Illinois Tool Works Inc. — Q2 2015 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2015. ITW is a diversified industrial manufacturer operating through seven reportable segments. Unless noted, amounts are in millions of U.S. dollars.
Financial performance
| Metric | Q2 2015 | Q2 2014 | Six months 2015 | Six months 2014 |
|---|---|---|---|---|
| Operating revenue | $3,434 | $3,719 | $6,776 | $7,288 |
| Operating income | $730 | $763 | $1,427 | $1,430 |
| Operating margin | 21.3% | 20.5% | 21.1% | 19.6% |
| Income from continuing operations | $480 | $494 | $938 | $922 |
| Diluted continuing-operations EPS | $1.30 | $1.21 | $2.51 | $2.22 |
| Net income | $480 | $1,492 | $938 | $1,965 |
- Revenue fell 7.6% in Q2 and 7.0% year to date, principally from unfavorable foreign currency translation. Organic revenue increased 0.2% and 0.4%, respectively; product-line simplification reduced organic growth by about one percentage point in both periods.
- Operating margin improved 80 basis points in Q2 and 150 basis points year to date. Management attributed improvement chiefly to enterprise initiatives, including strategic sourcing and business-structure simplification.
- Continuing-operations diluted EPS increased 7.4% in Q2 and 13.1% year to date. Currency translation reduced EPS by approximately $0.12 and $0.21, respectively.
- Prior-year net income included discontinued operations income of $998 million for Q2 and $1,043 million for the first half, including a $1.7 billion pretax gain on the 2014 Industrial Packaging sale. All businesses then classified as discontinued operations had been divested by Q2 2014.
Cash flow, liquidity and capital
- First-half operating cash flow was $890 million versus $887 million in 2014. Capital expenditures were $147 million; free operating cash flow, a company-defined non-GAAP measure, was $743 million versus $741 million, or 79% of net income. Q2 free operating cash flow was $384 million, or 80% of net income.
- Cash and equivalents were $2.858 billion at June 30, down from $3.990 billion at year-end 2014. Management said cash was primarily held by international subsidiaries and noted potential U.S. and foreign tax costs on repatriation.
- Total debt was $7.813 billion, up from $7.457 billion at year-end; short-term debt was $819 million and long-term debt $6.994 billion. Trailing-twelve-month total debt/EBITDA was 2.3x versus 2.2x at December 31, 2014.
- In May, ITW issued €500 million of 1.25% notes due 2023 and €500 million of 2.125% notes due 2030. Proceeds were used to repay commercial paper and for general corporate purposes; the notes were designated as net-investment hedges of euro-denominated operations.
- First-half share repurchases were $1.786 billion; cash dividends paid were $365 million. The 2015 authorization had approximately $5.7 billion remaining at June 30. The declared dividend was $0.485 per share for Q2.
Segments and material changes
- Organic growth was strongest in Automotive OEM, Food Equipment and Construction Products. Automotive OEM grew 6.0% and Food Equipment 4.2% in Q2; Construction Products grew 5.8%.
- Organic revenue declined in Test & Measurement and Electronics (4.9%), Polymers & Fluids (1.6%), Welding (6.0%) and Specialty Products (3.4%) in Q2. Management cited weak capital spending, softer oil and gas demand, regional weakness and product-line simplification.
- Foreign currency was a substantial drag on reported segment revenue. Despite lower reported revenue, several segments improved margins; Q2 margin declined in Welding and Specialty Products.
- Year-to-date interest expense declined to $109 million from $128 million, reflecting lower-rate debt issuances. Other income included a $15 million first-quarter gain on sale of a business. The first-half effective tax rate was 31%, versus 30% in 2014.
Outlook, commentary and risks
- Management described earnings performance as solid despite currency headwinds and a challenging macroeconomic environment. It did not provide a specific near-term earnings or revenue forecast in the supplied filing text.
- The five-year enterprise strategy targets, by 2017, organic growth 200 basis points above global GDP, operating margin of approximately 23%, after-tax ROIC above 20%, and free operating cash flow equal to 100% of net income. ITW reported Q2 operating margin of 21.3% and adjusted ROIC of 20.3%.
- Management expects product-line-simplification revenue headwinds to moderate beginning in 2016. The company’s long-term shareholder-return objective is 12%–14% annualized, assuming global GDP growth of 3%.
- Risks identified include economic and end-market weakness, foreign exchange, execution and timing of enterprise initiatives, financing and share-repurchase conditions, raw-material costs and availability, tax matters, pension exposure, litigation, divestiture liabilities, impairments, and cybersecurity or IT disruptions.
- An IRS deficiency notice asserts $70 million of additional tax for 2006, plus interest and penalties, relating to a return of capital. ITW is contesting the assessment and recorded no reserve, stating it believes it will prevail. Ongoing tax audits may also affect unrecognized tax benefits; the company said approximately $54 million could be resolved favorably within 12 months.
Key investor verification points
- Separate underlying organic growth from the reported revenue decline and assess continuing segment exposure to foreign exchange and weak end markets.
- Track whether margin gains from enterprise initiatives persist as organic growth remains modest and product-line simplification continues.
- Review cash availability and repatriation constraints alongside debt growth, the 2.3x debt/EBITDA ratio, and planned repurchases and dividends.
- Monitor strategy progress against the 2017 targets and whether management provides more specific forward guidance.
- Follow the IRS dispute, other tax audits, and the company’s disclosed cybersecurity and operational risks.