Illinois Tool Works Inc (ITW) — Q1 2018 Earnings Call Transcript

Thanks, Angela. Good morning and welcome to ITW's first quarter 2018 conference call. This morning I'm joined by our Chairman and CEO, Scott Santi, along with Senior Vice President and CFO, Michael Larsen. During today's call, we will discuss first quarter financial results and update you on our second quarter and full year 2018 outlook. Before we get to the results, let me remind you that this presentation contains our financial forecast for the second quarter and full year 2018, as well as other forward-looking statements identified on this slide. We refer you to the company's 2017 Form 10-K for more detail about important risks that could cause actual results to differ materially from our expectations. Also, this presentation uses certain non-GAAP measures, and a reconciliation of those measures to the most comparable GAAP measures is contained in the press release. With that, I'll turn the call over to our Chairman and CEO, Scott Santi.

Thank you, Karen. Good morning, everyone. We got off to a solid start in 2018 with revenue up 8% and earnings per share up 23%. The ITW team continues to execute at a high level in the quarter. The combination of continued progress in implementing our enterprise initiatives, disciplined price/cost management, and an improving demand environment resulted in strong overall operating performance, with operating income of $903 million, up 12%; operating margin of 24.1%, up 90 basis points; and after-tax return on invested capital of 27.7%, up 400 basis points. Despite lower-than-expected global auto builds impacting our Auto OEM segment in the quarter, we delivered 3% organic growth, and all seven business segments and major geographies were up year-on-year. CapEx-related demand continues to strengthen in a number of our end markets, which is driving accelerated organic growth in our Test & Measurement, Electronics, and Welding segments. Overall, based on our Q1 results, positive underlying demand trends across many of our businesses, and a strong pipeline of projects and activities supporting our enterprise initiatives, we are raising our full-year EPS guidance by $0.15 at the midpoint. I'll now turn the call over to Michael to provide you with more detail on the quarter and our updated guidance. Michael?

Thanks, Scott. Let's start with chart number 3 and I'll add some color on our financial performance. As Scott mentioned, revenue was up 8%, with solid demand trends and positive organic growth in all segments led by Welding and Test & Measurement, both up 8%. Operating margin improved by 90 basis points to 24.1%. After-tax return on invested capital was 27.7%, up 400 basis points, with the new U.S. tax legislation and our lower tax rate being key drivers. Free cash flow was $444 million, up 11% versus the prior year, and was 68% of net income, which is in line with typical seasonality. We expect 100% conversion or better for the full year. To date, we have repatriated over $1 billion in cash and expect to bring back another $1 billion by year-end. We accelerated our planned share repurchases to $500 million in the quarter. You will note that the tax rate was 23.2% in the quarter, slightly below our guidance midpoint of 25%, primarily as a result of the Q1 cash repatriation and a $14 million foreign tax credit benefit that resulted from that. We now expect a slightly lower tax rate for the year relative to guidance, between 25% and 26% in quarters two through four, and a full-year average tax rate of 24.5% to 25.5%. We continue to assess and clarify the provisions of U.S. tax reform, which could further impact our tax rate and future discrete items. Moving to chart number 4 and operating margin, operating margin was 24.1%, up 90 basis points versus prior year and a new Q1 record. Five years into our current enterprise strategy, we're still generating 110 basis points of savings from the strong execution of our 80/20 Front to Back Process and strategic sourcing initiatives. As per usual, we report strategic sourcing savings as part of our enterprise initiatives benefits, not as part of price/costs. Of that 110 basis points, roughly half was from sourcing initiatives. So if you match that up with price/cost headwinds of 50 basis points in the first quarter, our sourcing initiatives actually more than offset the margin impact from raw material cost inflation. We expect Q2 price/cost margin impact to look similar to Q1, and then improve from there in the second half of the year. Our model is to source and produce where we sell, and we have incorporated what we currently know about the impact of Section 232 steel and aluminum tariffs and the mitigating price actions into our business plan and company guidance.

Hi. Good morning, guys.

Good morning.

Good morning.

So I want to start first on the operating margins, specifically on segment margins. The segment margins were up about 40 basis points this quarter on a year-over-year basis, but there hasn't been any change to your operating margin guidance for the year. How much of that improvement is coming from lower corporate versus you expect to see an improvement on the year-over-year segment margins as we progress through the year and what's driving that?

So, Joe, we expect every segment to improve operating margin for the full year, like I said, ranging from 80 basis points to 130 basis points. The biggest driver there is the continued execution on the enterprise initiatives, along with volume leverage, as all of our businesses are going to grow on a year-over-year basis. What you're seeing in Q1 is primarily the impact of price/cost in these segments and the lag we've talked about in the past from when the material cost inflation shows up and the price actions are realized. This quarter, there was a 50 basis points of price/cost headwind at the enterprise level, which we expect Q2 to look similar, and then improve from there through the second half of the year as these price actions take hold and offset the known material cost inflation as we sit here today.

Got it. Michael, maybe focusing on price/cost for a second, specifically as it relates to Welding. The Welding margins were flat year-over-year. One of your large competitors talked about getting some significant pricing increases this quarter, but probably that hasn't flowed through results yet. Talk to me a little bit about the operational leverage in that specific segment. Just given growth is better, pricing seems to be pretty disciplined.

Yeah. I think what you are seeing, Joe, is similar to what I just described, which is this lag between when the price actions have been announced, and there have been a number, primarily on the Welding side. We expect to continue to expand margins from here based on what we know today.

Okay. Got it. And maybe one last one. Just shifting to growth a little bit and focusing specifically on Auto OEM. You've got a decent ramp on the organic growth side to hit your full year number. Talk a little bit about what your expectations are based on wins you already have as you progress through the year.

Things were a little softer from the standpoint of global builds in Q1 than it looked like they were going to be in Q4, but certainly as we've moved through Q1, the build picture in terms of input from our customers and some public data we can see, builds for the balance of the year have firmed up. As Michael talked about in his commentary, second quarter builds are projected to be up 5%. That's usually a reliable number, given the timing. Things seem to be firming up demand-wise and the overall production scenario, as we look through the balance of the year, is pretty solid.

Okay. Fair enough. I'll get back in queue.

Hey. Good morning, guys.

Good morning, Andy.

Scott and Michael, I know you just talked about Auto OEM, but maybe you could step back and tell us what you saw as the core evolved here and also here in April. You guys aren't alone, but I think at the beginning of the quarter we kind of thought that you might get closer to your high end for the year and through the 4% organic guidance. And then you had a couple of businesses, specifically Specialty Products, maybe Polymers & Fluids, which slowed down a bit, but your longer cycle CapEx businesses continue to improve. Is it going to be more of these longer cycle businesses carrying the torch here?

The delta in Q1 was what Scott just talked about, on a global basis the forecast we use projected a 1% increase in global builds for Q1, but ended up being down 1%. If you look at specifically North America, which has the highest concentration for vehicle, North America builds were down 3%. As Scott said, if you read some of the headlines, March was probably a little lower than what people expected. That number goes from down 3%, projected to be up 3% in Q2, with overall North America expecting to be positive for the year. So, we fully expect Auto to deliver 4% to 5% organic growth. We have good visibility to the content per vehicle growth that gets us from the auto build number to 4% to 5%. In addition, continued strong momentum and acceleration on the Welding side, we have pegged it at 5% to 6%. Hopefully, that will turn out to be a conservative number.

Great. And, Mike, I wanted to ask you about the guidance increase in the context of the beat in the quarter $0.05 versus the middle of the range and a little bit lower tax rate. If you can give us more color on the rest of the guidance increase, you talked about currency. You got a lower share count, but you also mentioned a better operating environment.

The $0.15 guidance increase today is basically the $0.05 beat from Q1. We update our assumptions for current foreign exchange rates. We have a slightly lower share count due to acceleration in Q1, and the balance in that $0.05 to $0.10 is better demand and stronger operations, so that's what's driving the $0.15 raise today.

Thanks, guys.

Yeah. Thanks, guys. Good morning.

Morning.

Just on food and beverage, I mean, I think you said institutional and chain restaurants up 7%, which seems like a pretty big number. How sustainable is that? What do you think is going on there? Is that your new products getting good reception, or is it CapEx picking up, or is it a timing issue?

It's really CapEx and stronger demand on the institutional side, specifically education. On the restaurant side, quick service was also very strong. Those trends look good for the balance of the year with good orders and backlog, along with new product rollouts coming in.

And clearly you seem pretty positive on your ability to offset the higher input costs with pricing. Can you shed any light on what you're assuming in your forecast for steel? Are you forecasting things to come down at all in the second half?

We're leaving the forecasting to others. We're taking what we're seeing in our businesses today in terms of inflation on steel, chemicals, resins, as well as the demand picture. All of that is included in our guidance today.

That's already absorbed, and there are certainly things out there that we're not seeing the full impact of yet, but we've already accounted for those in the guide, and we have taken pricing actions on them.

Thanks. And lastly, M&A, can you comment on the pipeline at all and likely that you could consider some smaller-to-midsize deals this year?

We remain focused on executing our current strategy, getting our businesses up to full potential from an operational perspective. We’ve talked about accelerating organic growth, which remains the focus. We don't have a particularly active agenda right now in that regard.

Hi. Good morning, everybody.

Good morning.

If you could just talk a little bit about the trends you're seeing in Europe across your broad portfolio. There's some questions out there about PMI slowing, particularly in Germany. Just curious what you guys are seeing in Europe specifically.

We haven't seen any slowdown. We were up a little bit less in the first quarter due to a tough comp. For the full year, we expect to be up in that 3% to 4% range in Europe, and we haven't really seen anything slow down at this point.

Thank you. And can you just talk about when you mention price increases, are all your businesses implementing price increases as opposed to surcharges? Should we consider backlogs not included or dates when price increases will specifically be implemented?

These are primarily price increases. We are not a backlog-driven company, so these will go into effect relatively quickly. We do have notification provisions and other elements in terms of how we transact with our customers that are applied here.

Any particular segments where it might be more difficult to get pricing in this environment, or are customers broadly accepting of price increases?

I think everybody gets it, and we are having price discussions everywhere across the company. Automotive can be a little bit more challenging, but we're working through that with our customers.

Hi. Good morning. You mentioned in the second quarter each business segment would have faster organic growth than the first quarter. Are the businesses – or which businesses do you feel are truly accelerating and how much is it just simply the comp easing the next two quarters?

These are all based on current levels of demand, so not counting on an acceleration. What you're seeing is the comps are easier in Q2 and Q3, and a little more challenging in Q4.

The demand environment is pretty good. I mean, order books are good. I think some quarter-to-quarter comparisons can be circumstantial. But from a sequential demand standpoint, the overall environment is firm to improving.

So none of them were thinking of taking down the full-year guide on organic? There wasn't any heavy discussion on Polymers or Food to take it down?

That's correct, other than the adjustment in Specialty we made.

Good morning, everyone.

Good morning.

Back to the price/cost a little bit here. You guys are saying you're going to have a headwind in Q2 and you think it will flatten out in Q3. I'm wondering why you're not taking a more conservative approach to the back half on the price/cost dynamic.

What we're telling you, Nathan, is what we really think is going to happen here based on actions we've taken and the raw material inflation we've seen so far. Q2 will look a lot like Q1, and we expect to be positive in dollar terms on price/cost news.

Okay. Quick one on tax. You repatriated the $1 billion. Is it possible you could get further tax credits for that?

There's no clarification on the so-called guilty tax. The $1 billion in Q1 led to a tax credit that was specific to where those funds came from. There might be further discrete items as we go through the year, but that's all in the guidance.

Thanks a lot. Good morning.

Good morning, Andy.

I wanted to go back to Polymers & Fluids. I'm just wondering if you could give a little more color on what's driving the organic reacceleration moving from flat to 2% to 3%. Is that all pricing?

That is a part of it. There is some seasonality related to the Automotive aftermarket business, which typically sees an improvement based on historical trends.

Okay. Thank you very much.

Thanks. Good morning.

Morning.

On your Auto business, just wondering how you're thinking about the gap between your growth rate and the market over the next year or so. You're outgrowing by 3 points in Q4, about 2 points this quarter. I imagine there's some quarter-to-quarter variation, but wanted to see if you have particular expectations about that degree of outgrowth over the next year.

Nothing's really changed. Historically, we've been in that 2-4 percentage point range. For the year, we're saying 4% to 5% organic growth in automotive builds, with global growth expected to be up 2%. We believe we can stay in that range for the foreseeable future.

Hi. Thanks. Good morning.

Good morning.

Could you provide some color on the organic growth really strong in Electronics? Is there a lumpiness to this business?

Orders and backlog look good. Tougher comps in Q4 in that business, but there's nothing to suggest that on a run rate basis things are slowing down.

Okay, great. And the margin pickup, that's 80/20 related and volume leverage?

That's right, really strong execution on the initiatives, and then combined with the volume leverage.

Thanks for fitting me in. Good morning. I want to go back to these pricing questions and how often you can change pricing through the year. Is there a way to differentiate between your segments vis-à-vis your flexibility in changing price in a given year?

There's no structural impediment. The environment is apparent for those using silicones or steel, so these are actionable and reasonable actions. We are confident in our ability to recover costs dollar-for-dollar and we're on track to perform as expected.

Hi. Good morning.

Good morning, Joe.

First question on the international Welding side. Is that a reflection of stabilization primarily in offshore?

The bulk of our international business is oil and gas. Stabilization is encouraging after a significant down cycle, but we’re not calling the bottom. It feels better than previous quarters.

Okay. And on Specialty, it looks like the lower organic growth in the quarter was more a blip and that you get right back on track. Any additional details around consumables?

The business can be lumpy, as seen before. We expect it to improve based on run rates and backlogs, but that's all I can share.

Okay. And last one on pricing and timing sensitivity. Was pricing raised during the first quarter or are there letters that have gone out?

All of the above.

Okay. Thanks, Michael. Angela, let's open up the lines for questions.

Thanks to everyone for joining on the call. We are well-positioned as we look at the back half of the year and expect to continue executing and delivering on our now revised and updated guidance. We'll talk to you after the end of Q2. Thank you.

If you have any follow-up, feel free to give me a call or email. Thanks, everybody.