Illinois Tool Works Inc (ITW) — Q2 2018 Earnings Call Transcript

Thanks, Brandon. Good morning, and welcome to ITW's Second Quarter 2018 Conference Call. I'm joined by our Chairman and CEO, Scott Santi; along with Senior Vice President and CFO, Michael Larsen. During today's call, we'll discuss second quarter financial results and update you on the outlook for the remainder of 2018. Before we get to the results, let me remind you that this presentation contains our financial forecast for the third 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 and subsequently filed Form 10-Qs 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. I will now turn the call over to our Chairman and CEO, Scott Santi. Scott?

Thank you, Karen, and good morning. ITW delivered another strong quarter, with revenue up 7% and organic growth of 4%. EPS of $1.97 was up 17% versus prior year and ahead of our expectations despite a $0.03 currency headwind versus the prior guidance. That's a translation headwind. If you exclude the benefit from a legal settlement we received in the second quarter of last year, EPS was up 19% year-on-year. We delivered strong results on all key financial metrics, including operating income of $932 million, up 9%; operating margin of 24.3%, up 50 basis points; and after-tax ROIC at 28.7%, up 440 basis points. Underlying demand trends remained strong, as evidenced by all 7 business segments in major geographies delivering positive organic growth in the quarter. In particular, CapEx-related demand continued to spur strong organic growth in our Test & Measurement and Electronics and our Welding segments. We saw improving growth momentum in Food Equipment, with growth 120 basis points higher sequentially versus Q1. Overall, the company delivered 4% organic growth despite a 40 basis points unfavorable impact from North American auto builds, which ended up being down 3% year-over-year versus an IHS forecast heading into the quarter that they would be up 3%. Additionally, we had 70 basis points of Product Line Simplification in the quarter. Michael will share more details later in the call. Overall, our teams are working to offset raw material cost increases on an ongoing basis, and through the first half, we have offset those increases on a dollar-for-dollar basis, continuing to expand margins despite these rising raw material costs. Continued progress in implementing our Enterprise Initiatives contributed 110 basis points margin benefit in Q2, as our business teams continued to apply our proprietary business model to deliver solid growth with best-in-class margins and returns. Looking ahead, we have adjusted our full year guidance to account for current foreign exchange rates, which represent roughly a 12% impact to the second half compared to the end of Q1 when we last updated guidance. We expect to deliver 15% EPS growth for the full year as we continue to execute well, accelerate organic growth and expand margins. We are well positioned to deliver continued strong results as we enter the second half of the year. And with that, I'll now turn the call over to Michael for more detail on the quarter. Michael?

Thanks, Scott. Organic revenue growth of 4% was up more than 100 basis points sequentially, and we're seeing good growth momentum across our business portfolio and in every major geography. Product Line Simplification in the quarter reduced organic growth by 70 basis points, and softer North American auto builds versus the industry forecast heading into the quarter was a 40 basis points drag on our overall organic growth rate. If we add those back, we would have been right around 5% organic growth. By segment, Welding led the way as demand continued to accelerate, delivering 13% organic growth, followed by Test & Measurement and Electronics and Specialty both up 4%. Scott mentioned good sequential growth momentum in our Food Equipment business, particularly evident in our North America foodservice equipment side with growth of 13% in Q2, following 7% in Q1, and with a positive outlook for the second half. Earnings per share of $1.97 were $0.02 above the $1.95 midpoint of our guidance, despite a $0.03 unfavorable currency translation impact. Operating margins were strong at 24.3%, up 50 basis points year-over-year, excluding the prior year legal settlement, and up 20 basis points sequentially. Free cash flow was excellent at $533 million, up 38% versus prior year. We repurchased $500 million of our shares this quarter for a total of $1 billion in the first half of 2018. Moving to Chart #4 on operating margin, we see strong margin performance as operating margin continued to improve sequentially and year-over-year. Operating margin of 24.3% was up 50 basis points versus the prior year, when excluding last year's benefit from a legal settlement. Similar to Q1, strong execution by our teams of Enterprise Initiatives contributed 110 basis points of margin improvement. Pricing actions continue across the company as we execute our strategy to cover raw material cost inflation with price adjustments on a dollar-for-dollar basis. I'll cover this and tariffs in more detail on Slide 10. Finally, we continue to invest in CapEx and people to support and further accelerate our long-term growth strategies. These growth investments amounted to 60 basis points. Turning to Chart #5 for a look at our first half performance, we delivered strong results with revenue up 7%, organic growth of 3% and earnings per share up 20%. All segments and major geographies contributed positive organic growth, showing excellent operational execution. Let's move on to Chart #6 and segment performance. The table summarizes organic growth by segment for the first and second quarter, indicating the good growth momentum we're building, with 5 out of 7 segments improving sequentially. Overall, organic growth was 4% in Q2, which includes the PLS initiative impact of 70 basis points. We remain confident that we will deliver 3% to 4% organic growth in Q3 and for the full year based on current run rates. Also, looking at our Automotive business, organic growth was 3%, up from 1% in Q1. Our North America growth of 2% was 5 percentage points above builds, which were down 3% this quarter. Thanks to the projects we've booked already, we expect to remain in the range of 2 to 4 percentage points above global auto builds. Looking ahead, we expect organic growth around 3% in the second half, with margins holding steady. Lastly, on Chart #10, we continue to execute our strategy to cover cost inflation with pricing actions on a dollar-for-dollar basis. We've done that year-to-date and expect to do the same in the second half. Our model is to source and produce where we sell, significantly mitigating tariff risks. The bottom line is our combination of continued progress on organic growth and the strength of our business model will drive continued margin expansion and strong earnings growth in 2018. Our guidance midpoint reflects margin expansion of about 80 basis points this year, following 70 basis points in the first half. Let's go to Chart #11 for the 2018 guidance. We see strength in demand trends across segments and continued strong margin expansion from Enterprise Initiatives, with clear visibility to projects contributing at least another 100 basis points of margin improvement again this year. While raw material cost inflation may impact margins in the second half, we are confident that we can offset those cost increases with price actions, thus not negatively impacting earnings. The updated operating margin guidance is 24% to 25%. For 2018, we're adjusting the EPS guidance midpoint by $0.10 to expect earnings in the range of $7.50 to $7.70 per share, representing 15% EPS growth from the prior year's underlying earnings per share. We also expect free cash flow conversion at 100% of net income or better. Through the first half, we repurchased $1 billion of our shares and now expect to repurchase an additional $500 million in the second half. As a reminder, we're planning to significantly raise our dividend as we increase ITW's dividend payout ratio to 50% of free cash flow. Today, we are providing guidance for Q3, a range of $1.80 to $1.90 per share versus $1.71 in the third quarter 2017.

Scott or Michael, this question is going to be a bit nitpicky because we know that you have still very high margins, but it seems like there's just been a little more volatility in some of your segments' margins over the last couple quarters. So if you look at Food Equipment, it was down 100 basis points year-over-year this quarter after being down last quarter. At the company level, you cited 60 basis points of growth investments, which you said was an investment in people but might be a surprise to us. Are you having to do more PLS than you thought, or the investment in people you've mentioned? Do you think this increased level of noise will diminish moving forward?

There was a lot there, Andy, but I think the bottom line is that we are very close to executing the plan we laid out at the beginning of the year. Really, the only delta that's meaningful is the price/cost equation, and that's just the margin percentage impact we talked about. Overall organic growth and margin expansion from Enterprise Initiatives continue in every segment. We're not done on the Enterprise Initiatives, and more is to come in the second half and beyond. So you're pointing out Food Equipment. Like I mentioned, we had slightly higher restructuring in Europe this quarter. And the balance is really a product mix item in Q2. However, in Food Equipment specifically, we expect continued progress here in the back half on organic growth as well as margin expansion. On PLS, we are running at about 70 basis points here in Q2, similar to what we did in Q1. That is consistent with the way we run our businesses and is integral to our operating system. It positions us for continued acceleration in organic growth with better margins and returns, making it the right thing to do despite the short-term headwind.

My first question is focusing on the growth investments again. If you look back, you have driven strong margin expansion and good cost control. Some might say that perhaps you got too close to the bone and now have to reinvest in either people or CapEx. Can you talk about where you think you are today regarding growth and the investment you need to make in the second half of the year and into 2019?

If you look back over the last 5 years, we have continued to invest in organic growth and support for acceleration in our organic growth rates. There's nothing significantly different now, but we are seeing an increase in our CapEx spend to support our customers, which are growing rapidly. The 60 basis points commentary is not a big number on a dollar basis; it just happens to be something we're outlining in this margin walk.

We are trying to be more transparent in terms of how we're investing in growth. This is not a new item; we've been doing this for the last 5 years. These investments are embedded in the growth conversations we've had and will continue moving forward.

Got it, that's helpful clarification. If I can just turn the conversation a little to organic growth, specifically focusing on Auto for a second. I know you have 3% baked in for the back half, but this is the first quarter we've seen you under-pace global auto builds. Can you talk about what happened specifically this quarter?

It's straightforward. The global build number includes geographies where we do not have a significant presence. The right way to look at this is on a geographic basis. In North America, our growth was up 5 points of penetration gains, in China, 8 points above builds, while Europe had some mix and PLS activities slightly below. Based on our booked projects, we expect to remain in the range of 2 to 4 percentage points above the global auto build numbers.

Trying to understand the reduction in margin outlook. You seem to be moving forward on Enterprise Initiatives while also stating you’ll offset raw material costs dollar-for-dollar. What has changed from a margin standpoint?

We're updating the margin guidance for our current view on how price/cost will impact overall operating margins. It's not impacting EPS; it’s purely a reflection of what we’ve observed year-to-date on price/cost dynamics and expectations for the remainder of the year.

Could you clarify the price/cost drag on margins, what is the current number for the year? And how should we expect this for 3Q and 4Q?

We're projecting a price/cost drag of 60 to 70 basis points for the year, consistent with the first half impacts.

Michael, the PLS headwind in the second half, is that the same as the first half? Will the cadence for the 3Q and 4Q be similar?

Yes, the PLS impact for the second half will be similar to that of the first half, around 70 basis points.

In your segment performance, Polymers & Fluids and Specialty Products seem to have relatively flat margins. Should we expect improvements as you catch up with pricing strategies?

In the near term, some chemicals are causing pressure, but overall, as we work through that, these segments are set to continue expanding margins.

Thanks, everyone. Brandon, let's go ahead and open up the lines for questions.