3M Company — Q3 2016 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2016; filed November 1, 2016. 3M is a diversified global manufacturer operating in Industrial, Safety and Graphics, Health Care, Electronics and Energy, and Consumer. Interim financial statements are unaudited and were reviewed by the independent auditor, not audited.
Financial performance and liquidity
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Net sales | $7.709B | $7.712B | $22.780B | $22.976B |
| Operating income | $1.904B | $1.876B | $5.558B | $5.446B |
| Net income attributable to 3M | $1.329B | $1.296B | $3.895B | $3.795B |
| Diluted EPS | $2.15 | $2.05 | $6.28 | $5.92 |
| Operating margin | 24.7% | 24.3% | 24.4% | 23.7% |
| Effective tax rate | 28.5% | 29.6% | 28.3% | 29.1% |
- Q3 organic local-currency sales fell 0.8%; reported sales were essentially flat. For the first nine months, organic local-currency sales fell 0.7% and reported sales declined 0.9%, with foreign currency translation reducing sales by 1.3%.
- For the first nine months, operating cash flow was $4.453B, capital expenditures were $984M, and free cash flow was $3.469B (a non-GAAP measure defined by 3M as operating cash flow less capital expenditures). Free cash flow conversion was 89%.
- At September 30, cash and cash equivalents were $2.308B; cash, cash equivalents and marketable securities totaled $2.680B. Total debt was $12.361B and net debt was $9.681B, versus $10.797B and $8.872B, respectively, at year-end 2015. Debt was 51% of total capital, up from 48%.
- Current assets were $12.179B and current liabilities $6.400B; working capital was $5.779B. The $3.75B revolving credit facility was undrawn. Its covenant required an EBITDA-to-interest ratio of at least 3.0:1; reported ratio was approximately 48:1.
- Cash dividends paid in the first nine months were $2.014B. The quarterly dividend was $1.11 per share; 3M also repurchased $2.829B of stock during the period.
Material changes and business performance
- Diluted EPS rose about 5% in Q3 and 6% year to date. Margin gains reflected higher selling prices, lower raw-material costs, lower pension and postretirement expense, restructuring productivity, and fewer shares outstanding. Organic volume declines, lower asset utilization, foreign exchange and higher interest expense offset some gains.
- Q3 segment sales and operating income were: Industrial $2.582B and $591M; Safety and Graphics $1.448B and $364M; Health Care $1.361B and $429M; Electronics and Energy $1.293B and $312M; Consumer $1.209B and $317M. Electronics and Energy was the principal weakness: organic local-currency sales fell 8.1% in Q3 and 9.6% year to date, amid weak consumer-electronics demand and energy-market challenges.
- Safety and Graphics and Consumer posted stronger Q3 operating income and margins. Health Care sales grew modestly, but Q3 operating income slipped 0.6%. Industrial organic sales remained weak, although management reported some improvement in U.S. trends.
- Interest expense was $50M in Q3 and $135M year to date, above prior-year periods, largely because of higher average debt. The company issued euro- and dollar-denominated notes in 2016 and repaid $1B of notes at maturity.
- 3M’s 2015 restructuring affected approximately 1,700 positions and generated an estimated $95M of pretax savings in the first nine months of 2016. A change to the pension cost methodology reduced estimated 2016 pension and postretirement expense by about $180M; management expected full-year expense to be approximately $320M lower than 2015.
- 3M early adopted share-based-payment accounting changes in 2016. The resulting excess tax benefits reduced tax expense by $175M year to date, including $35M in Q3. This helped reported EPS and is subject to variability.
Outlook, risks and contingencies
- Management expected a 2016 effective tax rate of approximately 29%, capital spending of $1.4B–$1.5B, full-year gross share repurchases of $3.5B–$4.5B, and approximately $400M of global pension and postretirement contributions. The filing text does not provide a clear company-wide full-year EPS or revenue guidance figure.
- Management anticipated Industrial sales growth turning positive in Q4, while noting near-term soft conditions in Health Care and persistent challenges across consumer-electronics applications. Management continued to prioritize R&D, commercialization, capital spending, acquisitions and shareholder returns.
- Key stated risks include global economic and political conditions, currency movements, competitive pressures and customer demand, raw-material availability and costs, execution of acquisitions and productivity initiatives, ERP and cybersecurity risks, pension funding and investment markets, and legal, environmental and regulatory proceedings. 3M noted that approximately 60% of revenue came from outside the United States.
- Legal and environmental exposures include respirator/asbestos litigation, PFC-related investigations and lawsuits, Bair Hugger patient-warming claims, and other product and commercial matters. Respirator mask/asbestos accruals were $142M (excluding Aearo), with $4M of related insurance receivables; Aearo-related accruals were $19M. 3M accrued $43M for respirator/asbestos matters in the first nine months and reversed a $35M insurance receivable after an arbitration decision. The company stated it could not estimate the potential loss above these accruals.
- Recorded environmental liabilities were $44M for remediation and $31M for other environmental matters, with related insurance receivables of $11M and $15M, respectively. The company said possible additional losses could not be estimated for certain ongoing remediation matters. Other notable legal matters include approximately 830 Bair Hugger lawsuits and several new PFC-related water contamination claims; 3M reported no accrual for those matters where liability was not considered probable and estimable.
- Moody’s downgraded 3M from Aa3 to A1 in March 2016, with a stable outlook; S&P rated it AA- with a stable outlook. Management said additional leverage could affect future ratings and borrowing costs.
Important facts for investors to verify
- Whether the sales and margin trends in Electronics and Energy, Industrial and Health Care improve as management anticipated, and how much growth depends on pricing, acquisitions or currency.
- The durability of cash generation and the effect of working-capital needs, capital spending, dividends and planned buybacks on debt and net debt.
- The contribution of the $175M year-to-date share-based-payment tax benefit to earnings, alongside the underlying effective tax rate and expected approximately 29% full-year rate.
- Potential exposure beyond recorded asbestos, PFC/environmental and product-liability accruals, including insurance recoveries, litigation outcomes and regulatory developments.
- Whether increased leverage affects credit ratings, funding costs, or management’s ability to sustain shareholder returns and planned investment.