Earnings Call Transcript
ILLINOIS TOOL WORKS INC (ITW)
Earnings Call Transcript - ITW Q1 2020
Operator, Operator
Good morning. My name is Julianne, and I will be your conference operator today. At this time, I would like to welcome everyone to the conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. For those participating in the Q&A, you'll have an opportunity to ask one question and, if needed, one follow-up question. Thank you. Karen Fletcher, Vice President of Investor Relations, you may begin your conference.
Karen Fletcher, Vice President of Investor Relations
Okay. Thanks, Julianne. Good morning, everyone, and welcome to ITW’s First Quarter 2020 Conference Call. I'm joined by our Chairman and CEO, Scott Santi; Vice Chairman, Chris O’Herlihy; and Senior Vice President and CFO, Michael Larsen. During today's call, we will discuss ITW’s first quarter 2020 financial results as well as the impact of the global pandemic on our business and our strategy for managing through it. Slide 2 is a reminder that this presentation contains forward-looking statements. We refer you to the company's 2019 Form 10-K, the Form 8-K filed today, and the Form 10-Q to be filed on May 7, for more detail about important risks that could cause actual results to differ materially from our expectations, including the potential effects of the COVID-19 pandemic on our business. This presentation uses certain non-GAAP measures and a reconciliation of those measures to the most comparable GAAP measures is contained in the press release. Please turn to slide 3. And it's now my pleasure to turn the call over to our Chairman and CEO, Scott Santi.
Scott Santi, CEO
Thank you, Karen, and good morning, everyone. Stating the obvious, a lot has changed relative to the environment we operated in for most of the first quarter. As a result, our focus this morning will be on the company's response to the COVID-19 pandemic and, more specifically, our strategy to leverage ITW’s considerable strengths in executing on the challenges and opportunities ahead. I will provide some brief commentary on our Q1 performance, and then we will transition to our pandemic strategy. We have included much of our normal quarterly performance detail in the appendix, and you are, of course, welcome to ask questions regarding our Q1 results during the Q&A session at the conclusion of our presentation. As Karen noted, I've asked our Vice Chairman, Chris O’Herlihy, to join Michael and me on the call this morning, as I thought that it would be helpful for you to hear perspectives from all three of us and how we are managing through the near-term challenges of the containment period we're currently in and on the actions we are taking now and will take over the coming weeks and months to ensure that the company is positioned to participate fully in the recovery. Before we jump in, I want to offer our heartfelt thanks to all of our ITW colleagues around the world. We talk often about the fact that our decentralized entrepreneurial culture is a key element of ITW’s secret sauce. It is core to who we are as a company and it is never more valuable than during times of significant and, in this case, rapid change. The proactive teamwork, ingenuity, and selflessness of our people and quickly adapting to rapidly changing conditions and tackling new challenges that seemingly arise daily at the moment is ITW at its finest. We thank all of our colleagues for the incredible level of care and commitment they are bringing to keeping their co-workers safe, while continuing to serve our customers with excellence. The fact that the ITW team has responded exactly as we expected they would doesn't make it any less extraordinary. Now on to first quarter results, total revenue declined 9% year on year with organic revenue down 6.6%, currency at 1.5% headwind, a negative 1% impact from divestitures and 40 basis points of PLS. The majority of the organic revenue decline occurred in the last two weeks of March where we saw organic revenue down more than 20%. By geography, North America was down 5%, and Europe was down 7%, China was down 24% for the quarter but appears to have bottomed in February and was flat year on year in April. An encouraging sign. In the face of a challenging demand environment, we continue to execute well on the elements within our control. Despite a 9% decline in revenues, operating margin was flat at 23.6%. Five of our seven segments expanded margins in the quarter due largely to benefits from enterprise initiatives which contributed 120 basis points to operating margin at the enterprise level. After-tax return on invested capital is 27%, and free cash flow was $554 million with a conversion rate of 98% of net income. Lastly, as noted in our press release this morning, given the uncertainties regarding the impact and duration of the COVID-19 pandemic, we are suspending our previously announced guidance for full year 2020. We will resume guidance once the market stabilizes and the recovery path becomes more clear. Now let's shift gears and talk about how we will manage ITW through the global pandemic. Please turn to slide 4. Despite the unusual and in some cases unprecedented challenges of the moment, we continue to execute at a high level and with our usual degree of focus and discipline across the company. As a result of all the work we have done over the last seven years in executing our enterprise strategy and the progress we have made on the path to our full potential performance, ITW is today in a position of significant strength in dealing with the effects of the global pandemic. Today's ITW is centered on our powerful and proprietary business model, and our people are better trained and more skilled at executing it than ever before in the history of our company. ITW is an 80/20 front to back methodology, and the laser-focused drive on the relatively handful of critical performance difference makers in every one of our businesses has served the company extremely well in times of both opportunity and challenges for a long time now. I have no doubt that this unique ITW skill will be a significant asset to us as we work our way through the COVID-19 pandemic and its aftermath. In addition, as I mentioned earlier, we are very fortunate to have a decentralized operating structure and an entrepreneurial culture that has been developed, nurtured, and protected over many years. Our people think and act like owners. They are accountable, and they deliver. They are deeply trained in our business model, our strategy, and our values, and I assure you that even in unprecedented times such as these, none of them are waiting around to be told what to do. In addition, in today's ITW, we have worked hard at shaping our portfolio and driving consistent high-quality execution across every business in it, both to position the company to deliver consistent upper-tier long-term earnings growth when global conditions are favorable and to build in a margin cushion and level of diversification that makes us highly resilient during most periods when they are not. And it follows from there that the robust free cash flow we generate through our strong margin profile, and the unique attributes of our business model, combined with our very disciplined capital allocation strategy gives us an extremely strong balance sheet and Tier 1 credit ratings. So with these elements as our foundation, our strategy for managing through the pandemic and its aftermath is to focus on the following four priorities. First, to protect the health and support the well-being of our ITW colleagues; second, to continue to serve our customers with excellence; third, to maintain financial strength, liquidity, and strategic optionality; and fourth, to leverage ITW's strengths to position the company to fully participate in the recovery. Chris will give you some additional color on priorities one and two. Michael will cover priority three, and I will come back and cover priority four. And then, we'll open it up for your questions, Chris. Good morning; over to you.
Chris O’Herlihy, Vice Chairman
Thank you, Scott, and good morning, everyone. This is a challenging time for all of us, as the world continues to grapple with the effects of a global pandemic. At this point, I'm sure that everyone of us has been impacted by this situation in ways that were unimaginable just a few months ago. And ITW as a company and the community is certainly being affected. Having said that, as Scott referenced, our divisional leaders think and act like owners and are able to react quickly and take the necessary actions to protect our people and serve our customers, which is a particular advantage of the company in times of significant challenge. Let's move to slide 6. The actions we took to protect the health and support the well-being of our colleagues included developing and deploying a number of practices to minimize exposure and prevent the spread of COVID-19 to keep our colleagues safe. We have followed CDC, WHO, and local government guidelines in doing so. Our ITW colleagues have redesigned production processes to ensure proper social distancing practices, adjusted shift schedules and assignments to support colleagues who have childcare needs due to school closings, and implemented aggressive new sanitation practices to minimize infection risk. We’re also providing full compensation to employees who have been quarantined. Additionally, our strategic sourcing team is heavily engaged in helping our businesses by coordinating the procurement of personal protective equipment to ensure all our employees receive the protection they need. I'm pleased to say that, as a result of our containment efforts to this point, we've largely been able to restrict infections to single cases in a minority of our locations, which is a testament to the actions our colleagues have taken to implement sound sanitation practices and social distancing and to protect one another to the best of their abilities. Turning to slide 7, let's shift to another important stakeholder group and how we continue to serve our customers with excellence. To support our customers, our teams have worked diligently to keep our factories open and operational. In areas around the world where governments have issued shelter in place orders, the vast majority of ITW businesses have been designated as critical or essential businesses and as such, they're needed to remain open and operational. In some cases, it's because our products directly impact the COVID-19 response effort. For example, our welding equipment is used to manufacture hospital beds, or structural products are utilized to build temporary medical facilities, or test and measurement products test medical and laboratory equipment. Our Polymers & Fluids products sanitize workplaces, and our food service equipment is used to feed people in hospitals. In other cases, our businesses are designated as critical because they play a vital role in serving and supporting industries essential to the physical and economic health of our communities. Although some facilities are subject to mandatory shutdowns, roughly 95% of our global manufacturing capacity is currently available to be deployed to serve our customers. The same is true for our service networks, particularly in food equipment and test and measurement, which we continue to keep fully available to ensure that we can help keep essential businesses and healthcare facilities in operation. In both cases, across all segments, we continue to maintain best-in-class performance for product and service quality and availability. Finally, we're rigorously managing our supplier base to mitigate near-term supply risk for critical raw materials and components and ensure that we are positioned to win in a wide range of recovery scenarios going forward. With that, I'll turn the call over to Michael.
Michael Larsen, CFO
Okay, thank you, Chris, and good morning, everyone. The primary objective of our enterprise strategy, an important byproduct, if you will, of a lot of work done over the last seven years, is that ITW is in a position of considerable financial strength to deal with highly disruptive events such as this global pandemic. In many ways, ITW was built for times like this. Throughout the pandemic, we will manage the company to maintain our financial strength, liquidity, and strategic optionality so that we can leverage our strong financial foundation and resilient profitability profile to position the company for maximum participation in the recovery. Turn to Slide 9; there's no question that in Q2, we will see an unprecedented level of demand contraction due to the complete shutdown of wide swaths of the global economy. ITW has more than enough financial strength and resilience to withstand this shock to the system that the global economy is experiencing over the next several months. We are prepared for it. We'll get through it, and we'll come out the other side strongly positioned for the recovery. As we sit here today, one month into the quarter, we're estimating Q2 revenues will be down 30% to 40% on a year-over-year basis. Obviously, there's a fair amount of uncertainty around how May and June will actually play out but that is our current view. As you would expect, given that most of our automotive OEM customers in North America and Western Europe have been essentially shut down since mid-March and are only beginning to restart production in early to mid-May, our automotive OEM business will be the hardest hit with revenues potentially down 60% to 70% year-over-year. An abrupt decline of this magnitude in the quarter is pretty unprecedented. As difficult as it may look, if it plays out this way, we expect that ITW will still make operating profit in the $200 million to $400 million range, generate free cash flow of more than $500 million and end the Q2 with cash on hand of about $1.5 billion. Onto slide 10. Knowing that we have the financial strength to withstand whatever comes our way over the next few months, our number one priority becomes positioning to play offense in the recovery. This is an area where our strong margin profile really helps us. Whether the pace of recovery is fast or slow, V-shaped or U-shaped, over the next few quarters, it doesn't really impact us that much. Under a very fast-paced recovery, we end up down 15% for the full year, and margins are 19% to 21%. In a much slower recovery, revenues are down 25%, yet our margins are still a strong 17% to 19%. This is against a backdrop where most of the companies that our divisions compete with came into the pandemic with margins at half of ours or less. As a result, a number of them may have to retrench in a major way to get through the epidemic, potentially creating some significant share gain opportunities for us in the recovery. With our margin cushion, we are not concerned with how quickly demand is going to recover in Q3 or Q4. We can be fairly certain that it will be incrementally better than Q2, but beyond that, it really doesn't affect us a whole lot, which allows us to think long-term and position for maximum participation in the recovery. Ensuring that we are in a strong position to fully support our customers as their businesses begin to re-accelerate, and that we are in an equally strong position to take share from competitors who can't, is the central imperative of our pandemic response planning for every one of our divisions. We will, of course, need to manage our businesses smartly across our portfolio and make some meaningful capacity and cost structure adjustments in businesses where we expect prolonged recovery periods, or maybe even permanent demand impacts from the pandemic. But as we always do, we will leave those decisions in the hands of our divisional leaders as they are in the best position to assess the pace and slope of the recovery in each of their respective businesses. Turning to slide 11. The financial benefits of our enterprise strategy, combined with the work we've done to optimize our capital efficiency, capital structure, and capital allocation over the years, has put ITW in a very strong position going into this crisis. At quarter end, we had more than $1.4 billion of cash and cash equivalents on hand. As of today, we have essentially no short-term debt, and we have not issued any commercial paper. Why, you might ask? Simply put, because we don't need to cash. We have a $2.5 billion undrawn credit facility available to us if needed in the future, bringing our total liquidity to about $4 billion as we sit here today. Our net leverage is only 1.7 times, and our next maturity is pretty small, $350 million, and not until September 2021. High quality of earnings and strong free cash flow are hallmarks of ITW. We consistently generate significantly more cash than we need for internal purposes, and our annual conversion rate from net income is consistently above 100%. We expect that to continue to be the case as we manage our way through the pandemic. As evidenced by Tier 1 credit ratings that are the highest in our peer group, we continue to have excellent access to credit markets should we need it. During this time of market volatility, it's also worth mentioning that our pension plans have remained in great shape. Over the years, we have consistently funded and de-risked our plans, and as we sit here today, our largest U.S. plan is funded at 104%. Turning to slide 12. So how do we think about and adjust our capital allocation approach during the pandemic? First, with regard to the dividend. We recognize the importance of ITW's dividend to our long-term shareholders. We have a long history, with more than 56 years of growing the dividend. We are part of a small group of so-called dividend aristocrats, and one of about 18 companies that has increased its dividend for more than 50 years. We view the dividend as a critical component of ITW's total shareholder return model. Since 2012, we have increased the annualized dividend from $1.52 per share to currently $4.28 per share, a cumulative annual growth rate of 16%. Simply put, we remain strongly committed to our dividend, and as we sit here today, we do not see a scenario where we would have to reduce the dividend. In terms of strategic optionality, we are clearly in a position of strength with ample balance sheet capacity, and we're certainly open to the possibility that opportunities might emerge as a result of the pandemic. It could be in the form of more reasonable valuation opportunities for assets we were already interested in, as well as unique opportunities with quality companies that may not have the financial strength to weather the pandemic. Given our financial strength and ample capacity, we will be in a strong position to react to any high-quality strategic opportunities that may emerge. We will continue to fully fund all internal investment and CapEx projects that meet our criteria, like we always have, but the number will likely come down in terms of aggregate spend in the near term due to the fact that we don't need any capacity expansion projects for the next several quarters. Finally, I think it comes as no surprise to anyone that we have suspended share repurchases until end markets stabilize and the recovery path becomes clearer. With that, I'll turn it back over to Scott.
Scott Santi, CEO
Thank you, Michael. As a priority four, which is all about leveraging our strengths to ensure that every one of our businesses is strongly positioned to fully participate in the recovery, in short, we are going to be there to serve every bit of our customers' needs as their businesses begin to reaccelerate and be well prepared to capture any share gain opportunities that may come our way. Food equipment had a good quarter with organic growth up 2% year-over-year despite a tough comp of 5% organic growth last year. The service business was solid, up 4% in the quarter. Equipment growth of 1% reflects double-digit growth in retail and modest decline in institutional and restaurants against tough year-over-year comps for both of those. Operating margin expanded 90 basis points to 27.5% with enterprise initiatives being the main contributor. Test and measurement in electronics had a very strong quarter, with test and measurement up 6%, and 13% growth in our Instron business. The segment also experienced a meaningful pickup in demand from semiconductor customers. Electronics was up 2%. Margin was the highlight as the team expanded operating margins 330 basis points to a record 28.1%, the highest in the company this quarter with strong contributions from enterprise initiatives and volume leverage. Also in the quarter, we divested an electronics business with 2019 revenues of approximately $60 million. In the face of an unprecedented demand contraction in Q2, as Michael commented earlier, we will still generate operating income in the hundreds of millions of dollars and generate over $500 million in free cash flow. We will manage discretionary expenses prudently, but we don't need to start cutting muscle immediately, and we certainly want to avoid doing so before we have some level of indication as to the shape and slope of the recovery in each of our businesses. With this principle in mind, to this point, we are providing full compensation and benefits support to all ITW colleagues around the world. We are doing it because we are in a position to support our people at a time of great personal and family stress and uncertainty. We think that it's the right thing to do. But we are also doing it to protect the significant investment we have made in training and developing great ITW people and great ITW leaders over the past seven years. As Michael mentioned, it is likely that we will need to make some staffing adjustments to align with prolonged or permanently lower demand in some of our businesses as a result of the pandemic. So we are committed to being there for all of our people during the worst of this, and we will take the time to make whatever longer-term adjustments need to be made thoughtfully. The second principle is that we're going to lean into the upside by remaining invested in structure to capture incremental demand. Given the profitability of our core businesses and the strength of our financial position, what's the bigger risk for ITW: carrying more cost and it turns out we need for a few months or cutting too much, and not being able to fully serve our customers' needs and take share from our competitors as the recovery accelerates? Obviously, we believe short-sheeting the upside potential of the recovery would be the far bigger mistake for ITW, and we're going to plan and execute our recovery strategies accordingly. The third principle is that we're going to leverage the strength of ITW to protect investment in areas of strategic importance to the execution of our long-term strategy. We're early in our planning around all these areas, but as one example, prior to the pandemic, we invested two-plus years in our strategic sales excellence initiative that included significant investments in new sales and sales leadership talent. We have the financial capacity to protect these types of long-term strategic investments, and doing so is worth a lot more over the long-term to the company than a few extra detrimental margin points in the short-term. That being said, decremental margins should likely be in our normal 35% to 40% range in Q4. Between now and then, we're going to focus on making sure ITW is in a strong position to fully participate in the recovery. Turning to slide 14, this is just a reminder that our long-term strategic priorities remain unchanged; we are committed to achieving and sustaining ITW potential performance and continuing on our quest to firmly establish ITW as one of the world's best performing, highest quality, and most respected industrial companies. Now let's move on to slide 15 to wrap things up. Once again, on behalf of Chris, Michael, and I, and our entire executive leadership team, we thank our ITW colleagues around the world for the exceptional job they are doing under the most challenging circumstances. As of right now, there's no way to know how severe this crisis will be, how long it will last, or how quickly our customers and markets will recover. What I do know is that the strength and resilience of ITW’s business model and our people put us in about a stronger position as an industrial manufacturing company can be in to deal with that whatever will unfold over the coming weeks and months. I have every confidence that ITW will rise to the challenges we always have over the course of our 108-year history. Our strong financial position and margin profile give us the ability to make strategic moves now to position the company to fully participate across a range of recovery scenarios, and to come out the other side ready to continue on our path to ITW full potential performance. With that, Karen, I'll turn it back to you.
Karen Fletcher, Vice President of Investor Relations
Okay. Thanks, Scott. As a reminder, please see the appendix in today's slide deck for the usual segment detail for the first quarter. So Julianne, let’s open up the line for questions.
Operator, Operator
Your first question comes from Ann Duignan from JPMorgan. Your line is open.
Ann Duignan, Analyst
Hi, good morning, everybody. Appreciate being on the call. Scott, maybe you could talk a little bit about your various businesses and whether you would anticipate that any of the businesses might be permanently impaired rather than just cyclical, and I'm thinking welding, oil and gas, I'm thinking through the equipment, you know, et cetera, et cetera. How are you thinking about that as we look forward?
Scott Santi, CEO
I'd say overall, it's just way too early to tell. I think I don't see anything, you know. We have a division that provides support equipment to the airline industry that is probably among the ones that I would say would see kind of the longest tail in terms of recovery. But from where we sit today, as early as it is in this whole process, I don't see anything that would be sort of obvious or apparent in terms of permanent change or damage, if you will, from this pandemic. There may be, but we'll deal with it.
Michael Larsen, CFO
I might just add, Ann, specific to oil and gas. If you look at the enterprise level, our sales into oil and gas are in the single digits and maybe as you were pointing out, primarily in welding, maybe 15% to 20% of welding, depending on what year you're in, primarily on the international side. But as Scott said, it's really too early to tell what the recovery path might look like in that part of the company.
Ann Duignan, Analyst
Perfect, thank you. And then maybe just to follow up on the strategic M&A and the opportunities to update at maximum participation when the recovery occurs, could you just expand on that a little bit? Like, it is interesting to hear you comment on that?
Scott Santi, CEO
Well, I think there is no, this is no, nothing I would characterize as a change in strategy; we had certainly talked for some time about the addition of some incremental growth from acquisitions as a core part of our strategy. I think there's, you know, it's not rocket science to anticipate that there are going to be either from the standpoint of a reset on valuation and/or given the level of financial stress that’s going to be out there that there might be some opportunities emerge as a result in our own commentary is that we are going to preserve our ability to access those that doesn't change the criteria one but this is not a matter of looking at things that we would have not looked at otherwise, but the sort of relative availability of things that would fit – I would expect would be perhaps more enhanced as a result of the situation.
Ann Duignan, Analyst
So we shouldn't anticipate you stepping up and making a larger than expected acquisition in a new platform or anything like that. Is that what you're saying? That there's no change in the strategy, just the opportunities might be more?
Scott Santi, CEO
Yeah, well, I'm not sure I would limit it based on size. I think it's a function of stick with that strategy. Obviously, we've talked about that criteria in the past and we’ve got an opportunity that kind of business that has high value-added content in terms of their products and the way their products impact their customers, and where we see a significant ability to impact the performance of a business through the application of our business model. That's what I'm saying is the same as it's always been. Whether that's big or small, will be a function of the quality of the asset less than the size.
Ann Duignan, Analyst
Okay, I appreciate. I'll get back into; thank you.
Operator, Operator
Your next question comes from John Inch from Gordon Haskett. Your line is open.
John Inch, Analyst
Thank you. Good morning, everybody. Hey, Scott, Michael.
Scott Santi, CEO
Good morning.
John Inch, Analyst
And Chris, given that there's no centralized cost containment actions that you guys are announcing today, I'm wondering if the detrimental as you've presented include assumptions that the businesses preserve respective cost containment actions, or are they more of a kind of a worst-case scenario?
Scott Santi, CEO
I'm trying to interpret the question. I think, John, I think if I'm going to paraphrase here, I think you're asking what is included from a restructuring standpoint for the balance of the year?
Chris O’Herlihy, Vice Chairman
Yeah. Absolutely, I mean, I think the honest answer is until we know what the recovery path looks like and the divisions have had a chance to really interpret, you know, division by division, what that path is, and therefore, what capacity and cost adjustments need to be made. We don't know what the restructuring is going to be. But obviously, we have included in the numbers that we're showing you today, a placeholder for an educated guess, I hope, for what restructuring might be. But it really is, John, as you might appreciate too early to tell at this point.
Scott Santi, CEO
Yeah, and I think the sort of core planning mandate around this and everything we've just tried to articulate is we're going to spend the next couple of quarters really making sure that we're in the right position to fully support our customers and access any incremental growth opportunities that might emerge from this recovery phase. And we'll do what we always do. We'll adjust our cost structure smartly. We're not going to do it from on high, we're going to do it business by business. That's no different than we've always done it. The difference now is that we are positioned from the standpoint of entry margins and the final cushion that we have that we can take the time to plan our way through it in a way that doesn't necessarily does our best to protect the upside potential, next really all we're saying. I said in my comments that we'll be back to our normal incremental by Q4. But there's really no benefit to us that I see of trying to as I said, when the – when the containment phase and you know, how fast we can cut costs is not something that we have to worry about, we have the luxury of building this position doesn't mean we're not going to be smart. It doesn't mean we're not going to have to adjust our cost structure over time, but we're going to do it from a position of much greater clarity business by business as to how this is likely going to play out. That clarity doesn't exist today. It's very hard to see until we get much further down through Q2 and into Q3.
John Inch, Analyst
Based on the way you're set, yeah, well – I was going to say Scott based on the way you're standing up for your people, I bet you you're going to get an awful lot of people knocking, very qualified people knocking on your doors wanting to work for ITW as this whole thing progresses.
Scott Santi, CEO
We’re just trying to be the same. Thank you.
John Inch, Analyst
Well, no, but it's other companies are not following this tax. So I think it's worth calling out. My question is, hold on, I don't have COVID, just – coming out of this, because there's been no broader centralized temporary cost actions, that you guys have to kind of get layered back. Because other companies are taught in leading model 2021. Please don't assume very high incremental because we have to layer in all these costs that have to come back that are temporary. Could you possibly infer that, I know you talked about the detrimental is going back to 30%, 35% in the fourth quarter because there's no big centralized temporary actions, could be incremental in 2021 be closer to 40% coming out of this, if not even a little bit higher?
Scott Santi, CEO
I see no reason why they wouldn't be our normal 35 plus.
Chris O’Herlihy, Vice Chairman
Thanks, John.
Operator, Operator
Your next question comes from Andrew Kaplowitz from Citibank. Your line is open.
Andrew Kaplowitz, Analyst
Good morning, guys. Hope you're well.
Chris O’Herlihy, Vice Chairman
Thank you, Andrew. Same to you.
Andrew Kaplowitz, Analyst
As you know, one of the main topics that you're going to talk about at your Investor Day that was canceled by the pandemic was to give us more color on ITWs overall portfolio, in terms of its ability to outgrow in the markets. So when you look at the 30% to 40% drop in Q2, we know a lot of it is auto related, but even excluding auto, it appears you're thinking about 20% to 30% decline for the rest of the businesses. So are any of these businesses still expected to underperform their markets or is it really that ITW has simply leveraged to some end markets right now such as auto or food equipment when the markets are just challenged by the pandemic?
Scott Santi, CEO
Well, I'd say a couple of things, specifically around Q2. One is, certainly in auto and what's going on in restaurants right now, food equipment, the whole sort of CapEx environment, why would most companies are certainly pulling back big time in any sort of CapEx until they have more clarity as to what the future will hold. What I would say also is in Q2, that's certainly a significant multiplier is all the supply chain, the brakes go on, there's a multiplying effect of both. Beyond just the consumption of whatever the products are. It's related to the reduction, radical reduction in inventories to supportive, significant double-digit drop. So I'm not sure there's a lot of comparisons to the market that are valid in Q2 for that reason. Let's get through it. Let the smoke clear a little bit and see how things are starting to normalize in Q3 before we make any assessments in terms of relative growth.
Andrew Kaplowitz, Analyst
Scott, if I could follow up on that, you usually provide guidance on run rates, so is that what's happening?
Scott Santi, CEO
We used to give Q2 run rate; we don’t quit.
Andrew Kaplowitz, Analyst
So maybe you can discuss what you're observing in April and regarding the pecking order, you mentioned food equipment. We know the automotive sector is going to be the weakest, so can you provide more details on which markets might outperform or which ones may be weaker, keeping in mind that automotive and food equipment are likely to be affected?
Scott Santi, CEO
Yeah. Let me ask Michael to address for April and sort of the relative Q2 performance across the segment.
Michael Larsen, CFO
As we mentioned, the automotive segment has been the most significantly affected, experiencing a decline of 60% to 70%. This impact accounts for a 10-point reduction in our overall revenue. Excluding automotive, the other segments have seen declines in the 20% to 30% range. The food equipment sector is particularly struggling in the short term, especially in the restaurant industry, although we are observing more stability within the institutional sector, such as healthcare and education, as well as in retail. Overall, the food equipment sector is likely to face a decline of about 35% to 45% in the near term, and its recovery will depend on factors like the reopening of restaurants and our ability to service the equipment. Welding is also facing challenges, particularly related to capital expenditures and oil and gas exposure. We expect welding to decline in line with the overall company average. However, there is notable resilience in areas like testing measurements and specialties, which may decrease by 10% to 20%. This quarter has been exceptionally tough, and things have changed rapidly. Despite these challenges, the company remains profitable and is projected to generate over $0.5 billion in free cash flow, with double-digit operating margins that will surpass some of our competitors' standards before the COVID situation. This positions us strongly, even in light of current macroeconomic disruptions. Looking at April, we had initially forecasted a decline of 30% to 40%. Both April and May will be challenging months, although there are signs of improvement. For instance, in China, we've seen stabilization with a low point in February and flat performance in April; the automotive sector there might remain flat in Q2. Nevertheless, this situation is highly uncertain. As of now, I am optimistic that we are at the lowest point and that we will navigate through these difficulties, setting the stage for a potential recovery in the second half of the year.
Andrew Kaplowitz, Analyst
Appreciate the color, guys.
Scott Santi, CEO
Sure, thanks.
Operator, Operator
Your next question comes from Jamie Cook from Credit Suisse. Your line is open.
Jamie Cook, Analyst
Hi, good morning and I hope everyone is doing well. I would like to ask about the market share opportunity, which I find very interesting as we come out of the downturn. Considering your markets, will your strategy focus more on specific businesses that you find more attractive in your broader portfolio? Historically, where have you identified the biggest opportunities during downturns? What kind of market share does ITW typically capture, and how sustainable is that market share? Thank you.
Scott Santi, CEO
I think it's important to note that the past may not be as relevant to our current situation. Our company is quite different now compared to previous downturns. This decline is more rapid and challenging than anything we've faced before. As for the impacts on various companies and the potential for recovery, it's crucial to recognize the need for a swift response throughout the supply chain, not just in our own operations. Each industry will face unique challenges in terms of recovery pace. At this moment, I cannot determine if one part of our business is better positioned for opportunity than another. However, we will be ready across all our sectors to capitalize on any opportunities that arise. We've made considerable efforts to ensure that every aspect of our portfolio is positioned for growth. We are not looking for temporary gains; instead, we aim for market share growth in areas we are already concentrating on. Our strategy focuses on long-term market presence, avoiding quick sales or supporting competitors in areas that don't align with our long-term interests. A significant part of our current planning involves ensuring we have the capacity to handle new opportunities while providing our divisions with clear direction on where to focus their efforts.
Jamie Cook, Analyst
Okay. Thank you. I appreciate your insights.
Operator, Operator
Your next question comes from Josh Pokrzywinski from Morgan Stanley. Your line is open.
Josh Pokrzywinski, Analyst
Hi. Good morning, all, and just wanted to echo the earlier comment on kind of that refreshing approach on preserving the employee base and kind of being farsighted on this. It's certainly not very common, as what we've heard so far.
Scott Santi, CEO
Thank you.
Josh Pokrzywinski, Analyst
I would like to follow up on Jamie's question about what it means for attracting more market share as we move forward. It likely varies by business, but is it due to competitors impacting the Salesforce, product development, or something else? I would say it's not a capacity issue, so what does that imply for your strategy? I can see that it's not a capacity issue, so where do you believe ITW has the greatest advantage based on your current activities?
Scott Santi, CEO
I think it's challenging to summarize a variety of scenarios in a single description, but I believe that productive capacity plays a significant role. As these markets shift, if you've not maintained a buffer in your supply chain and capacity, it becomes crucial. For instance, consider a situation where we find ourselves in the second quarter and a particular industry faces a 30% decline. If it only declines by 15% in the third quarter, that's a notable sequential improvement at a pace that hasn't been tested before. Therefore, I wouldn't underestimate your ability to deliver and supply as a key factor in where these opportunities may arise.
Josh Pokrzywinski, Analyst
Got it. And then just specifically on Food Equipment. Obviously, a business that three or six months ago, and people would love to have had a contingency plan the way they are today. What percentage of the weakness would you just attribute to kind of customers being closed, i.e. when the lights come on, maybe there is a new normal, but that's not particularly robust, but kind of a step function improvement. I understand it's a fragmented market, so maybe hard to give visibility, but just any additional color you might be able to provide.
Chris O’Herlihy, Vice Chairman
Yes. So if we think about food equipment and specifically with the restaurant side of the business, 25% to 30% of our business, and the recovery there is going to not just depend on lifting of shelter and place restrictions, but also in terms of core shelter and place, what additional restrictions will be on the business in terms of occupancy and so on. Clearly, a very, very uncertain environment. It's very difficult to predict what that will look like. But for us, we are somewhat comfortable by the fact that the other parts of our business, as Michael mentioned, the institutional piece, particularly health care, and higher education is doing quite well. Retail is doing quite well, as you would expect. The typical deli counter business is thriving right now. We are being slightly limited in terms of being able to put in installations because they're so busy, but the long-term demand trends there are pretty healthy.
Scott Santi, CEO
And then service?
Chris O’Herlihy, Vice Chairman
And in service is the other business where we continue to, to Scott's point, keep our service organization fully employed here. I mean we've taken a huge investment over the years in ensuring that we had a highly developed, highly trained service force. The last thing we want to do is let those folks go, acknowledging that even though capacity is down right now, that will recover in the medium term.
Josh Pokrzywinski, Analyst
Got it. Thanks, Scott. Thanks, Chris.
Operator, Operator
Your next question comes from Jeff Sprague from Vertical Research. Your line is open.
Jeff Sprague, Analyst
Thank you. Good morning, everyone.
Scott Santi, CEO
Good morning.
Jeff Sprague, Analyst
Good morning. I have two questions. First, before we look ahead, I want to reflect on Q1. The margin improvement despite decreased revenues is quite impressive. I'm interested in putting some context around this. We see a significant impact from the margin enhancement initiatives across the portfolio. It could be that some of the PLS initiatives are really showing results. I recognize that each division is unique, but perhaps we could focus on the polymers or electronics sectors where the margin performance was unexpectedly strong.
Michael Larsen, CFO
Thanks for the kind words, Jeff. I believe Q1 clearly illustrates what Scott mentioned about our divisions not waiting for direction; they respond swiftly to changes in demand. Despite a 9% drop in revenues, our margins remained stable in five out of seven segments, largely driven by our enterprise initiatives, which have contributed 120 basis points over the past seven years. Price cost is no longer a concern for us. Additionally, we managed to counter significant headwinds and maintain flat margins through volume leverage. We anticipate the enterprise initiatives will persist throughout the year. Although we may see a lower overall contribution compared to Q1 and last year, it will still be a significant factor within our control as we navigate through the more challenging Q2 and transition into recovery in Q3 and Q4. If you're interested in specifics, the main contributor by segment continues to be the enterprise initiatives, contributing between 70 to 160 basis points per segment. We expect this to remain a considerable advantage as we move forward.
Jeff Sprague, Analyst
Yeah. So maybe just to look at forward then, I mean, fully understand when revenues go down 30% or 40%, it does some pretty disruptive things to the decremental margins, and there's not a corporate-wide initiative. But it looks like you're implying 45% decrementals here in Q2. Wouldn't each one of these organizations, divisions individually, even though they're not cutting heads, right, they may be doing some pretty dramatic things on T&E and other discretionary levers that they can pull. I know it maybe doesn't roll up cleanly to the parent that you can view with real clarity. But maybe just frame that, just kind of…
Scott Santi, CEO
I can explain it. The main difference between Q1 and Q2 is the extent of the revenue decline. We had a 9% decline in Q1, with 7% being organic. The business-level adjustments we made, as Michael mentioned, were very effective. In Q2, however, the revenue decline is much more significant. Those adjustments are still in place and ongoing. When we say we are managing the business carefully, we mean that everything is still operational. We are advising our businesses not to overreact to this unprecedented Q2, as we do not expect these conditions to continue beyond this quarter. As we've discussed on various levels, we are committed to structuring ourselves appropriately for the future and not letting short-term Q2 conditions dictate our actions. Could we make the decrementals better in Q2 if we chose to push for that? Certainly, but we believe that is not the right course of action for our company.
Jeff Sprague, Analyst
So the corporate role here in Q2 is actually to give the divisions license not to do anything damaging to their business?
Scott Santi, CEO
100%? 100%.
Jeff Sprague, Analyst
Thank you.
Operator, Operator
Your next question comes from Andy Casey from Wells Fargo Securities. Your line is open.
Andy Casey, Analyst
Hi, good morning, and nice to hear all your voices.
Scott Santi, CEO
Good morning, Andy.
Andy Casey, Analyst
Question on the supply chain. Are you hearing about any suppliers that may run into liquidity issues?
Chris O’Herlihy, Vice Chairman
Yes, regarding the supply chain, we haven't encountered any significant issues with our suppliers up to this point. It's an area we are monitoring closely. Our approach of selling directly from produce has benefited us, and being centralized provides us with multiple touch points that keep us informed and allow us to respond swiftly. We're actively managing this situation, as mentioned in the presentation, and currently, there are no problems to report, but we remain vigilant.
Scott Santi, CEO
And I think that, we've always been a source-local company. So from the standpoint of the diversity of our supply base that we are not dependent on one source relationships of finance globally, that we've got some level of risk mitigation and ability to shift and or go down.
Michael Larsen, CFO
Right.
Andy Casey, Analyst
You mentioned, Scott, your rapid inventory reduction. I assume that's primarily in the distribution channel. Outside of the automotive sector, how significant is the inventory reduction you're observing in the channel? Does this imply that we might see a considerable restock if the volume in the end market begins to gradually improve?
Scott Santi, CEO
I would say that we have almost no visibility in the near term regarding how inventories have been adjusted. It's a safe assumption that anyone in the distribution business is managing that aspect very carefully. Ultimately, there is a significant decline and potentially a significant correction that will influence how companies are positioned to handle it. However, I don't think we can determine whether inventories are too high or too low across most of our businesses at this point.
Andy Casey, Analyst
Okay. And then, if I could squeeze one more in. You kind of touched on it earlier. But, end-markets, specifically in Europe and North America, some other companies have talked about stabilization. I know it's granular, but in the last two weeks of April, outside of auto and food equipment, have you seen anything similar to that? Or is it just kind of still really, really weak?
Scott Santi, CEO
It's still facing challenges. The closest we can discuss regarding stabilization are the data points from China, where, as I mentioned, our sales were down approximately 36% in February and were flat in April. That’s probably the best insight I can provide. Looking at the regional figures for Q2, the total company will be down by 30 to 40%, with North America likely leaning toward the lower end of that range, around 25% to 35%. Europe is expected to perform worse, while China remained flat for the quarter, potentially showing slight improvement. I don’t want to create a selection scenario, but I would mention that in many cases, things aren't as dire as we might have anticipated. It’s not catastrophic; it’s a unique situation. There are certainly segments of our portfolio that are stabilizing, particularly some aspects of the business that are holding steady. They are all under pressure, but I want to emphasize that we are still serving our customers and remain operational. We will navigate through this.
Andy Casey, Analyst
Okay, thank you very much. And good luck.
Scott Santi, CEO
Thank you.
Operator, Operator
Your next question comes from Joel Tiss from BMO. Your line is open.
Joel Tiss, Analyst
Hey, how's it going, guys?
Scott Santi, CEO
Good morning.
Joel Tiss, Analyst
I wanted to ask if you're noticing any pressure points and if you could provide more detail on the opportunities for new enterprise initiatives or further automating your factories. How do you plan to evolve from what you're observing and turn some of the challenges from the pandemic into strengths?
Scott Santi, CEO
I don't think that changes much. We are highly automated in certain areas of the company because it is essential for the business, not just in terms of cost efficiency but also for the quality we need in our products. As we've mentioned before, we have not faced constraints regarding capital investments. Therefore, I don't see any reason to believe that the pandemic will cause a shift in our strategy within the framework of our 80/20 business model. This model certainly helps us navigate many of the challenges we face, but I can't pinpoint anything specific in response to your question.
Joel Tiss, Analyst
I understand. As there were changes, I mean, those will be conceived at the divisional level, depending on local circumstances that that made sense for them given the operating environment that they're in.
Scott Santi, CEO
Yes, I wanted to mention that all the projects and activities contributing to the enterprise initiative savings are still in place. So, nothing has really changed in that regard.
Joel Tiss, Analyst
There are some stresses at the product line level that may not have been apparent before, indicating that there are businesses that might not be a good fit anymore or require more restructuring than we previously thought. However, these unusual times shouldn't lead us to make different decisions.
Scott Santi, CEO
I think we need to give it some time to get a clearer picture to address your question. I'm not sure, but I believe that there will be some businesses experiencing fundamental shifts in overall demand due to the pandemic. It's likely that, among our 85 divisions, we'll see some changes. Additionally, as we've discussed extensively, there will be some growth opportunities that require us to make certain investments. We will address all those issues, but it's challenging to make definitive statements at this point in early May given the current circumstances. We need to gain more clarity.
Michael Larsen, CFO
Right.
Joel Tiss, Analyst
Okay, well, thank you very much.
Operator, Operator
Your next question comes from David Raso from Evercore ISI. Your line is open.
David Raso, Analyst
Hi. Good morning.
Scott Santi, CEO
Good morning.
David Raso, Analyst
I’m trying to think through the margin recovery potential for 2021. I'm trying to understand the 2020 cadence a little bit better. It sounds that you feel the second quarter will be the worst of it. And the decremental margins implied are 45. But if I look at your scenarios for the year, if I use the middle scenario, it implies the decrementals get worse in the second half. They're actually 49. And if you're saying the fourth quarter, we'll be back to 35, it's really implying a well over 50% decremental on the third. So I guess the question is why would it get worse on the decrementals because the comp isn't that different? And maybe the answer is, and Michael, you alluded to it, what's the placeholder for the restructuring? And is that mostly in 3Q? Thank you.
Michael Larsen, CFO
You just answered your own question. So that's exactly right.
David Raso, Analyst
I was trying to have it quantified.
Michael Larsen, CFO
I know it's a nice try.
David Raso, Analyst
So is the third quarter restructure, I mean...
Michael Larsen, CFO
It’s a nice attempt. As I mentioned before, we still don’t have all the answers. This company operates from the ground up, and the restructuring will depend on the decisions made by our VP, GMs, and division leadership teams once they have a better understanding of the demand landscape. At that time, we have ample capacity and funding for all the investments we wish to pursue, including any necessary restructuring as we move forward. This is really the most I can offer you at this moment.
David Raso, Analyst
All right, so no quantification, but it feels more 3Q heavy based by that math on the cadence of the decremental. Is that at least fair?
Michael Larsen, CFO
That’s fair. I think the math...
David Raso, Analyst
Thank you so much.
Scott Santi, CEO
Yeah, thank you.
Operator, Operator
Your next question comes from Ross Gilardi from Bank of America. Your line is open.
Ross Gilardi, Analyst
Thank you for taking my question. I'm pleased to connect with you all. I hope everyone is doing well. I would appreciate getting ITW's perspective on the trend of onshoring more production and supply chains to the U.S. What are your western customers experiencing in terms of international business, especially in China? Additionally, do you believe there is enough potential for onshoring in the industrial economy over the next year or two that could impact the pace of economic recovery in the U.S.? Any insights on this would be very interesting.
Scott Santi, CEO
I can only speak for ITW on this matter, but we have always been a company focused on production and have discussed this frequently. Regarding how these factors affect our production and sourcing locations, none of this alters that. I do believe there will be more movement among global manufacturers toward localizing production for various reasons. There will definitely be lessons learned about balancing low-cost sourcing with the need for resilience and redundancy. I think this will play out in the industry. From our perspective, I don't see this as presenting any more or fewer opportunities. We serve our customers globally, and it may slightly affect some of our supply points geographically, but I don’t anticipate any significant shifts for us in either direction.
Ross Gilardi, Analyst
Thanks, Scott.
Operator, Operator
Unfortunately, we are out of time for questions today. I'd like to turn the call back over to Karen Fletcher for closing remarks.
Karen Fletcher, Vice President of Investor Relations
Okay. Thanks, Julianne. I just want to thank everybody for joining us this morning. We're available for the rest of the day for additional follow-up. Stay well, everyone. Thank you.
Operator, Operator
Thank you for participating in today's conference call. All lines may disconnect at this time.