Illinois Tool Works Inc (ITW) — Q1 2015 Earnings Call Transcript

Thanks very much. And good morning and welcome to ITW’s First Quarter 2015 Conference Call. Joining me this morning are our CEO, Scott Santi and our CFO Michael Larsen. During today’s call, we will discuss our first quarter financial results and update you on our earnings forecast. Before we get to the results let me remind you that this presentation contains our financial forecast for the 2015 second quarter and full year as well as other forward-looking statements identified on the slide. We refer you to the company’s 2014 Form 10-K for more details about important risks that could cause actual results to differ materially from our expectations. Also this presentation uses certain non-GAAP measures; a reconciliation of the non-GAAP measures to the most comparable GAAP measures is contained in the press release. So with that, I will turn at this time over to Scott.

Thanks, Aaron and good morning. Overall, a solid start to the year for the company as we delivered earnings per share at $1.21, an increase of 20% over the last year and $0.04 higher than the midpoint of our forecast. And that was despite an additional $0.03 of currency headwind versus where rates were when we issued our Q1 guidance on January 27. In the quarter we were able to deliver stronger performance despite a challenging macro environment. We continued to focus on executing on the things that are within our control and our business teams around the world continued to do a very good job of doing just that, as evidenced by the 220 basis point operating margin improvement that they delivered in the quarter. Q1 operating margin of 20.9% matched the all-time record high for the company set in Q3 of last year. Enterprise strategy initiatives, good tactical cost management and favorable mix as a result of our product line simplification program drove the bulk of the margin increase. Organic revenue growth for the quarter was 2% gross, 1% net including the impact of the product line simplification. This was below our 2% to 3% forecast as weaker capital spending generally and the oil and gas sector specifically resulted in modest year-on-year revenue declines in our welding test and measurement in electronics and specialty product segments. Despite the current macro challenges we are continuing to invest aggressively in support of our strategy to position ITW to deliver solid organic growth with world-class margins and returns on capital. In the quarter we invested more than $150 million in capital expenditures, restructuring, and innovation programs. As you likely saw in our press release, we are taking our full year EPS forecast down by $0.15 to reflect foreign exchange rates. At the new midpoint of $5.10, full year EPS growth is 9% despite a translation impact of $0.40 negative. On a constant currency basis, $5.15 EPS growth would be 18%; so overall a strong start for the year in a challenging environment. ITW is well positioned for another year of progress in 2015 and we remain solidly on track to meet or exceed our 2017 performance goals. I'll now turn the call over to Michael.

Thank you, Scott, and good morning. Starting with the financial summary on page 4, Scott mentioned first quarter EPS was $1.21, an increase of 20% versus prior year and $0.04 above the midpoint of our guidance. As expected, enterprise initiatives drove 100 basis points of margin expansion, which contributed to first quarter operating margin of 20.9% and operating income of $697 million. Also, good progress and after-tax return on invested capital with an improvement of 210 basis points to 19.3%. Revenues were $3.3 billion, up 1% organically after the expected 1% impact from product line simplification. Foreign currency translation reduced revenues by 7% resulting in total revenues declining 6%. Pre-operating cash flow was strong at $359 million, more than $100 million higher than last year. Also, during the quarter we were able to efficiently act on about $1.1 billion of cash outside of the U.S., which helped fund the buyback of $1.6 billion. Overall, solid execution in a more challenging environment and stronger margin performance offset currency and lower revenues in some of our equipment businesses. Turning to revenue by geography; organic revenue was up 1% with growth in all major geographies except South America, which as a reminder represents less than 3% of our sales. North America was at 1% as a result of strengthened food equipment of 7% and automotive OEM of 3%. Welding and Test & Measurement and Electronics were flat, while the specialty product was down 7%. International growth was up 1%. Q1 had a tough comparison. You may recall that last year international was up 6% in the first quarter. Europe was up 1% this quarter driven by automotive OEM up 13% partially offset by declines in welding, polymers and fluids and specialty products. Asia-Pacific was up 1% from strength in automotive OEM and food equipment, both up 5% offset by welding down 7%. China was solid and up 7% in the quarter with automotive food equipment and test and measurement on electronics all growing double digits. Overall, 2% gross organic revenue, 1% net after ongoing product line simplification activities reduced organic growth by 1%, and a mixed demand environment for some of our equipment-related businesses. Margin performance continues to be a highlight; hence the operating margin improved by 220 basis points to 20.9%, which marked a new record for a first quarter and tied for best quarterly operating margin performance ever. The margin expansion, as you can see, is significant across every segment. On the right side, you can see the key drivers of margin expansion this quarter with the largest contribution of 100 basis points from enterprise initiatives. Operating leverage was 20 basis points; price cost was also favorable 20 basis points. Finally, 80 basis points of improvement from cost management and the benefits of product line simplification for a total of 220 basis points. So in summary, significant sustainable progress on operating margin in every segment through the execution of our strategy with more to come as we work towards our 2017 goals. On this page, you can see the significant progress all the business teams have made on margin improvement over the first two years of this enterprise strategy. Five segments are now at or above 20% compared to only one segment when we started and overall 400 basis points of improvement. While much work is still ahead of us, significant progress and strong execution on the enterprise strategy so far. Also keep in mind that the reported margins for test and measurement and electronics and polymers and fluids, each include over 400 basis points of non-cash acquisition-related amortization expense that will run its course over time. For your information, we have included a schedule with the acquisition-related amortization expense for each segment in the appendix. With that, let me provide some additional color about each segment's performance in the first quarter. The automotive OEM segment has another really good quarter as organic revenue grew 7% and significantly outperformed worldwide auto builds of 1%. By geography, Europe stood out once again with revenues up 13% driven by new products and strong penetration gains across all platforms. In North America, our growth was slightly above auto builds at plus 3% as the Detroit 3 actually declined slightly versus the prior year. In China, organic revenues grew 14% outperforming auto builds by 8 percentage points. Profitability also improved with operating margin of 25%, 170 basis points higher than last year. In our test and measurement and electronics segments, organic revenue increased 1% in the quarter similar to the growth rate in the fourth quarter. Organic revenues in test and measurement declined 2% due to lower capital spending. That said, the largest division in test and measurement was up 5% in the quarter. Electronics business was essentially flat with the other electronics platform up 2% offset by a slight decline in the electronic assembly platform. Operating margin increased 250 basis points to 14.7% in the quarter, and I already discussed the significant impact related to acquisitions. Food equipment is up to a good start with organic growth of 4%. In North America, equipment was up 10% driven by new products and penetration gains in refrigeration and cooking. Internationally, equipment revenue was flat on a tough comparison. Service grew 4% in North America and 1% internationally. The segment's operating margin of 22.6% was 400 basis points higher than the prior year period driven by solid execution and lower restructuring. In the polymers and fluids segment, organic revenue declined 1% while operating margin expanded by 340 basis points as this segment reached 20% this quarter. Fluids and hygiene organic revenue was down 5% driven primarily by softness in Europe. Polymer was up a solid 4% and automotive, half the market was flat. And as I already mentioned, there is more than 400 basis points of non-cash acquisition related intangible amortization impact in these segment's margins. Welding organic revenue was down 3% this quarter as a result of weaker demand in oil and gas-related end markets. About 15% of this segment's revenues go into oil and gas, and that particular part of the welding business, the oil and gas part, was down 30% globally. Excluding oil and gas, welding organic revenues would have been up about 3%. North America was flat with growth in commercial welding offsetting declines in oil and gas. International is down 13% driven primarily by oil and gas. Nevertheless, welding delivered 120 basis points of margin expansion as operating margin came in at 26.9%. The construction product segment produced organic revenue growth of 2% in the quarter and margin expanded 118 basis points to 16.6%. North America was up 5% with growth in renovation and commercial while residential was flat. Asia-Pacific-East increased 1% for the quarter and Europe was up 1% as strength in the United Kingdom was partially offset by continued product line simplification. In specialty products, organic revenue was down 6% due to ongoing product line simplification along with weaker equipment sales. North America was down 7% and international down 3%. Operating margin improved 150 basis points to 22.6%. So that wraps up the segment discussion and turning to our guidance for 2015 and the second quarter; we have updated our 2015 full year EPS guidance by $0.15 to reflect current exchange rates. We now expect full year EPS of $5 to $5.20, which is a 9% growth at the midpoint or up 18% on the constant currency basis. Full year organic revenue growth is now forecast to be 1% to 2% due to a more challenging capital spending environment. As expected, PLS remains at a 1 percentage point drag throughout the year. Total revenue is expected to be down 5% to 6% as a result of the negative impact of foreign currency translation, which creates a 7% headwind at current rates. Given the strong first quarter results and continued positive momentum on margins, we now expect that operating margin will exceed 21% for the full year. This includes approximately 100 basis points of margin improvement from enterprise initiatives. On capital allocation for the full year, we now expect to allocate approximately $2 billion with share repurchases, while maintaining our target leverage ratio. ITW's board of directors authorized a new $6 billion share repurchase program in the first quarter. For the second quarter, we expect EPS to be in a range of $1.22 to $1.30 with $0.15 of negative impact from currency headwinds, which is $0.05 higher than what we saw in the first quarter. Organic revenue growth should be up 1% to 2% and we expect operating margin of approximately 21% which again includes approximately 100 basis points from enterprise initiatives. So that summarizes our guidance and as you can see in a more challenging environment, ITW continues to be well positioned to deliver another year of strong progress in 2015.

Thanks Michael. We’ll now open up the call to your questions. Please be brief to allow more people the opportunity to ask a question and remember our policy of one question and one follow-up question.

I just want to ask about -- kind of do a fine point on the guide. You basically sort of suggesting that the bulk of the reduction is currency and if you look at the way this sort of plays out that would proportionately hit mostly in the second quarter, but you did take organic growth for the year down and so my question is really if you could parse between what you’re seeing in terms of end markets and the context of reducing guidance second quarter versus the rest of year. Like for instance, why doesn’t the rest of the year come down further if you’re seeing systematic weakness as many companies are, so I’m just trying to understand the moving parts here?

Yes so John let me try to answer that, so the way we’ve modeled the rest of the year is based on current run rates. And so based on what we’re seeing in terms of revenues and orders in our businesses today. So we’re not assuming that things improve from here or deteriorate from where we are today. The other point around the guide, the adjustment that we’ve made is a $0.15 reduction just for currency. Here we are considering the lower organic growth rate but given the performance in the first quarter and the positive momentum on margins as well as a slight benefit from the lower share count, we’re projecting that we’ll be able to offset those lower revenues with better margins, we’re guiding to 21% plus operating margin today which is an improvement from where we were in January and we’re getting a little bit of benefit from the accelerated share repurchase program in the first quarter.

Okay so better execution really is offsetting the lower organic I think that’s what you’re --

Yes.

And then Michael, the share repo for the year had been tagged last quarter to 1.5 billion; you actually did 1.6 billion this quarter. So the question is sort of like how are you thinking about share repurchase for the rest of the year? Are you going to be sort of front-loading that and then seeing how the rest of the year plays out or would do you think consider raising some financial leverage? I’m just curious, because you obviously want to keep powder dry and I’m just curious how you’re thinking about share repo particularly against the backdrop of what clearly has been some economic softening and that just may present more favorable entry points sort of purchase your shares in future quarters that’s all?

Yes so John we’re in line with past factors, we’re not going to comment specifically on the timing of these share repurchases, but we’ve said before that our goal is to remain opportunistic as we go forward. I’d say in the first quarter the ability to access the foreign cash to the tune of about $1.1 billion is what helped fund the $1.6 billion of repurchase in the quarter which was essentially the guide that we’d given for the year. We expect to do approximately $2 billion for the year and the balance we’ll be opportunistic and we do not expect to increase leverage from here, certainly not to achieve the $2 billion. But as you know we have a strong balance sheet; we generate a lot of cash with the ITW business model and given the diversity of our businesses, and so certainly we are open. But given what we’re seeing today, we’re not expecting to increase our target leverage ratio beyond the 2.2 to 2.3 which is where we are right now. And we would like to be more opportunistic as we go forward for the balance of the year on the share repurchases.

Sorry Michael just as a clarification you took your repo for the year from 1.5 to 2. You’re sort of suggesting based on that was driven by the success to repatriate $1.1 billion, does that imply that you had thought you’re going to repatriate $600 million but you’re able to do $1.1 billion and that’s the difference or is there something else?

No that’s about right John, that’s about right.

And did you pay tax on that repatriation?

So our tax rate for the quarter at 31% as well as for the year we’re still guiding to 30% to 31%, so we were able to do this in an efficient manner from a tax standpoint.

Looking maybe for a little more color on your CapEx comments, I mean we know that mining and now there is energy CapEx is under a lot of pressure. But how do you think about CapEx trends more broadly outside of these three specific end markets?

I think we saw certainly soften up a bit in the quarter. I don't think it was anything overly dramatic but if you look at test to measurement and specialty in particular I think welding was largely impacted by oil and gas, there were other two segments. What I would say is in general we saw customers become a little bit more tentative about moving forward on capital expenditures again nothing overly dramatic, nothing that we don't think we can power through, we go through the year, but right now the environment is certainly a little choppy than it was as we ended the year.

Is it fair to say that you are starting to see hesitancy beyond these 3 end markets?

I think actually surely not in the equipment. So I think it's more for the industrial CapEx the food equipment business is much more tied to the consumer end of the economy. They continue to see growth; they saw there was growth in the quarter continue to accelerate. There are also reaching a place from the standpoint of their work through the enterprise initiative where they are how we focused on driving organic and I think you are seeing some of that progress show up. So I think we're again talking about test, measurement and specialty in terms of more generalized CapEx spending softness and welding in particular which related to oil and gas.

Alright, that's great and sticking with food equipment here, as I understood from your comments you hint that potentially some share gains in North America; any color there and really kind of what drove very good results their this quarter will be helpful.

We didn't hint at share gains, but sales were up 7% in the quarter in North America through a combination of, as I said, some continued strength in food equipment as well as new product pipeline things in the market as well as reaching the position they said earlier where they are much better prepared in a position to really focus on driving organic growth.

On the industrial CapEx comments, you described what you saw in North America during the quarter outside of the oil & gas sector. Specifically, was there any improvement through the quarter or did it just remain choppy?

I think in general that was pretty flat through the quarter. Actually, no better or no worse in terms of January, February, or March. Right, I think this quarter was pretty—the challenges we are talking about on the capital equipment side in oil & gas showed up fairly early in the quarter and we were able to take some cost actions here as we prepare for not just the quarter but for the rest of the year. But you can't certainly the price that didn't accelerate in the quarter and didn't improve in a meaningful way from the run rate that we saw earlier on.

Okay, thank you Michael and then is the same true of Europe?

You broke up a little bit. But I think this we saw the same trends essentially in Europe. Europe was a little bit weaker on the equipment side, down slightly. But I think again the comps were pretty challenging. Europe was up 5% in the first quarter last year. So would be too much into that at this time. But also Europe, Asia-Pacific was really consistent as we went through the quarter.

Hi, good morning. On the second quarter question of the margin and also sales, on the sales it looks that the organic growth you are expecting to accelerate a little bit. I'm just trying to figure out, is that simply because comps get a little bit easier or is there something you are saying to suggest the organic could accelerate a bit?

We are sequentially, we historically we typically see an increase through the seasonality from Q1 to Q2. If you look year-over-year, we are guiding to 1% to 2% which is a little bit higher than what we saw here in the first quarter, but not significantly higher. Maybe the other way that was kind of what you’re trying to get at is if you look at our EPS for the year this positions us at the first half earnings per share at about 48% of the year and 52% in the back end of the year so not a back-end loaded plan and very consistent with what we’ve been able to deliver historically. So again we’re not counting on acceleration here in terms of organic growth other than what we typically see, we’d love to see one. We’d love to take one, we’d certainly take it, we’re ready if it comes, but typically Q2 represents an improvement from Q1 on the top-line.

Yes I was referring more to year-over-year and I know it’s modest, but I was just curious…

And what I would add to that is go back to what Michael said before the comps move around, so we were plus 5 last year in Q1 and plus 1 in Q2.