Illinois Tool Works Inc. — Q2 2017 Form 10-Q
Business context and reporting period. Global diversified industrial manufacturer with seven reportable segments. This unaudited filing covers the three and six months ended June 30, 2017, compared with the corresponding 2016 periods.
Key financial metrics
| Metric | Q2 2017 | Six months 2017 | Comparable 2016 |
|---|---|---|---|
| Operating revenue | $3.599 billion; +4.9% | $7.070 billion; +5.4% | $3.431 billion and $6.705 billion |
| Organic revenue growth | 2.6% | 3.0% | Not stated here |
| Operating income | $874 million; +10.4% | $1.683 billion; +11.2% | $792 million and $1.514 billion |
| Operating margin | 24.3%; up 120 bps | 23.8%; up 120 bps | 23.1% and 22.6% |
| Net income | $587 million | $1.123 billion | $525 million and $993 million |
| Diluted EPS | $1.69; +15.8% | $3.23; +17.5% | $1.46 and $2.75 |
| Operating cash flow / free cash flow | $464 million / $387 million | $927 million / $786 million | Six-month free cash flow was $893 million |
For the six months, capital expenditures were $141 million. Cash dividends paid were $450 million and share repurchases were $500 million. Cash and equivalents at June 30 were $2.496 billion; total debt was $8.051 billion, including $691 million short-term debt. Total debt to trailing-twelve-month EBITDA was 2.2x. Cash was primarily held by international subsidiaries and may be subject to taxes if repatriated. Net working capital was $3.744 billion, up $381 million from year-end.
Material changes versus the prior comparable periods
- Revenue, operating income, net income and diluted EPS increased in both the quarter and year-to-date periods. Foreign currency translation reduced reported revenue growth by 1.2 percentage points in each period.
- Six of seven segments recorded organic growth in Q2; all seven grew organically year to date. Polymers & Fluids declined 1.0% organically in Q2, while Food Equipment and Specialty Products also had North American or year-to-date softness.
- Operating margin expanded 120 basis points in both periods, led mainly by enterprise initiatives, operating leverage and overhead efficiencies. All seven segments reported margins of at least 21% in both periods.
- Automotive OEM revenue growth included the acquired EF&C business, which contributed $128 million in Q2 and $256 million year to date. EF&C diluted segment margin by 270 basis points; the segment's margin fell 350 basis points in Q2 and 280 basis points year to date.
- Six-month free cash flow declined to $786 million from $893 million. Management attributed the decrease primarily to $160 million of discretionary pension contributions, compared with the prior-year period.
Outlook, management commentary, risks and unusual items
- Management emphasized execution of its 80/20 operating model, customer-back innovation, strategic sourcing and organic-growth strategy. It targeted a 1% reduction in sourcing spend in each of 2017 and 2018, and said divisions were progressing toward above-market organic growth. The filing does not provide a specific consolidated revenue or EPS forecast.
- A confidential litigation settlement is expected to provide $95 million within 120 days of execution. ITW recorded a $15 million Q2 operating-income gain; the remaining receipt was expected to benefit Q3 2017 results. The settlement increased Q2 and year-to-date EPS by $0.03 in each period.
- The 2017 effective tax rate was 28.4%, versus 30.0% in 2016; discrete stock-compensation tax benefits of $13 million for Q2 and $26 million year to date reduced the reported rate. Excluding those benefits, the rate would have been 30.0%.
- The company is contesting an IRS deficiency notice asserting $70 million of additional tax for 2006, plus interest and penalties. The Tax Court decision was expected in 2017 or 2018; ITW believes its position is supportable and recorded no reserve. Ongoing audits could also change unrecognized tax benefits; ITW said approximately $58 million could be reduced within 12 months.
- ITW made an additional $115 million discretionary pension contribution in Q2 and expected 2017 contributions of approximately $179 million to pension plans and $5 million to other postretirement plans.
- Risks highlighted include industrial-market weakness, economic and political conditions, execution of enterprise initiatives, foreign-exchange changes, raw-material costs and shortages, acquisition performance, pension funding, tax matters, legal proceedings, financing access and cybersecurity or service interruptions. ITW reported effective disclosure controls and no identified material change in internal control over financial reporting during the quarter.
- New standards: revenue recognition is scheduled for adoption in 2018 using the modified retrospective method, with no material impact currently expected; lease accounting is scheduled for 2019 and is expected to add operating-lease assets and liabilities. The impact of other pending standards was under assessment or not expected to be material.
Most important facts for investors to verify
- Whether organic growth and margin expansion persist, especially in softer end markets and segments.
- EF&C integration progress and its effect on Automotive OEM margins and returns.
- Timing and realization of the $95 million settlement receipt, including the portion beyond the $15 million already recognized.
- Cash conversion and free cash flow after pension contributions, dividends, repurchases and capital spending.
- International cash availability and any tax, legal or audit developments, including the IRS dispute and potential unrecognized-tax-benefit changes.
- Debt levels and refinancing needs, alongside continued share repurchases and the stated strategic investment priorities.