(FORTUNE Magazine) – At the 3M Co., stories are a big deal. Every employee knows about the 3M scientist who spilled chemicals on her tennis shoe--and came up with Scotchgard. Everyone knows about the researcher who wanted a better way to mark the pages of his church hymnal--and invented the Post-it Note. Every employee knows, too, the elements of a good 3M story: the moment of serendipity ... the skunkworks project...the boss who fails to see commercial potential...the lone researcher who prevails, against all odds, in developing a blockbuster.

Collectively these stories form a larger narrative about how 3M became, and remains, one of America's premier corporations. Lately, however, a new story has been unfolding. This one involves no heroic innovators, just terms like "cost controls," "Six Sigma," and "sourcing effectiveness"--not exactly the stuff of company lore. But it says everything about how 3M is changing under new CEO James McNerney, the first outside leader in the company's 100-year history.

Since he arrived in Minnesota in December 2000, McNerney--a foiled contender for the top job at General Electric--has given 3M's freewheeling culture a dose of GE's management science. He has slashed costs, rationalized purchasing, introduced a companywide process-improvement program, and challenged 3M to amp up its growth. Most significant, he has brought more centralized direction to a company that has always favored a laissez-faire approach of experimentation and doodling.

Wall Street is atingle with hopes that McNerney can transform 3M into the earnings-growth machine that Jack Welch made of GE. Others, though, are holding their breath. If McNerney turns 3M into "3E," will he kill off the quirky culture that made it successful in the first place?

Fears of management's heavy hand have deep roots in 3M mythology. Since its inception as the Minnesota Mining & Manufacturing Co. (a name that stuck until earlier this year, when it was retired in favor of 3M), the company has followed a simple formula for growth: Hire good scientists, give them ample resources, then get out of their way. The company's longtime CEO, an accountant turned sales manager named William McKnight, enshrined this approach in a 1948 manifesto now known as the McKnight Principles. "Mistakes will be made," it reads in part, "but if the man is essentially right himself, I think the mistakes he makes are not so serious in the long run as the mistakes management makes if it is dictatorial."

McKnight's admonition has defined 3M to this day. The company remains a model of decentralization and small government, with dozens of product laboratories scattered across 40 autonomous business units. Researchers can spend 15% of their time on any project of their choosing (a practice known as "bootlegging"). If management denies them funding, they can apply for a Genesis Grant, awarded by fellow scientists, or pitch their idea elsewhere in the company. Nothing is considered too small or too zany: In the 1920s one researcher hatched a scheme to persuade men to shave with sandpaper, not razorblades. It's all very messy, inefficient, redundant--and brilliant at turning out innovation after innovation. One-third of 3M's $16 billion in revenues comes from products that didn't exist four years ago.

But 3M has posted only middling results in recent years. Between 1995 and 2000, earnings per share grew by an average of 8.8% (vs. 14% for GE), while shareholder returns lagged behind both the Dow and the S&P 500. "We have not produced elite results that correspond to the view that this is an elite organization," says Bob Burgstahler, chief of business development and a 34-year 3M veteran. Some felt that under previous CEO Desi DeSimone the company grew a bit too loose, a bit too insular, a bit too complacent about its innovative prowess. "3M was not poorly run," says Bill Fiala, an analyst at Edward Jones, "but I think to a certain extent it was starting to get fat and happy. It was the ideal situation for Jim McNerney to come to."

Diplomatic, jocular, and one of three finalists to succeed Jack Welch at GE, McNerney, 52, also looked like a dream candidate for 3M. Besides degrees from Yale and Harvard Business School, he had worked all over GE: in the lighting, electrical, and financial services units and most recently in the aircraft engine business--where he revived a sagging commercial jet engine project, the GE-90. He also had experience overseas (where 3M gets 53% of its revenues), having spent two years running GE's Asian operations. "It was as close to a perfect fit as one could find," says Edward Brennan, a 3M board member and former chairman of Sears.

As for McNerney's dream of running GE, that came to an end in a Cincinnati airplane hangar on a rainy night in December 2000. ("Imagine the set of Casablanca," he says.) Jack Welch had flown in to give him the most disappointing news of his career. But unlike fellow runner-up Bob Nardelli--who hotly demanded an "autopsy" of Welch's decision--McNerney took it in stride, living up to his reputation as the smoothest of the GE finalists. "I didn't feel slighted, cheated," he says now. "I didn't demand a big explanation.... My hat's off to Jack." Welch, for his part, says McNerney handled the succession race "with great aplomb."

Also unlike Nardelli, who held off talking to suitors until Welch had made his decision, McNerney had been in touch with 3M's board for a good six months, and the board had delayed its final decision on a new CEO for several months in the hopes of landing him. Its patience was rewarded: Shares leaped from $99 to $105 on the day of his hiring; they have since climbed to $120 at a time when the S&P 500 has fallen 30%.

In some ways the company McNerney joined resembled the one he left: diversified, industrial, and roughly a century old. Yet for the most part they contrasted sharply. GE gave its managers a toolbox; 3M functioned more like a sandbox. GE was organized into 11 giant business units; 3M had 50,000 niche products scattered across a bewildering organizational chart. Most important, GE's corporate headquarters drove earnings growth across the whole organization; 3M's original corporate headquarters were used to house "the world's only sandpaper museum."

Would GE's vaunted management tools work in a 3M environment? At other companies GE transplants had reported mixed success. "At GE we whipped the horse and it ran faster," one is supposed to have said. "Here, we whip the horse and it lies down and asks for mercy." Some early moves by McNerney hinted at trouble. He announced the layoff of 6,500 of 3M's 75,000 workers, drawing comparisons to "Neutron" Jack Welch. Then he goofed at his first shareholders' meeting by referring to 3M as "GE." ("I ask each and every one of you for your forgiveness," he pleaded.)

But after 20 months in the job, it's clear that McNerney is more smart bomb than neutron bomb. His style has let employees feel that they, not McNerney, are driving the changes; 3M scientists particularly like the data-driven nature of Six Sigma. "More people told me to change things than told me not to change things," says McNerney. "They were far more direct than I was. They made me seem like a patent-leather-shoe diplomat." Says Bill Conaty, GE's head of human resources: "Jim's got a great touch. He knows how to make that organization change without tipping it upside down on its nose--without making it feel like this is the latest best practice from General Electric."

It helped that McNerney did not arrive with an army of GE executives in tow. "I think the story here is rejuvenation of a talented group of people rather than replacement of a mediocre group of people," he says. He has praised the 3M culture at every turn, making clear that he wanted to give employees tools, not orders. "This is a fundamentally strong company. The inventiveness of the people here is in contrast with any other place I've seen. Everybody wakes up in the morning trying to figure out how to grow. They really do." The diplomacy has generally played well with the 3M faithful. "He's delivered a very consistent message," says Althea Rupert, outgoing chair of Technical Forum, an internal society for all 3M technical people. "There's a sense of speed and a sense of urgency."

One of McNerney's most urgent problems was overhead: Costs had grown at twice the rate of sales in recent years. Efforts to contain costs saved a quick $500 million in 2001, while streamlined purchasing (e.g., reducing the number of packaging suppliers from 50 to five) saved another $100 million. A longer-term priority was leadership development. The company "had a broken pipeline," says University of Michigan management professor Noel Tichy, noting that 3M had not generated strong internal candidates for the CEO job. McNerney put the issue front and center by opening a leadership-development institute modeled after GE's famous Crotonville center. He also blew up 3M's seniority-based pay structure, forcing managers to grade every employee on a curve and to promote emerging stars faster. "Younger people are going to make a whole lot more money earlier than they did previously," says Mark Gulley, an analyst at Banc of America Securities.

Taking another page from the GE playbook, McNerney wants to push 3M into services. It's not clear how many owners of Scotch tape dispensers will sign up for long-term maintenance contracts. But the State Department has hired 3M to install its shatterproof films on the windows of American embassies worldwide.

A more controversial topic is acquisitions. McNerney wants to use them as part of his ambitious plan to grow sales 10% a year, nearly double the rate of the past decade. But while 3M has the cash flow and healthy balance sheet to go shopping, it has little experience integrating acquired companies. Some feel the task could distract management from the core task of innovating. "GE clearly knows how to do it," says Philip Bromiley, a management professor at the University of Minnesota. "3M doesn't."

As McNerney strengthens the corporate center, he also wants it to play a more active role in allocating resources. Cash from mature businesses, like adhesives and abrasives, will be diverted to growth businesses such as pharmaceuticals, which has developed a promising class of drugs known as immune response modifiers. The optical division will also get priority funding. "I want people to start competing for resources around here again," says McNerney. He has done away with another 3M totem: the requirement that each division get 30% of sales from products introduced in the past four years. To make that number, some managers were resorting to rather dubious "innovations," such as pink Post-it Notes. "It became a game: What could you do to get a new SKU?" says McNerney.

Yet for all his changes, McNerney insists that fears of "3E" are overblown. "I'm not trying to change the engine," he says, likening himself to an auto mechanic. "I'm trying to put in a new chassis, a new clutch, a new trickle-charge. But it's still going to be a car when I'm done. It's not going to be a boat."

The change that strikes closest to 3M's heart--and its mythology--is an initiative McNerney calls "acceleration." At any given time, 3M has about 1,500 products in the development pipeline. McNerney thinks that's too many. His idea is to funnel more money toward the most promising ideas--say, those with a potential market of $100 million or more--while culling the weakest-looking ones earlier. This Darwinian approach, McNerney believes, will make better use of 3M's $1 billion R&D budget and could halve the time that it takes to bring new products to market. "I've got to make it culturally okay to say no," he says. "A no means you can get back onto something that has a greater chance of success."

Some 3M watchers see a risk, however. If the company's history proves anything, it's that it is hard to tell which of today's tiny projects will become tomorrow's home runs. No one predicted that Scotchgard or the Post-it Note would earn millions. They began as little experiments--solutions to a problem that people didn't know they had--on the 3M principle that "no market, no end product is so small as to be scorned." The question is, Would those innovations get through the system today? McNerney has wrestled with the question. "I think we're world-class at the front end of the [innovation] process," he says. "If I dampen our enthusiasm for that, I've really screwed it up."

It's the back end of the process, he says, that he wants to change. "What has tended to happen here is, you start spending money before you've really analyzed what you're doing," he says. "So you pay a third of a million dollars for a pilot plant, and you really haven't brought the marketing guys into the discussion yet. We have too many examples of that"--which is why he talks about starting a management award for employees who accept no for an answer.

In doing so, McNerney knows he's going up against decades of 3M stories in which naysaying management is always the villain. "The mythology here is, 'Against all odds, I ended up with Post-it Notes,' " he says. "Mythology supports a lot of important and good behavior. But when it becomes apocryphal, it becomes dysfunctional.... You want to get people onto a more reality-based way of looking at the world." Says John Benson, head of the company's health-care business: "It's a myth, frankly, to suggest that all of this stuff is serendipity."

McNerney's challenge, then, will be to maintain the delicate counterpoise between the company's center and its periphery--between efficiency and innovation. "It will mean getting stronger business and marketing involvement earlier," says Burgstahler, "without killing off all the harebrained ideas."

On June 13, 3M celebrated its 100th birthday. Employees received small bags of anorthosite--the mineral 3M was originally set up to mine--and listened, again, to all the hoary stories. There were the chemicals spilled on the shoe, the pieces of paper in the hymnal. And there was Jim McNerney, maybe hoping that one day they'd be telling stories about his innovations too.

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