Illinois Tool Works Q1 2022 Earnings Call Transcript

Quartr
Provided by Quartr
May 3, 2022

There are 12 speakers on the call.

Operator

Good morning. My name is David and I will be your conference operator today. At this time, I would like to welcome everyone to the ITW Q1 2022 Earnings Conference Call. Today's conference is being recorded. All lines have been placed on mute to prevent any background noise.

Operator

After the speakers' remarks, there will be a question and answer session. If you would like to withdraw your question, press star 1 once again. For those participating in the Q and A, you will have the opportunity to ask one question and if needed one follow-up question. Karen Fletcher, Vice President of Investor Relations, you may begin your conference.

Speaker 1

Thank you, David. Good morning, everyone, and welcome to ITW's Q1 2022 conference call. I'm joined by our Chairman and CEO, Scott Santi and Senior Vice President and CFO, Michael Larsen. During today's call, we'll discuss ITW's Q1 financial results and update our guidance for full year 2022. Slide 2 is a reminder that this presentation contains forward looking statements.

Speaker 1

To the company's 2021 Form 10 ks for more detail about important risks that could cause actual results to differ materially from our expectations. This presentation uses certain non GAAP measures and a reconciliation of those measures to the most to the operator. Directly comparable GAAP measures is contained in the press release. So please turn to Slide 3, and it's now my pleasure to turn the call over to to Chairman and CEO, Scott Santi.

Speaker 2

Thanks, Karen, and good morning, everyone. We have talked often about the fact that the core focus of our enterprise strategy to leverage the performance power of the ITW business model to consistently deliver top tier performance in any environments. And our teams around the world continue to do an exceptional job of doing just that as evidenced by the 11% organic growth And 23% operating margins that they delivered in Q1. In the quarter, we saw continued strong demand almost across the board, while input cost to the company's position and supply chain issues remain challenging to say the least and our business has responded. Across the company, we continue to leverage the advantage supply capabilities inherent in our eightytwenty front to back operating system to support our customers and execute our Win the Recovery strategy to accelerate profitable market penetration and organic growth across our portfolio.

Speaker 2

Many of our businesses continue to receive strong feedback from their customers that their current delivery performance is truly differentiated And that they are being awarded additional share as a result. And despite another step up in input cost inflation in Q1, We more than offset cost increases on a dollar for dollar basis in the quarter. Looking ahead at the remainder of 2022 based on our Q1 results In projecting current demand, supply rates and all known cost increases through the balance of the year, we are raising our guidance for full year 2020 2 organic growth to 8.5 percent at the midpoint and GAAP EPS of 9.20 which is 14% earnings growth year out over year and would be an all time record for the company. While the near term environment certainly has its challenges, We remain focused on delivering differentiated service to our customers, differentiated financial performance for our shareholders and continue to progress on our path to ITW's full potential. Now I'll turn the call over to Michael who will provide more detail on the quarter and our full year outlook.

Speaker 3

Michael? Thank you, Scott, and good morning, everyone. In Q1, demand was strong across the board and supported by our advantaged supply position, ITW grew revenue by 11.2 percent to more than $3,900,000,000 Organic growth was 10.6% and the MTS acquisition contributed about $100,000,000 or 2.8 percent to revenue. Foreign currency translation reduced revenue by 2.2%. GAAP EPS of $2.11 tied last year's Q1 record.

Speaker 3

For currency translation reduced GAAP EPS by $0.05 By geography, North America grew 13%, International grew 7% with organic growth of 7% in Europe and China grew 1%. 6 of 7 segments delivered positive combined organic growth of 14%, while automotive OEM was down less than 1%. Orders remain strong across the board. And while we're doing significantly better than many of our competitors in terms of lead times And delivery performance, we grew backlogs again in the Q1. Sequentially, from Q4 to Q1, Organic revenue grew 6% on a sales per day basis as compared to our historical sequential of minus 1%.

Speaker 3

And while we are on the topic of sequential improvement, GAAP EPS of $2.11 grew 9% relative to Q4 'twenty one. Operating margin was 22.7%, 23.4%, excluding 70 basis points of margin dilution from the recent MTS acquisition. Enterprise Initiatives contributed 90 basis points. And as they always do, our business teams reacted appropriately to higher cost inflation by adjusting selling prices. And as a result, we remain positive on a dollar for dollar basis.

Speaker 3

Price cost was still dilutive to operating margin by 2 50 basis points. After tax, ROIC was 27.6%, 29.8%, excluding the impact of the MTS acquisition. Free cash flow was $249,000,000 with a conversion rate of 38%, which is below our typical 80% to 85% in the Q1. As we've talked about before, the lower conversion rate is due to intentional working capital investments that support our strong growth momentum, mitigate supply chain risk and sustain service levels to our key customers. And down the road, once supply conditions begin to normalize, so will our working capital needs, resulting in our typical strong cash flow performance.

Speaker 3

As planned, we repurchased $375,000,000 of our shares in the Q1 and the effective tax rate was 23.1%, 70 basis points higher than Q1 last year. So So overall for Q1, an excellent start to the year characterized by strong broad based demand supported by our differentiated supply position as we delivered organic growth of 11%, to operating margin of 23% and GAAP EPS of 2.11%. Moving to Slide 4, we're including an analysis of our current operating margin performance. Reported Q1 operating margin was 22.7%, but there are 3 factors pressuring our margins in the near term, starting with 250 basis points of margin dilution impact from price costs. At some point in the future, when raw material costs begin to normalize, we expect the margin impact from price cost to turn positive and that we will fully recover the margin differential.

Speaker 3

2nd, Q1 was also the 1st full quarter of the recent MTS acquisition, which as expected, diluted margins by 70 basis points. As we have talked about before, it will take us a few years to fully implement the IPTW business model in MTS and get the business growing organically at ITW Caliber Margins and Returns. Finally, we had slightly higher restructuring associated with eightytwenty front to back projects, Which impacted margins by 20 basis points. And the point here is that our core operating margins are currently running around 26% plus, which is closer to what we would expect from ITW in a normal environment and not far from our pre pandemic target of 28% plus And also further evidence of our continued progress on enterprise strategy driven structural margin improvement through the pandemic. If you recall, 2019 pre pandemic margins were right around 24% versus 26% on a core run rate basis here in Q1.

Speaker 3

And as we've said before, we have full confidence in our ability to deliver sustained above market organic growth at 30% to 40% to the margins and as a result, we will continue to expand operating margins as we grow. Moving on, Automotive OEM was the only segment that didn't grow this quarter with organic revenue down a little less than 1%, much improved compared to down 16% in Q4 'twenty one. By geography, North America grew 3%, Europe was down 11% And China grew 12%. You'll remember that the segment is up against a pretty tough comp of +8 percent organic growth in Q1 last year as the impact on auto production from chip shortages didn't fully materialize until Q2. At this point and for guidance purposes, we do not expect an improvement in the chip shortage situation until 2023.

Speaker 3

As a result, our guidance assumes that automotive production and our associated automotive OEM revenues are essentially capped at current Q1 levels through the balance of the year. Turning to Slide 5 for Food Equipment, which led the way with the highest organic growth rate this quarter at 28%. North America was up 23% with equipment up 24% and service up 21%. Restaurants were up over 40% with strength across the board and institutional growth was almost 10% led by education and lodging. International growth was strong at 36% with Europe up 45% and Asia Pacific up 4%.

Speaker 3

Both equipment and service revenues increased around 36%. In Test and Measurement and Electronics, organic growth was 8% with Test and Measurement up 10% and Electronics up 6%. Strong demand for semiconductor related equipment continued to drive organic growth in the mid teens, While demand for capital equipment also remains strong with Instron, for example, up 6%. Finally, as expected, the MTS acquisition diluted operating margin by about 400 basis points. Excluding the MTS impact, margins were 26% versus 26.4 percent in Q4 'twenty one.

Speaker 3

Moving to Slide 6, welding organic revenue grew 13% with equipment 10% and consumables up 17%. Industrial grew 14% and the commercial business grew almost 10%. North America was up 12% and international growth was 17%, including 18% growth in oil and gas. Europe was up 20% and Asia Pacific was up 15%. Due to strong operating leverage and a solid contribution from enterprise initiatives, Welding operating margin was a record 30.8 percent, an all time quarterly record for an ITW segment and another proof point that as we deliver organic growth with best in class margins, there's plenty of room for further margin expansion in all seven segments.

Speaker 3

In Polymers and Fluids organic growth was 13% as automotive aftermarket grew 17%. Polymers was up 11% with continued strength in MRO and Heavy Industry Applications. Fluids grew 6%. On a geographic basis, North America grew 15% and international was up 9%. Onto Slide 7.

Speaker 3

Construction delivered strong organic revenue growth of 21% as North America grew 32% with residential up 30 to 6% and commercial up 15%. Europe grew 16% and Australia and New Zealand was up 10%. While construction margins were impacted by rising steel costs, operating margin was still a solid 24.7 percent, to strong volume leverage and a meaningful contribution from Enterprise Initiatives. Specialty organic growth was 1% with North America up 7%, while international was down 9%. With that, let's turn to Slide 8 for an updated view of our full year 2022 guidance.

Speaker 3

And based on our Q1 results and projecting current levels of demand through the balance of the year as per our standard approach to guidance, We are now projecting organic growth of 7% to 10% and total revenue growth of 8.5% to to 11.5%. Due to the higher revenue growth projections, we're raising GAAP EPS by $0.10 to a range of $9 to 9.40 and the midpoint of 9.20 represents 14% earnings growth and puts the company on track for another year of record financial performance. Operating margin guidance is unchanged with strong volume leverage and 100 basis points of contribution from enterprise initiatives. When it comes to price cost, our operating teams will continue to more than cover inflation on a dollar for dollar basis. And as usual, our guidance includes all known costs and price increases as we sit here today.

Speaker 3

We expect strong free cash flow growth of 10% to 20% year over year with a conversion rate of 85% to 95 to the Q1 of 2019. As we've talked about before, this is below our target of 100% plus because of our decision to invest in the working capital necessary to support the to the strong growth, mitigate supply chain risk and sustain service levels to our key customers. Finally, we are on pace to repurchase $1,500,000,000 of our shares. We continue to expect an effective tax rate of 23% to 24%. So in summary, Q1 was another quarter of high quality execution in a very challenging environment.

Speaker 3

And as a result, we're off to a solid start in raising both our organic growth and EPS guidance for the full year. So with that, Karen, I'll turn it back to you.

Speaker 1

Okay. Thanks, Michael. David, let's open up the lines for questions, please.

Speaker 3

Absolutely.

Operator

We'll take our first question from Scott Davis with Melius Research. Your line is open.

Speaker 4

Good morning, guys. And thanks for making an uneventful quarter versus what we've seen in some other places.

Speaker 3

You're welcome.

Speaker 4

A couple of little things here. I mean, first, your guidance implies kind of or perhaps Doesn't imply, but you're not forecasting additional inflation. Does that mean that you've seen kind of some plateauing in the Supply chain price increases and materials, etcetera.

Speaker 3

Well, so let me just it's a good question. So let me just explain kind of how We are modeling price cost because I think there's opportunity to maybe clarify a few things. So what we are doing consistent with our past approach around Price cost is we're including in our guidance today all known cost increases and all of the associate price increases. Those are the two things that we know today. And based on that, you saw the actuals of 2 50 basis points of margin headwind in the Q1, but actually positive on a dollar for dollar basis.

Speaker 3

As we project into the future based on what we know today, that 250 basis points is going to become less of a drag on a go forward basis and maybe even turn slightly positive in the back half of the year. Okay. So that's kind of that's what we know. What we don't know And as to your question, what are the additional cost increases going to be? We Don't know as we sit here today, we have not seen anything to really suggest that inflation is slowing down, but we do know that our operating teams will offset any cost increases with price on a dollar for dollar basis.

Speaker 3

And so therefore, to EPS neutral, which is a really important point here. But obviously, that will create additional top line growth, but it will also to put pressure on margins as this additional top line growth comes through at essentially no incremental margin, if that makes sense. So hopefully that answers your question. So that's what's embedded here. Everything we know as we sit here today is included in our guidance.

Speaker 3

Additional inflation will be offset on a dollar for dollar basis. And to the extent that happens, that will put some further pressure on margins. And so hopefully that

Speaker 4

That's totally fair. Is there any way to disaggregate Content growth in auto versus kind of potential inventory builds versus sell through, etcetera. Just any color there would

Speaker 3

be helpful? I'd say at

Speaker 2

this point, that'd be really tough, Just given all that's going on.

Speaker 3

Yes, I agree with that. I would just add, I mean, I think it's a tough number And it doesn't make a lot of sense on a quarterly basis. I think in terms of long term, we're highly confident that we're outgrowing the underlying market by 2 to 3 percentage points. What exactly that was in 1 quarter versus the other is a little bit more difficult to ascertain, especially in the current environment. But on a full year basis, certainly The way these plans are set up is for 2 to 3 percentage points of outgrowth on an annual basis.

Speaker 4

Okay, sounds good. Thank you, guys. I appreciate the color. I'll pass it on.

Speaker 3

Sure. Thank you.

Operator

Next, we'll go to Tami Zakaria with JPMorgan. Your line is open.

Speaker 5

Hi, good morning. Thanks for taking my questions. So I wanted to get some clarity on the improved to organic growth guidance, you're raising it by a point. And is that a reflection of better than 1st quarter performance versus your internal expectations or does it embed improved organic growth you're seeing Quarter to date and if the latter, which segments are driving that? And is it solely coming from incremental pricing?

Speaker 5

Or are you expecting volume improvement as well?

Speaker 3

Yes. So Tammy, our growth projection is based on to the Q1 actual results that we are reporting today. And then we are projecting based on historical run rates into through the balance of the year. So there's really no assumption here, no economic forecasts or an underlying assumption, things are going to get better in the back half or worse in the back half of the year. It's based on, Again, revenue per day in Q1 and projected into through the balance of the year.

Speaker 5

Got it. And so you are not embedding any pricing benefit into the updated guidance?

Speaker 3

No, I think the only pricing that is included in our guidance is what we know as of today. So we know what price increases we have actioned and announced. And so that is known, but any further increases beyond that would not be included in our guidance as we sit here today.

Speaker 5

Got it. Super helpful. If I can ask one more follow-up.

Speaker 1

Have you

Speaker 5

seen any slowdown or impact in your business in the European markets Since the war in Ukraine broke, asked another way, have you do you feel the demand environment has changed since then.

Speaker 3

Well, so I think in Q1, I think Europe was up 7%. I think we're seeing to the operator. And if you look at the automotive numbers, the sales numbers, we saw a lot of strength on the food equipment side to offset that. I think and if you kind of look at the projection for the balance of the year, I think it adds up to somewhere in the low single digit type growth rate in Europe. Just to maybe comment everybody down, I think so far through April, Everything appears to be on track, including Europe.

Speaker 5

Great. Thank you so much.

Speaker 3

Sure.

Operator

Next, we will go to Joe Ritchie with Goldman Sachs. Your line is open.

Speaker 6

Thanks. Good morning, everybody.

Speaker 3

Good morning, Joe.

Speaker 6

I guess my first question, I want to just touch on China. I know it's a relatively small part of your business, saw that it grew double digits in the auto business, but maybe just provide some color on what you're seeing on the ground there with the COVID shutdowns and how that's impacting your business, if at all.

Speaker 3

Yes, I mean, I think just to kind of dimensionalize China, about 8% of our revenues. And I think we at this point, we've not seen we're obviously not immune to What's going on in China, but like I said, so far through April, everything appears to be on track, including in China.

Speaker 7

Okay. Good to know.

Speaker 6

And then I guess just a follow on question. You guys price cost negative 250 basis points, but only down 100 basis points for the year. I mean, it's fair to say, I think, like where you're seeing the most to the auto OEM segment. So I guess just maybe confirm that that's correct or if you're seeing other pressure across other to the track that come through as the year progresses.

Speaker 3

So everything that we know is baked in, Joe. So And I think it's fair to say that the inflationary pressures are real across all seven segments. They are a little more pronounced as you can see it in the margins in auto, maybe construction this quarter, I mentioned that as well as Polymers and Fluids. I think there is a little bit of a we're still catching up to some extent. So the 250 basis points of headwind will be better starting in Q2 based on what we know today somewhere closer to 200 and then from there in the back half if things stay the way they are, like said earlier, we're starting to turn positive and we're beginning I think the important point is we're beginning to recover to the margin impact that we've had over the last 4 or 5 quarters now.

Speaker 3

So I think once we get through this to cycle like I said in the prepared remarks and when things do begin to normalize down the road from a supply chain and from a cost standpoint, That is when the margin recovery begins. And so we're taking to some extent, this is a we described it as a near term pressure here in Q1. And over time we'll begin to recover those margins again.

Speaker 4

That's helpful. Thank you.

Operator

Next we'll go to Jeff Sprague with Vertical Research. Your line is open.

Speaker 8

Thank you. Good day, everyone. Just first on auto, Scott or Michael, is The idea that you're capped here, what you're hearing directly from your customers, what you can see on kind of forward build schedules or is this just, For lack of a better term, a dose of caution given the uncertainty.

Speaker 3

It's a combination of things. I think, Jeff, if you go back to to our last call. The what was baked into our guidance at the time was half of the IHS growth to build forecast of 9%. So we were basically at somewhere around 4% to 5% builds and that's where IHS is today. So I think There's actually not a big change relative to where we were 3 months ago.

Speaker 3

And what we're basically based on to various data inputs, including from our customers. We thought the best way to to update the kind of forecast the auto business is to say that revenue stay where they are, which is somewhere around 760,000,000 in Q1 and that's what we've assumed for Q2, Q3 and Q4. So and then ultimately, I mean, we still believe that down the road when these supply chain issues get resolved and automotive production recovers, this segment is going to be very well set up as a strong contributor to the overall organic growth rate of the enterprise, but we just think it's going to take a little bit longer based on everything that we are seeing and hearing from our customers.

Speaker 8

Understood. And then just back on price, Understanding that what you know is embedded in the guide, but if we think about the point addition to the organic growth guide, I suspect all of that, maybe even more than 100% of it is price. Could you just give us a little color on that?

Speaker 3

Well, I think you tried this on the last call to get me to tell you a little bit more about price versus volume. So and just to reiterate, These are best estimates. So I can't give you a lot of detail other than I can tell you that there is to volume leverage on the 1% revenue growth increase and that's really the $0.10 a share that we're adding to our guidance, Okay. So it is not from that you can infer it's not all price. It's a combination of things.

Speaker 8

Okay. Understood. Thank you for

Speaker 4

the color.

Speaker 3

Sure.

Operator

Thank you. Next, we'll go to Andy Kaplowitz with Citigroup. Your line is open.

Speaker 9

Good morning, everyone. Andy. Scott or Michael, so I know you probably don't want to update us on your segment revenue growth But outside of auto where you already gave specific guide, it looks like food equipment and construction accelerated versus your run rate, specialty products maybe weakened a bit. Is that a fair characterization of where revenue growth is moving versus your original forecast? And can you give a little more color regarding what you're seeing in Specialty Products that's to maybe holding down that business a bit, Segment.

Speaker 3

Yes, I think I heard your first part. What the second part was, what did you say slowdown? To our next question. Yes, I think specialty is really more of a timing issue related to some specific equipment projects in Europe and a few projects in China. So I think that's really more of a timing issue than anything else.

Speaker 3

I think if you just kind of to take a step back. I think you pointed out the right ones in terms of a lot of strength in certainly food equipment, but also welding, test and measurement, there are some up against some difficult comps, construction, there's certainly a lot of positive momentum really across the board. And what does not come And we've talked about this before, we're not a backlog driven company, but in the to segments that are more exposed to the capital equipment space. So that would include Test and Measurement, to Welding Food Equipment. We are building significant backlog and really despite the fact that we are Performing, like I said, at a high level relative to our competitors, we're building substantial backlog.

Speaker 3

That's not showing up obviously yet in our revenues.

Speaker 9

To And Michael, you obviously had a large number in construction. Specifically, you mentioned North American renovation, I think up in the low to the 30% range. It's been going on for a while here, but this is a big number and getting stronger despite sort of concerns about rising rates. So You're taking share there, is it just a lot of activity and sort of visibility going forward here in 'twenty two?

Speaker 3

Well, I think as you know, I mean there's still a lot of strength in the U. S. Housing market and that's where you saw these residential remodel numbers up 36%. And included in that is also to some meaningful share gains based on what we're seeing in portions of that business where it's difficult to to supply the market. We are taking advantage of our supply position to take share.

Speaker 3

The commercial side, 15% that's a smaller part of the business and then really on a geographic basis, it's not just North America, but it's also Europe up 16%, for example, the UK up 20% and then Australia and New Zealand still delivering a solid 10%. So it's pretty broad based. And Again, we're modeling based on run rates. And so we have not seen anything to suggest that the market is slowing down at this

Speaker 9

Appreciate the color.

Speaker 3

Sure.

Operator

Next, we'll go to Nigel Coe with Wolfe Research. Your line is open.

Speaker 10

Thanks. Good morning. And thanks for leaving lots of time for yes, good morning. It's actually great that you give so much time to Q and A. So thanks.

Speaker 10

So I wish I was coming to do this. So I know you don't like to talk about price. And I know Jeff took a crack at the question. But if I just put through the margin dilution from price cost And it seems neutral, then I get to a 9%, 10% type price impact. Is that kind of scale of pricing we're seeing here and is the message of pricing gets better from here through the year?

Speaker 3

Well, what does get better from here if things stay the way they are is price cost as we talked about. And so we're going from significant margin dilution here in Q1 of 2 50 basis points to maybe even slightly positive in the second half of the year. So that's so and that's based on everything that we know today. And Nigel, it's not that We don't want to so the issue around price is that it is an estimate at best, And it is not give especially, with in such a dynamic environment, it would be very difficult to sit here and give you a number with a high degree confidence and we've not done that historically. And like I think we talked about on the last call, we're not going to go down that path of breaking out price versus volume any further.

Speaker 3

So that's the best I can do here for you.

Speaker 10

Okay. No, that's fine. And then just turn to Page 4 as my follow-up, the margin bridge, enterprise was I think 90 bps of tailwinds. So if we put that in as sort of a tailwind to that bridge, there would be 90 bps elsewhere, so as an offset. So I'm assuming that's productivity in the plants, etcetera.

Speaker 10

Is that fair, Michael? And how do you see sort of productivity, labor productivity, etcetera, improving through the year?

Speaker 3

Well, I think that's productivity. I'm not sure exactly how you get there. I mean, I think there's 90 basis points of enterprise initiatives that's not on here. That's embedded in the 26.1. In the 26.1 and so is the any other productivity gains.

Speaker 3

There are a couple of things that are not in here is There's some margin dilution from increased sales commissions. When you grow your revenues double digit, your commissions are going to go up. But Broadly speaking, what we try to do is give you a fairly accurate representation of these near term pressures and therefore what our core operating margins are running at, which is somewhere around 26% plus in the current environment. And as we just talked about these price cost pressures normalize, that's where we would expect margins to head as we continue on our path to to our target of 28% plus.

Speaker 10

No, that's very fair. Thank you very much.

Speaker 3

Sure.

Operator

Thank you. Next, we'll go to Mitch Dobre with Baird. Your line is open.

Speaker 11

Good morning, everyone. So Michael, a question for you. I think I heard you mention that in the second quarter, the price cost headwind moderates to the tune of about 50 basis points. So when we're thinking about year over year margin, is it fair to still embed roughly 200 basis points of year over year compression in Q2 and then things get better in the back half basically.

Speaker 3

Yes, I think that is that's what I said. Yes, I think that's based again With the caveat that we are in a very dynamic uncertain environment, but to the extent that based on what we know today, that is that would be correct.

Speaker 11

Okay. And then, sorry to keep beating up this topping on price. It's just that this environment is not something I've encountered in my career, Frankly, before, when we're looking at PPI data, I mean, we're seeing some pretty material increases And I'm sort of wondering if your business is sort of kind of keeping up with this industry data as well or if there is some divergence That we need to be aware of because it would seem that most of the growth is really coming from pricing, not volume, if volume grows at all in 2022.

Speaker 2

Yes, I mean, we wouldn't share that view.

Speaker 3

Yes, we don't agree with that, Juan. 2, I'm not quite sure what you're what data you're looking at. So it's a little bit difficult for me to comment. All I can do is report the actual results for our food equipment business, for example, and I think we give you a fair bit of detail, including by end market. And beyond that, I can't really like I said before, we don't

Speaker 11

in this environment or is it fair to assume some pressure as we think about 'twenty three and beyond? Thank you.

Speaker 3

Well, so I think let me just start by saying that our customer relationships are strategic long term relationships. We're not trying to maximize price. We're trying to serve our customers and make sure that we get paid for offering a really differentiated Product, service or solutions. So we've always had pricing power in these businesses. I think ultimately, These are going to be discussions with customers when costs start to normalize and there might be a few exceptions, but by and large, to the operator.

Speaker 3

We expect to hold on to these price increases to recover the margins, like I said earlier. So that's typically what happens if you go back and look in time. We're going to end up with a period where we recover that margin percentage and we don't expect

Operator

Next, we will go to Julian Mitchell with Barclays. Your line is now open.

Speaker 7

Hi, good morning. Maybe just wanted to try and understand the sort of earnings framework for the year a little bit. So It looks as if sort of operating margins are set to go up by about 300 basis points between kind of Q1 and Q4 with a flattish dollar revenue. Is that all simply the price cost removal of the headwind? Is there any other kind of major moving part?

Speaker 7

And also to that point, are you sticking to that kind of 47, 53 first half, second half EPS split? Yes. So let

Speaker 3

me address that. I mean, I think we're still in that 46% to 47% in the first half and the balance in the second half. And the big driver really is what we've talked about, it feels like for a while here, is price cost beginning to to turn positive based again on the assumptions that we're making in our guidance. So that's the drive. Now Historically, we do 49, 51, so it's a couple of percentage points.

Speaker 3

So but it is a little bit more back end loaded. We expect that as we go through the year, sequentially starting in Q2 margins will improve and so will revenues. And that's just based again on kind of historical run rates. And so we expect a steady kind of improvement in Q2, Q3 and in Q4, including on the margin side. Whether it's exactly the number you laid out, I can't really comment, but directionally to That is the right way to look at it.

Speaker 7

Thanks, Michael. And then switching to the balance

Speaker 11

sheet, which I

Speaker 7

don't think has been touched on yet and maybe some customer element as well. But your inventories are up, I think almost sort of 50% year on year and up 10% plus sequentially in Q1. Just kind of trying to understand when do you think that starts to level out? And this major sort of inventory build that you're seeing, How sure are you that you are not seeing the same phenomenon across your customers and channel partners as well with obviously some risk to that if we do see final demand slowdown.

Speaker 3

Well, so I think if you look at our inventory levels, we're running at about 3 months on hand. To our historical is 2 months. And so we have an extra month of inventory on hand. And I think we've been very clear about why that is. It's to mitigate supply chain risk, it's to take care of our customers and ultimately to win this recovery and take share at a point where our competitors are maybe not able to to service our customers.

Speaker 3

So that's the vast majority of these inventory increases. Just kind of maybe a little housekeeping. If you look at our to conversion rate here in Q1. The difference between the 38% and the 80% to 85% is about $300,000,000 of working capital, very intentional Investments, we believe are really smart use of our balance sheet and you saw the top line growth, right, at 11% organic this quarter. That I would argue would not have happened if we had not taken this approach starting really last year to make a conscious decision to invest in inventory.

Speaker 3

And then obviously receivables will go up as you grow double digit. Ultimately, we don't see any reason why structurally when supply chain begins to normalize, both from an availability standpoint and also from a cost standpoint that we will go back to 2 months on hand. And at that point that happens, you'll see these free cash flow numbers will deliver above average performance until We're back to kind of normal levels. So we view this really as a temporary increase in working capital. To How quickly that will come down depends on a lot of things, including what you're talking about and which is to inventory in the channel where we really don't have a lot of visibility, other than I can tell you for the most part, the channel who does not carry a lot of inventory because they're used to the fact that we will take care of them when they need products.

Speaker 3

So there's no incentive for them to carry a lot of extra inventory. So that's probably the best I can give you, Julian.

Speaker 7

That's perfect. Thank you.

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Earnings Conference Call
Illinois Tool Works Q1 2022
00:00 / 00:00