Illinois Tool Works Earnings Stumble; Europe and China Surprisingly Strong


Illinois Tool Works encountered slower-than-expected revenue growth in North America during the second quarter, but Europe and China were surprisingly strong, especially in its automotive original-equipment manufacturing segment. While revenue and earnings per share slightly missed consensus expectations, the company is well positioned to meet its full-year EPS guidance given ramping enterprise initiative benefits and a bottoming in Europe.

Second-quarter results helped to confirm that weak firstquarter results reflected the trough in top-line performance. Second-quarter organic revenue was flat year over year and below internal expectations of up 1%, but was an improvement from 2.7% revenue contraction last quarter. North America was the laggard with organic revenue down 1% while international saw 1% year-over-year improvement. Encouragingly, Europe (down 1%) and China (up 14%) improved nicely from down 6% and up 10% last quarter.

Investors believe much of the improvement has come from its automotive OEM segment, where ITW’s components and fasteners were up 11% in Europe and 40% in China, well ahead of 1% and 11% industry auto builds, respectively. New platform penetration with the likes of Ford F , General Motors GM , and Volkswagen VLKAY should lead to continued outperformance over the next couple of years.

ITW is still in the early innings in execution of its strategic initiations, but so far, so good. Despite dis-synergies from lower revenue, operating margins expanded by 40 basis points to 17.4% in the second quarter as enterprise initiatives and favorable price/cost combined to aid margins by 100 basis points. Excluding a $0.05 per share impact from a pension settlement charge in the quarter, management maintained its full year 2013 guidance of $4.15-$4.35, a 15% improvement from 2012. Analysts are confident that the company will hit its 2017 goals of 20%-plus operating margins and 20%-plus returns on invested capital, a marked improvement from 16.3% and 14.3% in 2012.

As articulated in prior notes, we really like what ITW is doing to optimize business mix and performance. The highly decentralized model has historically worked well for the firm as the company made many acquisitions of underperforming companies on the cheap, and successfully applied its 80/20 toolbox to extract value. However, the number of independent divisions mushroomed to approximately 800 and what often remained after 80/20 implementation were companies with subpar growth prospects and encroaching commoditization.

All the while, the firm was not fully taking advantage of its scale to more cost effectively procure raw materials. Analysts continue to expect the firm’s major initiatives, including reducing division count to 100-120 with associated job cuts, strategic raw material sourcing at the corporate level, divestment of slower growing and commoditizing businesses, and fewer acquisitions of higher quality companies to significantly improve ITW’s organic revenue growth, margin, and ROIC profile over the next few years.


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