Illinois Tool Works Inc.

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 first quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star followed by the number one on your telephone keypad. If you would like to withdraw your question, again, press the star one. 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. Karen Fletcher, Vice President of Investor Relations. You may begin your conference.

Okay. Thank you, Rob. Good morning, and welcome to ITW's first quarter 2023 conference call. I'm joined by our Chairman and CEO, Scott Santee, and Senior Vice President and CFO, Michael Larson. During today's call, we will discuss ITW's first quarter financial results and provide an update on our outlook for the full year 2023. Slide two 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 three, and it's now my pleasure to turn the call over to our Chairman and CEO, Scott Santee.

Thank you, Karen, and good morning, everyone. As you saw from our earnings release this morning, we delivered a solid start to the year, with results coming in largely in line with our expectations heading into the quarter. Starting with the top line, organic growth was 5%, with four of seven segments delivering positive organic growth, led by food equipment up 16%, welding up 10%, automotive OEM up 8%, and tested measurement and electronics up 6%. Polymers and fluids was flat, construction was down 1%, and specialty was down 5%. Operating margin expanded 150 basis points to 24.2%, with 100 basis point contribution from enterprise initiatives. Gap earnings per share increased 10% to $2.33, which was a new Q1 record for the company. Our free cash flow conversion rate was 86% of net income, which was in line to modestly above normal Q1 levels. Looking ahead at the balance of the year, While there is, of course, some uncertainty with regard to the macro environment, I have no doubt that my ITW colleagues around the world will continue to read, react, and execute at a high level to whatever comes our way. I will now turn the call over to Michael to discuss our Q1 performance in more detail and our updated FOIA guidance. Michael? Thank you, Scott, and good morning, everyone.

ITW delivered another solid quarter operationally and financially, starting with organic growth of more than 5%. Foreign currency translation headwind and divestitures reduced revenue by 2% and 1% respectively. On the bottom line, operating income grew 9% with incremental margins of 98%. Operating margin improved 150 basis points to 24.2% with enterprise initiatives and price costs contributing 100 basis points and 190 basis points, respectively. In addition to higher wages and benefit costs year by year, we're funding our growth investments, including headcount, in the areas that support our organic growth strategies and initiatives. And we still delivered 150 basis points of margin improvement in the quarter. GAAP EPS grew 10% to $2.33, which included foreign currency translation headwind of 6 cents, and our Q1 tax rate was 22.6 percent. And as Scott said, it was encouraging to see our free cash flow performance return to normal levels. Overall for Q1, excellent operational execution across the board and strong financial performance, including record EPS. Please turn to slide four, starting with positive organic growth in all of our major geographies, including North America, which represents about 55 percent of total revenues, and grew 5%, and Europe was up 6%. Asia Pacific grew 2% despite a 6% decline in China due to COVID-related headwinds in Q1. Moving on to segment results, starting with automotive OEM and solid organic growth of 8%. North America was up 3%, and Europe grew 16%. China was down 5% due to COVID-related headwinds in Q1, and we're seeing the expected bounce back here in Q2. In terms of automotive OEM margins, we're beginning to recover the price-cost margin impact that has diluted margins in this segment by about 450 basis points over the last two years. As a result, we expect price-cost margin impact to turn positive starting in Q2, which combined with positive volume leverage and contributions from enterprise initiatives will lead to higher margins sequentially and year-over-year starting in Q2 and for the balance of the year. Turning to slide five, food equipment delivered another strong quarter with organic growth of 16% as North America led the way with organic growth of 21%. Institutional end markets were up more than 50% with particular strength in education and lodging. In addition, restaurants were up more than 30%. International revenue grew 9% with Europe up 11% and Asia Pacific was down 6% due to China. Strong progress on margins, with Q1 operating margin of 26.7%, an increase of more than 400 basis points year-over-year. Test and measurement and electronics delivered organic growth of 6%, despite a double-digit slowdown in semiconductor-related revenues, which represent about 20% of segment revenue. On the other hand, demand for our capital equipment remains strong, as evidenced by Instron, for example, which was up 22%. Overall, test and measurement grew 12% organically, and electronics was down 4%. Moving on to slide 6, welding delivered double-digit organic growth of 10% in Q1 on top of 13% in Q1 last year, as equipment grew 10% and consumables were up 11%. Industrial sales remained strong, with organic growth of 17%, while the commercial side was down 2%. North America grew 10 percent, and international grew 12 percent, driven by strength in the oil and gas business, which was up 15 percent. Operating margin expanded 110 basis points to 31.9 percent, a new record for the segment and the company. Organic growth in parmesan fluids was about flat against a difficult comparison of plus 13 percent last year. Automotive aftermarket was down 1 percent, Polymers grew 1%, and fluids was also up 1%. On a geographic basis, North America grew 1%, and international declined 2%. Turn to slide 7. Organic revenue and construction was down 1% against a tough comparison of plus 21% last year. Residential construction was down 1%, and commercial construction, which represents a little less than 20% of the business in North America, was up 5%. Europe was down 9%, and Australia, New Zealand was up 3%. Finally, specialty organic revenue was down 5%, which included three percentage points of headwind from product line simplification. On a geographic basis, North America was down 4%, and international was down 6%. Okay, let's move to slide eight for an update on our full year 2023 guidance. And as you saw this morning, we raised GAAP EPS guidance by 5 cents to a new range of 945 to 985, which considers the lower projected tax rate for the full year in the range of 23.5% to 24%. Given the level of macroeconomic uncertainty going forward, we're essentially holding our operational guidance and adjusting EPS to reflect the lower projected tax rate. Our organic growth projection of 3% to 5% reflects current levels of demand with some risk adjustment for further slowing in certain end markets. Combined, foreign currency translation impact at current rates and divestitures are projected to reduce revenue by 1 percent. Operating margin is projected to expand by more than 100 basis points at the midpoint of our range, which includes approximately 100 basis points from enterprise initiatives and positive price-cost margin impact. Like I said, we're off to a solid start to the year with some positive momentum heading into Q2, and we remain well positioned to continue to outperform in whatever economic conditions emerge through the balance of 2023. With that, Karen, I'll turn it back to you.

Okay. Thank you, Michael. Rob, let's open up the lines for questions, please.

Certainly. At this time, I would like to remind everyone, in order to ask a question, press star, then the number one on our telephone keypad. We'll pause for just a moment to compile the Q&A roster. And your first question comes from the line of Andy Kaplowitz from Citigroup. Your line is open.

Hey, good morning, everyone. Morning, Andy. Michael, can you give us a little more color into how you're thinking about the company's margins for the year? I know you didn't change your forecast, but margin, as you said, was up 150 base points in Q1. I think you guided us to 100 base points, and you said price versus cost in Q1. I think you said it was 190 points. I know you're thinking about 100 base points for the year. So are you thinking that should be materially higher now, especially given you're calling for return on automotive? So what held you back from not increasing your margin forecast for the year?

Well, I think Q1, Andy came in right along with our plan, really across the entire income statement and also on free cash flow. So Q1 margins expanded 150 basis points. That's typically... the low point for the year. And so if you go back and look historically, you'd expect margins to improve from here in Q2, again in Q3 and Q4. And based on our current planning, we expect about 100 basis points of margin improvement year over year in each one of the remaining quarters. And actually, across our segments, we're seeing similar trends in terms of margins improving from here. If you look at the bridge, and we talked about this last quarter as well, we're certainly seeing some positive operating leverage from our organic growth this year. We're seeing about 100 basis points of contribution from enterprise initiatives. That's well within our own control based on projects and activities that are going on inside the company. we are starting to see price-cost margin impact being positive. That really started in Q4, and as you said, another step forward here in Q1. We expect that to remain positive for the remainder of the year. As you know, we've diluted margins about 250 basis points at the enterprise level over the last two years, and maybe we'll recover about half of that this year, so maybe a little bit more than 100 basis points from price cost. And then the delta is what we talked about in terms of the investments that we're making to support our organic growth, including in our people. And so we're certainly seeing some increases there in terms of wages and benefit increases that everybody else is seeing. So that's kind of the margin picture for the year, Andy. I hope that answers your question.

Yeah, Michael, that's helpful. And then last quarter you said that 25% of your ITW businesses were slowing. Is that still the case? And did those businesses end up slowing at the run rate you projected, maybe better or worse than you projected? And then Q1 was a bit higher than you predicted in terms of seasonality. Are you still thinking that 49%, 51% in terms of EPS breakdown for the year?

Yeah, I think if you look at the – what we talked about last quarter was about 25% of the company's revenues slowing down. And so just to maybe remind everybody, we're talking about residential construction. We're talking about commercial welding and the automotive aftermarket being down here in Q1 and kind of in the low single digits. Our appliance components business and specialty products being down in the high single digits. And then semiconductor, we talked about orders coming down. We're now seeing that translate into revenues coming down in that 10 to 15 range, primarily in the test and measurement segment. So Q1 was actually in line with plan in terms of what we expected. We do expect some further slowing, primarily in this handful of businesses that I mentioned. And what I would just say... And that's not new. That's in our plan. That was in our plan, and that's included in our guidance and our plan for the rest of the year. I would just say, you know, there's a lot of strength in other parts of the company, obviously. The vast majority of our businesses are still seeing solid demand. We're always going to have some headwind and tailwind, and it kind of all nets out to some pretty solid performance, as you saw in Q1, and we'd expect the same for the remainder of the year. I'll just say this. I mean... The environment, obviously, this is pretty uncertain at this point. Things can change pretty quickly, but based on what we know today, we remain really well positioned to deliver solid performance here in Q2 and for the balance of the year.

Mike, are you still thinking that 49-51 split?

Yeah, from a planning standpoint, I think that's still a good assumption and in line with really what we have done historically.

Thank you.

Thank you.

Your next question comes from the line of Tammy Zakaria from JP Morgan. Your line is open.

Hi, good morning. Thank you so much for taking my question. So you mentioned sequentially you expect automotive margins to get better from here on. How about sales? Should we also expect the first quarter sales to be the lowest of the year and then build from here? Or is there some seasonality that we should be modeling?

I mean, there's very little improvement from here on out. I mean, I think it's really the growth rates year over year are more driven by the comparisons. So if you look at Q2 last year, there was a meaningful decline or a lower number in auto bills. That's going to be higher this year, so we'll see some good growth in Q2 on a year-over-year basis. But sequentially, you're not going to see you know, significant and certainly not an assumption baked in here in terms of significant revenue growth sequentially.

Got it. Thank you so much. I'll pass it on to the next person. Sure. Thanks, Tammy.

Your next question comes from the line of Jeff Sprague from Vertical Research Partners. Your line is open.

Hey, thank you. Good morning, everyone. Jeff. Hey, maybe two separate topics from me. If you think about the parts of the portfolio that are, you know, still resilient and you have visibility, I think one of the uncharacteristic things maybe you saw in the last year or so is, you know, backlog build where you wouldn't typically get, you know, backlog build. I just wonder if you could speak to that, kind of your forward visibility on some of the things that are a bit later, longer cycle, or the backlogs holding, you're starting to burn into them. Any color on orders there would be interesting.

Yeah, I mean, I think, as you point out, Jeff, we are not necessarily a backlog-driven company. And while backlogs have come down a little bit, they're still significantly higher today than kind of pre-COVID levels. So maybe not running at 2, 3x, but at least 50% higher in businesses like welding and food equipment, where we're still seeing a fair bit of backlog. You know, the other thing we talked about, Jeff, obviously you know this, as supply chain continues to, you know, moderate here in terms of the challenges, you know, we're going to see backlogs come down, and that's exactly what we're seeing across the company.

And I wonder if you could speak longer term to auto margins. I think you said, you know, kind of 450 basis point hit from just the price-cost arithmetic and, you know, the game had, you know, catch up there. margins are down only about 300 basis points right over the last year or so. Are you actually pointing us to kind of higher structural margins in auto on the other side of this? I know we don't get it all in 2023, but are we headed to a higher place than we were, you know, a year or two ago in auto margins?

Yeah, I'm not sure, Jeff, the exact comp you're referring to, but I think it's safe to say that auto margins, we see a... you know, a low to mid-20s business over the next two or three years. And, you know, it's a combination of great growth prospects there, the fact that all the new programs that we add are, you know, margin positive. And, in fact, just to put in a plug for our investor day in a couple of weeks, we're going to spend some time detailing out sort of the margin path on auto and more substance.

Great. That'll be interesting. I'll see you in Boston.

Your next question comes from a line of Scott Davis from Milius. Your line is open.

Hey, good morning, Scott, Michael, and Karen.

Hey, Scott.

I was wondering if you guys could give us a little bit of a window into what's going on in China. You know, I think the April PMI came in a little lighter than what folks were expecting and back down to contraction level. But they should be reopening. And I think January was probably the toughest month you had in the quarter. But you've had a chance, I'm guessing by now, to see at least an early look at April. What are you seeing there kind of just from a macro perspective and perhaps into each of the businesses, if that makes sense?

Yeah, I mean, I think we are, to answer your question, we're seeing a bounce back here in April, which supports a double-digit growth rate on a year-over-year basis in China here in the second quarter. You know, we did see here in the first quarter, as you point out, particularly in January, several of our customers, the automotive OEMs, as well as our, you know, restaurant, food equipment businesses were slower to open up. So we were definitely down in automotive OEMs. I think we said 5%. We were down at food equipment. Parmesan Fluids was also down kind of in that 15% to 20% range. And those businesses are all coming back pretty strong here in the second quarter. You'll see some big build numbers in automotive OEM China. That business could be up significantly or will be up significantly on a year-over-year basis. Also, the comps are easier here, so we're looking at a 40% to 50% growth rate in the automotive China business. Food equipment's coming back, colors and fluids, the welding business. So it all adds up to something Q2 year over year up somewhere around 20%, which obviously includes the bounce back from January, and it may be a little bit slower than expected reopening here in the first quarter.

All right. That's helpful. I want to go back to Jeff's question, and I don't want to blow up your investor day, so feel free to punt. But is the era of price de-escalators or price downs and the auto contracts, is that era over with and we're at least over the next five years envision more of a flattish price environment or is nothing really changed? And at the end of the day, we're going to be back into that. kind of usual down 1%, 2% price dynamic.

Yeah, I think it's more the latter, to be honest here. I think the industry has not really changed in terms of how these contracts are structured, where you get a lot of price up front. And so the key there is to continue to innovate and solve problems for customers in ways that nobody else can. And so as you win new programs and get new content on vehicles, that has to come in at a higher price. But in terms of the structure of of price downs every year, that has not changed at this point. Okay.

Thank you for the integrity of answer. I'll pass it on. Always.

Our next question comes from a line of Joe Ritchie from Goldman Sachs. Your line is open.