broad base growth across all business groups. Latin America Canada was up 5% organically, with broad base growth across Canada, Mexico, and Brazil. Asia Pacific grew organically 2% in Q4, led by double digit increase in health care, and mid single digit growth in electronics and energy. Organic growth was up 1% in China Hong Kong, versus 18% a year ago. China Hong Kong organic growth was led by health care and electronics and energy, while safety and graphics and consumer declined. Finally, organic growth was up .3% in EMEA, with West Europe flat. EMEA was led by mid single digit growth in both health care and safety and graphics, while consumer and electronics and energy declined. Please turn to slide six for the fourth quarter P&L highlights. Companywide, fourth quarter sales were $7.9 billion, with operating income of $1.8 billion, and operating margins of 22.4%. On the right hand side of this slide, you can see the components of our margin performance in the fourth quarter. Organic volume, productivity, and lower year on year portfolio and footprint actions added 100 basis points to margins. Lower year on year divestiture gains, net of actions reduced margins by 130 basis points. Higher selling prices continued to more than offset raw material inflation, contributing 20 basis points to fourth quarter margins. Finally, foreign currency net of hedging impacts increased margins by an additional 10 basis points. Let's now turn to slide seven for a closer look at earnings per share. Fourth quarter gap earnings were $2.27 per share. Please note that this result included a couple items that were not included in our guidance. First, during the quarter, we recorded a net 4-cent tax charge. This charge relates to the transition tax and the deductibility of our Q1 2018 legal settlement associated with the Tax Cuts and Jobs Act. Secondly, we completed the final piece of the communication markets divestiture, resulting in a net 2-cent earnings benefit. Taking into account these items, fourth quarter underlying earnings were $2.29 per share. As you see, a number of factors impacted fourth quarter earnings. The benefits of organic growth, productivity, and lower year on year portfolio and footprint actions added a combined 18 cents to per share earnings in the quarter. Lower year on year divestiture gains, net of related actions, reduced fourth quarter earnings by 13 cents per share versus last year. Foreign currency net of hedging was an additional 3 cents per share earnings headwind in the quarter. Other expense contributed 6 cents to earnings year on year. As higher Q4 2018 retirement expense and underlying net interest expense was more than offset by last year's fourth quarter repurchase of high coupon debt. Our underlying tax rate was lower year on year, which added 5 cents to Q4 earnings. And finally, average diluted shares outstanding declined by over 3% versus Q4 last year, adding an additional 8 cents to per share earnings. Please turn to slide 8 for a look at our cash flow performance. Fourth quarter free cash flow was $1.7 billion, up 23% year on year with a free cash flow conversion rate of 128%. Fourth quarter capital expenditures were $531 million, with the full year totaling $1.6 billion. Also during the fourth quarter, we returned $2.1 billion to shareholders via dividends and gross share repurchases. Let's now review our business group performance starting with industrial on slide 9. The industrial business delivered organic growth of .5% in Q4 and .2% for the year. With growth across all geographic areas for the quarter and full year. Growth was led by advanced materials of double digit, followed by low single digit growth in industrial adhesives and tapes, separation and purification, abrasives, and automotive aftermarket. Our automotive OEM business was down 1% year on year versus a 5% decline in fourth quarter global car and light truck builds. For both the quarter and the full year, our auto OEM business outperformed global car and light truck builds by 400 basis points, continuing our long track record of outperformance. On a geographic basis, industrial's organic growth was led by a 4% increase in the U.S., while the other three geographic areas each grew low single digits. Industrial delivered fourth quarter operating income of $627 million, with an operating margin of 21.2%. Underlying margins were up 40 basis points year on year, adjusting for last year's portfolio and footprint actions. Please turn to slide 10. Fourth quarter safety and graphic sales grew .3% organically versus in an 11% comparison. For the full year, safety and graphics was up 5.1%. Growth was led by our personal safety business, up 7% organically. Scott's safety continues to do well with strong double digit growth in Q4. Commercial solutions grew low single digits, while transportation safety declined mid single digits. Finally, our roofing granules business declined low teams as shingle manufacturers continued with lower production volumes in the quarter. Geographically, organic growth was led by a 7% increase in Latin America, Canada, followed by the U.S. and EMEA, which were each up 5%. Operating income in the fourth quarter was $345 million, with operating margins of 22%. Underlying margins were down 110 basis points year on year, due to the sales decline in roofing granules, along with some additional fourth quarter actions. Please turn to slide 11. Our healthcare business generated fourth quarter sales of $1.5 billion, up .8% organically. In Q4, our medical solutions business posted mid single digit organic growth, with particular strength in vascular access and securement solutions. Oral care grew 4% in the quarter, with positive growth in both the U.S. and international. Our 3M Clarity clear tray aligners launch continues to build momentum. Fourth quarter organic growth was led by a high single digit increase in food safety, followed by mid single digit growth in health information systems. On a geographic basis, healthcare grew across all areas, with continued strength in developing markets, led by China-Hong Kong up 18% in the quarter. Healthcare's fourth quarter operating income was $458 million, with margins of 30.2%. We continue to focus on investing in our priority growth platforms, in advanced wound care, population health, and custom orthodontics. Next, let's cover electronics and energy on slide 12. Electronics and energy finished the year with solid fourth quarter organic sales of $1.5 growth of 4.1%. The electronics side of the business delivered fourth quarter organic growth of 3%, with similar growth in both electronic materials and display solutions. On the energy side of the business, sales were up 5% organically, with strong growth in both grid modernization and renewable energy. On a geographic basis, organic growth was up 2.5%. The electronics side of the business was led by a 7% increase in Latin America-Canada, while both the U.S. and Asia Pacific were up mid single digits. Fourth quarter operating income for electronics and energy was $396 million, with operating margins of 29.5%. Please turn to slide 13. Fourth quarter sales and consumer were $1.2 billion, with organic growth of .9% year on year. Growth was led by our home improvement business up mid single digits, and stationary in office was up low single digits, while home care and consumer health care declined. Looking at consumer geographically, organic growth was led by a 6% increase in Latin America-Canada, with the U.S. up 5%. EMEA declined 7% as we continue to adjust our product portfolio in this region. Lastly, Asia Pacific declined 5% as we continue to experience lower year on year demand for our consumer respiratory solutions, particularly in China-Hong Kong due to improved air quality. Finally, fourth quarter operating income was $257 million, with operating margins of 21.3%. That wraps up our review of fourth quarter results. Please turn to slide 14, and I'll hand it back over to Mike. Mike? Thank you,

Nick. The fourth quarter kept an important year for 3M as we posted good results and continued to transform for the future. We delivered organic growth of more than 3%, with growth across all business groups and geographic areas. We expanded GAAP earnings per share by more than 12% to $8.89, or $9.96 on an underlying basis. We posted free cash flow conversion of 91%, along with a return on invested capital of more than 22%. In 2018, we also delivered record sales of $33 billion while returning significant cash to our shareholders. All in, we returned $8.1 billion to shareholders through both dividends and share repurchases. And last year was our 60th consecutive year of dividend increases. Please turn to slide 15. Beyond financial results, in 2018, we continued to position 3M for long-term growth and value creation. This includes executing our four priorities, which I laid out at our investor day in November. I'll comment briefly on the impact of each priority, starting with portfolio. The ongoing review and reshaping of our portfolio is critical to maximizing value for our customers and shareholders. In 2018, for example, we sold our communication markets business. This builds on the portfolio work we've done over the last several years in electronics and energy, which has led to improved growth and margins. Last month, we also announced the acquisition of M.Model's technology business, which is a leading provider of AI-powered healthcare solutions. As you recall, two years ago, we decided to retain and further invest in our health information systems business. This acquisition builds on that commitment and will expand our ability to improve outcomes for both patients and providers. We expect this transaction to close in the first quarter, and its impact is reflected in our updated guidance for 2019, which I'll cover shortly. Turning now to transformation, which is fundamentally improving how we serve our customers, how we work, and how we compete. 2018 was an important year in our transformation journey. Our team executed our ERP deployment across all five business groups in the United States, which accounts for nearly 40% of our global sales. This was a significant undertaking. I commend our success. I thank our customers for working closely with us through this change. With the U.S. rollout, we have deployed approximately 70% of our global revenue on the new ERP system. We are now stepping up our efforts to fully leverage this progress and accelerate value realization for our customers and company. Ultimately, transformation is making 3M a more agile, more efficient, and more competitive enterprise. Our next priority is innovation. Innovation is fundamental to our organic growth and is key to our long track record of delivering premium margins and return on invested capital. It allows us to create unique, differentiated solutions for our customers, which leads to superior returns for our shareholders. In 2018, we continued to invest in both research and development and CAPEX, with accelerated investments in our priority growth platforms focused around healthcare, transportation, safety, and infrastructure. Technology is advancing rapidly in these market spaces, and 3M will continue to capitalize on opportunities as we move ahead. This brings me to people and culture, which is foundational to each of the other priorities. Everything that differentiates 3M, our technologies, our manufacturing, our global reach, our brand, starts with our people. In 2018, we expanded development opportunities for 3Mers, while launching initiatives to deepen our commitment to sustainability, diversity, and inclusion. We also earned a number of external recognitions, including being named one of the world's most ethical companies for the fifth straight year. In summary, our team made good progress on each of our priorities in 2018, and we are positioned for a successful 2019. Please turn to slide 16. As you recall, at our investor day in November, we laid out our guidance framework for 2019. Since then, there has been slowing in key end markets, with the biggest impact coming from China, automotive, and electronics. Therefore, we are widening our range for expected organic growth to 1 to 4 percent, against the prior range of 2 to 4 percent. We now anticipate EPS of $10.45 to $10.90, which includes a 10-cent earnings headwind from the M-Model acquisition, against a previous range of $10.60 to $11.05. Please note that the prior range did not include the M-Model impact. We continue to expect a return on invested capital of 22 to 25 percent, along with a free cash flow conversion rate of 95 to 105 percent. Please turn to slide 17. Here you see a breakdown of our expectations for organic growth, starting with our business groups. We expect organic growth to be led by health care, with a range of 3 to 5 percent, followed by safety and graphics at 2 to 5 percent. Organic growth in industrial is expected in the range of 1 to 4 percent, with electronics and energy at 0 to 4 percent, and consumer at 1 to 3 percent. Looking by geographic area, we expect organic growth in the United States of 2 to 4 percent, followed by EMEA at 1 to 3 percent. Organic growth in Asia Pacific is expected in the range of 1 to 5 percent, with Latin America, Canada at 3 to 5 percent. I'll now turn it back to Nick, who will provide some color on our 2019 outlook.

Nick. Thanks, Mike. Please turn to slide 18. Here are our key planning assumptions in 2019. Most of our key assumptions remain unchanged from what we discussed at our November Investor Day, with the exception of three items. First is the expanded full-year organic growth range that Mike just discussed. Second is in regards to our global pension expense. December's market volatility lowered our 2019 earnings benefit versus our expectation in November. And lastly, we are now including the estimated full-year growth and earnings impact from the pending and modal acquisition. Other items to note, we are forecasting full-year foreign currency translation to be a 1 percent headwind to sales, but neutral to earnings. Turning to raw materials, we do anticipate higher -on-year costs, including tariff impacts. However, we continue to expect our selling prices, along with our global sourcing team's ongoing productivity efforts, to more than offset the expected raw material headwinds. We estimate the 2019 impact from the pending and modal acquisition net of the communication markets divestiture to be neutral to sales and an earnings headwind of 15 cents per share. We continue to increase our efforts to accelerate benefits from transformation, portfolio and footprint optimization, along with our manufacturing and SG&A productivity. Lastly, we forecast our full-year tax rate to be 20 to 22 percent versus our 2018 underlying rate of 20 percent. I'll now move to our 2019 capital allocation plan on slide 19. Our strong operational cash flow fuels our capital allocation plan. We expect another year of strong cash flow from operations, with 2019 estimated to be between $9.5 billion and $10.5 billion prior to our investments in R&D and our global pension plans. All in, including cash, marketable securities and added leverage, our 2019 plan calls for $14.5 to $16.5 billion of available capital. Our first priority for capital deployment remains investing in our business, which includes research and development and capex supplemented with acquisitions while at the same time returning cash to shareholders. Please turn to slide 20. Here you can see our 2019 earnings roadmap based on the key assumptions I just laid out. For 2019, we expect per share earnings in the range of $10.45 to $10.90, including a negative 10-cent impact from the M-modal acquisition. This earnings range represents an increase of 5 to 9 percent -on-year compared to our 2018 underlying EPS of $9.96. To wrap up, fourth quarter was a good finish to 2018. We are focused on executing our four priorities along with delivering on our financial objectives in 2019. With that, we thank you for your attention and will now take your questions.

Ladies and gentlemen, if you would like to register a question using a landline phone, please press the one followed by the four on your telephone keypad. You will hear a three-tone prompt to acknowledge your request. If your question has been answered and you would like to withdraw your registration, please press the one followed by the three. If you're using a speakerphone, please lift your handset before entering your request. Please limit your participation to one question and one follow-up. One moment please while we compile a Q&A roster. Our first question comes from the line of Andrew Oben, Bank of America Merrill Lynch. Please go ahead.

Good morning. Good morning, Andrew. Just a question on Asia. You guys clearly seem to have a better handle on your customers than a lot of other folks. As we think about 2019, do you have a sense when Asia growth bottoms X, whatever contingency you have on the tariff negotiations? How should we think about the pace of growth in Asia throughout 2019?

Andrew, if you look at the guidance we have for Asia in our outlook, we see it pretty balanced across the year within those ranges and within that range of guidance. Now, the caution as we start the year is really focused on not so much trade and tariff but on the impact and markets that we talked about. Automotive and electronics are the focus for the slower, more cautious view as we look to 2019. So I think as we get a better view of what's going to go on in those end markets, that would change where we are in the range. But I think that balance across the year is the way I'd have you think about it.

Just a follow-up question. A couple of people asked us about R&D spend. Your longer-term framework, 6% for the year. I think in 2018 it was .6% for the quarter, 5.5%. Any timing on R&D in 2018 and how should we think about R&D in 2019?

As you said, Andrew, this is still a priority and we're committed to this. This is what drives our differentiation, our innovation in 3M. If you look at where we are in the quarter, we saw some impact from the contract R&D work that we do for customers and I would say the divestiture of the communication markets. So those are a few of the things that kept us a little lower in the quarter. We are committed to driving that model, that 6% R&D and the investment in CapEx that goes along with it. And if you look at 2018, we actually did have an increase in headcount, so it's a better reflection maybe of our commitment to that ongoing investment.

Terrific. Thank you. Our next question comes from the line of Joe Ritchie of Goldman Sachs. Please proceed with your question.

Thanks. Good morning, guys. Hey, Joe. Good morning, Joe. So maybe just kind of following up on Andrew's question on China and more specifically, auto and electronics. You took the guy down by a point at the low end. Not really surprising given what we're seeing across the value chain. I guess the question though is, it seemed like those end markets were generally okay for the quarter. How did things progress during the quarter and what are you actually seeing in your core business that makes you feel like growth will be slower in those end markets for 2019?

Yeah, Joe. We talked about this a bit at the third quarter call that we saw some slowing in China as we went into Q4 and automotive was one of the things that we talked about. That said, we saw additional slowing as we exited the quarter. And you see it in the projection for build rates, the updated view of the build rates in the quarter and then the projection for where things are going in 2019. There's just caution. There's a revision down. It's not a huge step down, but it's a revision down in the first half of the year really driven by China. So I would say some additional slowing in the outlook for build rates in automotive. Electronics held up well in the quarter. We had a good solid finish for that business. In fact, you look at 2018, we were right in the range for what we were expecting in the electronics markets and we had a cautious outlook as we went through the year. I think you see it with the OEMs in that they're signaling a cautious view and it's more for first quarter than it was necessarily impacting Q4 of 2018.

Fair enough, Mike. And if I could follow up, Nick, just on price cost, you've seen commodities come in a little bit as we ended the year. We saw the raw-mat headwind on the bridge, maybe just talk a little bit about how much price do you think you'll be able to get in 2019 and are the pricing actions already in place for those benefits?

Yeah, Joe, I would say much of 2018 as well as Q4 has played out exactly how we expected. We expected fairly significant raw material headwinds that we've been more than offsetting throughout the year with our selling price increases. So as I look backwards on 2018, very much how we saw that happening. As we look forward into 2019, we do see raw material and tariff headwinds continuing, just not at the same level of what we saw in 2018. So you see in our earnings bridge, we're expecting 10 to 20 cents of headwinds and that's inclusive of tariffs. In November, when you were with us, I laid out that I expected that to be about a $100 million headwind from tariffs. Right now, we put that at about $70 million -on-year headwind from tariffs and that's built into that 10 to 20 cents. And we remain optimistic that selling prices will more than offset. And the last part of that question, the vast majority of our price increases have already been enacted, either late in the second half of 2018 or ones that have already been announced that go into effect early this year. So much of it, if not all of it, has already been actioned. Okay, thanks, guys. Thanks, Joe.

Our next question comes from the line of Andrew Kapowitz of Citi. Please proceed with your question.

Hey, good morning, guys. Morning, Andy. Morning, Andy. Can you talk about what happened in safety and graphics in terms of the 22% margin you report in the quarter? You mentioned some fourth quarter actions and weakness in roofing granules impacting margin, but margin was obviously lower than last year's Q4 despite now laughing Scott's safety. So was there, how much of the fourth quarter actions were unusual would you expect margin going forward to be significantly in 19 versus 18?

Yeah, Andy, one of the first things you should do is just look at, we had a noticeable gain in fourth quarter last year on the sale of our electronic monitoring business within safety and graphics. That's why we're explaining that the underlying margin, once we pull that gain out is down 110 basis points. The two primary things driving that 110 basis points margin contraction, one is that decline in roofing granules. And then we've also, as you know, we acquired the Scott safety business. We continue to take actions to integrate that. We've been taking a number of actions and that's that continued integration of Scott safety is the second contributing factor to the margin contraction. Overall, we're extremely pleased with Scott safety's performance, high growth in the quarter and very pleased with the contribution it's making to our safety and graphics business.

Okay, and then maybe shifting gears to healthcare. 4% growth in oral care is the best you've recorded in some time there. And China growth is obviously strong in healthcare. So, you know, the easier comps and drug delivery mean that the lumpiness really that we saw in 18 is probably behind 3M and the confidence level in your 3 to 5% organic growth in healthcare for 19 is reasonably high.

Yeah, Andy, I think it's still going to be lumpy in 2019. And that's primarily going to be driven by comps that what we saw in 2018. For the full year, we're not anticipating that drug delivery in total is going to have a noticeable impact on on healthcare's growth. But as I look at the seasonality of what we're staring into of in drug delivery, we will see it being negative in the first half of the year and likely positive in the second half of the year.

Hey, Andy, let me clarify negative comps from drug delivery. We're not seeing the healthcare business negative in the first half.

Right, but overall, the rest of the business does seem reasonably solid. And you would say you have pretty good visibility into the rest of the business, including the new product intros, you know, that you've got in oral care, you know, starting to impact that business.

Right. Yep.

All right. Thanks, guys.

All right. Next question comes from the line of John Walsh of Credit Suisse. Please proceed with your question.

Hi. Good morning. Morning, John. Morning, John. Hi. I guess maybe a quick one on what you're seeing in terms of channel inventory levels and if we're all still normal, if you're seeing anything different across any of your businesses.

Yeah, John, I would say as we came out of Q4, pretty balanced across the businesses in channel, you know, with something we watch very closely, you know, we're watching sell in, sell out, and it looks to be pretty balanced. You know, I would say with a word of caution around the end markets that are slowing, that always puts a focus on channel. So when you look at what's going on in automotive electronics, we're watching that closely, making sure that we have a good view of what's going on there. But as we exited 18, it looked to be a pretty good balance. And that's not just true with those specific end markets, but across, you know, a broader industrial and even across the

And then maybe just drilling down into one of those specifically, because every once in a while it kind of does get called out is on the automotive repair and refinish. Obviously, there was some channel consolidation there. That all seems to be behind the business. I just wanted to kind of confirm that.

Yeah, I think what I said about the broader industrial is true for automotive after market as we come out of 18 as well, pretty balanced across the channel. You know, that said what we've called out there, the consolidation, that's something that is ongoing. We saw a significant impact as we went through the first part of the year. I think that's something that can continue. So that's another one of those impacts on channel inventory that we watch as you see consolidation. But coming out of the year, pretty balanced in automotive after market as well.

Gotcha. And then maybe one more specific to the businesses here. I mean, you know, the acquisitions you've done, you know, personal safety now by sub-businesses, one of your larger exposures. Obviously, I think you said organic was up seven. Can you just kind of talk a little bit about what's happening there and if you think that kind of momentum can continue to carry on?

If you look at it, if you think about personal safety, it's been a leader for us in growth over the last two years, you know, 17 and 18, both strong growth. And that's really, I think, a testament to the organic priorities that we put there in the leading position that we've been able to develop organically. And then also the acquisitions that have complemented that portfolio well. It positions us well in the marketplace where the growth is happening. And so we continue to see, you know, leading growth for the company and we are, you know, a leader for our customers. So I expect, you know, it's a larger business and it's a very, you know, strong contributor to our growth as we move ahead. So I expect it to continue to lead in its market.

Great. Thank you. Thanks, Jim.

Our next question comes from the line of Julian Mitchell of Barclays. Please proceed with your question.

Hi, good morning. Hey, Julian. Morning, Julian. Hey, good morning. Just wanted to follow up if there was any extra color you'd give on how the year's starting out in Q1 versus either the sales ranges laid out on slide 17 or else the earnings bridge items on slide 20, things like FX hedging. I'm not sure how that plays out through the year. And on the revenue side in particular, just wondering how confident you are in Q1 that APAC and the EMEA regions can both see positive growth.

Yeah, Julian, so far what we're seeing as a start to this year is very much in line with the guidance that we've laid out. And just in terms of how we ended 2018, I'd say through as we went through the quarter, things were very much in line with what we were expecting. The only color I'd put is we probably saw some weakening in China as the quarter went on. Now, in terms of 2019 and our guidance and what we're expecting there, things that can impact quarter by quarter for an exchange, and I'll talk this on an EPS basis, we think that's going to be neutral for the year given where the currencies are, if they stay there, and given our hedging position, I will note that it will be a headwind in the first half of the year, particularly in Q1 and then a tailwind to us in the second half of 2019. Other things to note, we expect margin expansion throughout the year, full year, based on our guidance, it pencils out to about 100%, 100 basis point margin expansion. And the tax rates we expect by quarter were guiding 20 to 22. I'd expect to see the first quarter closer to the low end of that range and then the other quarters closer to the midpoint or high end of that range. And then as far as growth that you were asking about right now, our view is we see pretty much all the areas lining up with the ranges that we've laid out. I think in the case of China and Asia, where we're guiding low to mid single digits, if anything, I'd expect the first quarter to be the more challenged of those and then progressively better. But I don't think it's too much out of the range that we've just laid out here quarter by quarter.

Thank you, Nick. And then my follow up question would just be around some of the various cost levers in the P&L. You'd stated that operating margins should be up about 100 basis points for 2019 overall. I'm guessing R&D may be a slight headwind, R&D to sales coming up. So how do we about the delta on gross margin versus SG&A? And I asked particularly because you had very, very good SG&A control in the second half of the year in particular. Is that a one time that then needs a step back up in SG&A to sales in 2019? Or is it a function of productivity and business mix changes so it's sustainable?

So Julian, if I break it into the three components you're asking about, we do see our R&D expense as a percent of revenue going up in 2019. We see our gross margin improving and we see our SG&A percent to revenue going down. So that margin expansion is going to be coming from both gross margin improvement and SG&A productivity. The gross margin improvement, some of that has been going through our from our transformation. Some of it is coming from our footprint actions that we've been actioning over the last couple years. And then on the SG&A front, it's our continued leverage of the productivity through our transformation efforts that will be continuing to expand margin on that front. Great. Thanks very much. Thanks Julian.

Our next question comes from the line of Scott Davis of Mellius Research. Please proceed with your question.

Hi, good morning guys. Hi Scott. Hi, a couple small questions here. First one, I'm just kind of curious, how do you get Scott's safety to grow 10%? I mean, Tyco tried for a long time and I don't think they ever had a quarter anywhere close to that type of growth. Is it as simple as just plugging into your distribution system or is there something more to it?

Yeah, I think that's the Scott safety. It goes back to what I was talking about with the safety business in general. When we're bringing together those complementary portfolios, it's been a really, I think a win-win for us as we've integrated the teams together that we can go out with leading solutions and combine those. And that's having a noticeable impact. It's certainly energized the teams and it's had some impact on the business. I think we had a number of projects come together in Q4. That was part of it as well. So we certainly saw positive timing impacting it. But we are seeing a lift from having our leading personal safety portfolio combining with Scott's safety and capital safety for that matter and bringing those into the marketplace together.

That makes sense. And guys, as a follow-up, just curious on the cadence of cost out on the ERP. When you deploy, when you get 70% done, how long before you can cut the cord on the duplicate spend? There's obviously some duplicate spend for a while until you are 100% comfortable going with that new ERP system. Is that a material change in cadence through the year of cost out or into 2020?

Scott, I wouldn't call it a material change throughout the year. I'd call it a continued progression of what we were seeing in 2018 into 2019. So there's not going to be one significant triggering event, but every quarter additional productivity as we realize those benefits, as we ensure that our supply chain is functioning as we expected, as we're meeting our customers' requirements, as we continue to work through those things, we continue to see more and more SG&A opportunity for benefits, but not a cliff. It will just continue to evolve over the next couple of years.

And Scott, maybe to add to that, we have a value realization map and as we deploy and we stabilize, we get benefits from that as we take better advantage of our service models that we put in place, we get benefit. But we're also, we talked about this in the Investor Day, really doubling down on leveraging the new capabilities we have and that gives you a steady opportunity to drive productivity. And that's what I think you'll see. And that's the next point. It's going to be a steady progression as we take full advantage of the capabilities that we're putting in place.

Fair enough. Good luck and thank you, fellas.

Yeah. Thanks,

Scott. Our next question comes from the line of Dean Dre of RBC Capital Markets. Please proceed with your question.

Thank you. Good morning, everyone. Morning, Dean. A little chilly for you guys this morning, I see too.

A little bit.

Glad everyone made it in. For Nick, it looks like free cash flow, yes, you're above 100% for the fourth quarter, but it did lag your historical fourth quarter conversion pretty significantly. You just walk us through the puts and takes there, please.

Yeah, it's, as part of what I've shared before, we in 2018 built inventory in anticipation of some of our goal lives for our business transformation ERP deployments. And as we've progressed through out the year, one of the more significant things is that that extra inventory that we're seeing that's been impacting our cash flow. It's one of the things that we start starting to see change in the fourth quarter. And our expectation as we guide 95 to 105% free cash flow conversion in 2019, the expectation that that we make even more significant improvements on that going it going through 2019. So working capital is the biggest thing I'll call out there that we see that it's one of our biggest room places for opportunity in our free cash flow conversion.

Got it. And then on one of the businesses that had a soft spot in the third quarter was office retail, but I see it swung into one of the growth areas this quarter. Could we just drill down for bit on office retail, maybe address e commerce and expectations in 2019?

Yeah, Dean, this has been a evolving story. And there's, you know, we've talked a lot about the, you know, kind of the channel and the restructuring that's going on there. And, and it ends up in we see it as, you know, a sell in sell out kind of story we even through that transformation, we were seeing sell out for our portfolio still being positive. We were seeing a negative sell in as, as we saw the restructuring of the channel and inventory coming out. You know, there's certainly e commerce is is another growth platform for that portfolio. And we continue to do very well there in that category. It's a strong growth driver for that business. So as we came through 18, we started to see the balance between sell out and sell in come a little closer. And so we saw some, you know, some positive growth on the sell in. And again, that sell out remaining still strong. So as we get into 19, the story will be, you know, what what additional structure changes that happen in the channel? How does that shift? We're going to continue to be focused on the end user and, and driving that demand and driving that sell out. And, and I think, you know, we'll, we'll, you know, we'll continue to drive a positive growth from that over the long run.

Got it. And just a last quick question on your comment on the air quality improvement in China caught me a little bit by surprise, but I see news reports now, real significant improvement, especially in Beijing. Is that going to be a recurring theme? Because you've got some tough comps in that business throughout that you'll be looking at in 2019.

Yeah, Dean, we saw we certainly had some tough comps as we came through the second half of 18. With an improvement in air quality, you saw that play out as part of the, you know, part of the slowing that we saw in China in the second half of the year and impacted those businesses related to it as well. When we go into 19, we still see, you know, some comp in the first half of the year, but it gets a little more normalized and it will depend on what happens to air quality as we move ahead. You know, is there, is, does it continue to see an improvement? But our, you know, the base for gets more in line with what we saw in 18 as we, as we go through 19.

Thank you. Our next question comes from the line of Steve Tusa of JPMorgan. Please proceed with your question.

Hi guys, good morning. Can we just maybe just help kind of calibrate what, what perhaps with some numbers, what could happen here in the first quarter? I mean, I hear a lot of commentary about, you know, from you guys and from everybody, obviously it's kind of more of a macro thing about things, you know, slowing toward the end of the quarter and then into the first quarter, you had a couple electronics guys who really saw a fall off towards kind of the end of the quarter into the first. And you said it's not going to be too different, but kind of sounding like it's toward the low end of the range you over the first quarter of the year. I mean, are we talking about basically like, you know, kind of a, will you grow organically in the first quarter kind of at the low end of that range? I mean, is that kind of what you're, what, what your talk, what you're

saying? Steve, I would not be surprised if in the first half of the year, partially based on comps, we're in the lower half of the range and in the second half of the year, we're in the upper half the range. Much of what we have is lined up that way. I don't see us in negative growth territory in any quarter. And I, in the second quarter, the only reason I say that Steve is we noted in, in second quarter last year that we felt there was some pull ahead of revenue from third quarter into second quarter. So we'll be facing into that comp second quarter of this year.

Uh, that, that, that makes a lot of sense. And then your kind of normal seasonality is up, you know, uh, low double digit from four Q to one Q. Should we think about that as kind of a little bit lower organic offset by, um, lower tax or is the organic enough to kind of make first quarter a bit, um, less of a seasonal performance?

I think, uh, I think taxes typically are lowest, our first quarters, typically our lowest tax expense. I do see it a bit more normalized of, of tax expense. If you look quarter by quarter, um, if you look at 2018, our tax expense in the first quarter was noticeably below the range. I don't see that happening in first quarter of, of 19. I think it'll be in the range, but closer to the low end. And then the other piece, Steve, as I mentioned, FX will be a bit of an abnormal pattern throughout the year that it will be headwind to us in the first half and in particular in the first quarter. And then it will be offsetting and flipping. And that's primarily driven by, by hedging that we're seeing that we had hedging losses in 2018. And if currencies stay where they are, they'll be flipping the hedging gains in 2019.

And how big are those gains for 19?

Uh, we were had hedging losses of approximately little over $80 million in 2018 and currency stayed where they are. They'd be in the 50, 60, $70 million of gains right now.

One last quick one for you guys on portfolio management. Um, this year you're kind of flipping the portfolio around a little bit. It seems like it's a bit of a headwind, you know, this kind of 15 cent headwind. I mean, is that, you know, I know it's, some of it is temporary, but is that kind of, should we be ready for a bit of kind of year one dilution as you work through, you know, um, as you continue to work through the portfolio kind of on an annual basis? Or does it all kind of, you know, it doesn't catch up towards the end? Cause I know that you've guided to positive, ultimately positive benefits over the long term, but obviously this year is a bit of a negative. How should we think about that? You know, in the context of a long-term guide on portfolio management?

Yeah, like if I use a modal as an example, um, that one we see as a 10 cent headwind this year, that's driven by some of our transaction costs one time, some of our integration costs at the, at the beginning of, of the, uh, of our time of owning it, as well as some ongoing amortization. This, this particular one we guided that we think by year three, it'll be about a 10 times, um, that this would equate to a 10 times EBITDA. So it'll be generating a hundred plus million of EBITDA by year three. I'd say that's not uncommon of what to expect that often in the first year, we want to aggressively integrate whatever we buy into the company to be a fully realizing the value model that we can create by having it part of 3M.

Okay. Thanks a lot.

Our next question comes from the line of Josh Pokowinski of Morgan Stanley. Please proceed with your question.

Hi, good morning guys. Morning, Josh. Morning, Josh. Just maybe to start out, can Nick, can you talk about, you know, what some of the offsetting factors are in guidance? I guess if I add up, you know, pension, the, uh, and modal, and then, um, the, the, uh, the, the lower organic growth, it seems like a bit more than what you've tweaked the range by. You mentioned that, you know, the tariff headwind was a little lower. Is there anything else in the bridge that, that we should be aware of as being kind of an offsetting item?

In terms of what, what we were anticipating back in November, those, the things, those three things you just called out, Josh, those would all be tweaks, tweaks down as far as tweaks up since November. We're seeing a less, a less negative environment for raw material prices that, that if, if I had called out specifically in, in back in November, what we were expecting for raw material headwinds, I would have been quoting a higher number there. And that's partially offsetting, um, some of these tweaks down that, that, uh, we, that I've, that I've laid out. That's the single biggest one that, that's changed.

Got it. That's helpful. And then just as, as an exporter, did you see any of your customers in the fourth quarter, uh, do any pre-buy work, you know, when the, when January was still kind of a target date for, for tariffs, we've seen some of that and some other short cycle guys, curious if that impacted you at all.

Yeah, Josh, you know, we watched that closely and it's part of what we look at in the channel. Do we see, you know, when we see these macro, you know, changes, are they impacting the pre-buy? We, we didn't see that as we came through the quarter and it, you know, as Nick said, the quarter progressed the way we expected. Uh, we're, it's not just watching from a distance. We're close with those partners and, and we don't, we didn't have any indication of that, you know, happening, certainly not at any significant level.

Got it. Appreciate it. Thanks Mike.

Yep. All right. Next question comes from the line of John Inch of Gordon Haskett. Please proceed with your question.

Um, good morning everybody. Morning,

John.

Morning, guys. Hey, uh, so Europe, uh, Western Europe flat, how much of that was self-inflicted by your own actions to withdraw from certain product lines and markets versus the actual market? And what kind of a, I don't know if there's a way to quantify it, but what, you know, how does that sort of spill into kind of the 2019 outlook as well? Is there a way to quantify

that? John, I'd estimate that there's about 200 basis points of us taking specific actions of adjusting our portfolio at product lines that we're choosing to exit, uh, that are built, built into that. There will be some carry forward of that into, into 19, but not, uh, not on as a significant level as what we saw in 2018.

And Nick, are you still on track to get to the 20% margins in Europe? I forget exactly what you said in November is what your timeline was, but how is that, how's that tracking? Is that ahead of schedule or just on track?

Yeah, we're

on, we're on track to do that. John, 2019 will be a noticeable year where we've done a number of things in 17 and 18 to set us up for that 19 will be a year of seeing noticeable margin improvement to get us on track to that 20% by 2020.

20% by 2020. Okay. And then, you know, there's a lot of moving parts here to this guide. Um, understand why you took the lower end of the range down a point, but the midpoint, if you adjust for a modal really only declines, uh, by five cents, right? Which I guess you could argue that that's the impact of half a point, but there must be some other things. I'm curious, uh, specifically in raw materials, I don't, you know, I get what you're saying. On the other hand, Nick, didn't you say that tariffs would be fully offset and versus November, this raw material productivity, the minus 20 cents to minus 10 cents, is that actually lower? Because obviously things like oil and other things have actually declined. So just trying to calibrate, um, you know, why, even though you lower the guide, we're only kind of the midpoint is five cents lower. And is it any of this being offset because raw materials are, well, still a headwind, slightly better, if that makes sense.

Yes, we, we, uh, if, if I had shown this, what we expected it to look like in November, we, I would have been showing a higher raw material headwind there, as we've seen with oil. And, um, some of the things that we were expecting on tariffs haven't turned out, uh, quite as bad as what we were estimating. Um, back in November, we, I said we were confident that we could more than offset whatever we see with raw materials and tariffs with our selling prices. And, uh, we remain, I'd say even more confident on that front.

And then just lastly, Nick, how did the semi con piece of 3M do specifically? I think that's remind us, is that about a billion dollars? I know consumer electronics is around too. Um, the semi con, was it seeing kind of the weakness, particularly in Asia, that a lot of these companies are calling out or, uh, did you do better? If you did better, actually, why, do you think that's the case? Yeah, John,

maybe I'll take that. If you look at the business, our electronic materials, uh, businesses is got the semiconductor piece of it. It's, it's not largest piece of that. And when you look at that, we've got, um, you know, other businesses in there, we have materials into consumer electronics, we have assembly solutions, but we, a big portion of it goes into semi con. We, you know, we, we certainly, uh, we expected to see some slowing as we went through the quarter. You know, they, as Nick talked about, they were in line, that business was in line with the overall, you know, three percent, three percent growth that we saw in the quarter. Uh, going forward, there's more caution in that marketplace in the, in the semiconductor manufacturers are part of that. So I would say the, it was less of an impact on Q4, but more of a part of the caution as we guide going into 19.

Understood. Got it. Thanks, guys. Appreciate it. Thanks, Sean.

Our next question comes from the line of Lawrence Alexander of Jeffries and Company. Please proceed with your question.

Hi, uh, two quick ones. Could you characterize what you're seeing in Latin American a little bit more detail, um, like where the pockets of strength are? And, um, can you speak a little bit more broadly about in 2019, 2020, what kind of impact you may see on 3M from emerging market, um, customers re aligning their supply chains to work around the current tariff disputes?

Lawrence, talking about, uh, Latin America first, you know, we saw a broader based growth in Latin America across our portfolio and, and, you know, both Brazil and Mexico, the largest, uh, countries there, you know, performing well as we came through Q4. So it was, you know, pretty balanced and pretty broad based in, uh, portfolio and growth. And, and we're, we have that same kind of outlook as we, as we look to 20, as we 2019. And, you know, I, your, your question about the supply chain and, and are we seeing changes there? You know, it's certainly something we watch for. We expect the supply chain to react, uh, over time as, as tariffs come into play. We haven't seen a significant impact to that at this point. It hasn't shown up that way. You know, we watch it closely at the customer and, and we're connected with them on, you know, the design in and specification of our products. And, and that includes pretty good visibility on the, on the supply chain. We just haven't seen it react that strongly to this point. Thank you.

Yeah. Thanks, Lawrence.

Our next question comes from the line of Nigel Coe of Wolf Research. Please proceed with your question.

Thanks. Good morning. And thanks for going along here. Can you hear me okay? Yes. Yes. Good. Good. I'm having some problems with the phones here, so I'm on a cell phone. Um, just want to go back to the, um, the electronics, uh, outlook zero four. And obviously you've, you've provided some red color in terms of the quarterly cadence. If we dig into these, into the businesses, electronics versus energy, are you seeing any appreciable, you know, difference in the two subsegments for the, for the 19?

In the, Nigel, you're talking about the subsegments of energy or the, you're talking about energy versus electronics?

Energy versus electronics. I'm looking at that 2% midpoint. How would that break out between the two subsegments? Yeah.

Yep. You know, we highlighted the, uh, you know, the, the good performance from energy markets in Q4 and, and we have an outlook for that to continue as we go into, into 2019. So I would say that is, you know, more, uh, you know, more of the same, you know, the electronics, we've been coloring that all morning, you know, based on the outlook in the end markets. I would say that's the one that we're a little more cautious about. Energy looks pretty stable as we go into the year, but, you know, both of them, uh, contributing, I would say kind of evenly across the year with that, with that kind of, uh, caution on the end markets in play.

Okay. Is there any appreciable difference in the, uh, margin profile between energy and electronics? I've always assumed that electronics has higher margins, but, but to clarify that.

Yeah, Nigel, there's really not a discernible difference between the, between the margins in the different components there between our electronics and our energy. They're, they're very, very similar, Nigel.

Okay. And then Nick, maybe just, uh, if you could just quickly clarify the comments you made on 15 graphics margins for 4Q, you called out, uh, Scott safety, uh, integration, uh, uh, headwinds, but then we're competent against some of the purchase accounting headwinds in 4Q of 17. So I'm just wondering why we wouldn't have seen a benefit from Scott safety in 4Q 18.

Yeah. When I'm, uh, backing out last year, there were one-time costs with, with Scott bringing them in as well as the, as well as the, uh, gain that we had on the sale of electronic, um, our electronic monitoring business. So that's when I go and say it's 110 basis, uh, underlying margin contraction, that's already discounting for that piece. Now that we've taken that out and it's part of our ongoing business, we are continuing to take actions in Scott and other parts of our safety and graphics business. But Scott's the largest one that we're taking actions on. That's, that's one of the things that, that's behind that. The other piece that I maybe didn't highlight clearly enough for you, Nigel is the sales decline that we're seeing in roofing granules that is creating a year on year margin contraction in safety and graphics that's impacting that, that total.

Understood. Thanks, Nick.

Yeah.

Thanks Nigel.

That concludes the question and answer portion of our conference call. I'll now turn the call back over to Mike Roman for some closing comments.

Thank you. In summary, the fourth quarter kept another year of significant accomplishments for 3M as we posted good results while strengthening our company for the long term. Moving ahead, we are focused on executing our four priorities and delivering for our customers and shareholders in 2019. Thank you again for joining us this morning and have a good day.

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