Illinois Tool Works Inc.

Good morning. My name is Kathleen and I will be your conference operator today. At this time, I would like to welcome everyone to the ITW's Third 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. If you would like to ask a question during this time, simply press star followed by the number one on your telephone keypad. And if you would like to withdraw your question, just press the star one again. 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 Linehan, Vice President of Investor Relations. You may begin your conference.

Thank you, Kathleen. Good morning and welcome to ITW's Third Quarter 2024 Conference Call. Today I'm joined by our President and CEO, Chris O'Harelyhee, and Senior Vice President and CFO, Michael Larson. During today's call, we will discuss ITW's Third Quarter financial results and provide an update on our outlook for full year 2024. Slide two is a reminder that this presentation contains forward-looking statements. Please refer to the company's 2023 Form 10K 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 President and CEO, Chris O'Harelyhee. Chris?

Thank you, Erin, and good morning, everyone. As you saw in our press release this morning, during the third quarter, the market demand environment continued to moderate across our portfolio with further softness in the automotive and construction markets. Overall, third quarter revenues came in approximately half a percentage point, or $25 million below what they would have been, had demand held at the level we were seeing exiting the second quarter. That said, the slowdown in Q3 was less than in Q2, where revenue came in approximately one percentage point, or $50 million below run rate. As a result, third quarter organic revenue declined one percent, with five segments down year over year, partially offset by growth in two segments. This one percent revenue decline compares to our end markets, which we believe were down in the low to mid-single digits. As we have all year, the ITW team continued to successfully navigate and overcome these market challenges with strong operational execution. Those efforts resulted in operating income of $1.05 billion, with operating margin of 26.5 percent, which included a 130 basis point contribution from enterprise initiatives. With little operating leverage, six of seven segments still increased operating margin, resulting in segment operating margin expansion of 110 basis points. EPS grew four percent to $2.65, excluding the gains from the divestiture that Michael will review in more detail. The continued contribution from enterprise initiatives, regardless of volume, speaks to the power and resilience of our business model. And it is notable that for the first time, three of our segments delivered operating margin above 30 percent in the quarter. And we are well on our way to achieve our goal of 30 percent operating margin for the by 2030. Our continued focused execution and typical operational excellence have enabled ITW to effectively counter persistent market headwinds and achieve increased profitability, while we continue to invest to maximize growth and performance over the long term. Consistent with our long-term commitment to return surplus capital to shareholders by an attractive and growing dividend, on August 2nd, we announced our 61st consecutive dividend increase, raising our dividend by 7 percent. And year to date, we have repurchased more than $1.1 billion of our outstanding shares. Today we are raising our full year gap EPS guidance by $1.33 from a range of 1030 to 1040 to a new range of 1163 to 1173 to incorporate the impact of the divestiture gain and a lower projected tax rate for the full year. Based on current levels of demand exiting Q3, we are maintaining our previous operational guidance for revenue and organic growth to be approximately flat for the year and our operating margin to be between 26.5 and 27 percent. While the ITW team is on a commendable job managing the short-term challenges this year, perhaps more importantly, we continue to deliver solid progress on our next phase enterprise strategy priorities. As we outlined to you a year ago, the central focus of the next phase of our enterprise strategy is to elevate high quality organic growth and customer-backed innovation as key ITW differentiators, on par with our -in-class operational capabilities and financial performance. This quarter, we made further progress in our journey to achieve this strategic goal. We believe that customer-backed innovation, or CBI as we call it, is the most impactful driver of our ability to consistently grow revenue above market. In essence, the customer-backed innovation revenue of today fuels the ability to drive market penetration and share gain in the future. Over the past few years, we've made progress on expanding our revenue from CBI from less than a percent in 2017 to approximately 2 percent today. And at our September leadership conference, we launched the next phase CBI framework for our 84 divisions around the world. Just as we successfully focused the entire organization on 80-20 front to back over a decade ago, we are now doubling down on customer-backed innovation. And I, for one, can feel the energy, excitement, and momentum from our team as they implement this strategy at each division. With our continued laser focus and our typical -we-say execution, it is with strong conviction that I know we will build above market organic growth fueled by customer-backed innovation into a defining ITW strength. In concluding my remarks, I want to thank all of our ITW colleagues around the world for their exceptional efforts and dedication in serving our customers with excellence and driving continuous progress on our path to ITW's full potential. I now turn the call over to Michael to discuss our Q3 performance and full year guidance in more detail. Michael. Thank you,

Chris, and good morning, everyone. Starting on slide three, as expected, the third quarter ended up looking a lot like the second quarter with continued strong operational execution in a moderating demand environment. Total revenue declined .6% with organic revenue down 1.4%. Foreign currency translation reduced revenue by .4% and acquisitions increased revenue by 0.2%. On a geographic basis, organic revenue declined about 3% in North America. Europe was down half a percent and Asia Pacific was down 1% with China, essentially flat. In this environment, the ITW team continued to focus and execute well on the things that we can control as evidenced by six of our seven segments expanding operating margin, driven primarily by enterprise initiatives that contributed between 70 and 180 basis points to each segment and 130 basis points at the enterprise level. Third quarter operating margin was 26.5%, up 30 basis points sequentially from the second quarter and flat with the prior year due to a tough comparison. As you may recall, last year's Q3 margin of .5% expanded 200 basis points compared to 2022 due in part to the favorable impact of a few corporate items that we discussed on the call last year, including a one-time insurance recovery. Excluding those one-time items last year and looking just at segment operating margin, which is included in the press release tables, our segment operating margin increased by 110 basis points compared to the prior year, which is more in line with our typical margin expansion on a quarterly basis. Gap EPS of $3.91 was up 53% and included $1.26 gain from the divestiture of our non-controlling equity interest in Wilson Art. Excluding this gain, EPS of $2.65 was an increase of 4% -over-year. I want to spend a minute on a previously announced Wilson Art divestiture. The proceeds from the transaction, net of transaction costs, were approximately $395 million, which we used to reduce our commercial paper balance. The transaction resulted in a pre-tax gain of $363 million and income taxes on the gain were more than offset by a discrete tax benefit of $107 million related to the utilization of capital loss carried forwards, which resulted in the favorable gap EPS impact of $1.26. Free cash flow was $783 million, which was 102% conversion of adjusted net income. And as Chris mentioned, in the third quarter, we raised our dividend by 7% to an annualized of $6 per share, which marks our 61st consecutive year of increases. And as planned, we repurchased $375 million of our own shares during the quarter. The effective tax rate in the quarter of .9% was below our typical tax rate in the -25% range. As you can see from the reconciliation and the press release, the tax rate was favorably impacted by several discrete items in the quarter, including the Wilson-Dard transaction. Excluding these discrete items, our core tax rate was 23.7%. So in summary, the third quarter looked a lot like the second quarter with moderating, but also stable demand and solid operating margin and profitability performance as we continue to focus and execute well on the things that we can control. Please turn to slide four for a look at our -to-date segment margin performance. And as you can see from the table on the left side, six of our seven segments have expanded their already -in-class margins -to-date and three segments by more than 100 basis points. Food equipment is a bit of an outlier due to the growth investments in our service business and specifically the near-term inefficiencies associated with onboarding of new service technicians to support accelerated organic growth in this business. This margin headwind is now largely behind the food equipment segment as evidenced by 110 basis points of margin improvement in the third quarter. Total company margin is up 180 basis points, which in fairness includes 100 basis points from the one-time LIFO adjustment in the first quarter, but still solid performance in the current environment. Moving to the segments and starting with automotive OEM, organic revenue declined 3% in the third quarter as industry build rates continue to come down. North America was down 6% as the D3 customer builds were down 9%. Europe was down 5% and China was down 2%. Compared to the automobile industry build data, the segment has outperformed builds by about 200 basis points -to-date and we expect similar outperformance in the fourth quarter. The segment also delivered solid operating margin performance of .4% and 50 basis points increase despite lower volume and we expect more progress in the fourth quarter and next year as we continue to work towards our long-term goal of achieving operating margins in the mid-20s by 2026 in this segment. Turning to slide 5, organic revenue and food equipment was about flat against a tough comp of plus 6% last year as equipment was down 4% and offset by service, which grew 7%. Regionally, North America was down 2% after being up 10% last year with institutional sales about flat as healthcare was up mid-single digits and restaurants were down about 10%. International was solid, up 3% with the service business up 8% and Europe up 4%. Operating margin improved 110 basis points due to the service margin normalizing and a solid contribution from enterprise initiatives. As we mentioned last quarter, we expect margin to continue to improve as we go through the Test and measurement and electronics organic revenue was down only 1% after being down 3% last quarter with stable demand in semiconductor, electronics and capex sensitive end markets. While test and measurement was down 3%, electronics was up 1% in the quarter after being down 3% last quarter and this marked the first quarter of positive growth in electronics since the end of 2022. And we're beginning to see increased semiconductor customer activity suggesting that perhaps we are near a bottom for this market. As we've discussed before, we remain very well positioned to capitalize on the growth opportunities in this space when the inevitable recovery does happen. Operating margin expanded by 190 basis points in the quarter to 25.7%. Moving on to slide 6, welding's organic revenue declined 1%, a meaningful improvement from being down 5% in the second quarter as both equipment and consumables revenue declined 1%. Both America revenue was down 2% but international was up 6% with solid growth in Europe and China. As we talked about at the beginning of the year, the welding team was planning on a solid contribution to the top line from the launch of new products which in the third quarter resulted in a 3% plus contribution to growth. And this is just one of many examples inside the company that illustrates how continued progress on CBI, as Chris was talking about, gives our segments the ability to gain share and outgrow their end markets. Operating margin of .3% was the third quarter record for the welding segment. Polymers and fluids organic revenue grew 1% with polymers up 10% due to international strength and fluids was up 3%. Automotive aftermarket which as you know is tied closely to consumer discretionary spending was down 3% in the quarter. On a geographic basis, North America declined 5% and international grew 11% with Europe again showing solid demand. Turning to slide 7, organic revenue in construction products was down 9% as construction end markets took a sizable step back from the second quarter with new housing starts down 10% on an annualized basis as compared to down 6% in the second quarter. As a result, North America declined 10% with residential down 12% and commercial construction down 7%. Europe was down 4% and Australia and New Zealand was down 11%. Despite the lower volume, operating margin of .2% was a record for the segment with another significant contribution from enterprise initiatives. Finally, specialty products had a solid quarter with organic revenue growth of 6% with strength across the portfolio as both equipment and consumables were up 6%. North America was up 8% and international grew 2%. The 6% growth rate for the segment included about 200 basis points of PLS or product line simplification in the quarter as we continue to make progress on repositioning some of our specialty products divisions for consistent above market organic growth. We expect about 300 basis points of PLS in the fourth quarter and that the segment will be flat to up low single digits for the full year. Operating margin expanded 330 basis points to 31.1%, a third quarter record for the segment with strong contributions from operating leverage and enterprise initiatives. Moving to slide 8 and our updated full year 2024 guidance. As you've seen all year, the ITW team continues to execute at a very high level and find a way to leverage our business model and high quality diversified business portfolio to deliver solid operational and financial results in a challenging demand environment. Looking ahead at the fourth quarter, we do not expect the near term demand environment to improve and as usual, our guidance is based on current levels of demand, seasonally adjusted and foreign currency exchange rates. As a result, we're maintaining our previous projection for revenue and organic growth to be approximately flat for the year. We're also maintaining our full year operating margin guidance, which is projected to be between 26.5 and 27%, an improvement of 165 basis points at the midpoint with enterprise initiatives contributing more than 100 basis points. As you saw in the press release, we incorporated the impact of the Wilson Art divestiture gain and a lower projected effective tax rate of .5% for the full year into our EPS guidance. As we raised gap EPS guidance from a range of $10.30 to $10.40 per share by $1.33 to a new range of $11.63 to $11.73 per share. Excluding the Wilson Art gain,

the

EPS range is $10.37 to $10.47 per share or $10.42 at the midpoint. So in summary, while the overall demand environment remains pretty uncertain and challenging in the near term, we remain laser focused on leveraging ITW's unique strengths and capabilities to optimize our ability to deliver differentiated performance over the long term. And with that, Erin, I'll turn it back to you.

Thank you, Michael. Kathleen, will you please open the queue for questions?

At this time, I would like to remind everyone, free to ask a question, please press star then the number one on your telephone keypad. We will pause for just a moment to compile the Q&A roster. And your first question comes from the line of Jeff Sprague of Vertical Research Partners. Your line is now open.

Hello. Good morning, everyone. Morning, Jeff. Morning, Jeff. Good morning. Hey, I just wanted to sort of pick up sort of where you left off there, Michael, with kind of the trends into the fourth quarter. I don't know unless my math is wrong. I think kind of sequentially you're looking at revenues up maybe 4% or 5% when normally they declined slightly. So, you know, was your exit rate in September or your early read in October, you know, kind of better than what we saw in the quarter in aggregate or maybe you could just clarify if I'm missing anything there?

Yeah, sure, Jeff. So let me start by saying, as you know, we don't give quarterly guidance. And, you know, as you were trying to do based on our -to-day performance and our full year guidance, you can get pretty close in terms of figuring out Q4. But maybe let me try to help out a little bit. So I'd say at a high level, Q4 looks a lot like Q3. You know, typically what we see from a seasonality standpoint is a sequential improvement in revenues from Q3 to Q4, about a point to a point and a half. And that's going all the way back to 2017. So at current run rates, typically we're up a point to a point and a half. We do have easier comparisons in the fourth quarter. And for what it's worth, there's also an extra shipping day in the quarter. So you add all that up, we get to about flat revenues on a -over-year basis. We expect, again, our typical margin improvement of about 100 basis points on a -over-year basis. So that is a slight decline from Q3 to Q4, which is kind of the typical seasonality. And the main driver here remains another strong contribution from the enterprise initiatives. And then factoring in a more kind of normal tax rate for us in that 24, 25 percent range. And you get to EPS at the midpoint. And I'm just doing the math. I'm not giving guidance that's in that 251 range for the fourth quarter. So I'll just add, while we're talking about the fourth quarter, we do expect a strong quarter, again, from a free cash flow standpoint. And we're projecting some meaningful improvement on our inventory levels in the fourth quarter, which is not easy in the current demand environment. So hopefully that's helpful, Jeff.

Yes, that's very helpful. Thanks for that color. And then just kind of secondarily, your business in China is not huge. It's very important for auto, though. And it was just kind of interesting that China welding was solid. A lot of cross-currents there. We had some pretty ugly China numbers out of Trane and Otis today. Those are different businesses, obviously. But maybe this is for Chris. Can you just maybe give us your bigger picture view on what's going on there? And also just kind of given the importance of auto, anything in this kind of China, Europe, you know, care of spat around automotive, you know, influence your view or outlook at all?

Yeah, so I think from an auto China standpoint, Jeff, I mean, China builds this year on auto. We expect it to be up 1%. We expect to be up 8%. So our businesses continue to penetrate very successfully in China. EV obviously is a large part of the story, given the fact that China is producing about 60% of the world's EVs. But we're making very strong penetration gains in EV in China, as evidenced by the market growth. In auto in general, we expect to be up a couple of percent against flat builds this year. Sorry, flat versus negative down two builds, so up 2%, I would say. As we have been kind of historically, we would expect to be on into the future. And that strength has been pretty much across all three geographies, Europe, North America, but especially in China. So let me

just add a little bit of color to this. So I think if you look at the third quarter, about flat with auto, as we said, down two. And certainly some challenges also in test and measurement down single digits, low single digits, same in food equipment. So strength in welding, which is tied to oil and gas, LNG, transportation, and also some strength in our specialty products, appliance business. So you all add up, you get to about flat for the quarter. Six percent yitter date, we think, in the fourth quarter, as Chris said, we'll see a pickup on the automotive side, continued strength in welding. And so Q4 should be kind of flat, maybe up a low single digit and the full year up in that five percent range. So as we sit here today, I think we feel pretty good about China. I know there's a lot of talk about stimulus and so forth. We haven't seen a lot of that yet. So if that's still to come, that would certainly be helpful. But as we sit here today, we feel pretty good about China.

OK, thank you for the color.

Sure.

Your next question comes from the line of Jamie Cook of Jewish Securities. Please go ahead.

Hi. Good morning. I have two questions. Two questions. One, I was impressed with the specialty growth in the quarter, despite headwinds from PLS. And I know specialty special because there's a lot of different businesses in there. So can you just sort of break down what you're seeing within that business? You know, what segments drove sort of the organic growth? That would be my first question, and then I'll give you my follow up after that.

Yeah, so, Jimmy, I think a good part of the specialty story is strength in aerospace. We have one particular business that's focused on aerospace. And again, we saw about 30 percent growth in that business this quarter. We saw, I'd say, pockets of strong demand, I think, throughout the segment. Areas like consumer packaging, consumer packaging equipment were also pretty strong. And we did have some favorable comments in specialty versus last year. But, you know, even with all that, we expect specialty to be kind of low single digits for the full year. And it's really strengthening our conviction that on the basis of the strategic portfolio positioning we've been doing in that segment, which involves some, as we said before, some partly improving throughout the segment, which is certainly choppy and it's creating a bit of a drag, as Michael just indicated, a couple of hundred basis points this year. But what it does, what this is all doing is really strengthening our conviction that the objective to make specialty a four percent grower in the long term is well on track here. And everything we've seen this year gives us a strong belief that we can do that.

And I think the only thing

I'd add is just, Jimmy, if you look at the margin performance, you can see what happens in ITW. And this is not unique to specialty. When you get a little bit of operating leverage, you know, suddenly you're in that 31 percent plus range, which is certainly very encouraging and gives us, as we said earlier, a lot of conviction in our ability to get to that 30 percent target at the enterprise level with three segments this quarter above 30 percent, which is that's the first time that's happened. And again, that's with very little operating leverage. So that's certainly really, really gives pretty encouraging as we look also into into next year in terms of the momentum around the margin performance of the company continues.

I mean, that's helpful because I think some of the bears think the 30 percent plus is is is challenging for you guys to do. So it's nice to see that. I guess one more follow up, Chris. You talked about market outgrowth in auto. You talked about, you know, welding from the new product introductions and even on food, you know, the increased service effort as you go through CBI. And you're now, you know, you've done with ITW forever, but CEO, you know, for for a longer period of time. Are there any businesses that you're considering are more challenged, like over the longer term that you think is going to be tough to to get to the organic growth targets that you have? You don't have to say which ones, but just understanding if there's any difference in how you're thinking about the portfolio relative to when you first took over.

Thanks. Not at all, Jamie. I think if we go back to investor day last year, we were very overt in our comments that we felt that all seven of our segments have the capability to go four percent plus. And we certainly believe that today and even more so with respect to CBI, the CBI opportunity, I think is very relevant across all seven segments. You know, we're at different points in terms of the development around that. But I think, you know, everything we've seen would indicate that all these segments have a pretty far-tide innovation environment, have critical customer pain points that are there to be solved. You know, we're certainly mobilizing the company around that in a very similar way to the way we mobilize the company around front to back, you know, 10, 12 years ago with the same kind of capability build and investment and resources, a much higher level of leadership, kind of time and focus on CBI. We have lots of great innovation practice across the company and we've now codified that into a very effective innovation framework. And this is the exact same approach that we took on 80-20 front to back, which, as we know, was very successful. And we've seen this. I mean, this is not something that's starting today. We've been working on this for a couple of years now in terms of focused investment and resources on CBI. And we've seen that in terms of the improvement in yield that we've seen from CBI. So there is a lot of conviction here that, you know, the yield improvement from one to somewhere over two today will be north of three in due course. And we have a very clear path to doing that. And like I said, that's going to result in improvements in every one of our segments on the ultimate journey to having everyone be segments growing at four plus.

Thank

you. Your next question comes from the line of Andy Kaplowicz at CD Group. Please go ahead.

Good morning, everyone.

Morning, Andy.

Question, Michael, I know you've been hopeful about a turn in test of measurement for much of this year. And you did mention maybe more positive discussions with semiconductor customers and you did see electronics turn positive. So maybe you can give us some more color on the conversations you're having, you know, the outlook. Obviously, it was going to predict run rates. But as you go into twenty five, you see a better outlook for the segment.

Yeah, I think based on the customer conversations that we are having, we're starting to see a bottoming, particularly in semi, you know, just to characterize semi is about 15 percent of test the measurement. It represents a couple of percent of ITW's revenues. So just to put it in context, but there's no doubt that we saw a bottoming and a slight improvement in this, I think, in the third quarter. Electronics, similarly, had been down for quite a while, significantly down earlier this year, is starting to bottom there as well. And then I think an important kind of bellwether for us, you know, the Instron business, which is a critical business within test of measurement, had very solid growth during the quarter. And I certainly encourage as we look here for the balance of the year and on into next year.

Helpful, Chris. And then, Michael, I think you mentioned I think what you call the solid step back in construction markets in Q3. Do you see any hint of stabilization as you go toward the end of the year in those markets? I mean, obviously, we started US cutting rate cutting cycle. Maybe what changed in Q3 versus Q2 in your businesses that led to the step down?

Well, I think we're talking about our most interest rate sensitive segment. So, you know, I think what we're seeing here is a market that's, you know, down in the low teens. I pointed in the script to kind of the housing start numbers being down 10 percent on an annualized basis, which kind of mirrors our business in North America. Maybe we're a little bit better than that. And then we're seeing similar type of softness in Australia, New Zealand, which is a meaningful part of our business. So I think at this point, it's really too early to point to any signs or indicators that things are getting better here over the long term. You know, certainly the fact that interest rates appear to be coming down is, you know, has been a leading indicator, but we've not seen anything to suggest that things are picking up in construction at this point. So and I'll just say in that context, I think it's even more remarkable that, you know, we've the team put up margins of 30 percent plus here in the third quarter, you know, in an environment that's certainly pretty challenging. So and about as challenging as we see across the company at this point in the cycle.

Appreciate it,

guys. Sure. See you, Andy.

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

Hi, good morning, team ITW. Hope you're doing well.

Good morning. Thank you.

So my first question is on margins, very nice margin performance in the quarter. I'm curious, what was price cost in the quarter and more broadly, how are you thinking about enterprise initiatives and related margin improvement potential in 2025? It seems like almost like an endless well at this point, and I mean it positively. So any hard looking comments about enterprise initiatives and what you're expecting for next year would be helpful.

Yeah, let me let me do price cost. And then, Chris, you can add some commentary on enterprise initiatives. But I think at this point, Tammy, as we said before, price cost is kind of normalized. This is no longer a distraction as it was back in in twenty one, twenty two and twenty three. At this point, price dollars are ahead of costs on a dollar basis and modestly positive from a margin standpoint. Now, that just to be clear doesn't mean that costs are coming down, particularly electronics, energy in certain geographies, components that have labor content. We're also seeing it in our employee costs, health and welfare and other pockets overhead costs, such as just point out rental, expense, leases, software licenses. So we have to continue to be very diligent in this area and make sure that we get price to offset all of these pressures. But overall, nothing significant to point to on the price cost equation and then maybe on the enterprise initiatives. Chris,

sure. So Tammy, as you said, enterprise initiatives continue to be an important contributor to results. And how we think about these initiatives is that these initiatives are independent of volume and they're really a no come of the continuous improvement mindset. That's very much part of ITW's DNA, I would say. And this is what really drives this divisional kind of quality of practice and 80, 20 front to back in sourcing. And typically very bottom up initiatives driven by our talented people in our divisions at a very granular level. Most of these initiatives are in the couple of hundred thousand dollar range in terms of individually. But when you have 84 divisions, these add up to a very meaningful number. So the divisions have a lot of visibility, ownership and accountability on these. And the track record is indicator over the last 11 years. Our divisions kind of do what they say when they forecast these. So our confidence on enterprise initiatives going forward that this will continue really is an outcome of this strong ownership and accountability that resides in our divisions and the strong continuous improvement mindset that I refer to. That's really hard word into our divisions at this point. And the case of 80, 20, as we know, this is the gift that keeps on giving. So with that, we certainly see an ongoing contribution from enterprise initiatives going forward, including in 2025. And this is a fundamental part of how we drive differentiated execution in any environment.

Got it. That is very helpful. Thank you. And my second question is more strategic. So there's a lot of optimism around data centers, A.I., power generation, power demand, so on and so forth. How do you assess these opportunities internally? Do you see an opportunity for ITW to increase the exposure to some of these trends, maybe organically or through acquisition? So how do you evaluate some of these things?

So I think as it relates to data centers specifically, we have standard characteristics of businesses that we would pursue for acquisition based on sustainable differentiation. So if an opportunity came along that was data center related and met our normal criteria, then we'd be all in based on the characteristics of having a business that could grow above market, that we could leverage our business model and we could acquire at the right valuation. And that applies to everything, not just data centers. So we don't have a specific focus on data centers. We kind of look at all these things on an equal basis in terms of their long term attractiveness for us.

Got

it. Thank you. Your next question comes from the line of Joe Odia from Wells Fargo. Please go ahead.

Hi, good morning. First, just wanted to ask on and kind of specific to North America, but interested in and a capex versus op ex trends and I think, you know, appreciating a pretty quick book and ship model. Not sure how much you would see this, but we do hear about inquiry activity being better than border activity out there. And so curious the degree to which you see some of that or hear some of that from your sales force and customer tone. As you think about rates starting to come down, I think some folks waiting for getting post election and just the idea that you're getting a sense that there is some pent up demand that hasn't moved forward with some uncertainty overhang. And thoughts on that potentially moving forward near term.

Well, I think you're a suffer thing. Yeah, we're not economists, and we're not trying to predict the impossible here, which is where the economy is going. We are, as you said, you know, much more short cycle, our divisions to a great job kind of reading and reacting to what's going on in their respective end markets. I'll just make a broader comment based on what we saw in the third quarter, which is some stability in the more capex sensitive businesses. So I'll point to welding, as I mentioned, I'll point to test and measurement, including our in strong business, which was up in a meaningful way on a year over year basis and improve kind of quoting and order activity. So so maybe that squares with what you were talking about. And then the softness in Q3 was really much more tied to construction and automotive production, specifically with our customers, with the three customers. But certainly some stability in capex. And we'll see where it goes from here. We're modeling based on current run rates. So based on what we're seeing in our businesses today, and we'll see how it all plays out as as we go into 2025 and and interest rates maybe would be a little helpful if they if they came lower for sure.

So. Nope, I appreciate that color. And then just wanted to ask on on CBI and we think about as we think about it becoming sort of a growing initiative. I just what it what it means on the R&D side and the degree to which you can keep R&D relative to sales at sort of similar levels or what you're doing there as we would think to drive more innovation, you might need to allocate a little bit more there.

Yes, so for us, you know, spending in in R&D or innovation is largely an outcome of basically request more divisions. Basically, we fund we fund all the good projects we've been making over the last three or four years baking, making very focused investments in areas like innovation and strategic marketing. We expect that to continue. But if that number was to go up, that's not a problem for us. It's really an outcome of funding all these good projects and our teams are really focused on their 80 opportunities in their markets with their key customers. And whatever we spend in R&D typically is an outcome of that. And we're very happy to spend it because it's typically money well spent on the degree of focus that our businesses have.

Yeah, just from a numerical standpoint, I'd say, you know, R&D spend the way we've defined it here over the years is about one point eight percent of sales. So as sales grow, so will the R&D dollar spend. And, you know, we don't foresee any significant change in that as we go forward. As Chris said, we really fund every project that our divisions put forward, put forward. And that's important to them. And so that's how we approach it here, really in terms of it's an outcome of this process that Chris described. I appreciate it. Thank

you.

Sure.

Your next question comes from the line of Sabrina Abrams of Bank of America. Please go ahead. Hi. Good

morning.

Morning.

As a follow up to some of the CBI commentary and questions, I think back at your investor day, the framework for CBI for segment was about two to three percent contribution and its most meaningful driver to reach the long term targets. Are you on track for that this year? And I understand it's relevant to all seven segments. But maybe if you could provide any color on which segments you think are more mature in this journey.

Yes. So we're very much on track to do three percent plus in line with our target by 2030, if not indeed before that, based on the progress that we are making. We're at varying levels of accomplishment currently across our seven segments. I would point to welding as an example. This year, as we've highlighted, Michael highlighted in his commentary, our welding business is suffering some significant end market challenges, but we're getting north of three percent contribution of CBI in welding. As we forecasted at the beginning of the year, several new product launches. So welding will be one test and measurement electronics, obviously an area of significant attractiveness around innovation in the context of what's going on in those segments. New materials being developed, all of which require to be tested, increasing stringency in areas like R&D and in quality control, all of which requires more and more sophisticated testing equipment, which really speaks to our competitive advantages. And then the other one I highlighted is food equipment. Food equipment sustainability in areas of energy savings, water savings is a very fertile innovation environment. And we've managed to leverage that for several years. And the other one, of course, I point to is auto. Auto, given the disruptive nature of auto right now, particularly with the increased penetration of electric vehicles, provides enormous opportunity for innovation. And we're capitalizing on that as evidenced by the fact that our electric vehicle penetration into electric vehicles is higher than the market average. So I feel pretty good about all seven segments, but those are the four that I highlight right now.

Thank you. And it seems some of the above average PLS and specialty product is behind us and that business is growing nicely. You guys got rid of Wilsonart. Moving past some of this portfolio rationalization, is there more appetite to do M&A given some of these divestitures are behind us?

Yes, I would say our posture on M&A hasn't changed since we outlined this at the leadership conference. We've got a pretty disciplined portfolio strategy, clear, we believe clear and well-defined view of what fits our strategy. And so it's a case of us finding the right opportunities. And for us, we're focused on high quality acquisitions that extend our ability to grow at a minimum 4% over the long term. So that's the first criteria. The second criteria we look at is that we're able to leverage the business model to improve margins. And then obviously, acquiring the business at the right valuation to provide a decent long term return for our shareholders. We review opportunities on an ongoing basis, but we're very selective on the basis of these criteria. And if I could point to MTS as an example, MTS was an example of an acquisition we did two and a half years ago, which fulfilled all of our criteria. And thanks to very strong execution, that's now turning out to be a one run on the basis of being pretty selectable. The criteria going in strong execution when we acquire it. I know we've got a business that in the long term, who will be a superb ITW business.

Thank you. Your next question comes from the line of Julian Mitchell of Parkless. Please go ahead.

Hi, good morning. I was hoping this might be one call I could escape AI data centers, but I think they got dragged in.

We didn't bring it up just for the record. No,

totally fair. Totally fair. If we think just for a second, Michael or Chris, about sort of inventories, you know, just curious about your own levels and those of your customers or distributor partners. I think your own inventories dollar wise are pretty steady sequentially this year, but still running a little bit high as a share of revenue versus pre-COVID, you know, maybe 11% versus something like 8%, five years ago, six years ago. Is 11 sort of a good run rate from here? Or no, it should come down over time, but gradually just as the revenue picks up. And then how do you assess the sort of state of play of inventories that your distributors and customers, are they kind of generally right size now after two years of being leaned out?

Yeah, I think that's right, Julian. Let's start there. The channel, I think those inventory levels have normalized. You know, our channel doesn't carry a lot of inventory because they're used to our kind of place and order today, we ship you tomorrow. So with that level of customer service, there's no incentive for them to carry a lot of inventory. And then I was kind of pivoting to our own inventory levels. I'd say just more broadly on free cash flow. So it was good to be above 100% again here in the third quarter, which is more in line with the typical levels that you expect from us. And we expect to continue to make meaningful progress again in Q4 on inventory and free cash flow. So we've talked about our focus on reducing our months on hand, getting back to kind of pre-COVID levels of about two and a half months on hand, we're about three. The difference here is in that three to four hundred million dollar range of additional inventory that we'll expect to come out, you know, Q4 and then into next year. So we view that, I think the same way you do, as a big opportunity to drive above average free cash flow for the company here in the near term. I think we've made some progress, you know, down. I think it's six percent year over year. Last year, inventory came down 17 percent, but we can certainly we agree that there's there's some opportunity here and we want to do that. Reduce our return levels while maintaining those customer service levels, which is where I started, because we believe they're a real competitive advantage for us. And the last thing I'll say is, you know, all of this, you know, the fact that maybe we're a little bit lower this year, free cash flow than in prior years, you know, doesn't impact our capital allocation plans. You know, we were investing in our businesses for growth and productivity. All new products are funded. You know, we raised a dividend seven percent in August and we're buying back one point five billion of our shares this year as planned. So, but I agree with you that there's there's definitely an opportunity here and we're going after it in every one of our four divisions in a meaningful way here.

That's a very good answer. Thank you. And then just my follow up sort of thinking again about that question of customer back innovation and driving up organic growth and market share. I think, as you said, sort of R&D to sales is pretty steady. So maybe flattish dollars year to date versus last year, you know, capex sort of flattish year to date down somewhat in the third quarter year on year. So when we're thinking about kind of, you know, the levers of getting that market share up and it's in the context of a sort of decentralized operating structure where, you know, you're sort of letting the businesses ask you for R&D dollars. Maybe give us, you know, one or two examples of how you're driving up that share. You know, how does that interplay work between trying to get more dollars of spend into different businesses with a high return versus that kind of decentralized nature? Any sort of examples around that might be helpful for me at least.

Yes, I would say Julian that our spend and innovation has been rising over the last two or three years. I mean, we've seen double digit increases in spend on the basis of pretty focused investments in strategic marketing and innovation across the portfolio. But a lot of this goes beyond spend. It really comes down to a much higher level of, I think, leadership time and focus. As I said, we're already doubling down on this in the same way we doubled down on 80-20 front to back last time. And we've been investing in building capability really for the last three years here. And I think you can see that in the increased yield that we've had since like 17, 18, where it was about 1 percent to now where it's about 2 percent. So we're already seeing the investments. And this capability build is both in our divisions, but also at our segment level, you know, to really enable our businesses to be able to achieve this. A lot of this comes down to the quality of the framework. We have a lot of great innovation practice across the company. We've codified that and now we want to make sure that it resides everywhere in every division in ITW. And this is the exact same approach that we took on 80-20 front to back that was very successful in the last phase of our strategy. So we're on a great path here. We've already seen the outcomes. We expect to see continuous improvement in CBI contribution every year from here on out, starting in 2025.

That's great. Thanks, Chris. Sure. Thank

you. Your next question comes from the line of Nathan Jones at Staple. Please go ahead.

Good morning. This is Adam Parley on for Nathan. I wanted to follow up on welding. You know, what impact do you believe the upcoming election is having on the sentiment and the underlying industrial market? We've potentially seen improvement in 25, maybe post-election.

Maybe you want to jump in?

Yes. So at a high level, Nathan, I would say, look, you know, we're a short-sighted company. So we're kind of reading and reacting to what's in front of us. There's nothing overt or specific that we're hearing from our customers related to the election, I would say.

Yeah, I would agree with that. I think there are some other than anecdotes, anecdotes. There's really nothing specific that we can point to. And, you know, I think that's what kind of leave it at that.

OK, fair enough. I know it wasn't called out in the press always, but was there any hurricane impact at your sites or maybe at your customer sites?

No, not at our sites. I can't speak for all of our thousands of customers in those affected regions. But there was no impact on our facilities or and thank God on our people in those areas.

OK, thank you for taking my call.

All right. Thanks,

Adam.

Kathleen, I think that ends the call for

us today. Yep. There are no further questions at this time. Thank you, everyone, for participating in today's conference call. All lines may disconnect at this time.