Illinois Tool Works Inc. (NYSE:ITW) Q2 2023 Earnings Call Transcript

Illinois Tool Works Inc. (NYSE:ITW) Q2 2023 Earnings Call Transcript August 1, 2023

Illinois Tool Works Inc. misses on earnings expectations. Reported EPS is $2.37 EPS, expectations were $2.39.

Operator: Good morning. My name is Rob, and I will be your conference operator today. At this time, I would like to welcome everyone to the ITW Second 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] Thank you. Karen Fletcher, Vice President of Investor Relations, you may begin your conference.

Karen Fletcher: Thanks, Rob. Good morning, and welcome to ITW’s second quarter 2023 conference call. I’m joined by our Chairman and CEO, Scott Santi; and Senior Vice President and CFO, Michael Larsen. During today’s call, we’ll discuss ITW’s second quarter financial results and provide an update on our full year 2023 outlook. Slide 2 is a reminder that this presentation contains forward-looking statements. We refer you to the company’s 2022 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 Chairman and CEO, Scott Santi.

Scott Santi: Thanks, Karen, and good morning, everyone. As you saw from our earnings release this morning, the ITW team delivered another quarter of strong operational execution and financial performance. Quarterly operating income grew 9% and exceeded $1 billion for the first time in ITW’s history. Operating margin expanded 170 basis points year-on-year to 24.8%, a second quarter record with a 130 basis point contribution from enterprise initiatives. Operating margins for the company are now solidly above 2019 levels. And with a normalizing price/cost environment, we are back to making progress toward our 2030 goal of 30%. With regard to revenues, organic growth was 3% as stable underlying demand in many of ITW’s industrial end markets was partially offset by inventory reductions at our end customers and channel partners in response to stabilizing supply chain performance.

We estimate that this impacted organic growth by 1 point to 1.5 points in the quarter. GAAP EPS of $2.48 was also a Q2 record for the company and excluding one-off tax items in both years, grew – EPS grew 9%. Looking ahead, while customer and channel inventory normalization will continue to be a factor for the next several quarters at least, we expect stable underlying demand and continued strong margin and profitability performance through the balance of the year. As a result, we are raising our full year 2023 EPS guidance by $0.10 at the midpoint. I’ll now turn the call over to Michael to discuss our Q2 performance and full year guidance in more detail. Michael?

Michael Larsen: Thanks, Scott, and good morning, everyone. Q2 revenue grew by 2% with organic growth of 3%, and divestitures reduced revenue by 1%. Foreign currency translation impact was neutral and not a headwind for the first time since the third quarter of 2021. Underlying demand remains stable across the majority of our end markets with some softness in about 25% of our portfolio. As Scott mentioned, our businesses estimate that inventory reduction efforts by our end customers and channel partners reduced organic growth by 1% to 1.5% at the enterprise level. By geography, North America was flat, Europe grew 5%, Asia Pacific grew 11%, with China up 22%. On the bottom line, operating income grew 9%, exceeding $1 billion for the first time ever.

Operating margins were a real highlight this quarter as they improved to a new Q2 record of 24.8% with Enterprise Initiatives contributing 130 basis points. Price/cost margin impact contributed 260 basis points in Q2, while higher wages and benefit costs lowered margins by around 100 basis points. In addition, we continue to fund our growth investments, including headcount additions to support our organic growth strategies and initiatives. All in, we delivered 170 basis points of margin improvement in the quarter, with margin expansion in six of our seven segments, three of them, welding, food equipment and construction products, recorded all-time highs. GAAP EPS was $2.48, an increase of 5%, and excluding one-time tax items in both years, EPS grew 9%.

Our cash performance was strong as free cash flow grew 68% to $705 million, a new Q2 record. Free cash flow was 94% of net income, about 10 percentage points above our historical Q2 average, helped by an inventory reduction of 6% since year-end. Like our end customers and channel partners, our divisions are also beginning to reduce inventory levels as supply chains normalize. That being said, we added almost $1 billion of inventory over the last two years to mitigate supply chain challenges and it would likely take us until the first half of next year to get our inventory levels from currently 3.2 months on hand back to our normal months on hand levels of about two. We expect that it will be much the same for many of our channel partners and customers.

Overall, for Q2, excellent operational execution and financial performance across the board, including record operating income, operating margin and GAAP EPS. Turning to Slide 4. We wanted to spend a minute on ITW’s operating margin performance in Q2. Like I said, one of the highlights of the quarter. Not only did margins significantly expand year-over-year and quarter-over-quarter, but at 24.8% margins and are now also solidly above pre-pandemic levels, and we are back on track in terms of making progress towards our goal of 30% in 2030. Let’s move to the segment results, starting with automotive OEM, which led the segments with strong organic growth of 16% and positive growth in all regions. North America was up 3% and Europe grew 18%.

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China grew 51%. Operating margin expanded 250 basis points to 16.8%, and price/cost margin impact turned positive for the first time in more than three years as this segment continues on the margin recovery and improvement path that we laid out at our 2023 Investor Day. As a reminder, we’re executing a plan to get auto OEM margins solidly back into the 20s over the next three years. Organic growth in this segment in the second half reflects some tougher comparisons, and we expect continued meaningful sequential improvement in operating margins in Q3 and Q4. Turning to Slide 5. Food equipment also delivered strong organic growth of 7% with North America up 8%. Institutional end markets were up 13%, with continued strength across the board.

International revenue grew 5%, with Europe up 5% and Asia Pacific up 2%. A real highlight was service revenue, which grew 16%, the ninth quarter in a row with double-digit growth as we continue to support existing customers, new product installations and gain market share. Operating margin expanded 310 basis points to 27.8%, an all-time record for the food equipment segment. Test and measurement and electronics delivered positive organic growth of 1%. The slowdown in semiconductor-related revenues, which represent about 20% of the segment, reduced the segment growth rate by 6 percentage points. Test and measurement grew 10% with continued strong demand for capital equipment as evidenced, for example, by Instron, which grew 30%. Electronics declined 13% on semiconductor softness, which is, however, beginning to show some signs of bottoming out.

Moving on to Slide 6. Welding delivered 1% organic growth against a tough comparison of plus 22% in the prior year. Equipment revenue was essentially flat and consumables were up 2%. Industrial sales were really solid with organic growth of plus 5% on top of 27% in the prior year, while the commercial side was down 9%, about as expected against the comparison of 19% last year. North America revenue was flat and international grew 5%. This quarter’s highlight was definitely operating margin expansion of 460 basis points to 33.9%, a new record for the segment and for the company. And the fact that our highest margin segment continues to improve margins and not just by a little bit, is a good example of the never satisfied continuous improvement mindset and is so core to the ITW culture and mindset across the company.

Polymers and fluids organic revenue was down 1% against a difficult comparison of plus 10% last year. Divestitures impacted revenue by 6%. Automotive aftermarket was up 1%, polymers down 2% and fluids down 1%. On a geographic basis, North America grew 1% and international declined 3%. Turning to Slide 7. Organic revenue in construction was down 6% against a comparison of plus 15% last year. North America was down 3% with U.S. residential construction down 2% and commercial construction, which represents about 15% of the region, down 5%. Europe was down 14%, and Australia and New Zealand was down 4%. Despite some challenging end market conditions, operating margin expanded 170 basis points to 29.3%, an all-time record for the Construction Products segment.

Finally, Specialty organic revenue was down 4%, which included 1 point of headwind from product line simplification and an estimated 3 percentage points from end customer and channel inventory reduction efforts. North America was down 7% and international grew 4%. Equipment revenue, which represents about 20% of the segment, was up 23%, and consumables were down 9%. With that, let’s move to Slide 8 for an update on our full year 2023 guidance. As you saw this morning, we raised our GAAP EPS guidance by $0.10 with a new midpoint of $9.75 based on our strong first half performance with record first half GAAP EPS of $4.81 and the expectation for stable underlying demand and continued strong margin and profitability performance through the balance of the year.

Our organic growth guidance of 3% to 5% includes our expectation that end customer and channel inventory normalization activities will continue to modestly impact overall demand through at least the balance of the year. Operating margin is projected to expand by more than 100 basis points at the midpoint of our range of 24.5% to 25.5%, which includes a contribution of more than 100 basis points from enterprise initiatives. We’re also projecting strong free cash flow performance with a conversion of over 100% of net income. Finally, on the tax rate, our first half rate was 22%, and we expect our typical 24% in the second half for an expected full year rate of around 23%. In summary, a strong first half, both operationally and financially. And as we head into the second half, we are in a strong position to continue to deliver differentiated performance through the balance of the year.

With that, Karen, I will turn it back to you.

Karen Fletcher: All right. Thank you, Michael. Rob, can you please open up the lines for questions?

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Q&A Session

Operator: [Operator Instructions] And our first question comes from the line of Jeffrey Sprague from Vertical Research. Your line is open.

Jeffrey Sprague: Thank you. Hello everyone.

Scott Santi: Hello Jeff.

Jeffrey Sprague: Yes hi, thank you. I wonder if we could address Michael, just kind of the price-cost algorithm for the remainder of the year now. You are up 260 bps in the Q2. I know you still got some more work to do there, particularly in Automotive. So maybe you could address that on a total ITW basis? And how do you see Automotive margins progressing into the back half of the year towards that two handle on margins there?

Michael Larsen: Yes, sure, Jeff. So I think overall, on price-cost, we’d say we’re on track to recover the margin impact from a period over the last two years of unprecedented inflation, which has now stabilized. So, in the first quarter, price-cost was positive 190 basis points, Q2 260 basis points and for the balance of the year, we’re looking at a more normalized 130 to 150 basis points range. And for the full year, we should recover somewhere around 150 to 200 basis points at the enterprise level. I think what was encouraging is every segment is now margin positive, including Automotive OEM and we expect that for [indiscernible] your question specifically to remain the case for the back half of the year. And combined with enterprise initiatives, we expect sequential improvement in Q3 and Q4 in the Automotive segment, and we should end up somewhere in the high teens as we exit 2023.

We’re still a long way to go over the next two to three years to get back to kind of the low to mid-20s, which is the path that we laid out at Investor Day.

Jeffrey Sprague: Great. And your comments about the supply chain normalization and everything were pretty clear, but I just wonder if you could give us some perspective on your backlogs, right? Typically, you don’t have big backlogs, but you got to kind of 2x normal in a number of your businesses. Where are we at the ITW level and kind of getting things back to the normal run rate?

Michael Larsen: Yes, I think, similar to what we talked about on the last call, supply chain performance continues to improve. And as that happened, our backlogs are also starting to come down. And at this point, we’re still above our normal levels. If you look at the businesses where we do carry some backlog Food Equipment, for example, we’re running at 2x normal levels, and the same is true in Welding. But as I said, those backlogs are coming down pretty quickly as supply chain performance improves.

Jeffrey Sprague: Thank you very much.

Michael Larsen: Sure.

Operator: Your next question comes from the line of Jamie Cook from Credit Suisse. Your line is open.

Jamie Cook : Hi, good morning. Two questions. A follow-up on the inventory reductions from your customers and channel partners. Exactly what’s embedded in the back half of the year, is it another visit 1 to 1.5 points and in the guide in the back half of the year? And then as a follow-up to that, you are maintaining your revenue guide despite this, so what’s doing better than expectations? And sort of my last question is Construction margins were very impressive considering the sales decline. So any color on that? Thank you.

Michael Larsen: Yes. I think the inventory reduction impact that we saw here in Q2 is now embedded in our run rates, and therefore, embedded in our guidance for the balance of the year. Actually, if you look at our Q2, it came in right in line with run rate except for these – the inventory impact that we estimate at 1 point to 1.5 points. And underlying demand, as we said, is really stable, if not strong in places like Auto and Food Equipment. So we feel really good about our assumptions here going into the back half of the year. Your question specifically on Construction, I agree with you, that’s some pretty impressive performance given the challenging end markets, particularly if you look at Europe. The big drivers here continue to be enterprise initiatives, which has been called the gift that keeps on giving.