Illinois Tool Works Inc. — Q2 2018 Form 10-Q
Reporting period: Three and six months ended June 30, 2018. ITW is a diversified global manufacturer with 85 divisions in 55 countries, reported through seven operating segments.
Financial performance
| Metric | Q2 2018 | Q2 2017 | First half 2018 | First half 2017 |
|---|---|---|---|---|
| Operating revenue | $3.831 billion | $3.599 billion | $7.575 billion | $7.070 billion |
| Operating income | $932 million | $872 million | $1.835 billion | $1.679 billion |
| Operating margin | 24.3% | 24.2% | 24.2% | 23.7% |
| Net income | $666 million | $587 million | $1.318 billion | $1.123 billion |
| Diluted EPS | $1.97 | $1.69 | $3.87 | $3.23 |
| Effective tax rate | 25.5% | 28.4% | 24.4% | 28.4% |
Q2 revenue increased 6.5%, including 3.7% organic growth and 2.8% favorable currency translation. First-half revenue rose 7.1%, including 3.2% organic growth and 3.9% currency benefit. Management attributed organic growth to penetration gains, stronger end-market demand and product innovation; product line simplification reduced organic growth by 70 basis points in both periods.
Operating margin rose 10 basis points in Q2 and 50 basis points year to date. Excluding the prior-year legal settlement, management said margin improved 50 and 70 basis points, respectively, principally from enterprise initiatives and operating leverage, partly offset by unfavorable price/cost and growth investments. Diluted EPS increased 16.6% in Q2 and 19.8% year to date; excluding the settlement’s $0.03 per-share benefit in the 2017 comparisons, increases were 18.7% and 20.9%.
Cash flow: Operating cash flow was $620 million in Q2 and $1.158 billion year to date; capital expenditures were $87 million and $181 million. Free cash flow, a company-defined non-GAAP measure, was $533 million and $977 million, versus $387 million and $786 million in 2017. First-half cash dividends paid were $530 million and share repurchases were $1.0 billion.
Liquidity and debt: Cash and equivalents were $1.628 billion at June 30, down from $3.094 billion at year-end. Total debt was $7.419 billion, down from $8.328 billion; debt to trailing-twelve-month EBITDA was 1.8x versus 2.1x at year-end. Current liabilities were $3.547 billion and net working capital was $2.572 billion, compared with $3.053 billion and $4.225 billion at year-end. No commercial paper was outstanding at quarter-end. Short-term debt included $649 million of notes due March 2019 and $699 million due April 2019. The company reported $1.6 billion cash on hand and access to credit facilities and public debt markets.
Segments and changes versus prior period
All seven segments posted organic revenue growth in Q2 and the first half; each reported operating margin above 21% in both periods. Q2 organic growth was strongest in Welding (13.3%) and Test & Measurement and Electronics (3.9%). Food Equipment (1.6%), Construction Products (1.7%), Polymers & Fluids (0.9%) and Automotive OEM (2.8%) grew more modestly. Specialty Products grew 4.0% organically.
Q2 segment margin developments were mixed: Test & Measurement and Electronics improved 160 basis points to 23.5%, and Welding improved 210 basis points to 29.3%. Food Equipment declined 100 basis points to 25.4%, while Polymers & Fluids and Specialty Products each declined 20 basis points. Automotive OEM margin was 22.5%, up 20 basis points; Construction Products was 24.5%, up 50 basis points.
The Q2 2017 comparison included $15 million of favorable operating income from a confidential legal settlement ($80 million more was recognized in Q3 2017). Currency translation was a substantial contributor to reported revenue growth. Q2 2018 also recorded a $299 million after-tax foreign currency translation loss in other comprehensive income; first-half translation loss was $216 million.
Outlook, commentary and risks
- Management estimated a full-year 2018 effective tax rate of approximately 25%. The filing provides no clear full-year revenue or EPS guidance.
- Management described the external environment as challenging while emphasizing continued execution of ITW’s business model, organic growth focus and enterprise initiatives. It expects strategic sourcing to reduce spend by about 1% in 2018, consistent with the average annual reduction achieved from 2013 through 2017.
- ITW repatriated approximately $2.4 billion of overseas cash in the first half; some proceeds were used to repay commercial paper and fund additional repurchases. Most quarter-end cash was held by international subsidiaries and may be subject to withholding taxes if repatriated.
- The company adopted new tax guidance for intra-entity asset transfers, reducing deferred tax assets and retained earnings by $406 million; revenue guidance adoption reduced retained earnings by $9 million. These adoption adjustments reduced equity by $415 million in total. Management said the new revenue standard had an immaterial effect on period results.
- The IRS tax dispute concerns a 2006 transaction and a $70 million deficiency, plus interest and penalties. The company has recorded no reserve and expects a Tax Court decision in 2018; it stated its position remains supportable. Ongoing tax audits could change unrecognized tax benefits; the company said those benefits could decrease by approximately $18 million within 12 months.
- Principal disclosed risks include end-market weakness, economic and political uncertainty, foreign exchange, raw-material cost and availability, trade barriers, tax-law changes, pension exposure, litigation, acquisitions, cybersecurity and data-privacy incidents, and execution of enterprise initiatives. ITW added emphasis on cyber/data risks and international political and economic risks.
- The company expected to recognize right-of-use assets and lease liabilities for operating leases upon adoption of the new lease standard, effective for ITW beginning January 1, 2019; its impact assessment was ongoing.
Important facts for investors to verify
- Whether organic growth and margin progress continue, particularly given product line simplification and unfavorable price/cost pressures.
- How much repatriated cash, free cash flow and future borrowing support dividends and buybacks; $1.4 billion remained authorized under the repurchase program at June 30, 2018.
- The outcome of the IRS dispute and other tax audits, and any changes to the company’s estimated tax rate or tax exposures.
- The effect of foreign exchange and international market conditions, including the impact on revenue, cash and accumulated comprehensive income.
- Whether the expected lease-accounting adoption, cybersecurity and data-privacy risks, or other disclosed contingencies result in material financial effects.