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

Hello, again. It's Steve Volkmann again with Jefferies. And thanks for sticking with us through the end of day 1 of the Jefferies Industrials Conference. And for me, we're starting to wind down, but we're doing it on a high note with Illinois Tool Works and quite happy to welcome Michael Larsen, the CFO of ITW. Michael and I are going to do a bit of a fireside chat. But once again, I would love to have help. And if anybody has a question or a topic they'd love to see covered in the next half hour, just type that into the small box at the bottom of your screen, and it will show up on my screen, and I will weave it into the conversation. So Michael, thanks so much for joining us.

Yes. Thanks for having us.

Great. So I think I was going to sort of start high level, and the big differentiator in my mind for you guys relative to most of the other companies I look at is the kind of let's not win the downturn, let's win the recovery strategy. So maybe just describe sort of that strategy and how you guys came to that and why?

Well, sure, I'd be happy to. I think every year for the last 3 or 4 years, when we do our strategy update with the Board, we include a section on what could go wrong. And the one thing that we talked about as part of that was the impact of a global recession on ITW. And what the analysis showed every year was given ITW's margin profile and how resilient the business model and the portfolio was going to be in a recession, we certainly have the option to stay invested in our people, in our projects and in our strategies for the inevitable recovery as a result of that. So that was a discussion we've had every year for the last 3 or 4 years with the Board. And so obviously, the pandemic that was kind of a different scenario. But this concept of the profitability, the resilience of the business model and the portfolio that we've built up over the last 7 years in conjunction with this enterprise strategy, that was not foreign to us. And so after, I'd say, a vigorous internal debate and back and forth and pros and cons, we decided that rather than focused on delivering the best decremental margins in -- during this -- during the containment phase, the best thing we could do for the company and for our shareholders was to stay invested, by and large, in our people, in our strategies and stay the course and really use this pandemic as a way of accelerating, in particular, our organic growth agenda. And I'm sure we can talk a little bit more about that. But that was kind of the -- those are the origins of this pandemic strategy that we started executing on back-end in the April time.

So I guess that sort of begs the question of sort of what's the payback. And I'm sort of thinking, you mentioned growth. Should we expect growth to be stronger than it might have otherwise been? Or do margins kind of bump up another 50, 100 basis points? I mean what can we, as outsiders, expect to be the sort of the payback of winning the recovery?

Yes. I think the biggest thing that we've been focused on for the last 3 years or so -- 3 or 4 years of this enterprise strategy has been achieving an above-market organic growth rate in that 3% to 5% range, which is what we need to deliver on our total shareholder return model that gets us to kind of the low double digits in a normal environment. And so you should expect that this will get us there faster. And the way we're positioned to do that, we laid out kind of 3 themes that we've been talking about internally with every one of our divisions. The first one is as a result of this strategy, our ability to continue to deliver and supply our customers with the world-class excellence that they've gotten used to from us despite a global pandemic. And I think in the second quarter, we were able to do just that. And I think on the earnings call, we pointed to a little over $100 million in new incremental business as a result of our ability to service our existing customers when our competitors couldn't. So we're starting to see kind of some early some early wins on that front. I think the other -- the second thing is we've seen customers wanting to localize and derisk their global supply chains. So I think quite a few people got caught with these complex global supply chain, sourcing from places like Mexico and China that essentially -- that was very difficult in the second quarter. As you know, Steve, we've had this very long-standing supply chain strategy, where we -- produce where we sell. And so we are basically a local manufacturer. And we believe that, that is going to result in additional opportunities for us down the road here. And then the third piece is what we just talked about, the ability to provide full compensation and benefits for our team here globally in the second quarter. The ability to stay invested, for example, in our commercial team and all of our strategic sales excellence efforts. So sales side, marketing as well as staying invested in our innovation efforts. I think we saw an increase actually in our patent filings year-over-year in the second quarter. So those -- that's kind of this long-term view and staying invested in our people, our strategies, our programs. We believe that as a result of that -- of all these 3 things, it will accelerate our efforts to deliver a consistent, sustainable above-market organic growth rate. I think in addition to that, I think as we're starting to see maybe the early phases -- early stages here of recovery, we're -- obviously, we're still going to be down year-over-year here in the second half of the year. But as you look at the time, maybe next year when the growth turns positive again, I think what you should expect to see in addition to this above-market organic growth rate is continued progress towards our full potential from an operating margin standpoint. I think our confidence in the ability to get to operating margins in that 28% range, which is what we've put out there as our long-term goal, that confidence is as high today as it was pre-pandemic. And maybe as things start to recover, we'll deliver some better incremental margins in the near term. Certainly, that's our expectation, and it will further accelerate our progress towards those margin and return targets that we've put out there.

So it sounds like the longer-term margin targets and growth targets that you put out there, the way to think about this is that those are still intact. They're not being raised, but you may be able to get there a little quicker?

Yes. I mean, obviously, we've lost some time here, right? I mean I think this year, it's a pretty severe. I think we're guiding -- not guiding, but we're giving a smit scenario where revenues this year organically are down almost 15%. And margins at the midpoint kind of in that 21% range. Last year, we did 24%. So we've definitely lost some time, but I think we're going to come out of this recovery, hopefully, being able to see some accelerated progress towards our margin goals if things stay the way they are. The good thing about next year is that 2020 is over and that the comps are really easy, right? So even if things just stay the way they are, we should benefit for -- from some volume leverage in addition to the enterprise initiatives that 7 years in still are contributing 100 basis points here in the second quarter of 2020. So I think the confidence in the margin expansion is every bit as high as it was pre-pandemic. I think with the things we talked about, we view this as a real opportunity to accelerate our organic growth agenda. And that's really the focus of all the recovery phase planning that's going on inside the company in every one of our 84 divisions is really on that. What are the specific programs and actions customer-by-customer or target-by-target that you need to take in your division to deliver on that above-market organic growth rate in every one of our divisions that sort of discussions that we're having?

Good. Okay. I don't get much pushback from anybody about your enterprise strategy and your margin trajectory, that seems pretty obvious and impressive. But you mentioned just now that you sort of spent the last 3 years focused on organic growth. It's very hard to measure that, obviously, relative to your end markets because you're in so many. But do you feel like you've been outgrowing your end markets? Because that certainly doesn't feel like the perception at the -- in the investor base?

Yes. Yes, I think that's fair. I mean I think -- and I think you're right in terms of maybe where the pushback is. And organic growth is one of those issues, one of those -- you're just going to have to deliver and show it. It's -- and we're very well aware of that. I do think if you look at last year, and I think this was on the earnings call in Q1 here or maybe it was the prior in Q4, so that might be in January, we laid out our estimate of what the underlying market growth was in every one of our segments and then compared to the ITW growth rate in that segment. And we believe, based on that analysis that we outgrew the underlying markets by a percentage point in 2019. We would have expected to make progress on that in 2020, but this year, it's really hard to tell what the underlying growth rates are. But we feel like we have enough things here within our control that we'll be able to continue to make progress. And that 1 percentage point of above-market growth becomes 2% and maybe 2% to 3% in the not-too-distant future. So we've got all the focus, all the incentives, everything is lined up to deliver on that organic growth agenda. And like I said, I think this pandemic is only going to increase the focus on the opportunities that are there to take share from our competitors that are maybe not in as solid a position financially and from a liquidity standpoint as ITW. Read this as Stephen, if you're -- if our competitors are focused on cost takeout, cash preservation, that's very different from kind of what our focus is inside the company. Our focus is on how do we take share.

So are your new incentive compensation systems kind of especially geared toward organic growth at this point?

Yes. So they haven't changed. They didn't change this year. We are -- 40% of our annual bonus is tied to progress on organic growth year-over-year, and 60% is tied to operating income growth year-over-year. Obviously, this year is not going to be a good year in terms of payout, but we believe that, that creates some really meaningful focus on the organic growth priority.

Can you imagine a scenario where those 2 get flipped at some point?

We've talked about it. Ultimately, it will be up to the comp committee to decide what to do. I honestly think that it's a little hard to explain. But given the ITW culture, when we decide to focus on something and we align all of our skills around it from an execution standpoint, things tend to get done regardless of what the incentives are. So I think 40%, 60% seems like a pretty good balance, but it's something that we look at every year with the comp committee. So I don't know what 2021 might look like at this point.

So let's talk a little bit broadly about sort of what does the post-COVID world look like to you? Does it change the outlook for any of your businesses in your view? Does it sort of suggest -- I know Scott mentioned something on the call about being ready for the next segment at some point. Is there something coming out of the COVID crisis that suggests itself as a new segment? Or what does the world look like post-COVID to you?

Well, I think his comment was in response to a question around what doesn't fit anymore. And is there anything that doesn't fit as a result of the pandemic and I agree with him. I think it's much more likely that we find something that we'd like to acquire rather than divest something inside the company other than what we've identified at this point. So -- and I think whether that is an 8th segment or bolt-on acquisitions to our existing segments, I think our position is that we're certainly interested in looking at acquisitions. We have the capacity from a financial liquidity standpoint to do acquisitions. I think it's more -- the challenge in the near term is more an issue of supply. Our -- do -- if you don't have to sell right now just given what your 2020 numbers might look like and given that your focus may be on a version of our pandemic strategy, maybe the focus is more on cost and cash than it is on trying to sell on 2020 numbers. So I think it's going to be a while until things kind of settle down. And when the path to recovery is a little bit clear, I think there will be opportunities. Certainly, we've been pretty transparent, I think, in terms of what our criteria are from a strategic standpoint for acquisitions. And if we see something that checks those boxes, we're certainly going to take a closer look.

Okay. Great. I got a number of questions, I'm sure you did too, around sort of restructuring type [Audio Gap]

Steve, I can't hear you.

How about now?

Yes, I can hear you.

This is -- this basically tells you that my headset will not make it through 8 of these in a row. So hopefully, this is not annoying, but this is my speaker phone. So...

Yes, that's fine. You were on restructuring, right?

The only problem is I can't hear you. There we go. Okay. Yes. So sorry about that. The cost savings in the first half, I guess, come back in the second half or after the second half, just give us your thinking about that trajectory?

Yes. So in terms of the restructuring spend, we basically put that on hold when the global pandemic hit back in the March-April time frame, and we kind of decided on our pandemic strategy. So we've now had a chance to look at what the demand might look like division by division, 2 quarters out. And as a result of that, we're projecting that we'll spend approximately $60 million on restructuring here in the second half of the year after spending essentially nothing in the first half of the year. Interestingly, of those $60 million, $45 million was already in the plan for this year. So those were already front-to-back projects that we had identified as part of the plan. We expect that the $60 million will be more weighted towards Q3 than Q4. And the average payback just as an item of interest is less than 12 months. So this is part of the reason when I expressed a lot of confidence around the margin side of things and the progress next year, that's one of the reasons. The projects here that we've lined up are all going to provide additional margin tailwind in 2021. So that's kind of the overview on the restructuring side of things.

And then next year, do we go back to kind of normal, I don't know, $80 million-ish or something?

I think $80 million might be -- I mean, it depends on the environment. I think this year in kind of a normal environment, we've planned for $45 million. And so maybe it's -- maybe if you were to really twist my arm right now, I'd say, maybe somewhere around $50 million, $60 million, but it depends on what -- I think one of the advantages we have with this business model and our highly decentralized kind of entrepreneurial culture is that we can read and react very quickly. So when things change in the demand environment, our business units, frankly, they see it way before we do at corporate. And so they will do the right things, they will react, they will manage your cost, just like they did in the second quarter. It's actually interesting. I'll give you a little bit of a -- kind of an interesting, at least for me, a data point on how Q2 played out. It took us a little bit of time in April to kind of formulate our strategy in terms of managing your costs and being prudent and so forth. And now when we look back the divisions we're already doing that in April without any prompt from the kind of the Bright Minds and Glenview. And it speaks to this culture of where nobody is sitting around waiting to be told what to do. I mean our teams really get on with it. They have the divisions that are the closest to customers and end markets, and they can react and -- much faster than we can here at corporate.

So that sort of reminds me of another question I wanted to make sure to ask, which is that it seems like things are slowly improving, not just for you, but just across the economy. So this isn't the base case. But if we did have another shutdown or relapse or something like that, I assume you would continue this differentiated strategy. You would maintain your cost structure rather than sort of -- you're willing to do this on a longer-term basis than just a quarter or 2, I guess, is the question.

Yes, I think so. I mean I think this is -- hopefully, things don't shut back down again. But if they do, we will, like I said, read and react and respond accordingly. We believe that, like I said, after 7 years of executing on this enterprise strategy, we came into the pandemic with operating margins in the mid-20s, and we were really uniquely positioned to take a longer-term view here to get kind of like you said, I think, win the recovery and not the contraction. So that's our focus, and I would expect that it would remain our focus if things were to unfortunately shut down again.

Right. Okay. Good. And by the way, folks, we have about 10 minutes left. So if you do have a question or topic, feel free to go ahead and put that into the box on your screen. We do have a couple more that I'll get through here. But one person is sort of asking what is your capital allocation strategy through the pandemic.

Yes. So we covered that on the earnings call back in May. It hasn't really changed. Our priority remains to fund our businesses and fund CapEx and fund new products and restructuring projects because those projects have the highest rate of return of anything that we can do. Whenever we invest behind this business model, that's when we generate. If you look at the total company last year, after-tax return on invested capital in the high 20s. That's because of the discipline and focus around the internal investments. Now obviously, our CapEx spend will be down this year, probably somewhere around 25%. Just not because we're holding back, but because our divisions don't need some of the planned capacity expansions. So the second priority is very important to our long-term shareholders and our total shareholder return model. It's our dividend. I think we qualify as a dividend. Aristocrat, it's been 57 years of...

Almost starts to be a trend?

Yes, it's a little bit of a trend, one that we like a lot, and that's really important to our shareholders. And so the dividend is really important, and we're fully committed to our dividend. And then the third and fourth pieces. The third piece are -- is the acquisitions. We'd definitely be interested in taking a closer look at acquisitions that meet our strategic criteria. As you know, we don't have to do acquisitions. We believe that the core business can outperform in terms of earnings growth and the dividend on top of that. And if we don't find acquisitions, we make the choice to return that capital through an active share repurchase program. Now that repurchase program, in fairness, we suspended after Q1, and it remains on hold until we have kind of a clearer picture of what this recovery path might look like. So that's kind of -- those are kind of the highlights around our capital allocation strategy.

Great. Okay. We have a few quick things on some of the segments. In Automotive, I think on your call, you mentioned that some of the OEs were trying to take some steps to further localize, and you guys are well positioned to take advantage of that.

Yes. It kind of goes back to what I said earlier and I think the auto OEMs that relied on global complex supply chains, including Mexico and China, I think, had a tough time getting things started back up again. And when you saw these -- in June, auto producers start, stop, start, stop, it was not just safety related. It was also making sure that suppliers could keep up and a lot of the suppliers that struggled were the ones outside of the U.S. So like I said earlier, our produce where we sell strategy, we're really uniquely positioned and we've -- as part of those numbers we cited in terms of share gains, part of that was our ability to supply our customers. And so if you're dual sourced and one supplier can't get you the product, you're going to go to ITW that you know that we have the ability to supply with the quality and lead times that you expect from ITW.

The $100 million that you cited on the call, did you -- or would you talk about which segments that might be in?

Yes. So we try to, like, stay away from that. And we also don't want to mention customer names at this point. But I can tell you that it's across a number of different segments. It's not all in one segment. It's Polymers & Fluids. It's Test & Measurement. It's pretty broad-based.

Okay. And Food Equipment was one of the harder hit segments. Did that improve through the quarter? Does July a little bit better there?

Yes. So I think like we said on the earnings call, April, at least as far as we were concerned was the bottom. We saw a sequential improvement in May and in June. We late -- those numbers are on the charts if you haven't -- for those that haven't seen. I know you have, Steve, but if you haven't seen them. And we saw that trend continue into the month of July. And the same -- that is also true for the Food Equipment business, which, as you pointed out, was the hardest hit, particularly on the restaurant side. I'm a little more resilient on the institutional side and definitely more resilient on the retail kind of grocery side. So that, including the service portion of that was held up fairly well.

Is there an opportunity maybe on the warewash side as people focus more on hygiene and so forth post COVID?

Yes. I mean I think you'd be surprised how many restaurants don't have dishwashers, commercial warewash in the back, particularly if you travel outside the U.S. and maybe go to China. So we love that business. We think there's tremendous growth potential over the long term. And maybe as a result of this, maybe that will give an additional boost. I think it's a little too early to tell, but it's a business that we really like. It's very profitable. And it's a great place to be and an area we'll continue to invest.

Okay. Construction, on the other hand, was pretty good. And I guess, probably driven by what refurbishment model, big box type stuff, how sustainable is that?

Well, Steve, if I had told you, there's going to be a global pandemic, there's going to be a recession and construction is going to be one of the more resilient business just inside of ITW, you probably would have laughed at me. But you're right, it's -- particularly, North America is the home center channel, so think Home Depot, Lowe's and into all the residential renovation projects that people are doing at their homes, contractors are doing. And that was certainly a pleasant surprise. We saw that same trend in portions of Polymers & Fluids and the Automotive aftermarket side of things. And so that was -- there was certainly some more strength on that side of the business than we maybe had expected going in. And we'll see how sustainable it is. I think, like I said, the trends continued into July.

And we're hearing some supply shortages in those markets here and there. Anything there impacting you guys?

No. Our ability to supply has been uninterrupted throughout this whole thing and remains uninterrupted. All our facilities are up and running and our lead times are the same as they were pre COVID.

Okay. I guess that's the strategy, right?

That's the play. Yes.

All right. Well, on that note, I think we're at the bottom of the hour, and very much appreciate you doing this with us. And I would not have laughed at you, by the way. I might have [sought it] but I would never do that. But thank you so much for joining us, and I wish you a very good rest of your summer.

Yes. Thanks for having us, and stay safe. I'll see us soon.

You too. Cheers. Bye.