Illinois Tool Works Inc. (NYSE:ITW) Q1 2024 Earnings Call Transcript

Illinois Tool Works Inc. (NYSE:ITW) Q1 2024 Earnings Call Transcript April 30, 2024

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Operator: Good morning. My name is Krista, and I will be your conference operator today. At this time, I would like to welcome everyone to the ITW First Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] For those participating in the Q&A, you will have the opportunity to ask one question and, if needed, one follow-up question. Thank you. Erin Linnihan, Vice President of Investor Relations. You may begin your conference.

Erin Linnihan: Thank you, Krista. Good morning, and welcome to ITW’s first quarter 2024 conference call. Today, I’m joined by our President and CEO, Chris O’Herlihy; Senior Vice President and CFO, Mike Larsen, and Vice President of Investor Relations, Karen Fletcher. During today’s call, we will discuss ITW’s first quarter financial results and provide an update on our outlook for full year 2024. Slide 2 is a reminder that this presentation contains forward-looking statements. We refer you to the company’s 2023 Form 10-K and subsequent reports filed with the SEC for more detail about important risks that could cause actual results to differ materially from our expectations. This presentation uses certain non-GAAP measures, and a reconciliation of those measures to the most directly comparable GAAP measures is contained in the press release. Please turn to Slide 3, and it’s now my pleasure to turn the call over to our President and CEO, Chris O’Herlihy.

Christopher O’Herlihy: Thank you, Erin, and good morning, everyone. While the near-term demand environment across the majority of our segments was certainly challenging as we anticipated, the ITW team delivered a solid start to the year as our first quarter results came in as expected. And we remain solidly on track to deliver on our 2024 performance targets. Starting with the top line. Organic growth was down 0.6% as five of seven segments declined in the face of a tough demand environment and versus some difficult comparisons year-over-year. Those comparisons are more favorable for the balance of the year and based on current levels of demand, we are confident that we will deliver on our full year performance targets, including organic growth of 1% to 3%.

The ITW team continued to execute at a very high level and delivered strong margin and profitability performance in the first quarter. Excluding a one-time inventory accounting item, quarterly operating income grew 4% as operating margin expanded 120 basis points to 25.4%, with a strong contribution from enterprise initiatives of 140 basis points, as we continue to make solid progress towards our goal of 30% operating margin by 2030. GAAP EPS of $2.73 increased 17%, and excluding the one-time item, we grew EPS 5% to $2.44. The free cash flow conversion rate of 68% was in line with normal Q1 levels. Looking ahead, where we did raise our GAAP EPS and margin guidance for the year to account for the one-time item, our operational guidance remains unchanged.

We continue to expect that current levels of demand across the majority of our end markets and favorable year-over-year comparisons will translate to positive organic growth through the balance of the year. Combined with our continued strong margin and profitability performance, we are confident that ITW is firmly on track and well positioned to deliver on our 2024 guidance. In concluding my remarks, I want to thank all of our ITW colleagues around the world for their exceptional efforts and for their dedication to serving our customers with excellence and driving continuous progress on our path to ITW’s full potential. I will now turn the call over to Michael to discuss our first quarter performance in more detail as well as our updated full year guidance.

Michael?

Michael Larsen: Thank you, Chris, and good morning, everyone. In Q1, we delivered a solid start to the year with some high-quality execution in a pretty challenging demand environment as expected. Despite an organic revenue decline of 0.6%, operating income grew 4% and operating margin improved 120 basis points to 25.4% as enterprise initiatives contributed 140 basis points. EPS increased 5% to $2.44, excluding a onetime item. Our free cash flow was $494 million, and we repurchased $375 million of our own shares during the quarter as planned. GAAP EPS increased 17% to $2.73, and operating margin expanded 420 basis points to 28.4%. As you saw this morning, our GAAP results include a onetime LIFO inventory accounting change that resulted in a favorable pretax impact of $117 million to cost of revenue equal to $0.29 a share.

In Q1, we made the decision to transition from the LIFO to FIFO inventory accounting method for all of our US businesses because it is a more consistent and simple method for valuing inventory across our operations. In summary, Q1 results were as expected in the current environment, and growth rates are projected to improve as we go through the balance of the year. Our margin and profitability performance continues to be strong, and we’re solidly on track to deliver on our guidance, which I will discuss in a few slides. Please turn to Slide 4 for a look at organic growth by geography. As you can see, the 4% decline in North America was partially offset by positive growth internationally, as Europe grew 1% and Asia-Pacific grew 6%, led by China up 15%.

Excluding the 23% growth rate in our Chinese automotive OEM business, organic growth in China was still up 7%. For the full year and for our usual process, which is based on current levels of demand, we expect organic growth of 1% to 3% in both North America and Europe, with Asia-Pacific up in the mid-single digits, led by China. Moving on to segment results and starting with the Automotive OEM segment, which delivered solid organic growth of 3% despite North America being down 6%, as Europe grew 2% and China grew 23%, driven by continued strong penetration and market share gains. For the full year, we continue to expect solid above-market growth with our typical penetration gains of 2% to 3% and continued outgrowth in China. Margin and profitability performance was strong as margins improved by 370 basis points to 19.8%, and enterprise initiatives contributed more than 200 basis points.

We continue to make solid progress on the margin enhancement plan in this segment, and we are firmly on track to deliver margins in the low to mid-20s by 2026, which you will recall is what we said we would do at our Investor Day last year. Turning to Slide 5. Food Equipment organic revenue declined 1% as expected against a tough comparison of plus 16% in the first quarter last year. Equipment was down 4%, and service grew 3%. And by region, North America declined 2% due to a particularly difficult comparison of plus 21%. On a positive note, the retail business was up 10%, fueled by new product launches and overall North America order activity in Q1 was pretty encouraging across the board. International revenue was flat with Europe down 1% and Asia-Pacific up 6%.

While 5 of our subsegments improved their margins in Q1, Food Equipment margins declined modestly to 26% as a result of focused capacity investments to support and accelerate continued above-market organic growth in our very attractive service business. Looking forward, we expect margins to continue to improve sequentially as we go through the year. Turning to Test & Measurement and Electronics. Organic revenue was down modestly as Test & Measurement grew 2% despite a tough comparison of plus 12%. Electronics was down 8% due to challenging near-term demand trends in electronic assembly. The recent MTS acquisition continues to perform well and grew more than 20%. With margins that are improving, but still in the mid-teens, this created a mix headwind for this segment and diluted segment margins by about 250 basis points.

Looking ahead, we expect Test & Measurement and Electronics margins to improve from here as we go through the balance of the year. Moving on to Slide 6. And as expected, Welding faced a tough demand environment and year-over-year comparison of plus 10%, which resulted in a decline of 3% in Q1. Equipment declined 2% and consumables were down 6%. Industrial sales declined 1% versus an 18% comparison and the commercial side was down 6%. By region, North America declined 3% against the comparison of plus 10% and international declined 8%. On a positive note, operating margin improved 80 basis points to 32.7% with a solid contribution from enterprise initiatives. Organic revenue in Polymers & Fluids declined modestly as automotive aftermarket was down 2%, and both Fluids and Polymers were essentially flat in the quarter.

On a geographic basis, North America declined 5% and international grew 5%, led by China. Operating margins improved 140 basis points to 25.8%. Turning to Slide 7. Near-term demand trends in Construction Products continue to be challenging on a global basis as organic revenue declined 7% in Q1. North America was down 3% as the residential and renovation business was down 1%. And international markets remained soft as Europe was down 11% and Australia and New Zealand was down 12%. On a positive note, operating margin improved 190 basis points to 29.4%, driven primarily by another solid contribution from enterprise initiatives. Finally, Specialty Products. Organic revenue growth was up 6%, due primarily to the timing of large equipment orders in two European businesses.

As a result, international was up 19% and North America was down 1%. As we have talked about before, we’re working to reposition the Specialty segment for consistent above-market organic growth, which involves some strategic portfolio work and more significant product line simplification as we go forward. Operating margin improved 410 basis points to 29.7%, driven by operating leverage and a solid contribution from enterprise initiatives. With that, let’s move to Slide 8 for an update on our full year 2024 guidance. With Q1 results that were right in line with our expectations, we’re solidly on track to deliver on our 2024 performance targets and guidance. Looking ahead and starting with the top line, we do see some positives in terms of stable demand, more favorable comparisons year-over-year as we move forward, a normalized pricing and inflationary environment, new product launches and no meaningful headwind from inventory destocking.

Per our usual process, our organic growth guidance of 1% to 3% is based on current run rates adjusted for typical seasonality. Operating margin is expected to improve by 140 basis points at the midpoint to a range of 26% to 27%, which includes more than 100 basis points contribution from enterprise initiatives, and 50 basis points from the onetime item in Q1. As I mentioned on our last call, every segment is projecting to improve their operating margin performance, again, in 2024 with another solid contribution from enterprise initiatives across the board. After-tax return on capital is expected to remain firmly above 30%, and we expect strong free cash flows, again, with conversion greater than net income. As you saw this morning, we raised our full year GAAP EPS guidance to a new range of $10.30 to $10.70, which now includes $0.30 of EPS from the Q1 inventory accounting change.

Setting that item aside, our operational guidance remains essentially unchanged as we expect a combined headwind of about $0.30 from higher interest expense, currency and income taxes with an expected tax rate in the range of 24% to 24.5%. In terms of cadence for the year, we expect our first half, second half EPS split to be about 50/50 this year as we factor in the onetime item in the first quarter, which compares to our typical split of 49/51, so slightly less back-end loaded than usual. To wrap things up, as expected, the ITW team continues to execute at a very high level, in a challenging near-term demand environment, which we anticipate will improve as we go through the balance of the year based on current levels of demand and more favorable comparison.

In addition, our first quarter results came in as expected, and we are solidly on track to deliver on our 2024 guidance. n a separate note, today is Karen Fletcher’s last ITW earnings call. Over the last six years, Karen has been instrumental in articulating ITW’s unique and differentiated competitive advantages and our plan to leverage them to their full potential to you, the investment community in a clear and compelling manner. In doing so, she has helped us position ITW as one of the world’s highest quality, best performing and most respected industrial companies. Please join Chris and me in thanking Karen, for her many contributions to ITW and wishing her all the best in retirement.

Karen Fletcher: Thank you, Michael. That means a lot, and it’s been a privilege to do that.

Michael Larsen: Thank you, Karen. And with that, Erin, I’ll turn it back to you.

Erin Linnihan: Thank you, Michael. Krista, will you please open the line for questions?

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Q&A Session

Operator: [Operator Instructions] Your first question comes from Jamie Cook from Truist Securities. Please go ahead. Your line is open.

Jamie Cook: Hey good morning, and congrats Karen, and thanks for all your help over the past six years.

Karen Fletcher: Thank you, Jamie.

Jamie Cook: Thanks Karen. My first question on the Food Equipment side, I think, Michael, you noted some positive order activity in North America. If you could just speak to what you’re seeing there? And then how much of a margin headwind was the capacity investments that you spoke about? And then my follow-up question, just on Specialty. I know you spoke to taking portfolio actions in PLS, you could just give a little more color there. Where are you taking actions? And how much is that — how much is PLS, I guess, a headwind to organic growth within Specialty for the year? Thank you.

Michael Larsen: I think that was 4 questions in one, Jamie. I’m going to try….

Jamie Cook: …quarter so I get.

Michael Larsen: I’m going to try my best here. So the comment on Food Equipment, I think for many of our segments, if you take a step back, these growth rates are a little unusual for us, which is really driven, as I said, by these really significant comparisons — challenging comparisons that we’re dealing with including in Food Equipment. So, the additional color, even though we’re not necessarily a backlog-driven company, was directed around the order activity in North America, which grew double digit in the first quarter here and which I think give some additional credibility. What we’re saying is that we are expecting a return to more typical growth rates here including in Food Equipment as we go forward. The margin pressure, the margin impact is about 100 basis points in Food Equipment here in Q1 and Q2.

And it’s really as a result of taking advantage of a huge growth opportunity that’s sitting right in front of us in our service business. So what we’re talking about is adding a significant number of service technicians to help us meet the demand in one of the most attractive parts of our Food Equipment business. And as you know, we’re the only captive OEM with the service business, which is a huge competitive advantage for us in this segment. So I think that — those were the two questions around food equipment. I don’t know if you want to add anything to that, Chris?

Christopher O’Herlihy: No. I just — I guess, accentuate the point of the differentiation aspect of the service business within Food, with the unique captive manufacturer. And this is a necessary investment at this point to capitalize on what is an undoubtedly stellar growth opportunity on the service side for us.

Michael Larsen: And then on Specialty, the organic growth rate here was really driven by large equipment orders that — and the timing around those in two of our businesses in Europe. What we’re trying to articulate is on a go-forward basis is that we still expect meaningful PLS, product line simplification, as we move forward and strategically reposition this business for 4% plus growth on a consistent basis. And so we still expect a meaningful impact from that as we move forward. And I think the kind of what we’re saying is don’t count on 6% organic growth as we move forward. We had guided to this segment at our last call to be down 1% to 3%. And so please keep that in mind. And the same is true for the margins. I mean, I think with what you’re seeing here on the margins is what we — what happens when we get some growth in these businesses and the operating leverage here contributing in a meaningful way to 29.7% operating margins in the Specialty segment.

I think that is not — on a go-forward basis, that’s Q1, both growth rate and margins are a little bit of an anomaly, and I think we expect to return to more — still very profitable margins kind of in the high 20s, but maybe not something that starts with a 29.

Jamie Cook: Thank you and congrats again, Karen.

Karen Fletcher: Thanks, Jamie.

Operator: Your next question comes from the line of Tami Zakaria from JPMorgan. Please go ahead. Your line is open.

Tami Zakaria: Hi, good morning. First off to Karen, I’ll definitely miss you, but I wish you all the best of luck. And welcome aboard, Aaron, looking forward to working with you.

Erin Linnihan: Thanks, Tami.

Tami Zakaria: Of course. So my first question is just wanted to get a little color here. I think, you expect organic growth to be positive throughout the balance of the year. Does that mean you expect organic growth to be within that full year range of 1% to 3% growth?

Michael Larsen: So Tami, as you know, we don’t give quarterly guidance. What I will tell you to try and help you out here a little bit is that if you model current levels of demand or run rate as we call them, into Q2, and what we’re typically seeing is a step-up in revenues in the low single digits from Q1 to Q2, and in automotive OEM, actually, a meaningful improvement in the builds from Q1 to Q2, an increase in the low to mid-single digits there as well. So you will see a slightly higher revenues in Q2 and given that the comparison gets easier on a year-over-year basis, we’re up 5% in Q1 last year, up 3% in Q2. It is certainly possible that we’ll see slightly positive organic growth here in Q2. But the more meaningful step-up really starts in the second half of the year, which is kind of what’s implied in our guidance here.

So think about it may be as flattish in the first half, maybe slightly positive in and then an improvement in the second half of the year, the comparisons year-over-year improve by four points relative to the first half of the year. So in the second half last year, revenues were essentially flat and at current run rates, you’d expect to see positive organic growth rates in the low single digits in the second half. And I might just add for those keeping track, that there are two extra shipping days in the second half this year compared to the second half last year, which at least mathematically should provide some additional revenue growth for us.

Tami Zakaria: Got it. That’s very helpful. My second question is similar to the first one, but on the margin side. I think that in the first quarter, you had $117 million tailwind. That’s about 70 basis points tailwind for the full year, but you raised the full year guide by about only $50 million. And the first quarter margin also came in a little better than what most people on the Street were modeling. Just trying to understand, as we think about the next three quarters, is there any incremental cost pressures or maybe price cost headwind than originally thought? Or is it just your conservatism that you raised the full year guide by only 50 basis points?

Michael Larsen: Well, what I would say, Tami, is that we’re really pleased with our first quarter operational performance here, as you saw in the margin rates. And if you exclude the onetime item, 140 basis points from initiatives, 120 basis points of overall margin expansion and margins at 25.4% is a pretty significant accomplishment here for the first quarter. And we do expect, as we typically do going through the year that margins improved sequentially from here on out. So you should see a modest improvement sequentially from Q1 to Q2 and then again into Q3 and Q4. The only thing I would highlight as you think about the second quarter is as we typically – similar to last year, we do expect some higher restructuring expense in the second quarter, and these are all projects that are tied to a typical 80/20 front-to-back projects.

These are not tied to any concerns around volume growth whatsoever. I don’t want you to think that this is pure planned restructuring for the second quarter. So — and as I said, just real quick on Q1, again, five of seven segments improved margins in the current environment and including with revenues down in five of seven segments. And we expect based on — consistent with our bottom-up planning process here for the full year that every segment will improve margins as we go through the year and on a year-over-year basis.

Tami Zakaria: Great. Thank you. This is very helpful.

Michael Larsen: Sure. You’re welcome.

Operator: Your next question comes from Steve Volkmann with Jefferies. Please go ahead. Your line is open.

Steve Volkmann: Great. Good morning everybody. Karen, I can add my congratulations, and we will miss you and Aaron, welcome. And I’m impressed that you already have Karen’s cadence down so well. So…

Karen Fletcher: Thank you.

Steve Volkmann: Can I ask a little bit about China? That seemed to be a bit of an outlier there. I guess, quite a bit of that automotive, but even without that, things seem to be relatively good. Any color you can give us on that?

Michael Larsen: Yes. I think as you pointed out, Steve, the big driver is obviously our Automotive OEM business, up 23%. And the team there is doing a great job growing content on new vehicles, including on the EV side and gaining market share. Even excluding those, as I said, China was still up 7% year-over-year. Strong contribution from Polymers & Fluids. Some of that is tied also to market share gains on the EV side of things and the bonding of some of these batteries in the assembly process where we have a really unique and differentiated product. Specialty products also contributed, Test & Measurement grew and Food Equipment. So across the board, really solid performance in China. And moving forward, we’d say that looks pretty sustainable as we go into Q2 and then the second half, the comps get a little bit more difficult.

But as I said, for the full year, China should be up in the mid to high single digits here, which is certainly encouraging. And again, I think it speaks to kind of the benefit of being as diversified from a geography standpoint as we are. And so certainly some challenges in the first quarter in North America, but offset in Europe and in China, which is really a big benefit for us.

Steve Volkmann: Super. And then the follow-up is on Automotive margins. Obviously, going well there, and I think you said 200 basis points or better than 200 basis points of enterprise there. And I’m just trying to get a sense of how we should think of the cadence in auto margins as the year progresses. And I don’t know, maybe the exit rate or the total year enterprise something?

Michael Larsen: Yes. I mean, I think I wouldn’t expect a lot of regression from where we are. These are absolutely sustainable here in the 19%-plus range. And I think that’s probably where we’ll end up for the year, maybe a little bit better in the back half. Some of that depends on the build assumptions. There might be a little bit of restructuring here in the second quarter. But big picture, I’d say, Automotive really solid progress here on a year-over-year basis. We expect full year margins in 19%, almost 20% range, an improvement of 240 basis points on a year-over-year basis and lots of room to go as we work through our margin enhancement plan.

Christopher O’Herlihy: Yeah. And Steve, I suppose just to support that, I mean, this is very much an improvement plan that’s on track to get back to the low to mid-20s margins by 2026, as we outlined at our Investor Day, largely to a combination of over that time, volume recovery, enterprise initiatives and higher-margin innovation. So both in 2023 and again in 2024, we’re very much tracking on that cadence with respect to what we outlined at our Investor Day last year.

Michael Larsen: Yeah. So nothing unusual in terms of the margins in Q1 and sustainable, with lots of room for improvement from here.

Steve Volkmann: Super. Thank you.

Michael Larsen: You’re welcome.

Operator: Your next question comes from Andy Kaplowitz with Citigroup. Please go ahead. Your line is open.

Andy Kaplowitz: Hey, good morning, everyone. And Karen, congratulations. We’ll miss you.

Karen Fletcher: Thanks, Andy.

Andy Kaplowitz: So Michael, probably, I’m guessing you don’t want to reset your organic growth guide for your segments every quarter, but just higher level, you had Construction, Specialty forecast to be down, I think, one to three, while the other segments were projected to be up between two and four and three and five. Specialty was actually much better, has that changed the segment’s outlook at all? I know you talked about a little bit of a pull forward in some equipment orders. And were any of the other segments like weaker than you thought to start?

Michael Larsen: I think, Andy, you’re right. We don’t want to update our guidance for the segments every quarter. And what I will tell you is, given our portfolio, there’s always going to be some puts and takes. And I think that’s, again, I just talked about the competitive advantage with being as diversified as we are geographically. And the same is true when you look at this portfolio of businesses, you’re always going to have some things that maybe are a little more pressure from a market standpoint in the short term. And those are typically offset by segments that are performing a little bit better. And it all kind of evens out to that 1% to 3% organic growth guidance. So I’m not really going to go through segment by segment here, but I’d say there’s definitely some puts and takes. But overall, not too far off from what we talked about on the last call. And certainly, our full year guidance, we’re firmly on track to deliver on that.