Illinois Tool Works Inc. (NYSE:ITW) Q4 2023 Earnings Call Transcript

Illinois Tool Works Inc. (NYSE:ITW) Q4 2023 Earnings Call Transcript February 1, 2024

Illinois Tool Works Inc. beats earnings expectations. Reported EPS is $2.42, expectations were $2.39. Illinois Tool Works Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good morning. My name is Eric, and I’ll be your conference operator today. At this time, I would like to welcome everyone to the ITW Fourth 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: Thank you, Eric. Good morning, and welcome to ITW’s fourth quarter 2023 conference call. I’m joined by our President and CEO, Chris O’Herlihy; and Senior Vice President and CFO, Michael Larsen. Also with us today is Erin Linnihan who joined our Investor Relations team last month as Vice President. Erin, welcome to ITW. During today’s call, we’ll discuss ITW’s fourth quarter and full-year 2023 financial results and provide guidance for full-year 2024. 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 President and CEO, Chris O’Herlihy.

Christopher O’Herlihy: Thank you, Karen, and good morning, everyone. In Q4, we delivered a solid finish to a year of high quality execution and face some pretty unique challenges, including slowing demand for CapEx, headwinds from customer and channel inventory reductions and an automotive industry strike. As a result, organic growth was essentially flat in the fourth quarter. Operating margin came in at 24.8% with 150 basis point contribution from enterprise initiatives and free cash flow grew almost 40%. GAAP EPS of $2.38 included $0.04 of unfavorable impact from the devaluation of the Argentine currency. Throughout 2023, the ITW team continued to leverage the strength and resilience of the business model and our high quality diversified business portfolio to deliver a year of strong operational and financial performance, including solid organic growth of 2% on top of 12% growth in both 2021 and 2022.

Operating margin of 25.1% and an improvement year-over-year of 130 basis points. Income growth of 7% to a record $4 billion, after-tax ROIC of more than 30%, 50% plus free cash flow growth and GAAP EPS of $9.74. We delivered these results while investing almost $800 million to sustain productivity and accelerate our organic growth initiatives in our highly profitable core businesses. As we outlined at our Investor Day, our key strategic priority as we enter this next phase of our enterprise strategy in 2024 is to build above market organic growth fueled by customer-back innovation into defining ITW strength on par with our world class financial and operational capabilities. Turning now to our 2024 guidance. We are encouraged by what we are seeing in terms of demand across the majority of our portfolio, along with some meaningful improvements in both customer and channel partner inventory levels and input cost inflation, as well as continued progress on customer-back innovation.

For our usual process, our organic growth projection for 2024 of 1% to 3%, and our EPS guidance of $10.20 at the midpoint, reflect current levels of demand adjusted for seasonality. Operating margin is projected to improve by about a 100 basis points at the midpoint to a range of 25.5% to 26.5%. This includes another solid contribution of approximately a 100 basis points from enterprise initiatives. Before I turn the call over to Michael to provide more detail on the quarter and full-year performance as well as our guidance for 2024, I want to thank my ITW colleagues around the world. Their extraordinary dedication and commitment to serving our customers and executing our strategy with excellence and for their incredible support as I transition into the CEO role.

Michael?

Michael Larsen: Thank you, Chris, and good morning, everyone. In Q4, the ITW team delivered a solid finish operationally and financially to a strong year for the company. Starting with the topline, the soft market demand for CapEx that we talked about on our Q3 earnings call continued into the fourth quarter. In addition, customer and channel inventory reductions and the automotive industry strike reduced our organic growth rate by approximately 1.5%, resulting in essentially Fed revenue and organic growth on a year-over-year basis. That said, we finished the year with stable to slightly improving demand on a sales per day basis, as evidenced by sequential revenue growth of plus 2.5% from Q3 into Q4 compared to our historical sequential growth of plus 1.5%.

Foreign currency translation added 1.2% to revenue and divestitures reduced revenue by 0.4%. GAAP EPS was $2.38 and included $0.04 impact from the devaluation of the Argentine currency. On the bottom line, operating income was a Q4 record of $988 million and operating margin was flat year-over-year as enterprise initiatives of 150 basis points and 60 basis points of price, cost, margin benefit, net of year-over-year inventory revaluations were offset by a combination of growth investments including headcount ads, higher employee-related costs, such as wages and benefits, as well as increased restructuring expenses year-over-year. Free cash flow grew 39% to a fourth quarter record of 908 million with a conversion to net income of 127%. Overall for Q4, solid operational execution and financial performance in a pretty challenging environment.

Please turn to Slide 4, starting with one of the highlights for Q4 and the year. Our free cash flow performance on the left side of the page. And as you can see, our full-year free cash flow was up more than a $1 billion to a record $3.1 billion as our inventory months on hand metric continued its slide path to pre-COVID levels. Now let’s move to the segment results starting with automotive OEM, which led the way with organic growth of 8%, despite North America being down 9% due to the impact of the automotive strike. Meanwhile, Europe’s organic growth rate was plus 11%, and China was up 31% driven by strong market share and penetration gains in the rapidly growing EV market. Operating margin was 19.2% excluding 160 basis points of headwind from higher 80/20 front-to-back restructuring expenses as the automotive OEM team continues to work toward its margin goal in the low to mid-20s over the next two to three years as outlined at our Investor Day.

Looking forward, we expect automotive OEM to grow 3% to 5% in 2024, based on an assumption of essentially flat global auto bills year-over-year, plus our typical penetration gains of 2% to 3% and continued above market organic growth in China. Turn to Slide 5. Food equipment delivered organic growth of 3% against a tough comparison of plus 17% in Q4 last year. Equipment grew 1% and service was very strong, up 7% for the quarter. By region, North America grew 4% with institutional end markets up in the mid-teens, retail up mid-single digits and restaurants down in the high-single digits. Europe and Asia Pacific both grew 1%. Test and measurement and electronics, organic revenue was down 1% due to continued softness in semiconductor-related end markets.

While test and measurement grew 5%, electronics declined 14%. Moving on to Slide 6. Slower demand in welding resulted in an organic revenue decline of 7%. Equipment was down 8% and consumables were down 6%. Industrial sales declined 11% versus a tough comparison of plus 23%. Commercial was down 2% and oil and gas was down 3%. Overall, North America was down 7% and international was down 6%. Polymers & Fluids, organic revenue declined 2% with our automotive aftermarket down 3%, Polymers grew 6% and Fluids was down 7%. Operating margin expanded 270 basis points to an all-time high of 28.5% for the segment. Turning to Slide 7. In a tough housing market, construction products, organic revenue declined 4% as North America was essentially flat with residential renovation flat and commercial construction up 3%.

International markets have been soft all year and in the fourth quarter, Europe was down 9% and Australia, New Zealand was down 5%. Specialty products, organic revenue was down 5% as North America was down 6% and international declined 5%. Consumables were down 10% and equipment revenue grew 8%. Moving to Slide 8 and full-year 2023 results. And as Chris said, throughout the year, our colleagues around the world did an exceptional job of delivering for our customers and responding decisively to a challenging and volatile market demand environment. As a result of their efforts, ITW delivered record financial performance in 2023 with solid organic growth of 2% on top of 12% growth in both 2021 and 2022. Best-in-class margins of more than 25% and after-tax return on invested capital of more than 30%.

And we delivered these results while continuing to fully fund projects to accelerate above market organic growth and sustain productivity in our highly profitable core businesses. We raised our dividend 7% and return more than $3 billion of shareholders in the form of dividends and share repurchases. Let’s move to Slide 9 and our guidance for full-year 2024. And looking ahead, we definitely see some positives in terms of moderating headwinds in the external environment from supply chain, input cost inflation, and customer channel partner inventory reductions. But there are certainly some challenges, including lower automotive bills that I talked about earlier for example. For our usual process, our topline guidance of revenue growth of 2% to 4%, an organic growth of 1% to 3% is based on current levels of demand adjusted for typical seasonality and incorporate current foreign exchange rates.

Operating margin is expected to improve by about a 100 basis points to a range of 25.5% to 26.5%, which includes a 100 basis points contribution from our enterprise initiatives. After-tax return on invested capital is expected to remain firmly at 30% plus, and we expect strong free cash flows again with conversion greater than net income. For 2024, we are projecting GAAP EPS in the range of $10 to $10.40, which includes headwinds of about $0.10 of higher interest expense and $0.20 of higher income tax expense with an expected tax rate in the range of 24% to 24.5%. In terms of cadence for the year, we expect our typical first half, second half EPS split of 49% and 51%. Our capital allocation plans for 2024 are consistent with our longstanding disciplined capital allocation framework that we discussed at last year’s Investor Day.

Our top priority remains internal investments to support the organic growth initiatives associated with the next phase of the enterprise strategy and sustained productivity in our highly profitable core businesses. Second priority is an attractive dividend that grows in line with earnings over time, which remains a critical component of ITW’s total shareholder return model. Third, selective high quality acquisitions that enhance ITW’s long-term profitable growth potential, have significant margin improvement opportunity from the application of our proprietary and powerful 80/20 front to back methodology and can generate acceptable risk adjusted returns on our shareholders’ capital. And finally, ITW’s surplus capital is allocated to an active share repurchase program as we plan to buy back $1.5 billion of our own shares in 2024.

Turn to our last slide, Slide 10 for our 2024 organic growth projections by segment. And as you can see, five of seven segments combined are projecting organic growth of approximately 4% at the midpoint, partially offset by some unique challenges in construction and specialty products. These segment projections are the outcome of the bottom up planning process that we completed in January, and a combination of several factors including current levels of demand, deep underground market and customer insights from our divisions, market share gain expectations, and the growing contribution from our customer-back innovation efforts and the associated new product launches in every one of our divisions. Consistent with ITWs continuous improvement, never satisfied mindset, every segment is projecting to improve their operating margin performance again in 2024 with another solid contribution from enterprise initiatives across the Board.

So overall, we are heading into the first year of our next phase enterprise strategy, well positioned to continue to outperform in whatever economic conditions emerge as we move through 2024. With that, Karen, I’ll turn it back to you.

Karen Fletcher: Okay. Thank you, Michael. Eric, can you please open up the lines for questions.

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Q&A Session

Operator: [Operator Instructions] Your first question comes from the line of Tami Zakaria with JPMorgan. Your line is open.

Tami Zakaria: Hello. Good morning. Thank you so much. So my first question is, when we look at the annual guide, organic growth guide for 2024 for each segment, how should we think about these segment growth rates for the first quarter? Should it be similar to the annual guide, or do you expect any deviation from that in the first quarter and then maybe improvement throughout the year?

Michael Larsen: Well, I think, you’ll see improvement in the year-over-year organic growth rates as the comparisons get easier as we move through the year. But by and large, the projections here track kind of typical seasonality from Q4 into Q1 and so forth. So there’s really nothing unusual there. The other thing to keep in mind is while the guidance at the enterprise level is essentially based on current run rates as we talked about. It’s a much more granular projection at the segment level, which includes also significant contribution again from new products as well as our normal pricing less drag from the inventory reduction that we’ve been talking about really all year. And so really give a better kind of number as we look at the segments. So that’s how I would think about it.

Tami Zakaria: Got it. That’s very helpful. And then it seems like the inside incremental margin for the year is in the 60% to 70% range, probably in the high 60 if my math is right versus normally 35% to 40%. So what’s really driving this? Any specific segment you want to call up that may drive this overall high incremental for the year?

Michael Larsen: Yes. I think Tami, we’ve got fairly modest kind of revenue growth that we’re calling for here, 1% to 3%. And our incremental margins embedded in the guidance are higher than our typical long-term 35% to 40%, which is what I would still use in terms of long-term modeling. The reason why is a 100 basis points contribution from enterprise initiatives that give us a higher incremental margin in 2024. As part of our planning process that I just described, we’ve now had a chance to go through all the projects and activities that contribute to a 100 basis points of enterprise initiatives, again in 2024. And I might add, these are largely independent of volume. So regardless of what volume does, we’re seeing another significant contribution here, which is certainly a nice thing to have in your hip pocket in what we would describe still as a fairly uncertain and volatile environment.

Tami Zakaria: Got it. Thank you so much.

Michael Larsen: Sure.

Operator: Your next question comes from the line of Steve Volkmann with Jefferies. Your line is open.

Stephen Volkmann: Great. Good morning, everybody. I actually wanted to ask – excuse me – I wanted to ask the margin question a little bit differently, Michael, because if you have a 100 basis points from enterprise, and that’s kind of the total that we’re looking for, I suppose there must be some offsets in maybe some other costs or something because we’re not really getting underlying incrementals. We’re sort of getting it all from the enterprise initiatives, if you follow me. So just any detail on that would be great.

Michael Larsen: Yes. So I think the math is actually pretty simple for 2024. So we’ve got some volume leverage at that 2% to 4% revenue growth, maybe just round numbers, maybe that’s about 50 basis points. The enterprise initiatives add about a 100 basis points. We’re entering into what we would describe as a normal price cost environment at this point. And so there’s like a modest positive contribution from our price cost efforts. And then the offset is really our continued investments in growth, including some headcount, some employee-related cost, wages and benefits, even though those costs are moderating in 2023 that’s still is approximately a 100 basis points of headwind, which then gets us to that midpoint of 26% in 2024. And I might add, well, on our way to our 30% target here by 2030 that we talked about at Investor Day.

Stephen Volkmann: Super. Okay. Thanks for filling that in. And then maybe if I could just follow-up, the food guide, the bottoms up food sort of outlook of 3% to 5% seems like a bit of an acceleration from sort of recent trends, and we don’t have super easy comps, I don’t think. So what are you seeing in that end market?

Christopher O’Herlihy: Yes. Sure, Steve. So on Food Equipment, projecting 3% to 5% growth next year, really on the back of a few different aspects. Firstly, as always, with Food Equipment, it’s a very fertile environment for innovation. So we see several new product launches across all product categories. We would expect less channel destocking Food Equipment in 2024. And also I would say we have a continued recovery in service. As I think, service is about one-third of our revenues in food. We’re the only major manufacturer with that captive service business and service is a business that’s still in recovery pretty much from COVID, equipment has recovered, but we will see probably the final year of recovery in service in 2024, and all that is adding up to a 3% to 5% growth rate in food next year.

Stephen Volkmann: Understood. Thank you.

Operator: Your next question comes from the line of Andy Kaplowitz with Citigroup. Your line is open.

Andrew Kaplowitz: Good morning, everyone.

Christopher O’Herlihy: Good morning.

Andrew Kaplowitz: Michael, when we look at your 1% to 3% organic growth forecast for 2024, you have a nice acceleration dialed into for your CapEx businesses such as welding and T&M. You’re saying you’re basing your guidance and current run rates. So you obviously did mention some improvement in sequential demand in Q4. Could you give us more color on what you’re seeing in these CapEx businesses that’s allowing you to forecast what you’re forecasting? I would imagine you’re dialing an improvements in semicon and electronics, for instance, in T&M, but that goes into now what you usually do. I’m just curious as to what’s flushing out.

Michael Larsen: Well, I think, like we’ve said, really most of the year we’ve seen some slowing in demand for CapEx and certainly in Q3 and Q4. I think as we go into 2024, as Chris just said, we’ve got less headwind from these customer and channel partner inventory reductions that were drag of about 1% in 2023. We have a meaningful contribution and increased contribution from new products, given all the efforts around customer-back innovation that we’re driving. And then we have normal pricing, and you put all of that together and just based on, I think as you point out, it was encouraging that we saw a pickup in the sequential revenue per day from Q3 to Q4, that I think tells you that there’s certainly some stability here and some of the headwinds I just described are maybe mostly behind us.