Illinois Tool Works Inc. (ITW) Earnings Call Transcript & Summary

Excited to have Illinois Tool Works, ITW, with us, and Michael Larsen. I've known Mike for a very long time. He's the Senior Vice President and CFO of ITW. Joined in 2013. Previously served as the President, CEO and Director of Gardner Denver, had other roles, was at GE for a long time. But of course, has now been in ITW for a lot of time. And so that's what we want to talk about today.

I'm going to come over here and just to start off with Michael, like some investors in the room probably don't know the company that well. And so I think what actually would be helpful is to talk about the special sauce of ITW, 80/20. What differentiates you as sort of the leaders in 80/20 and what makes you special?

Yes. I think you hit on it. ITW's core competitive advantage is the ITW business model. And we describe ourselves as a business model-centric company. Just to give you a little bit of an overview, if you're not familiar, there's 3 components to our business model, the first one being, what you're talking about, which is our 80/20 operating system. You've heard of Lean and Six Sigma and the operating system inside the company that we utilize is 80/20. It's been around since the mid-80s. And I can tell you, I have never seen anything as powerful as this business model in terms of the outcomes you get by applying this system with a high degree of excellence. You see it in the performance of the company over the last 8 years, certainly. The second piece is our approach to innovation, which is very much a customer-back innovation process. So that describes kind of how we innovate for customers. Think of it as this is not big-eye innovation, trying to invent new-to-the-world molecules or products. This is typically taking an existing innovation of ours that's part of our 18,000 patent portfolio, and using that technology to solve a problem for a customer in a really unique way. And it's been a big contributor to our overall growth rate and success of the company over a very long period of time. It contributes roughly 1% to our organic growth rate every year. And then the third element, which is a little bit harder to maybe describe as this really unique culture inside the company. We are a highly decentralized entrepreneurial company. We're organized in -- at the core is really 87 divisions -- 84. If you read the 10-K, we did some divestitures last year. And our people are -- that are running these businesses operate with a high degree of freedom within the framework that this business model provides. The enterprise strategy that we're currently executing with it was launched in 2012 in December at the Investor Day. You were probably there, Andy. And so the objective is to leverage this really powerful proprietary business model to its full potential, and in doing so, consistently provide and deliver top-quartile financial performance and also position the company as one of the world's highest quality, most respected industrial companies. And so that's what we've been working on over the last 8 years.

Great. So I want to follow-up on a couple of things you said. Customer-back innovation is something that a lot of companies talk about, but you guys seem to do really, really well. So maybe you could sort of give us some more color on why you're able to spend, what, 2% of sales on R&D and still get significant margin performance every year, some growth. I look at other companies that have on this stage, and they spend 6% of sales and have growth that's either at or less than you.

Yes. And I don't think one is -- it's not that one's good and one's bad. What works for us is a highly focused approach on our largest, most important customers. And the strategy starts with getting up close and personal with those customers and really understanding what their, we call them, pain points are. What are the specific problems that they deal with in terms of their products or their manufacturing operations, and then identifying areas where we are uniquely positioned, given our capabilities, to solve those problems for customers. And so again, it's not trying to invent new-to-the-world products. It's taking an existing application, something that we know. And we know that when we solve this problem for the customer, we have a purchase order. And so I think it's a lower-risk approach to innovation. It's -- inherently, it's going to be more singles and doubles. There's -- and when you add it all up, it's a very efficient way, low-risk way of contributing to the overall organic growth rate.

So I think I asked you this on the last earnings call, but let me ask you, too, in a different way. So it seems like every year in enterprise strategy, you've been able to at least do as well as the last year, if not better. And lately, you've been averaging, what, 120 basis points of enterprise strategy tailwind. And you've got this target out there of 28% margin by '23. I remember sitting here at this conference, and 20% was going to be a stretch. And here you are talking about 28%. So the sort of feedback I get is, well, what really is the peak for ITW? Is 28% as good as -- as well as you can do? And why have you been able to actually improve enterprise strategy as the program has gotten more mature?

Well, I think when we started back in 2012, we looked at the best divisions inside the company and tried to figure out what was special about them. And what we realized was that they were the businesses that were executing on 80/20 and innovation and had the culture that was more in line with what we were -- what we thought it could look like. And so the best divisions were operating at 20% margins. And in very simple terms, the goal was if we could get the average of everybody operating at 20%. That was our first margin goal back in 2012. The more we executed around 80/20, the more we learned also from each other inside the company. 80/20 is -- there's an element here of continuous improvement. It's significantly more powerful today than it was 5 years ago, 3 years ago. And today, it's the most powerful it's ever been, as we've gotten better, our people have gotten better and executing around 80/20. And then there's an element that we did a lot of work around the portfolio. So the quality of the raw material today is significantly better than when we started. If you recall, we sold roughly 25% of our revenues, businesses that had a lower level of differentiation than what we needed for the business model to really operate at full potential. And so it's not that we were sandbagging from -- we did not know when we started that we would have clear line of sight to a goal of 28% operating margins. It's just as we kind of go along, we learn more, we get better at 80/20, and the raw material is significantly better. So today, we're sitting here at 24%, 25%. The goal, as you said, is, through the continued application of 80/20 and strategic sourcing. There's an element of addition by subtraction with some of these divestitures that we're working on right now and so we have a clear path to 28% operating margins. In terms of what's the limit. I mean, the theoretical limit is -- our incremental margins across the company are 35%. And so we're -- we only need a little bit of a reasonable amount of organic growth to get to 28% and then beyond. And I guess the theoretical limit, as we sit here today, is in the 30s.

So you do have -- you mentioned at the last Analyst Day, you do have one coming up. I'm sure you don't want to sort of front-run your own Investor Day, but I'll ask you this question. Like, is it more about still finishing the job when you go to this Analyst Day? Or is it more about what are the next steps?

It's all of the above. So you'll have to -- so this is an invitation to our March 13 Investor Day.

See, I'm promoting it.

No, I appreciate that. Karen will appreciate that. I mean, I think, really, what we're trying to do is by having our Investor Day at one of our divisions is to showcase this really powerful business model in action. And so we talk about these concepts that we use to run all of our divisions, and we'll be able to talk about those and then show you what it really looks like in a division. So there's definitely an element of finishing the job. We have -- we're currently growing 1 percentage point above the underlying markets. We think we have another point to 2 points to go after, as we continue to execute on our organic growth initiatives. That's the #1 focus inside the company. And then we have another 300 to 400 basis points to go get from these enterprise initiatives and the divestitures that I talked about. So that will certainly be a part of it. I think we are looking forward to giving everybody an update on -- and a little bit more detail on our efforts around organic growth and the progress we've made. It seems to kind of -- it gets lost a little bit, just given the current market conditions. So we'll give you a little bit of an update in terms of the divisions that are operating at their full potential from an organic growth standpoint and the ones that we're still working on, so.

So I want to get to the markets a little bit, but let me just ask you 1 thought to what you just said, and that is sort of perception of organic growth at ITW. I mean, I know you get the question all the time, right? Are you really keeping up in the markets? And you put that slide into your last earnings deck, suggesting that, again, you are growing 1 point above the market. But the feedback I get a lot of times is, well, 80/20, an enterprise strategy, like, because you're focused on Product Line Simplification, it's hard to grow faster because by its essence, it's sort of cutting products down, if you may. So tell me what's wrong with that? Why can they sort of coexist?

Well, no, I mean, I think it is factually correct that Product Line Simplification, which is the pruning of the portfolio that we do every year as part of our front-to-back 80/20 process, it does create a drag on the business in the near term. That drag, as we approach full potential, by the way, has continued to decline. We expect about 50 basis points of headwind this year. We did 60 last year, 70 the year before, and we believe at full potential -- when we look at our businesses at full potential, that kind of the steady-state run rate is somewhere around 30 basis points. Now we're doing that to really focus all of our efforts and resources on the most differentiated product lines and customers that have the highest organic growth potential. So it's really -- we're preparing this portfolio for a point where it can grow consistently 200 to 300 basis points above the underlying market. And so the other thing, I think, that's important to remember is, our aspiration is not to be the fastest organic grower in the industrial space. We don't need to be. We only need a reasonable amount of organic growth given our 35% incremental margins, given our capital allocation to generate EPS growth, fairly low risk, high probability in the high single digits. And you add an attractive dividend yield on top of that and you get to double-digit TSR at a reasonable amount of organic growth. And so just given the overall profitability of the company and the cash flows, we don't have to be, and we don't aspire to be, the fastest organic grower. We will be one of the most predictable, consistent organic growers with the best margins, best returns and some of the best cash flows of anybody in the industrial space. That's our aspiration.

So let me ask you about the markets in this context. I mean, historically, you've been 60% consumer, 40% industrial. You see a lot of markets, right? You've got some representative CapEx businesses, whether it's Instron or Test & Measurement. Instron and Food Equipment did a little bit better in Q4. You've got the coronavirus now that is an impact. So maybe you can update us on sort of what you're seeing out there.

Yes. Yes, sure. I mean, I think 2019 was certainly a challenging year. At the enterprise level, 2018, our organic growth rate was a little over 2% organic. And then in 2019, at the enterprise level, we were down 2%. So that's a 4 point -- that's a big swing for a company our size, right? So in many ways, 2019 was a pretty unusual year. Our revenues were down 4.5%, $700 million in yet margins, earnings growth, free cash flow growth, right? So I think it was another proof point in terms of the power of this business model and this highly diversified portfolio. But your question was around what's going on in the world. I think last year was certainly pretty challenging, first half, in terms of automotive production, down mid- to high single digits. So we kind of powered through that. The tariff issues, that maybe contributed to a slowdown in the CapEx businesses. Welding went from up 10% in 2018 to basically flat in '19, which is really an illustration of the demand for CapEx related to goods. Welding equipment, Test & Measurement equipment slowed down. And so at the end of the day, of our 7 segments, all 7 had a lower growth rate in '19 than in '18. Only food equipment, as you pointed out, had a positive organic growth rate in '19 at plus 1%. And so I guess the good news is '19 is behind us, and it gives us a fairly easy comp as we move forward. I think at current run rates, which is the way we provide guidance, we expect organic growth to be up 0% to 2% organic for the year. And we expect, just based again on -- not assuming any acceleration in demand, every one of our segments will see a higher organic growth rate in 2020 than in 2019. And by the way, margins, based on kind of the bottoms up from our divisions, operating margins should improve in every segment as well in 2020 compared to 2019. So I think, pretty resilient performance in 2019 in a challenging industrial environment. And I think it's too early to tell kind of -- when we were on the earnings call, it's too early to tell whether anything has changed. I think, so far, it's -- we're in a pretty challenging industrial kind of demand environment. I think the China, the coronavirus issue, certainly adds to that in terms of uncertainty in the near term. But we'll continue to do our thing and focus on the things within our own control. We have 100 basis points of margin expansion from the enterprise initiatives again this year. We have -- the price/cost issue that we were dealing with for a number of quarters is behind us. We did a fair bit of restructuring last year. Those benefits are coming through in a meaningful way. And so we're really positioned really well for whatever the environment is going to be in 2020. And we're -- I think we've demonstrated that. If the demand environment changes, that we know how to respond and react and still deliver pretty solid financial performance no matter what the environment is.

So Michael, just focusing on what you can control. One of the questions I get with all of our companies is factories, have you been able to get them back online in China? Supply chain? Any sort of on-the-ground comment you can make?

Yes. Yes, so maybe a little bit of a background. So China is roughly 6% to 7% of our total sales. So maybe that's in line with the peer group, maybe a little bit lower, but we're also more profitable. So 40% of our business in China is a fast-growing, high-margin automotive business. And we're kind of in the same position as everybody else at this point. I think the factories are opening back up again. We're working to get our people back. And it's really too early to tell what the impact may be here in Q1. I think how things are going to -- once we get back to kind of normal, are these lost sales, are they going to come back in Q2 or the second half, I mean, nobody really knows. And so we'll just have to deal with the very fluid situation. And when we get on the earnings call in April, I think once we see February and March, we'll have a much better sense for what's really going on. And then on the earnings call, we'll give you an update on kind of what we saw in Q1. And hopefully -- I'm an optimist. And so hopefully, by then, late April, this issue will be behind us.

Agreed. Hopefully, that's the case. So let me ask you a follow-up then on sort of offsets, too. If you do have a little bit weaker end markets or whatever, like price versus cost, you mentioned, is that -- is now more -- at least last quarter, there was a 30 basis point tailwind. Now I know you set your prices sort of bottoms up versus top down, and -- but at the same time, so it maybe gives us a little less visibility. But maybe you can talk about that because it seems like price versus cost with relatively stable material prices for you, you've got resins, all that kind of stuff, should be, a positive?

Yes. I think, like I said earlier, price/cost is not an issue any longer. I mean, I think we -- '18 was certainly challenging when you had raw material costs and then you have the tariffs on top of that. And I think that we did a pretty good job responding, our divisions responding by raising prices to offset those pressures. And that's really all we were trying to do, and that's historically what we've done. I mean, I think the real organic growth there is going to come from share gains and serving our customers with excellence and launching products. It's not by being better at pricing than everybody else. And so I think that issue is behind us at this point. I think we said we expect price/cost to be roughly flat from a margin standpoint in 2020, and I think that's still the base assumption here.

Got it. I want to turn over to the audience in case they have questions in a second. But let me ask you about another topic that comes up now probably pretty often for you, and that is, when are you going to start making acquisitions again, right? And I think it was December 17 where you said, "Well, we're starting to like gear back toward acquisitions," and then it's been obviously quite very quiet. And so maybe talk about like when do you -- I'm sure you never feel like I have to do it, right? But if you just passed over a bunch of things, and you're just...

I'd say this, I mean, the starting point is really good, right? The core TSR model without any acquisitions is pretty awesome, right? And so priority #1 is, and we said this at the onset of the strategy, is that the primary growth engine of the company has to be organic growth. And if we just get a little bit of organic growth here, we're in a great position to deliver double-digit TSR over any 5-year period. And so it's fair to say, why would you even do acquisitions, right? So I think the -- and why would you do some -- so if we do an acquisition, it has to be a great fit with our strategy overall, right? So we have -- we should only acquire assets that can contribute to the overall organic growth rate of the company. And if our goal is to grow 3% to 5%, then acquisitions should be able to grow 3% to 5%. And we should have a high level of differentiation, that -- which means that these are businesses where the performance of the product really matters. The customer will pay for the solution that we're providing, not commodity. And then finally, we have to see our way to significant margin improvement through the application of 80/20. And so I think the strategic fit criteria to us are very clear. And then the second element is if we're going to spend our shareholders' money and our own big organizational effort, time and energy on an acquisition, it should be worth it, right? And that's really where -- now we start talking about returns and valuations. And I think we're certainly not in the position where, like I said, we don't need to do anything. And so if we were to do something, it has to contribute in a meaningful way to the overall performance of the company. And it can't be a deal where we -- if everything in the spreadsheet works out, we clear our cost of capital by year 5. So you're not going to see those types of deals from ITW. So I think last year -- that said, we are leaning in. We have a clear view of what we're looking for. We're talking more kind of division-size acquisitions, if we could do 1 to 3 a year, maybe totaling $500 million of required revenues, and we can sustain that over a 5-year period. Actually, if you're being very honest, they don't contribute a whole lot in the near term. I know that there's all kinds of ways that -- to adjust for the real accounting cost. But if you're being totally honest about it, the contributions at current, just given where valuations are, are not that meaningful over a 5-year period. Now once you get beyond that, that's where you see kind of the benefit. And then obviously -- so we cast a fairly wide net last year in terms of looking at these mid-sized industrial deals. And long story short, I mean, for a variety of reasons, we didn't find anything we really liked. And I think so the quality, the fit in terms of the strategy, some of the end market exposures, we weren't that interested in. And in a very few number of cases, the valuation looked a little bit challenging. So but we're optimistic. I mean, I think, like I said, we're only trying to do a couple a year, and so we'll continue to work it.