Illinois Tool Works Inc. — Q3 2016 Form 10-Q
Reporting period: Three and nine months ended September 30, 2016. ITW is a diversified global industrial manufacturer with seven reportable segments. Financial amounts are in U.S. dollars; dollar figures below are in millions unless stated otherwise.
Financial performance
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Revenue | $3,495 | $3,354 | $10,200 | $10,130 |
| Operating income | $808 | $761 | $2,322 | $2,188 |
| Operating margin | 23.1% | 22.7% | 22.8% | 21.6% |
| Net income | $535 | $511 | $1,528 | $1,449 |
| Diluted EPS | $1.50 | $1.39 | $4.25 | $3.90 |
| Operating cash flow | $624 | $706 | $1,638 | $1,596 |
| Free cash flow | $543 | $644 | $1,436 | $1,387 |
- Q3 revenue rose 4.2%, including 1.6% organic growth, 3.5% from acquisitions/divestitures, and a 0.9% foreign-currency headwind. Nine-month revenue increased 0.7%, including 1.2% organic growth and a 1.6% currency headwind.
- Operating margin improved 40 basis points in Q3 and 120 basis points year to date. Management attributed gains chiefly to enterprise initiatives and cost management; the EF&C acquisition reduced margins by 80 basis points in Q3 and 20 basis points year to date.
- Q3 diluted EPS increased 7.9%; nine-month EPS increased 9.0%. The nine-month effective tax rate was 30.0%, versus 30.5% in 2015.
- Consumer-facing businesses, about 60% of revenue, grew organically 2% in Q3 and 3% year to date. Industrial-facing businesses were flat in Q3 and down 1% year to date. Product line simplification reduced organic growth by about one percentage point.
Segments and notable operating trends
- Six of seven segments delivered worldwide organic revenue growth in Q3 and year to date. Welding was the exception, with organic revenue down 8.5% in Q3 and 9.4% year to date, reflecting weak oil and gas and industrial demand and soft capital spending.
- Automotive OEM revenue rose 24.8% in Q3, including the EF&C acquisition; organic growth was 6.6%. Its margin fell 360 basis points to 21.8%, primarily from acquisition dilution.
- Test & Measurement and Electronics operating income increased 33.2% in Q3, and margin expanded 440 basis points to 21.0%. Specialty Products’ Q3 margin rose 210 basis points to 26.1%.
- All seven segments had operating margins of at least 21% in Q3. Year to date, five of seven met or exceeded that level.
Cash, liquidity and capital structure
- Cash and equivalents were $2,299 at September 30, down from $3,090 at December 31, 2015. Management said the decline was primarily driven by share repurchases; cash was primarily held by international subsidiaries and may be subject to tax if repatriated to the U.S.
- Total debt was $7,693, up from $7,422 at year-end; short-term debt increased to $1,364 from $526, partly because $649 of notes due in February 2017 was reclassified as current. Trailing-twelve-month total debt to EBITDA was 2.2 times, unchanged from December 2015.
- Net working capital declined to $2,699 from $4,352, mainly due to lower cash and increased short-term debt. The company had a $2.5 billion five-year credit facility, with no borrowings outstanding at quarter-end.
- Nine-month operating cash flow was $1,638, versus $1,596; free cash flow was $1,436, versus $1,387. Q3 operating cash flow and free cash flow declined year over year.
- In the first nine months, ITW paid $593 in dividends and repurchased $1,482 of stock. The quarterly dividend was increased 18.2% in Q3; approximately $3.9 billion remained authorized under the repurchase program.
Outlook, commentary and risks
- No specific consolidated revenue or earnings guidance is stated in the supplied filing text. Management reported continued execution of its enterprise strategy and expected approximately 85% of businesses to be ready to grow by year-end 2016. It described the preparation for accelerated organic growth as generally taking 18 to 24 months.
- Management expected EF&C to be slightly accretive to earnings in its first 12 months, with better performance in later years through application of ITW’s 80/20 business process. The acquisition was completed July 1 for approximately $450 million and contributed $117 million of Q3 revenue.
- Management cited challenging macroeconomic conditions, foreign-currency headwinds, weak industrial and oil and gas markets, and ongoing product-line simplification. The UK’s vote to leave the EU was identified as a source of uncertainty; the UK represented approximately 5% of 2015 consolidated revenue.
- The IRS tax dispute concerns a 2006 transaction and a $70 million tax deficiency assessment, plus interest and penalties. The trial occurred in Q3 2016; a Tax Court decision was expected in 2017. ITW said its position remained supportable and recorded no reserve. Separately, the company said unrecognized tax benefits could decrease by approximately $104 million within 12 months, predominantly related to intercompany transactions.
- Other stated risks include economic and political conditions, currency movements, acquisition execution and impairment, financing access and credit ratings, raw-material costs and supply, tax rulings, pension funding, litigation, cybersecurity, and regulatory compliance.
Important facts for investors to verify
- Whether organic growth and margin improvements continue, particularly given weak industrial demand and Welding’s contraction.
- EF&C’s contribution to growth, margin dilution, integration progress, and expected earnings accretion.
- Cash generation relative to dividends, repurchases, acquisitions, and debt; also the location and potential repatriation costs of cash balances.
- Resolution and potential financial consequences of the IRS dispute and ongoing tax audits.
- Progress toward management’s year-end 2016 readiness target and the eventual delivery of accelerated organic growth.