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

Great. Good morning, everybody. It's Steve Volkmann here with Jefferies. Thank you for joining us for this session with Illinois Tool Works. Very pleased to welcome Michael Larsen, the Chief Financial Officer, to join me for about a 25-minute chat. If you'd like to participate here, we'd love to have your input. [Operator Instructions] You could send me an e-mail if that's easier for you as well, and we'll make that happen. So Michael, thank you so much for joining us, and welcome.

Yes. Thanks for having us. Great to be here.

Good. So let's move forward. Obviously, you guys just reported the quarter. I think this is probably an opportune time to maybe go through a little bit of what you guys saw there because it was interesting on a number of levels, I think. But obviously, sort of automotive is the area that we've all been focused on in terms of various types of constraints. And that business was a little bit, I think, weaker than most of us had forecasted. So just give us your read of automotive. Did it sort of do what you thought it would do? And kind of the outlook there?

Yes. I think if I can, Steve, let me just take a step back here and just talk about this at the enterprise level. I think what we saw was really continued improvement in demand across the portfolio. So like the breadth by segment, by geography, in terms of the organic growth rate is really strong. I think it's -- with organic growth up year-over-year of 37%, auto OEM almost double on a year-over-year basis. So I think that's kind of the good news that the order intake is really strong across the board. And then kind of the challenges, I'm sure we'll talk about kind of the raw material cost environment. But I also think some of the constraints in the supply chain that are impacting our customers at this point and predominantly in the automotive business. So our estimate is that the chip shortage that we've all talked about and the slowdown in production as a result of that and our customers reduced the automotive OEM revenues by about $60 million in the quarter. And that's actually, if you go back to the call in April, that's kind of how we had it penciled in. So we were certainly not overly surprised to see that in Q2. I think the challenges that this is probably going to go on for a little while longer than most people expected back in April. So we're doing everything that we can to support our customers. We're executing -- our teams are executing really well in a very challenging supply chain environment. I think the fact that last year, we took the strategy to stay focused on winning the recovery. And therefore, we held on to our people. We stayed invested in our new products. And our strategy is serving us really well. So I think we're probably in a better position than most to serve our customers in this really strong demand environment. So auto OEM, just -- it's certainly challenging. I think it will remain challenging for at least a couple of quarters. And we've been through these things before. And I think we'll continue to execute really well and do everything we can to help our customers through this challenging time.

So the $60 million of missed business, just to be clear, that's because they didn't ask you to send stuff, not because you, ITW, have preference, right?

Absolutely. Yes, we're completely ready. And I think they had plant shutdowns here in Q2. There's going to be some of that again in Q3. I think it was $25 million in Q1, $16 million in Q2. And we'll probably see something similar here in the back half of the year. I think the important thing to keep in mind is these are not lost sales, right? So really, what's happening to some extent, the positive is that this recovery is being extended on the back end. I think for cars remains really strong. The consumer is doing well. Dealer inventories are at historic lows. It's going to take, just to get dealer inventories back to kind of normal levels, I mean we're talking, depending on who you believe, 18 months. So I think that the cycle being extended here is actually a really helpful thing. So...

And what about on the margin side? And maybe this is specific to automotive but anywhere else as well. I mean I would imagine that there's a lot of kind of inconsistency around sort of the timing of orders and just sort of things that would weigh on productivity might impact margin. Any way to call that out?

Well, I think it's certainly challenging. I think if you talk to Scott, our CEO; Chris, our Vice-Chair, who have been around almost 40 years inside of ITW, they will tell you that this is one of the most challenging environments that they have seen from a supply chain standpoint, but I said, we're executing really well. And I think on the margin side, price cost is really putting more pressure on margins than the supply chain constraints, right? So -- and even so, I think we had 3 segments with record -- all-time record margin performance here in the quarter. So I think our teams are doing a great job. I think we still have a lot of runway in terms of margin improvement. Once we get through these near-term price cost challenges for the year, it will be somewhere around 100 basis points of margin impact -- margin percentage impact, okay? I think the other thing to keep in mind is from a profitability standpoint, it's neutral. We're working really hard to offset any cost increases with price. But we're still going to improve margins more than 200 basis points this year to all-time record highs for the company in that 25% range. So the enterprise initiatives are still delivering a significant contribution. We did 150 basis points in Q2. We can talk a little bit about that. I know you had a question on the call about the sustainability of that. And then really strong volume leverage. I think if you look at our incremental margins of 40% in the quarter, I think -- I don't know if there are any other companies who follow that were able to put up 40% incrementals in the quarter. But as long as we continue to grow, our margins will continue to improve just mathematically with the -- just given how strong our incrementals are, plus the enterprise initiatives. And then eventually, we'll get ahead of price cost like we always do. And so I think there's plenty of runway towards our long-term operating margin targets that we've laid out of 28% in that neighborhood. And so I think that's kind of the important thing to keep in mind when you look at the current environment and some of the pressures on margins from price cost.

So let's just draw that out for a second. So obviously, the plan here, and I think you're successfully doing it, is to cover dollar inflation, sort of dollar for dollar, so you don't have any EBIT dollar impact. But of course, that does impact margin. And how do we look at that as we go forward? Do you then put through sort of a little bit more price in year 2 so that you're capturing the margin? Or do you have to go back and sort of do enterprise initiatives to offset that? Just what strategically are you...

I mean I think typically what happens, Steve, is we go into the year with an assumption that price is going to be ahead of cost. And then any incremental cost increases that are coming through, as we're seeing right now, second quarter was a pretty dramatic acceleration in inflation, we offset those on a dollar-per-dollar basis. There's always a little bit of a timing lag from when you see the cost increases to when you can actually realize price. I think for ITW, because our margins are best-in-class in that mid-20s range, just mathematically, we may have a little bit more impact from price cost than other companies. I also think you got to keep in mind, we tend to be more short cycle relative to many of our peers. And we don't do any hedging. So the costs that are flowing through right now are actual costs, right? So I think others that are hedging are extending that a little bit further. But eventually, we're all going to have to deal with the same raw material cost environment. So I think those are all things to keep in mind here when you think about price costs. I think ultimately, these raw material cost increases are going to stabilize. They may come back down again. And then what good companies will do that are competing in with really differentiated solutions, products and offerings will hold -- price will remain -- selling price will remain. And then these cost increases, raw material costs will come back down again. And that's how you kind of get it back over time. That's historically how it worked. If you go back and look at the last cycle in '18, that's how this plays out. It's a little bit more challenging in automotive because of the nature of the industry. These contracts, you're locked in for a longer period of time. And so it's -- when raw material costs go up, it certainly works against you. When they go down, it's to your benefit. And so over time, it all evens out. And I think automotive -- I think margins were somewhere around 18%, 19% in the quarter. We'll be back where we were, which is in the low to mid-20s at some point when these price cost pressures settle down a little bit.

So I guess the final thing I'm thinking about here, obviously, it's August. We're starting to think a little bit about the next year. Is there any reason not to think that your incrementals might be even a little bit better as you capture the margin, not just the dollars on this price cost?

Well, so just for the record, so we're not really thinking about next year at this point. We're trying to -- it is a pretty challenging environment. It's all hands on deck in terms of let's make sure that we can serve our customers better than anybody else. And we have some real advantages in terms of how our supply chain is set up and our manufacturing system is set up. And that's really -- our goal is how do we position ourselves to serve customers with this surge in demand, do it better than anybody else and gain share. That's really what the win the recovery strategy go about. I think when we get to the annual planning, our budgeting process in the fall, that's when we'll go through kind of in detail. And you asked about enterprise initiatives. Specifically, what are the projects and activities that are planned for 2022 that will continue to contribute in a meaningful way specifically around our 80/20 front-to-back process but also our strategic sourcing efforts. So I think all of that will kind of get consolidated and reviewed at the end of -- in the fall. And then when we provide guidance at some point next year, we'll give you a sense for what the benefit is going to be. I think what I can tell you is 9 years in, these enterprise initiatives continue to contribute in a meaningful way and will continue to improve our margins on a go-forward basis. What exactly that number is next year? This year, it's going to be a little bit more than 100 basis points. Whether we'll get that same contribution next year, that's what I don't know until we've gone through all the pipeline of projects and activities. But I'm pretty confident that there will be a meaningful contribution in 2022.

Okay. And just since we're touching on enterprise initiatives, I think you mentioned you did 150 basis points in the second quarter. I think you might have done, what, 120 in the first...

120 in Q1 and 150 in Q2. Yes.

And the full year target is at least 100.

Yes.

I guess that gives us a wide range, perhaps. But is there any reason to think that would decelerate in the second half?