3M Company

Thank you for standing by. As a reminder, this conference is being recorded Tuesday, July 27th, 2021. I would now like to turn the call over to Bruce Germeland, Senior Vice President of Investor Relations at 3M.

Thank you and good morning, everyone, and welcome to our second quarter earnings conference call. With me today are Mike Roman, 3M's Chairman and Chief Executive Officer, and Monish Patelawalla, our chief financial officer. Mike and Monish will make some formal comments, then we will 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. As we have done throughout the year, I would like to remind you to mark your calendars for our next earnings call, which will take place on Tuesday, October 26. 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. Please note, throughout today's presentation, we'll be making references to certain non-GAAP financial measures. Reconciliations of the non-GAAP measures can be found in the attachments to today's press release. Please turn to slide four, and I'll now hand it off to Mike. Mike?

Thank you, Bruce, and good morning, everyone. 3M's performance in the second quarter was strong as we posted organic growth across all business groups and geographic areas. Our team executed well and delivered increased earnings, expanded margins, and robust cash flow. From a macro perspective, the global economy continues to improve, though uncertainty remains due to COVID-19, and heightened concern over the increase in Delta variant cases. We saw ongoing strength in many end markets, including home improvement, oral care, and general industrial, along with a pickup in healthcare elective procedures. We continue to work to mitigate ongoing inflationary pressures and supply chain challenges, as well as end market dynamics, such as the semiconductor shortage impacting automotive build rates and electronics. We're also beginning to see a decline in pandemic-related demand for disposable respirators, which I will discuss on the next slide. Looking forward, we will stay focused on investing in emerging growth opportunities, improving productivity, and advancing sustainability. We are confident in our ability to continue executing well in the face of COVID-19 uncertainties and are raising our full-year guidance for organic growth to 6% to 9%. and earnings per share to $9.70 to $10.10. Please turn to slide five. In the second quarter, we delivered total sales of $8.9 billion. We posted organic growth of 21% versus a 13% decline in last year's second quarter, along with earnings of $2.59 per share. We expanded adjusted EBITDA margins to over 27%. and increased adjusted free cash flow to $1.6 billion with a conversion rate of 103%. Strong cash flow allowed us to further strengthen our balance sheet while returning $1.4 billion to shareholders through dividends and share repurchases. I am proud of our team's execution in a dynamic environment. We are finding new ways to innovate for customers and improve our operational performance. In addition to our strong day-to-day execution, we are investing to capitalize on favorable market trends and serve emerging customer needs. I want to share a few impactful examples. In healthcare, our innovative Pravena Therapy Incision Management System is the first and only medical device indicated by the U.S. FDA to help reduce surgical site infections in high-risk patients. helping lower the costly financial burden of complications, delivering on both improved clinical outcomes and cost savings for the healthcare system. In automotive electrification, we are building on 3M's long history in consumer electronics and now expanding our solutions for the future of transportation, including new display technologies for both electric and internal combustion engines, helping us drive above-market growth in our automotive business. In home improvement, we are building out a suite of innovations to help consumers personalize their homes, including our fast-growing line of Command damage-free hanging solutions, a half-a-billion-dollar franchise that leverages our world-class adhesive platform, with even greater opportunities ahead. We have increased opportunities across our businesses to apply 3M science and drive long-term growth, and we will continue to invest and win in those areas. As you all have seen, the ongoing impact of COVID-19 is highly variable across geographies. Since the onset of the pandemic, we have increased our annual respirator production fourfold to 2.5 billion by activating idle surge capacity and building additional lines. while shifting 90% of distribution into healthcare to protect nurses, doctors, and first responders. One of our strengths is to quickly adapt to changing marketplace needs. Global demand reached its peak in Q1 of this year, which included stockpiling from governments and hospitals. We are now seeing a deceleration in overall healthcare demand and are adjusting production, increasing supply to industrial and consumer channels. while continuing to prioritize healthcare workers in the geography seeing increased COVID-19 cases and elevated hospitalization rates. As we do this, we are reducing overall output to meet end market trends. Like we have in the past, we are prepared to rapidly increase production in response to COVID-19 related needs or future emergencies when needed. As I reflect on the first half, I am pleased with our performance. We delivered strong sales and margin growth along with good cash flow while building for the future and advancing sustainability with significant new carbon, water, and plastic commitments. In the second half, in addition to investing in growth, productivity, and sustainability, we also must navigate ongoing COVID-19 impacts and continue taking actions to address inflationary pressures and supply chain challenges. We will do this by driving an unrelenting focus on operational performance, which includes improving service, quality, operating costs, and cash generation. I would like to thank 3Mers for your commitment and resilience as we bring together people, ideas, and science to help transform businesses, solve customer challenges, and improve lives around the world. That wraps up my opening comments. And I'll turn it over to Monish to cover more details on the quarter and our updated guidance.

Monish. Thank you, Mike, and I wish you all a very good morning. Please turn to slide six. Company-wide, second quarter sales were $8.9 billion, up 25% year-on-year, or an increase of 21% on an organic basis. Sales growth combined with operating rigor and disciplined cost management drove adjusted operating income of $2 billion, up 40%, with adjusted operating margins of 22%, up 240 basis points year-on-year. Second quarter gap and adjusted earnings per share were $2.59, up 44% compared to last year's adjusted results. On this slide, you can see the components that impacted both operating margins and earnings per share as compared to Q2 last year. A strong year-on-year organic volume growth, along with ongoing productivity, restructuring efforts, and other items, added 4.1 percentage points to operating margins and 89 cents to earnings per share year-on-year. Included in this margin and earnings benefit were a few items of note. First, during the quarter, the Brazilian Supreme Court issued a ruling that clarified the calculation of Brazil's federal sales-based social tax, essentially lowering the social tax that 3M should have paid in prior years. This favorable ruling added $91 million to operating income, or one percentage point to operating margins, and 12 cents to earnings per share. Next, as you will see later today in our 10Q, We increased our other environmental liability by nearly $60 million and our respirator liabilities by approximately $20 million as part of our regular review. In addition, we also incurred a year-on-year increase in ongoing legal defense costs. We are currently scheduled to begin a PFAS-related trial in Michigan in October. along with the next step in the combat arms year-plug multi-district litigation, with one trial in September and one in October. And finally, during the second quarter, we incurred a pre-tax restructuring charge of approximately $40 million as part of the program we announced in Q4 of last year. Second quarter, net selling price and raw materials performance reduced both operating margins and earnings per share significantly, by 140 basis points and 17 cents, respectively. This headwind was larger than forecasted as we experienced broad-based cost increases for chemicals, resins, outsourced manufacturing, and logistics as the quarter progressed. As a result of these increasing cost trends, we now forecast a full-year raw materials and logistics cost headwind in the range of 65 to 80 cents per share, versus a prior expectation of 30 to 50 cents. As we have discussed, we have been and are taking multiple actions, including increasing selling prices, to address these cost headwinds. As a result, we expect continued improvement in our selling price performance in the second half of the year. However, given the pace of cost increases, we currently expect a third quarter net selling price and raw materials headwind to margins in the range of 50 to 100 basis points, which we anticipate will turn to a net benefit in the fourth quarter as our selling price and other actions start catching up to the increased costs. Moving to divestiture impacts, The lost income from the sale of drug delivery in May of last year was a headwind of 10 basis points to operating margins and 2 cents to earnings per share. Foreign currency net of hedging impacts reduced margins 20 basis points while benefiting earnings by 8 cents per share. Finally, three non-operating items combined had a net neutral impact to earnings per share year on year. This result included a six-cent earnings benefit from lower other expenses that was offset by higher tax rate and diluted share count, which were each a headwind of three cents per share versus last year. Please turn to slide seven for discussion of our cash flow and balance sheet. We delivered another quarter of robust free cash flow, with second quarter adjusted free cash flow of $1.6 billion up 2% year-on-year, along with conversion of 103%. Our year-on-year free cash flow performance was driven by strong double-digit growth in sales and income, which was mostly offset by timing of an income tax payment of approximately $400 million in last year's Q3, which is traditionally paid in Q2. Through the first half of the year, we increased adjusted free cash flow to $3 billion versus $2.5 billion last year. Second quarter capital expenditures were $394 million and approximately $700 million year-to-date. For the full year, we are currently tracking to the low end of our expected CapEx range of $1.8 to $2 billion given vendor constraints and the pace of capital projects. During the quarter, we returned $1.4 billion to shareholders through the combination of cash dividends of $858 million and share repurchases of $503 million. Year-to-date, we have returned $2.5 billion to shareholders in the form of dividends and share repurchases. Our strong cash flow generation and disciplined capital allocation enabled us to continue to strengthen our capital structure. We ended the quarter with $12.7 billion in net debt, a reduction of $3.5 billion since the end of Q2 last year. As a result, our net debt to EBITDA ratio has declined from 1.9 a year ago to 1.3 at the end of Q2. Our net debt position, along with our strong cash flow generation capability, continues to provide us financial flexibility to invest in our business, pursue strategic opportunities, and return cash to shareholders while maintaining a strong capital structure. Please turn to slide eight, where I will summarize the business group performance for Q2. I will start with our safety and industrial business, which posted organic growth of 18 percent year-on-year in the second quarter, driven by improving industrial manufacturing activity and prior pandemic impacts. First, Starting with our personal safety business, we posted double-digit organic growth in our head, face, hearing, and fall protection solutions as demand in general industrial and construction end markets remained strong. However, this growth was more than offset by a decline in our overall respiratory portfolio due to last year's strong COVID-related demand, resulting in an organic sales decline of low single digits for our personal safety business. Within our respiratory portfolio, second quarter disposable respirator sales increased 3% year-on-year, but declined 11% sequentially as COVID-related hospitalizations declined. Looking ahead, we anticipate continued deceleration in disposable respirator demand through the balance of this year and into 2022. Turning to the rest of safety and industrial, Organic growth was broad-based, led by double-digit increases in automotive aftermarket, roofing granules, abrasives, adhesives and tapes, and electrical markets. Safety and industrial second quarter operating income was $718 million, up 15% versus last year. Operating margins were 22.1%, down 130 basis points year-on-year. as leverage on sales growth was more than offset by increases in raw materials, logistics, and ongoing legal costs. Moving to transportation and electronics, which grew 24% organically despite sustained challenges from semiconductor supply chain constraints. Organic growth was led by our auto OEM business up 76% year-on-year compared to a 49% increase in global car and light truck bills. This outperformance was due to several factors. First, the regional mix of year-on-year growth in car and light truck bills were in regions where we have high dollar content per vehicle. Second, a year-on-year increase in sell-in of 3M products versus the change in build rate. Lastly, we continue to apply 3M innovation to vehicles, gaining penetration onto new platforms. Our electronics-related business was up double digits organically with continued strength in semiconductor, factory automation, and data centers, along with consumer electronic devices, namely tablets and TVs. Looking ahead, we continue to monitor the global semiconductor supply chain and its potential impact on the electronics and automotive industries. Turning to the rest of transportation and electronics, advanced materials, commercial solutions, and transportation safety each grew double digits year on year. Second quarter operating income was $546 million, up over 50% year on year. Operating margins were 22%, up 340 basis points year on year. driven by strong leverage on sales growth, which was partially offset by increases in raw materials and logistic costs. Turning to our healthcare business, which delivered second quarter organic sales growth of 23%. Organic growth was driven by continued year-on-year and sequential improvements in healthcare elective procedure volumes as COVID-related hospitalizations declined. Our medical solutions business grew mid-teens organically, or up approximately 20%, excluding the decline in disposable respirator demand. I am pleased with the performance of Accelity, which grew nearly 20% organically in the quarter, as it helps us build on our leadership in advanced wound care. Sales in our oral care business more than doubled from a year ago, as patient visits have nearly returned to pre-COVID levels. The separation and purification business increased 10% year-on-year due to ongoing demand for biopharma filtration solutions for COVID-related vaccine and therapeutics, along with improving demand for water filtration solutions. Health information systems grew high single digits, driven by strong growth in clinician solutions. And finally, food safety increased double digits organically, as food safety activity returns, along with continued strong growth from new product introduction. Healthcare's second quarter operating income was $576 million, up over 90% year-on-year. Operating margins were 25.3%, up 880 basis points. Second quarter margins were driven by leverage on sales growth, which was partially offset by increasing raw materials and logistics costs. along with increased investments in growth. Lastly, second quarter organic growth for our consumer business was 18% year-on-year, with strong sell-in and sell-out trends across most retail channels. Our home improvement business continues to perform well, up high teens organically on top of a strong comparison from a year ago. This business continued to experience strong demand in many of our category-leading franchises, particularly Command, Filtrate, and Meguiar's. Stationery and office grew strong double digits organically in Q2 as this business lapsed last year's COVID-related comparisons. We continue to see strength in consumer demand for Scotch-branded packaging and shipping products, along with improved selling trends in postage solutions and Scotch-branded home and office tapes as retailers prepare for back to school and return to workplace. Our home care business was up low single digits organically versus last year's strong COVID-driven comparison. And finally, our consumer health and safety business was up double digits as we lapped COVID-related impacts from a year ago, along with improved supply of safety products for our retail customers. Consumers' operating income was $311 million, up 12% year-on-year. Operating margins were 21 percent, down 160 basis points, as increased costs for raw materials, logistics, and outsourced hard goods manufacturing, along with investments in advertising and merchandising, more than offset leverage from sales growth. Please turn to slide nine for a discussion of our full-year 2021 guidance. While uncertainty remains, we expect global economic and end-market growth to remain strong. However, continue to be fluid as the world wrestles with ongoing COVID-related impacts that we all see and monitor. Therefore, there are a number of items that will need to be navigated as we go through the second half of the year. For example, we anticipate continuous sequential improvement in healthcare elective procedure volumes. Also, we expect ongoing strength in the home improvement market and currently anticipate students returning to classrooms and more people returning to the workplace. Next, we remain focused on driving innovation and penetration with our global auto OEM and electronics customers. These two end markets continue to converge, as highlighted by the well-known constraints in semiconductor chip supply. This limited chip supply is expected to reduce year-on-year automotive and electronics production volumes in the second half. As mentioned earlier, we expect demand for disposable respirators to wane and negatively impact second-half revenues by approximately $100 million to $300 million year-on-year. Turning to raw materials and logistics, as noted, we anticipate a year-on-year earnings headwind of $0.65 to $0.80 per share for the full year, or $0.40 to $0.55 in the second half due to rising cost pressures. We are taking a number of actions, including broad-based selling price increases, to help mitigate this headwind. And finally, the restructuring program we announced last December remains on track. As part of this program, we expect to incur a pre-tax charge in the range of $60 to $110 million in the second half of this year. Thus, taking into account our first-half performance, along with these factors, we are raising our full-year guidance for both organic growth and earnings per share. Organic growth is estimated to be 6% to 9%, up from the previous range of 3% to 6%. We now anticipate earnings of $9.70 to $10.10 per share against a prior range of $9.20 to $9.70 per share. Also, as you can see, we now expect free cash flow conversion in the range of 90 to 100 percent, versus a prior range of 95 to 105 percent. This adjustment is primarily due to ongoing challenges in global supply chains, raw materials, and logistics, which are expected to persist for some time. Turning to the third quarter, let me highlight a few items of note. we currently anticipate continued improvement in healthcare elective procedure volumes across most parts of the world. Global smartphone shipments are expected to be down high single digits year-on-year, while global car and light truck bills are expected to be down 3% year-on-year. Relative to disposable respirators, we anticipate a year-on-year reduction in sales of $50 to $100 million due to continued decline in global demand. As mentioned earlier, we are anticipating a third-quarter year-on-year operating margin headwind of 50 to 100 basis points from selling prices, net of higher raw materials, and logistic costs. On the restructuring front, which I previously discussed, we expect a Q3 pre-tax charge in the range of $50 to $75 million as a part of this program. And finally, we expect higher investments in growth, productivity, and sustainability in the quarter, along with higher legal defense costs as proceedings progress. To wrap up, our team has delivered a strong first half performance, including broad-based growth, good operational execution, robust cash flows, and an enhanced capital structure. With that being said, there's always more we can do and will do. We continue to prioritize capital to our greatest opportunities for growth, productivity, and sustainability, while remaining focused on delivering for our customers, improving operating rigor, and enhancing daily management. I want to thank our customers and vendors for their ongoing loyalty and partnership, and especially our employees for their dedication, perseverance, and execution in these uncertain times. With that, I thank you for your attention and we will now take your questions.

Ladies and gentlemen, if you would like to register your question using a landline phone, please press the 1 followed by the 4 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 1 followed by the 3. 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 the Q&A roster. Our first question comes from the line of Scott Davis with Milius Research. Please go ahead.

Hi. Good morning, Mike and Monish. I'm on slide 13, the appendix, just looking at the price data. And based on my notes, price was up about, I think, 70 basis points last quarter. It looks like 10 basis points this quarter. But the real headwind was Asia Pacific. What – can you give us a little color into kind of – I know some of this might be mixed. So, you know, what – what's impacting the price dynamic? Perhaps there's some comp issues too there. So I'll just leave it at that.

Yeah, sure, Scott. It's a great question. And you're right. But as I first said, you know, we are raising prices everywhere. It's taking a little bit of time, but it's broad-based. You've seen what we have said we'll do in the third quarter and the fourth quarter. To answer your question specifically on the second quarter, You hit on one point, which is a comp issue from year over year. But the second piece of this was also as the volumes came in pretty strong in the second quarter, we had some rebates that get accounted for with that extra volume, and that drove it. But when you reflect on the guide that we gave you, price pretty much came in where we had thought. It's just slightly lower than that, so we were expecting this.

Okay. And then... Was there a supply chain impact on sales, an explicit supply chain impact on sales that held back sales, or was it more just a cost logistics issue?

I would say, Scott, it's really hard to figure out exactly what the impact was. There definitely was an impact, I would say, in general in the larger market, and 3M was no different where supply constraints were there. The team's done a marvelous job of trying to keep the factories running the best they can and making sure that We are taking care of our customers as quickly as we can. So I would say there were more inefficiencies that we have had to deal with, just as raw material was not as fluid as we would have thought through this process. But overall, we have done our best to keep our customers whole through this process. But this is an ongoing piece, Scott, that we'll have to watch how the second half plays itself out. You're seeing not only us but end markets also getting impacted. by some of the raw material shortages, and we're just going to keep working this as we go through the second half.

Our next question comes from the line of Joe Ritchie with Goldman Sachs. Please go ahead.

Thanks. Good morning, everybody. Good morning, Joe. Can you guys talk a little bit about the durability in the healthcare margins? You know, impressive, you know, back to 25% this quarter. I'm just wondering if this is now kind of like a baseline going forward, you know, we're back to kind of like the, you know, the 2019-ish type levels.

Yeah, I think, Joe, that's a great question. I think we also keep looking at that all the time. I would just start with the team's done a really nice job. of continuing to drive margins up while still investing in the business. The sharp increase on a year-over-year basis is driven by a lot of the volume increase that you saw Q2 of last year versus Q2 of this year. Third, I would say the volume leverage was helped, but we still got hurt by raw materials and logistics costs, and we continue to invest in the business. To answer your specific question on what does it look like going forward, I think it all comes down to ultimately where does volume turn out to be, as I said in my prepared remarks, that disposable respirators are starting to slow down. You're seeing a Q3 impact of $50 million to $100 million on a year-over-year basis and $100 million to $300 million for the second half. Most of that should hit the healthcare segment. So we'll see where volume plays itself out. But secondly, I think, is how much investments we keep driving as we see hospitalizations increase and elective procedures go up. So I think it's going to be a trade between that. Overall, I would say the team and I, we all believe in continuous improvement. So we're going to keep driving productivity, continuing to reduce cost, investing where we think it's the right place to invest, and driving efficiency in SG&A as much as we can.

Thanks, Manish. Maybe just following up on that, and it's helpful to have that context, is I think about, you know, just the healthcare business, right? You did mention that elective procedures have increased, and perhaps maybe that's going to offset some of the respirator issue. Should we think of that as being, you know, mixed accretive, if in fact, you know, elective procedures are, you know, are increasing and are, you know, potentially offsetting the weakness in respirators?

I would tell you I think the way we've got to think about it is as electives go up, we don't have a one-for-one perfect connection between electives. So it depends on which piece of the demand goes up, Joe. So it's really hard to give you the perfect answer on whether it's mixed or not. What I generally believe is as elective procedures go up and as volume ticks up, you will see us getting more leverage because of that. how much the disposable respirator volume goes down and where it comes from will also have an impact. So it's a hard one for me to quantify exactly.

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

Thank you. Good morning, everyone. Hey, Dean. Hi, Dean. Hey, just want to say that slide nine is especially helpful with all the moving parts, your assumptions for the year and assumptions for the third quarter. So appreciate all those specifics. And my first question is on capital allocation. You got the balance sheet in good shape, 1.3 times net leverage. You did restart buybacks, but still share count creep looks like it increased. Why would you not be doing more buybacks here? And can we start there, please?

Yeah, sure, Dean. As I told you, from our priority of capital allocation, our first priority is always investing organically between R&D and CapEx because we think that's the biggest return for our money. The second is dividend. You've seen we have increased dividend. It's 63rd year in a row that dividend's up. It matters to our shareholders. That's our second priority. Our third priority is M&A, and we will normally do M&A in the area where We believe that the target that we can acquire can benefit from being a part of 3M. Right now, we are busy integrating Accelity, and the team is doing a nice job integrating that. So we don't see any acquisition of the size of Accelity in the near future, but we have an active pipeline of a number of things. And then our last, discretionary use of capital allocation and share buybacks. So for the year to date, we have done $700 million, give or take. And I would say share buyback and continued share buyback depends on what the volume is going to be, depends on the needs of future capital uses that we have, as well as what the cash flow that we generate will depend on that. So I would say we'll keep you posted during these quarterly calls as we continue this program and decide how much we do.

Terrific. And then just as a follow-up, given all the changes it seems like day-to-day in the macro, any commentary about how July has started, especially regionally, would be helpful here. Thanks.

Yeah, Dean. I would say I start with the expectation that the team is going to continue to execute well as we go into the second half of the year. We've talked about some of the dynamics. Monish outlined a number that we're seeing. I would say so far no surprises as we start the first few weeks of July and We are expecting the global macroeconomic and market strength to continue. It will remain fluid. We talk about the uncertainties as we look into the second half. We expect and are seeing continued increase in elective procedures in health care, home improvement expected to remain strong, industrial more broadly, you know, generally improving as we go in the second half. You know, we talked about it. In the first half, we saw broad-based growth across geographies, and we expect this to continue it. The uncertainty there is COVID and the impact on any increases in cases and hospitalizations. There are certainly some areas around the world where we're seeing that, even as we talk about the decline in respirator, disposable respirator demand globally, we're seeing areas that we are increasing supply. And so that's going to be one of the things that can impact second half geographically across the world. So while we expect overall pandemic-related respirator demand to decline, we expect some areas we'll see stronger demand as COVID plays out. So that gives you a little bit of a view of how we look around the world second half.

Thank you. Our next question comes from the line of John Walsh with Credit Suisse. Please proceed with your question.

Hi. Good morning, everyone. Hey, maybe just for the first one, a clarification. Wanted to know if you could give us an order of magnitude of what you're looking at in terms of price increases that you plan to put through across the product portfolio and obviously understand it will probably vary by product line. And then second question is, if I look at your kind of organic growth, you know, kind of the same growth on growth in Q2 as Q1, was curious if you have any commentary around customer channel inventory and if you're seeing any change in behavior there. Thank you.

Yeah, John, I would say price, our teams are focused, as Monish talked about, on taking price in the second half to help us offset what we're seeing in inflation. And that's fairly broad-based. We, you know, it takes, as we talked about, it takes some time to implement price changes and get ahead of inflation. And it's been, inflation has been, you know, an ongoing challenge as we've gone through the year. So we're expecting inflation. to see stronger price broad-based as we get into the second half and into fourth quarter. We start to see a price-raw positive impact. If you look at where our channel inventory is today, you know, this is something we're always asking ourselves. It's a dynamic that we are continuously measuring and assessing every region of the world. And I would say, given the dynamics in the marketplace, the snapback in the economy, the fluid and an uneven market dynamic, it's difficult to know what the right level is today. We get visibility on where our sell-in and sell-out is. With that snapback in demand, it's hard to get clear visibility on levels, appropriate levels of inventory. There are some areas, of course, that are very visible, the ongoing semiconductor chip shortages, and they're impacting production volumes, and we see our inventory in the channel aligning with that. We've talked quite a bit about the visibility we're putting on N95 respirators specifically. But beyond that, it's really going to depend on how demand plays out in each market to really get a view as we go through third quarter of where inventory in the channel sits.

Great. Thanks for taking the questions.

Thank you. As a reminder, we ask that you please limit your participation to one question and one follow-up. Our next question comes from the line of Julian Mitchell with Barclays. Please proceed with your question.

Hi, good morning. Good morning. Just wanted to try and circle back to the safety and industrial outlook. I suppose it's possible if we look at Q4 that your sales in that segment could be down year on year in aggregate because of respirators. Just wondered any perspectives on that. And also the margin implication, you know, in 2020, your S&I margins were up a good amount. Q2, they're softer, I think, sequentially and year on year as the respirator business. rolls over. So should we expect that sort of mixed headwind to play out for a few more quarters?

Yeah, I think, Julian, it's a great question on safety and industrials. So to answer your specific question first on the impact, could it be negative on a year-over-year basis? As we As we said, and just a reminder, in 2019, we used to have revenue approximately $600 million of disposable respirators. That went up to $1.4 billion in 2020. And as I look at the second half, we told you there could be a risk of $100 to $300 million, which is the range of where we think disposable respirator volume would come down on a year-over-year basis. And if we go to that higher end of the range, which is 300, yes, the answer is you could definitely see negative volumes. What we have been doing as a part of this as healthcare demand has waned due to lower hospitalizations due to COVID and increase in electives is we have been moving production out from the hospital channel to different parts, which is industrial and governments, which we are actively doing. The other piece of safety and industrial is, as I mentioned in Q2, we have seen growth in quite a few other segments of safety and industrial, whether it's in our respiratory portfolio or our safety portfolio. with head and face masks, whether you've seen us increase in our abrasive business, in our adhesives business, our roofing granules, so all the other segments, automotive aftermarket, have seen increase. And depending on how the economy plays itself out, and as long as industrial activity continues, you should see continued growth in those areas. And our current assumption is that long-term those markets will come back I think it's going to be a little fluid in the second half, depending on how COVID plays itself out. To answer your second question on margin, you're right. As we have seen in 2019 versus 20, we did get benefited a lot by the volume leverage that we got across safety and industrial. So ultimately, where volume lands in the second half will have an impact on where margins ultimately go. We are actively working on price increases, broad-based in that segment. It's how much of that is offset by price and laws and logistics costs. is the second offset. And then the third one is the ongoing legal fees or reserves that we've taken will be the third one. And then the last one, I would say, is what do we invest in growth, productivity, and sustainability, and especially growth? Because as industrial activity goes up in 22 and 23, we're going to continue to invest in that segment. So put all that together, that's how we see where margins are going to land.

Thank you. Our next question comes from the line of Stephen Tusa with J.P. Morgan. Please proceed with your question.

Hi, good morning. Hey, Stephen. Good morning. Can you just maybe talk about, other than the mask headwind kind of sequentially, do you expect – the kind of auto stuff, like what else is getting worse sequentially, kind of when we think about three to four, three and four key trends?

So, Steve, I would say I would just put everything in the context of back to end markets in total. We feel we'll remain strong. I think you're going to see volatility as we get through the second half with what happens with COVID. So a couple of items to note. We believe that elective procedures will continue to go up quarter over quarter, but in some parts of the world you could see it go down. Secondly, I would say auto does show an increase. It's still on a year-over-year headwind, down 3% in the third quarter, and if my memory is right, it's projected to be down 3.7 in the fourth quarter. I think the semiconductor shortages will have an impact on what happens there, and we'll see where that plays itself out. Smartphone shipments are supposed to be down on a year-over-year basis. We'll see where it lands sequentially. And then tablets and TVs, which also were benefited tremendously last year, are also projected to be down on a year-over-year basis. But hard to quantify what exactly it looks like on a sequential basis. You've seen a pretty good increase in stationery and office supply in the second quarter. That momentum is there right now where we are seeing sell-in trends as retailers are planning to have more people return to the workplace, kids in school. But depending on how the pandemic plays out, that could have an impact. And then on safety and industrial, as I mentioned in the prior question, I think there's an assumption that industrial activity continues. But currently, the supply chain shortages across the world also put a lot of variability onto what that demand looks like. And that's why when we put all that together, we said we are prudent to call the year at 6% to 9% for the year versus the 3% to 6% that we had said earlier. But overall, I would... Go ahead.

I guess at the high end of the range, I think first half to second half sales are down, which makes sense because of the mask dynamic. And normally, seasonally... I think you're down in the 4Q from a modestly up 3Q versus 2Q. But I guess is there anything this year seasonally, i.e. kind of the semi-shortages kind of pushing demand to be a little bit better seasonally, sequentially? You're kind of saying there's a lot of moving parts, so it's kind of normal seasonality and then including kind of the masks.

That's right, Steve. There is a lot of variability. But we'll keep you posted.

Okay. All right. Thanks a lot. I appreciate it. Cool.

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

Good morning, everyone. Good morning, Nigel. Yeah, so on the raw math side, You know, Manish, based on, you know, your FICO convention and, you know, forward purchasing, et cetera, when do you expect commodity inflation to peak? I don't know whether that's on a year-to-year basis or whether it's on a sequential basis, but when do you expect, you know, to see the peak in those raw maps?

So if you're asking specifically on commodities, I think it's a really hard one to call. You know, for example, I would tell you when we first gave our guide of 30 to 50 cents, which is now being guided to 65 to 80, I would tell you what we have seen is a broad-based increase in all commodities, whether it is polypropylene, chemical, resins. We are seeing... in our outsourced manufacturing goods, not just the labor cost, but other commodities that go into that also getting passed. And then logistics cost has continued to be a pretty strong headwind. Where that will peak, I think, in my view, and I may be wrong, yet at some point demand and supply need to start settling itself out. There's a lot of demand. There's not enough supply based on all the V-shaped recovery with congestion in the ports, et cetera. And until that stabilizes itself out, I think we're going to continue to see inflation. We have seen where crude prices have gone up much heavier than we have thought coming into the year. Polypropylene has remained strong or heavy. Inflationary ocean rates have gone up a lot in the last three to six months. So it's really hard for us to come back and say when does it peak and when does it start coming down. So we have taken what we know. We have put in all the factors that we know. We have had a prediction of where we think these things could go. And we have come up with 65 to 80 cents, which currently is our best guide of where we think inflation is going to be. But with that said, as I've mentioned, we are taking broad-based price increases everywhere to help offset the mitigation of this. We are also increasing yield. We are working with our suppliers to reduce prices. And then in the third quarter, we'll see a headwind of 50 to 100 basis points, price versus raw. And in the fourth quarter, our anticipation is that we should be able to get it to be flat to positive, which means price will offset the raw material inflation.

Okay, that's really helpful. Thanks, Manish. I think I'll stick with you here on the second half outlook. You're calling out legal costs, legal defense costs in the second half of the year. You didn't give a number around that, so I'm assuming it's not that material. But just basically, how do you think about the magnitude of that in the back half? And just confirm, the defense costs are not settlements necessarily. I'm thinking here about earplug litigation and also this Hudson Falls settlement that you just announced.

Yeah, so I think the first one, that the Hoosick Falls settlement, was a part of our reserve. So that was a part of the calculus already. I would say... We will. It's ongoing litigation. If you look at all the SEC material that we file, as well as the queue that will get filed later in the day, it should give you an update of all the cases. But just for your benefit, we got a PFAS case coming up in the October of this year. It's with Wolverine and the use of PFAS in there. And we've got two combat arm trials coming up. So as we prepare for those cases, that's the increased cost in legal fees. And what I would tell you is we will spend what is required to defend ourselves as we go through these cases, and that's what the cost is being incurred for.

Thank you. Our next question comes from the line of Andrew Obin with Bank of America. Please proceed with your question.

Yes, good morning. Morning, Andrew. Just a sort of longer-term question. You know, I think historically 3M has a very strong position in terms of sort of global capacity in your key technologies. How do you think about sort of global non-woven capacity post-COVID? And, you know, are you seeing emergence of new players? You know, does it change sort of strategic landscape for 3M vis-a-vis players, particularly players out of Asia longer term? Thank you.

Thanks, Andrew. As I highlighted in my prepared remarks, we saw probably the peak of demand, at least near term, in Q1. And we, as you know, we built additional capacity as we went through 2020. By the end of the year, we were at a run rate of 2.5%. billion N95 respirators on an annual basis. And so that's the capacity we come into the year. Other manufacturers build capacity as well to respond to the pandemic. And I think you see some of them idling some of their capacity as demand comes off the peak. And we'll begin that process as well to idle lines, to be ready for the next emergency or changes in COVID-19. I mean, we can ramp up quickly. So our strategy is to be in a position to be a leader in personal safety, personal protective equipment in normal times. And that's really serving the broader industrial markets, serving consumer markets, serving healthcare markets. And that's our strategy for where we manufacture and the volumes. And then we have that idle capacity so we can surge in times of emergency. I think we're in a better position than ever before globally to be able to respond to a pandemic. And I would add, it's been good to see governments following through on their commitments to stockpile. That's something that we have a number of efforts underway around the world that we're supporting as we've come through the first half of the year. So that I think prepares the world better for the next emergency, the next pandemic. So it will depend. When you look at where are we going to end up with respirator demand, we think we'll end up somewhere above where we were pre-pandemic as use and protocols are changing around the world. We'll be well aligned to serve that. Our brand will be strong. We've got a leading brand position in PPE and can and really take advantage of that position around the world. And so I think we've got the model well aligned. I think there's surge capacity that will be available. How much will depend both on the demand that comes in any kind of future emergency. And I think we're, like I said, we're ready for our part of that.

Oh, I guess my question was sort of broad and longer term. You know, a lot of this technology is used, you know, air filters, automotive. And I was just wondering if you expect this incremental capacity that was brought on by your competitors to go into these industrial adjacencies and generate just more global competition. That was the question, actually.

Yeah, Andrew, I can speak about us. I mean, our non-woven capacity, we do leverage that and utilize that in other areas, other products that we have, like, air filtration. So it is an opportunity for us that even with the capacity that we've built to respond to the pandemic, we can take advantage of that and use that in other areas. And that's something that we're able to do broadly. We take our technologies and find innovative uses for them, and air filtration is one of those. Will others do that? I'm sure there'll be a focus in other you know, other markets for some of that capacity around the world. I don't know how to give you a view of that perspective. The world will continue to grow, and we see trends in personal safety, air filtration, so the demand is going to continue to grow. So to some degree, the capacity will grow into the demand as we go forward over time.

Thank you. Our next question is, comes from the line of Nicole DeBlaise from Deutsche Bank. Please proceed with your question.

Yeah, thanks. Good morning, guys. Good morning, Nicole. So you always give kind of helpful color by geography, and there's been a lot of noise about things kind of slowing down in China with respect to a lot of different pieces of macro data. Can you guys just talk a little bit about what you're seeing in China across your businesses? Sure.

Sure, Nicole. Like I highlighted for the broader business, we saw broad-based growth, double-digit growth in our transportation electronics, our safety industrial, and our healthcare businesses. Consumer was up mid-single digits as we came through the quarter. And our growth was led by general industrial, some of the segments that are growing there, including our braces portfolio, auto, OEM had strong growth, and electronics. It's an important market for us. It's 10% of our total revenue. It grew over 20% in the first half. Last year, second quarter, we saw 3% growth, so China recovered, if you remember, ahead of other regions around the world. And when you look at the second half, comparisons start to get a little more challenging. And so we're expecting just year-over-year comps, I would say. We expect to see a little more challenge there. We still see opportunities for growth across our businesses in some of the same areas that we've highlighted on a global basis. Automotive will continue to be a focus, penetrating with the OEMs there. And we see, even though it's our smallest business, we see significant opportunities to serve Chinese consumers through our consumer business, especially in areas like air and water quality. So we see opportunities, maybe a more challenging year-over-year comp, but still opportunities for growth.

Got it. Thanks, Mike. And If I could just follow up on the second half margin outlooks, there's clearly a lot of moving pieces here with legal costs, growth investments, price costs. Maybe just to boil it down, do you guys still expect to kind of be in that 30% to 40% incremental margin range in 3Q and 4Q? No.

So I would just say, Nicole, volume is the biggest driver that gives us leverage. So I think that's step number one with all the volatility, the uncertainty that's out there. The question is where does second half volumes land? As well as we've given you a range on disposable respirators are going to be down 100 to 300 million on a year-over-year basis. The team continues to drive operating rigors or driving productivity and efficiency across the supply chain. We are going after price increases, and our anticipation is that in the fourth quarter we should be able to offset the price, the raw and logistics cost impact. So I would boil it down to saying what margin will come down to in the second half and what incrementals are will depend on the volume, will depend on our ability to offset the price, the raw and logistics pressure through price increase. continued productivity and good execution by the 3M team, and then finally our decision on how much we're going to invest in growth, productivity, and sustainability, plus a lot of these indirects that start snapping back as hopefully people start traveling. You've seen we've been very disciplined in the first half of making sure that we didn't spend ahead of what volumes come back. But as we see volumes coming back in, you're going to see those indirects start snapping back up. And then the last one is the legal fees and continuing to do what we think is right to protect ourselves as these cases go through. So that's all the factors that will ultimately impact what the incrementals are going to be.

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

This is Eitan Bookbinder on for Andy Kaplowitz. Good morning. Good morning, Eitan. Hi, Tom. Priority growth platforms delivered 10% growth in Q1. Can you update on how the group performed in Q2 as well as your outlook for the faster growing businesses in the back half of the year?

Yeah, the priority growth platforms also had strong growth. We talked about it at Q1, second quarter as well. So overall, they were up over 40% in second quarter, now over half a billion dollars in revenue as a group. And I highlighted a couple of other areas of our businesses that are seeing strong sequential growth and market dynamics that are attractive. So these priority growth platforms broadly are in attractive market spaces. part of that priority investment in growth that we've been talking about, even as we came through 2020, staying focused and aggressively investing in growth areas. And PGPs, as we call them, the priority growth platforms, continue to be an important part in performing well.

Thank you. That's helpful. The electronics business group was up 13% year over year, but down sequentially about 4%. So could ongoing chip supply constraints lead the business to decline sequentially in Q3?

Well, we saw, as we said, some strength in their end markets. And I think it's, you know, the first half we were up overall, you know, still low teens for the business. And maybe it's, I would say, you know, it was really more of a seasonality situation. than a sequential dynamic. And as we get to the second half, the one other thing I would add, we're going to start to see some more challenging comps. We saw strong growth dynamics not only in our home improvement and other areas in consumer, but also in the cleaning supplies business as we went through the pandemic. So that's the other dynamic to watch.

Thank you. That concludes the question and answer portion of our conference call. I will now turn the call back over to Mike Roman for closing comments.

To wrap up, our second quarter performance was strong, marked by broad-based growth, increased margins, and robust cash flow. I'm confident in our ability to continue executing well as we navigate COVID-19 impacts, and we will stay focused on taking advantage of market trends and overcoming supply challenges while continuing to invest in growth, productivity, and sustainability. Thank you for joining us.

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