Illinois Tool Works Inc. — Q2 2016 Form 10-Q
Business context and period: Global diversified industrial manufacturer operating through seven reportable segments. This filing covers the quarter and six months ended June 30, 2016; comparisons are with the corresponding 2015 periods. Amounts are in millions except per-share data.
Financial performance
| Metric | Q2 2016 | Q2 2015 | First half 2016 | First half 2015 |
|---|---|---|---|---|
| Revenue | $3,431 | $3,434 | $6,705 | $6,776 |
| Operating income | $792 | $730 | $1,514 | $1,427 |
| Operating margin | 23.1% | 21.3% | 22.6% | 21.1% |
| Net income | $525 | $480 | $993 | $938 |
| Diluted EPS | $1.46 | $1.30 | $2.75 | $2.51 |
| Operating cash flow | $535 | $448 | $1,014 | $890 |
| Free cash flow | $471 | $384 | $893 | $743 |
Free cash flow is a company-defined non-GAAP measure: operating cash flow less capital expenditures. Q2 revenue was essentially flat, while first-half revenue declined 1.0%; organic revenue grew 1.2% and 0.9%, respectively. Currency translation reduced reported revenue growth. Management attributed margin expansion principally to enterprise initiatives, which contributed 120 basis points in both periods, alongside favorable price/cost and operating leverage.
Cash and equivalents were $2,355 at June 30, down from $3,090 at year-end 2015. Total debt was $7,164, versus $7,422 at year-end; total debt to trailing-twelve-month EBITDA was 2.1x, compared with 2.2x. Short-term debt was $864 and long-term debt $6,300. The company had an undrawn $2.5 billion five-year credit facility. Management said available cash, free cash flow, credit facilities, and debt-market access were sufficient for debt service and capital priorities. Most cash was held by international subsidiaries and may face taxes if repatriated to the U.S.
Changes and segment performance
- Operating income increased 8.4% in Q2 and 6.1% in the first half; diluted EPS rose 12.3% and 9.6%, respectively. Share repurchases reduced average diluted shares year over year.
- Six of seven segments recorded worldwide organic revenue growth in both periods. Welding was the exception: organic revenue fell 11.3% in Q2 and 9.9% in the first half amid weak oil-and-gas and industrial demand; its margins also contracted.
- Construction Products, Food Equipment, and Specialty Products delivered notable margin expansion. Companywide share repurchases were approximately $500 million in Q2 and $1.0 billion in the first half; dividends paid were $198 million and $398 million, respectively.
- Net working capital declined to $3,343 from $4,352 at year-end, primarily because cash decreased and short-term debt increased, including reclassification of $649 million of notes due in February 2017.
Outlook, risks, and unusual items
- No specific revenue or EPS forecast is provided in the filing. Management expects approximately 85% of its businesses to be “ready to grow” by year-end 2016, and says the preparation for accelerated organic growth generally takes 18–24 months. It expects strategic sourcing to continue reducing spend by an average of 1% annually in 2016 and 2017.
- On July 1, 2016, after quarter-end, ITW completed its approximately $450 million acquisition of ZF TRW’s Engineered Fasteners and Components business, to be reported in Automotive OEM. The filing identifies integration, performance, liability, and impairment risks.
- The UK’s June 2016 vote to leave the EU adds uncertainty; the UK represented approximately 5% of 2015 consolidated revenue. Other stated risks include global economic weakness, currency movements, raw-material costs and availability, financing and credit conditions, cybersecurity, litigation, and execution of enterprise initiatives.
- Tax authorities were auditing the company; management said unrecognized tax benefits could decrease by approximately $111 million within 12 months. An IRS dispute concerns a claimed $70 million tax deficiency for 2006, plus interest and penalties. The company recorded no reserve, believes its position is defensible, and expected trial in Q3 2016.
- Other income included a $6 million loss related to an anticipated business sale in Q2. First-half interest expense rose to $116 million from $109 million, primarily due to Euro notes issued in 2015. The six-month effective tax rate was 30.0%, versus 31.0%.
Investor verification priorities
- Review the drivers and sustainability of margin gains and organic growth, particularly continued weakness in Welding and the effects of product-line simplification.
- Assess cash generation against substantial buybacks and dividends, and monitor cash held overseas, upcoming debt maturities, and leverage.
- Verify the acquisition’s purchase accounting, integration progress, and contribution to Automotive OEM results.
- Track the IRS tax litigation and the timing and realization of potential tax-benefit reductions.
- Consider foreign-currency exposure, Brexit-related uncertainty, and the company’s stated non-GAAP definitions when comparing results.