Illinois Tool Works Inc. (NYSE:ITW) Q3 2023 Earnings Call Transcript

Illinois Tool Works Inc. (NYSE:ITW) Q3 2023 Earnings Call Transcript October 24, 2023

Illinois Tool Works Inc. beats earnings expectations. Reported EPS is $2.55, expectations were $2.45.

Operator: Good morning. My name is Krista, and I’ll be your conference operator today. At this time, I would like to welcome everyone to the ITW Third Quarter Earnings Conference Call. [Operator Instructions] Thank you. Karen Fletcher, Vice President of Investor Relations. You may begin.

Karen Fletcher: Okay. Thanks, Krista. Good morning, and welcome to ITW’s third quarter 2023 conference call. I’m joined by our Chairman and CEO, Scott Santi; Vice Chairman, Chris O’Herlihy; and Senior Vice President and CFO, Michael Larsen. During today’s call, we’ll discuss ITW’s third 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. Please refer 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: Thank you, Karen, and good morning, everyone. As you are all aware, on September 7, we announced our CEO succession plan, wherein I will be turning over the CEO role to my colleague, Chris O’Herlihy at year-end. Chris is an exceptional leader with deep expertise in ITW’s highly differentiated business model, our focused strategy to leverage it to full potential and the company’s unique one-of-a-kind culture. He has been an invaluable partner and collaborator with me over the past 11 years. We have worked closely together to prepare for this transition. He is more than ready and he will do an exceptional job as ITW’s next CEO. If you allow me a brief bit of reflection in the last 11 years, I will simply say that everything we did was driven by our fundamental belief in the performance power of the differentiated set of strategic and operational capabilities and practices that we refer to as the ITW business model.

In this past phase, we focused on getting the company properly positioned to be able to leverage them to their full potential over the long term. With this as our foundation, ITW enters our next phase in a position of great strength and resilience with these unique skills and capabilities sharply honed. I wholeheartedly believe that there will be an even bigger source of competitive advantage and differentiated performance in the company’s next phase than they were in the last one, especially if you believe as I do that the level of volatility and unpredictability of the world will only increase from here forward. I have absolutely no doubt that Chris and the incredibly talented ITW leadership team behind him will utilize all of the differentiated tools at ITW’s disposal to read and react to whatever comes our way and lead the company to even greater heights in our next phase.

Let me close by saying that it has been both a privilege and an honor to lead this great company for the last 11 years. And I offer my deepest gratitude to all of my ITW colleagues past and present for all of their support and for their unwavering commitment to working every day to be the best ITW that we can be. With that, it is now my pleasure to turn the call and in a few months, the company over to Chris O’Herlihy. Chris, over to you.

Christopher O’Herlihy: Thank you, Scott, and good morning, everyone. First, I want to thank Scott and our Board of Directors for their trust and confidence in electing me as ITW’s next CEO. I’m incredibly humbled by the opportunity to lead this great company, our exceptionally talented leadership team and our 46,000 dedicated colleagues around the world. As Scott said, as a result of the work done over the last 11 years in executing our enterprise strategy to leverage the ITW business model to its full potential, our company has never performed better or been better positioned for the future. The central focus of the next phase of our enterprise strategy is to elevate high quality organic growth and customer back innovation as key ITW differentiators on par with our best-in-class operational capabilities and financial performance.

Our leadership team and I are deeply committed to doing just that in delivering on ITW’s 2030 Enterprise Performance Goals. Now, let’s turn to our Q3 performance. The strength and resilience of ITW’s proprietary business model and high-quality diversified portfolio once again drove strong operational execution and financial performance this quarter. Starting with the top line, organic growth was 2% on an equal days basis, as demand for CapEx slowed down in test and measurement and electronics and welding. Our margin and income performance continues to be very robust. Operating margin improved 200 basis points year-over-year to 26.5% as enterprise initiatives contributed 140 basis points. Quarterly operating income grew 9% to $1.1 billion. GAAP EPS grew 9% to $2.55 and free cash flow was up 40%.

With three quarters behind us, we are narrowing our EPS guidance to a range of $9.65 to $9.85, which now incorporates a $0.12 adjustment to the impact of the auto strike in Q4. Looking ahead at the balance of the year, the company remains well positioned to deliver another year of differentiated performance. I’ll now turn the call over to Michael to discuss our Q3 performance and full year guidance in more detail. Michael.

A factory in operation, its machinery humming as new industrial products get built.

Michael Larsen: Thank you, Chris, and good morning, everyone. Organic growth in the third quarter was essentially flat and plus 2% on an equal days basis as Q3 this year had one less shipping day compared to Q3 last year. Foreign currency translation impact was favorable by 1.5% and divestitures reduced revenue by 1.2%. The net result was revenue growth of 0.5%. Third quarter operating margin was 26.5%, an increase of 200 basis points year-over-year as enterprise initiatives contributed 140 basis points and price cost margin impact was positive 210 basis points. GAAP EPS of $2.55 was up 9% and included $0.07 net of favorable corporate items on a year-over-year basis starting with unallocated expense, which improved by $43 million due to lower employee related expenses, including health and welfare and a one-time insurance recovery.

This favorable item was partially offset by $16 million of lower other income, primarily due to lower investment income. As I said, the net effect of these two items was favorable $0.07 net per share. Free cash flow grew 40% to $856 million, with a conversion to net income of 111% as we continue to make solid progress on returning to our normal historical inventory levels. We repurchased $375 million of our shares this quarter and raised our dividend by 7% to an annualized payout of $5.60 per share, which marks our 60th year of raising the dividend. In summary, Q3 was another quarter of strong operational execution and financial performance. Turning to Slide 4, organic revenue growth by geography. As you can see, North America was down 2%, Europe was about flat, and Asia Pacific was up 6%, with China up 8%, driven by the Automotive OEM segment.

Excluding auto, China was down 1%. Moving to the segments and starting with our Automotive OEM, organic growth was 4%. North America was down 5%, Europe was up 5% and China was up 18%. There was essentially no impact on Automotive OEM segment revenues from the auto strike in Q3. But as Chris noted, that will not be the case in Q4. As a reminder, our North American Automotive OEM business represents approximately 40% of total segment revenues. And within that 40%, approximately two-thirds of our annual sales are tied to D3 automotive customers. Included in our updated earnings guidance today is our estimate that the impact of the auto strike will reduce our Q4 earnings by $0.12 per share, which is essentially based on October D3 domestic production levels continuing through the remainder of the quarter.

Turning to Slide 5. Food Equipment delivered solid organic growth of 6% as Equipment was up 5% and Service grew 9%. North America grew 10%, with institutional sales up in the mid-teens, restaurants up high single digits and retail up in the high teens on the back of new product rollouts. Europe, however, was flat and Asia Pacific was up 6%. In Test & Measurement and Electronics, organic revenue was down 4%, weighed down six percentage points by semiconductor-related demand, which represents about 15% of segments and for context, only 3% of ITW revenues. Overall, Test & Measurement grew 2% and as demand for CapEx slowed in the quarter and Electronics declined 13%. Moving on to Slide 6. Welding’s organic revenue declined 2%, as Equipment revenue was down 3% on the back of softer demand for CapEx. Consumables were down 1% as industrial sales declined 9% versus a tough comparison of plus 30% last year.

Commercial, however, was up 6% against an easier year-over-year comparison of down 10%. Overall, though North America revenue was down 3% and international was essentially flat. Polymers & Fluids, organic revenue grew 3% as automotive aftermarket grew 10% due to the launch of new products. Polymers was down 1% and Fluids was down 4%. Margins were solid as operating margin improved 280 basis points to 28.1%. Turning to Slide 7, organic revenue in Construction was down 2%, as North America grew 2%, with residential up 2% with some strength on the residential renovation side, which was up 7%. Commercial construction was down 2%. International markets were soft, with Europe down 8%; and Australia and New Zealand down 4%. Margins were solid as operating margin improved 420 basis points to 29.9% with strong contributions from enterprise initiatives and price cost.

Finally, Specialty Products, organic revenue was down 6%. North America was down 9% and international grew 1%. Consumables were down 9% and Equipment revenue, which represents about 20% of the segment, was up 9%. Moving to Slide 8 and our updated full year 2023 guidance, as you saw this morning, we are narrowing the range of our GAAP EPS guidance to a new range of $9.65 to $9.85 which, as I mentioned earlier, includes a $0.12 adjustment for the estimated auto strike impact in Q4. Based on current levels of demand exiting Q3, including the estimated impact of the auto strike, we’re projecting organic growth of 2% to 3% for the full year. We are raising our full year operating margin guidance to 25% to 25.5%, to reflect our stronger margin performance exiting the third quarter, and we expect that margins for the full year will improve by 150 basis points at the midpoint, including a contribution of more than 100 basis points from enterprise initiatives.

We are projecting free cash flow conversion of more than 100% of net income for the year. So while the overall demand environment clearly has some uncertainties in the near-term, inventory normalization, elevated interest rates, increasing CapEx caution and the auto strike just to mention a few. The entire team at ITW remains focused on leveraging ITW’s unique strengths and capabilities to optimize our ability to continue to deliver differentiated long-term performance. With that, Karen, I’ll turn it back to you.

Karen Fletcher: Thank you, Michael. Krista, please open the lines up for questions.

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Q&A Session

Operator: [Operator Instructions] Your first question comes from the line of Scott Davis from Melius Research. Please go ahead. Your line is open.

Scott Davis: Good morning Scott and Chris and Michael and Karen.

Michael Larsen: Good morning.

Scott Santi: Good morning.

Scott Davis: I was — the price/cost positive 200 basis — 210, was better. I think we were thinking just some simple math kind of more like 100, 150. What — were you able to get more, price in the quarter? Or was it lower cost or a little bit of both? Or just a little color there would be helpful. Thanks.

Michael Larsen: Yes. So let me give you a little bit of context here. So we are definitely on track to recover the margin impact now from more than two years of unprecedented inflation, which now appears to have stabilized. There’s definitely still some pressure on the cost side, on the labor side, components as well as energy. That said we’ve made some good progress. Price/cost was positive 190 basis points in Q1, 216 in Q2, which was the peak and then 210 here in the third quarter. And we’re now looking at somewhere around 150 basis points in Q4, and that would put us around 200 basis points recovery for the full year. Price is holding, and we’re seeing a little bit of deflation on the — more on the commodity side. So these would be the metals, in particular, which drove the stronger performance here on price/cost in the third quarter.

Scott Davis: That’s helpful. Chris, I know it’s early. You’ve got another couple of months, but is there kind of a plan for the first 90 days? Or where do you see the — I guess the focus shifting, is there a little bit more emphasis on portfolio or — I know you mentioned kind of driving higher growth rates, but they’re just — given the diversity of end markets you sell into, there’s just so much you can do on that front. But maybe just a little color on where you planning on spending your first kind of three to six months and focusing?

Christopher O’Herlihy: Yes. So Scott, I would say, in general, our plan is very much in line with what we outlined at our Investor Day in terms of really ensuring that we continue to strengthen our foundation, which is our business model and obviously then building organic growth as a core strength on par with our operational capabilities and financial performance over time. I think the first 90 days I’m just learning the job, just go out and pretty good understanding of our businesses already, but obviously, working with our businesses to make sure that our strategy is well part of dominant businesses, which, of course, it is, that’s really the plan for the first 90 days, I would say. But it’s really in the context of being very committed to this — the strategy for the next phase, which is to sustain the strong foundation we have around our business model, we’re really leaning in and continuing to build our organic growth capabilities to be on par with our operational capabilities and our financial performance.

Scott Davis: Okay. Best of luck. Thanks all. And congrats, Scott, a fantastic run, really exceptional. So thank you all. Best of luck.

Scott Santi: Thank you.

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. Thank you so much. So my first question is, I wanted to understand the operating margin expansion a bit better, 200 basis points, enterprise initiative 140, price/cost 210. So what was the drag to get to the 200 basis points expansion. I remember you were investing in labor and compensation this year. Is that still there? And when do you expect that to taper off, especially as you look into 2024?