Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

3M

1 Analysis

Business Summary

3M uses its expertise in materials science to develop new consumer, commercial, and
industrial products. The company is organized around six lines of business: consumer,
industrial, healthcare, display and graphics, safety, and electronics. Some examples of
consumer products are Post-it products, Scotch Tape, Filtrete air filters, and Scotch-Brite
cleaning products. The display and graphics business does not actually compete in the
highly competitive display business, but rather manufactures films used to enhance
display quality. This business also produces paint used for marking roadways and special
materials used to enhance sign visibility. The electronics business’s products include
PCB connectors & insulation, disk drive lubricants, and high voltage power line
conductors; the healthcare business’s products include orthodontic products, medical
equipment and devices, and medical database software; the industrial business’s products
include water filtration systems, high strength tapes used in aircraft manufacture,
disposable diaper closures, and supply chain software; while the safety & protection
business’s products include passport and driver’s license authentication technology,
energy control products, protective equipment, and respirators. These are just a few of
the company’s products in each segment: 3M has a remarkable range of products.

Historically, the company tried to get by with as little manufacturing capacity as possible,
by sometimes routing a single product through multiple facilities around the world.
Although in theory this should raise return on capital, the strategy has recently started to
result in supply constraints and decreasing inventory turnover, which will negatively
impact return on capital (inventory being a portion of total capital). In response,
management recently decided to ramp up production capacity, and concentrate
production in major markets, with the goal of shortening supply chains and increasing
inventory turnover.

Page 1 of 9
Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

Revenue by Segment Operating Income by Segment

Electro &
Electro & Communications
Communications 8% Industrial &
11% Industrial & Transportation
Safety, Security & 23%
Safety, Security & Transportation
Protection
Protection 30%
10%
13%
Consumer & Office
11%

Consumer & Office

14%
Health Care Display & Graphics Health Care
16% 19% 29%
Display & Graphics
16%

End Markets Revenue by Geography

Latin America &

Construction
Canada
5%
Industrial 10%
22% Transportation
12%
United States
Europe, ME & 36%
Gov't & Africa
Infrastructure 27%
16%
Health Care
17%

Electronics
Consumer 11%
Asia / Pacific
17% 27%

Segment Industrial Healthcare Display Consumer Safety Electro

OPM 19.5% 35.5% 28.5% 18.7% 21.5% 17.5%
ROAA 25.1% 59.0% 29.5% 27.9% 25.4% 23.2%

Operating History (3.0)

Ten Year Operating History

ROAA OPM RORE RORE+D GM InvTurn E/FCF E/E+D-C
25.5% 20.5% 13.3% 11.5% 45.1% 4.4 0.99 0.93
3.2 3.1 2.8 <- Rating
ROAA: Return on Adjusted Assets; OPM: Operating Margin; RORE: Return on Retained
Earnings; RORE+D: Return on Retained Earnings & Change in Debt; GM: Gross Margin;
InvTurn: Inventory Turnover; E/FCF: Earnings to Free Cash Flow; E/E+D-C: Earnings to
Earnings+Depreciation-Capex

The company’s earnings dropped sharply in both the 2001 and 1990 recessions, but the
company remained profitable, with dividends comfortably covered by earnings.
Dividends have steadily risen since 1972 (earliest data). Earnings grew from 1972 to

Page 2 of 9
Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

1997 at an annualized rate of 8.7%; this period covered multiple recessions, two of them
severe1. Over the same period, the SP500 had an annualized EPS growth rate of 8%.

Future Prospects (3.0)

3M’s competitive advantage is differentiation. 3M uses its expertise in material science to

insure that many of its products are genuinely more useful than its competitors, and this
differentiation is protected by both patents and proprietary technology. 3M has strong
brand recognition, which signals this value to buyers.

Buyer Bargaining Power

Buyer bargaining power is reduced due to the strength of the company’s well-known
brands, such as Post-it, Scotch, Nexcare, and Filtrete. Buyer concentration varies from
extremely low for products sold to consumers to very high for products sold to
government agencies. Although the company’s products create great value for customers,
they tend to be a small percentage of the customer’s annual expenses. This tends to make
demand somewhat resilient to price increases.

Supplier Bargaining Power

Inputs are primarily commodities such as metal, wood pulp, and oil derived raw
materials, and are readily available from multiple sources. Employees are productive,
with earnings per employee of $43,956 in 2008. To date, employee bargaining power
has not reduced profitability, and 3M’s strong bargaining power with employees was
recently illustrated when they closed their defined benefit pension plan to new members.

Threat of New Entrants

Many of 3M’s products are sold through distribution channels of limited size, creating a
barrier to a company attempting to enter one of the industries that 3M competes in. 3M’s
products are differentiated - protected by patents, proprietary technology, or both. Many
of 3M’s products also have strong brand identity. Since many of the company’s products
are on the cutting edge of technology, there is probably little risk of competition eroding
profit margins; this has certainly been the case to date, as the company continues to grow
revenue worldwide.

3M’s manufacturing expertise gives the company a sustainable cost advantage. 3M’s cost
advantage is enhanced by economies of scale in both R&D and marketing. 3M can also
share material science advances across a broad line of products.

1
From Jeremy Siegel’s “Stocks for the Long Run”, chapter on nifty fifty.

Page 3 of 9
Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

Threat of Substitution

The company has a good track record of consistently developing new products using
advanced material technology. If this continues, then potential substitutes will find it hard
to provide a compelling ratio of perceived value to price. For the most part, the low
prices of 3M’s products in relation to overall buyer purchases mean that buyers have a
low incentive to search for substitutes.

Intensity of Rivalry

3M’s markets will likely grow in line with global GDP, leading to moderate rivalry.
Some of 3M’s products have strong brand identity, which will reduce this rivalry.

Other Considerations

Due to the diversity of the company’s product line, patent expirations do not pose a
significant risk to revenue. Unlike pharmaceutical companies, even the loss of patent
protection does not necessarily indicate a subsequent loss in revenue with the associated
product, as the both the company’s brand and manufacturing expertise are significant
components of the company’s competitive advantage.

Key risks:

• 3M must continually innovate to maintain its competitive advantage

•

Upside

3M’s markets will likely grow in line with global GDP.

Financial Strength (3)

Credit Rating Ave. Maturing Debt to Earnings Fixed Charge Pension Benefits
Debt to RE Cov. Paid / PBT
AA1 0.39 2.1 16.8 17%

The company’s earnings are somewhat cyclic, being influenced by the strength of the
economy in general, but the company certainly has the financial strength to weather a
severe recession. The company’s total pension obligation is manageable at 5 times
earnings, and is 82% funded. Over the last ten years, contributions to the pension plan
averaged 20% of earnings. In 2008 3M switched over to a defined contribution plan for
all new hires. Over time, this should bring down 3M’s pension obligation and reduce

Page 4 of 9
Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

pension risk. 3M estimates that over the next ten years, benefits paid will average around
$1B annually.

Fixed costs are relatively low; in 2008 half of COGS was raw material, and we can
assume that the rest was relatively fixed (labor, depreciation, power).

Management
Management has historically remained focused on creating new products using the
company’s expertise in materials science. Management has also done a good job
balancing internal growth with returning cash to shareholders.

Summary

Operating History Financial Strength Future Prospects Combined Rating

3 3 2.5 2.9

Page 5 of 9