Earnings Call Transcript - ITW Q4 2022

Operator, Operator

Good morning. My name is Cheryl, and I will be your conference operator today. I would like to welcome everyone to the ITW Fourth Quarter Earnings Conference Call. Karen Fletcher, Vice President of Investor Relations, you may begin your conference.

Karen Fletcher, Vice President of Investor Relations

Thank you, Cheryl. Good morning, and welcome to ITW's Fourth Quarter 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 will discuss ITW's fourth quarter and full year 2022 financial results and provide guidance for full year 2023. Slide 2 is a reminder that this presentation contains forward-looking statements. We refer you to the company's 2021 Form 10-K and subsequent reports filed with the SEC 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 directly 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, Chairman and CEO

Thanks, Karen, and good morning, everyone. As you saw from our release this morning, in Q4, we delivered a strong finish to a year of high-quality execution in the face of some pretty unique challenges in the operating environment. Starting with the top line, organic growth was 12% as all segments delivered positive organic growth, and five of our seven segments grew double digits, led by Auto OEM, up 20%, Food Equipment, up 17%, Welding, up 15%, Polymers & Fluids, up 11%, and Test & Measurement and Electronics, up 10%. Construction Products was up 4%, and Specialty Products was up 3%. Operating margin expanded 210 basis points to 24.8%, with a 110 basis point contribution from enterprise initiatives and a favorable price/cost margin impact of 70 basis points, which was favorable for the first time in nine quarters. Incremental margin was 52%, and operating income grew 18%. GAAP earnings per share increased 53% to a record $2.95, including $0.61 of gains from divestitures and $0.12 of negative currency. Excluding divestiture gains and negative currency, EPS growth was 27%. For all of 2022, the company delivered organic growth of 12% for the second year in a row, with a best-in-class operating margin of 24.4% in our base business, after-tax return on invested capital of 29.1%, and record GAAP EPS of $9.77, an increase of 15% versus the prior year. There's no question that our decision to stay invested in our enterprise strategy and in our people throughout the pandemic and the quality of our team's execution of our 'win the recovery' focus coming out of it are powering the strong growth and financial performance ITW is currently delivering. As a result, we are very pleased with our momentum and positioning heading into 2023. Turning to our 2023 guidance, demand remained solid across the majority of our portfolio, and we are seeing meaningful improvements in supply chain performance and moderating input cost inflation. At the same time, there's no question that the economic outlook remains certainly dynamic. As a result, our organic growth projection for 2023 is 3% to 5%, and our EPS guidance of $9.60 at the midpoint reflects current levels of demand and a risk adjustment for further slowing in certain end markets. Michael will provide more detail on that in just a minute. Before I turn it over to Michael, I want to again thank my ITW colleagues around the world for their extraordinary dedication and commitment to serving our customers and executing our strategy with excellence. Michael, over to you.

Michael Larsen, Senior Vice President and CFO

Thank you, Scott, and good morning, everyone. The demand growth that we've experienced all year continued into the fourth quarter as revenue grew 8% with organic growth of 12%. On an equal day's basis, organic growth was 14% as the fourth quarter this year had one less shipping day compared to the prior year. We finished the year with strong growth momentum as evidenced by our sequential organic revenue growth of plus 4% from Q3 into Q4 on a sales per day basis as compared to our historical sequential of plus 2%. By geography, every major region grew double digits, with North America up 13%, Europe up 11%, and China up 10%. Foreign currency translation headwind reduced revenue by 5%, and the net impact from acquisitions and divestitures was plus 1%. GAAP EPS grew 53% to $2.95 and included a $0.61 gain from two divestitures. Excluding those gains, EPS increased 21% to $2.34, which included $0.12 of EPS headwind from foreign currency translation. So, on an apples-to-apples basis, eliminating both divestiture gains and currency headwind, EPS increased 27%. On the bottom line, operating income grew 18%, with strong incremental margin performance of 52%, and operating margin improved 210 basis points to 24.8%. Operating margin in our base businesses, excluding MTS, was 25.2%. In the fourth quarter, we achieved a favorable price/cost margin impact of 70 basis points. As you saw in the press release, we completed two divestitures in the fourth quarter, resulting in a combined pretax gain on sale of $197 million recorded in nonoperating income and an EPS impact of $0.61. By utilizing capital loss carryforwards to offset taxes on the divestiture gains, the overall tax rate for the company was 19.1%. So overall, for Q4, we had excellent operational execution across the board, strong financial performance, and what remains a pretty uncertain and volatile environment. Okay, please turn to Slide 4, starting with our progress on organic growth. We've been aggressively executing a very focused growth strategy to build consistent above-market organic growth into a core ITW strength on par with our operational 80/20 front-to-back capabilities. As you can see from the data on the left side of the slide, ITW's 12% organic growth rate for each of the last two years compares favorably to our proxy peers at about 9% both years, suggesting that we are making solid progress. Moving on to segment results, starting with Automotive OEM, which led the way with organic growth of 20%. North America was up 15%, and Europe grew 23%. China was up 17% with particularly strong growth in electric vehicles. Going forward, we expect Automotive OEM to grow 5% to 7% in 2023 based on a risk-adjusted auto build assumption in the low single digits plus our typical penetration gains of 2% to 3%. Turning to Slide 5, Food Equipment delivered another very strong quarter with organic growth of 17%. North America grew 25% with double-digit growth in all major categories and end markets. Institutional was up more than 40%, restaurants were up 30%, and retail grew 20%. International revenue grew 7%, with Europe up 9%, and Asia Pacific was flat with some near-term softness in China. The Food Equipment team also delivered excellent progress on margins, with Q4 operating margin of 27.6%, an increase of almost 500 basis points year-over-year. Obviously, strong momentum in this segment, and we expect Food Equipment to grow 8% to 10% in 2023. Test & Measurement and Electronics revenue grew 15%, with organic growth of 10%. During the quarter, we are beginning to see a slowdown in demand after three years of very strong growth. Embedded in our 2023 organic growth projection of 2% to 4% for this segment is anticipated further slowing in semi-related end markets. Overall demand in Construction slowed to an organic growth rate of plus 4%. North America was still up 9%, with residential up 11%. As you know, Construction is our most interest rate-sensitive segment, and we are projecting further slowing in 2023 and a negative organic growth rate of minus 5% to minus 3%. Specialty organic growth was 3%. We expect Specialty organic revenue for 2023 to be negative 1% to positive 1%. We expect Polymers & Fluids to grow 3% to 5% in 2023. Overall, we're heading into 2023 with strong momentum, and we're well positioned to continue to outperform in whatever economic conditions emerge. So, just to recap for the full year, ITW grew organic revenue by 12% with double-digit growth in five of seven segments after significant price/cost margin pressures. Our GAAP EPS of $9.77 was a record for ITW with EPS growth of 15% on top of 28% EPS growth in 2021. We also invested more than $700 million to accelerate organic growth, raised our dividend by 7%, marking the 59th year of consecutive increases, and returned $3.3 billion to shareholders. Moving to Slide 9 for our full year 2023 guidance, we see positives in supply chain easing but also some uncertainty in the economic outlook. Our organic growth rate projection for 2023 is 3% to 5%. This includes anticipated further slowing in end markets related to construction, commercial welding, auto aftermarket, appliances, and semiconductors. Operating margin is expected to improve by 100 basis points or more to a range of 24.5% to 25.5%. We are expecting strong free cash flow and a conversion greater than net income. Our capital allocation plans remain consistent with our long-standing disciplined framework. Our top priority continues to be internal investments to support organic growth. The second is an attractive dividend that grows with earnings over time. Third, selective high-quality acquisitions that enhance growth potential. Finally, surplus capital will be allocated to an active share repurchase program, where we expect to buy back approximately $1.5 billion of our own shares in 2023.

Karen Fletcher, Vice President of Investor Relations

Thank you, Michael. Cheryl, please open up the lines for questions.

Operator, Operator

Your first question is from Jamie Cook of Credit Suisse. Your line is open.

Jamie Cook, Analyst

Hi, good morning. Congratulations on a strong quarter. My first question is about the 25% of your portfolio where you're starting to see weakness. Can you provide more details on what you're observing in semiconductors? Regarding the other 75% of your portfolio, are the trends in line with your expectations, or are they more positive or negative compared to last quarter? Additionally, my follow-up question is about the price versus cost for the quarter, which I believe was 70 basis points positive. That seems slightly better than you anticipated. Was that mainly due to price increases or a decrease in raw materials? Lastly, what are your expectations for maintaining price levels in 2023? Thank you.

Michael Larsen, Senior Vice President and CFO

Okay, that was a lot to cover, Jamie. I'll do my best. I think the situation in the semiconductor sector shows that we are coming off a strong growth period with growth in the high teens or better over the past three years. However, we are starting to see a slowdown in order intake, particularly in the fourth quarter. While this hasn't yet reflected in our financial results in a significant way, we anticipate this trend will continue into 2023. On a positive note, the other 75% of our portfolio is performing well, evidenced by the 12% organic growth reported in the fourth quarter. Regarding pricing and costs, we were pleased to report slightly positive margins related to price/cost in Q4. This improvement was driven by both price adjustments and cost reductions, marking the first positive shift since the third quarter of 2020. This is certainly a positive sign as we head into 2023.

Scott Davis, Analyst

Hey, good morning. Congrats on another strong year in '22.

Scott Santi, Chairman and CEO

Thank you.

Michael Larsen, Senior Vice President and CFO

Thank you.

Scott Davis, Analyst

A little bit of a nit, but on the 3% to 5% 2023 top line growth forecast. Is there any real price in that? Or are you more in the neutral-ish to maybe slightly positive versus a bigger number?

Michael Larsen, Senior Vice President and CFO

Well, I think we are certainly lapping some bigger price numbers. We don't break out price and volume separately for all the reasons we've talked about in the past. But there's both price and volume in the numbers that we've laid out for 2023. And the 3% to 5% organic growth is a risk-adjusted number. If you do a pure run rate, you end up at a higher number. We just thought, given everything we talked about, it was reasonable to take a more cautious approach given the environment.

Scott Davis, Analyst

Yes, no, it totally makes sense. What about the inflation assumptions in general when you guys think about the '23 outlook as far as breaking out materials versus labor? Is it fair to assume that labor inflation remains reasonably high, but material inflation is more moderated?

Michael Larsen, Senior Vice President and CFO

Yes. I think that's reasonable. Certainly, materials and components are remaining at a fairly elevated level, and we are experiencing the same labor cost inflation as others, but we're still expanding margins by 100 basis points or better here in 2023. So hopefully, that answers your question.

Tami Zakaria, Analyst

Good morning. Congrats on the great results. So I have a couple of quick ones. The first one is how should we think about your EBIT margin progression throughout the year? Is the 24.5% to 25.5% range going to be fairly consistent in all the quarters?

Michael Larsen, Senior Vice President and CFO

So Tami, like I said, we're back to our typical cadence here. I think we said first half, 49% of our EPS for the full year; the second half, 51%. Q1 is typically our lowest quarter in terms of revenue, and we're expecting somewhere in the mid-single-digit type growth. Margins will probably start out a little bit lower, but still 100 basis points of margin improvement on a year-over-year basis. We're also expecting Q1 contribution to EPS overall to be around 23% of the full year, which reflects a nice balance as we move through the quarters.

Andy Kaplowitz, Analyst

Good morning, everyone. Michael, when we think about margin expectations for '23 across your segments, does the lag in price versus cost flip the most in Auto OEMs, so you could see a nice jump in margin in that segment?

Michael Larsen, Senior Vice President and CFO

I think, Andy, we expect all of our segments to improve margins year-over-year in 2023. However, the segments with higher growth rates will likely see more volume leverage and therefore a more significant improvement in operating margin. But every segment is expected to improve, albeit some will take longer to recover price/cost margin impacts, such as Automotive. It might take two to three years to get back to automotive margins in the low to mid-20s.

Andy Kaplowitz, Analyst

Very helpful, Michael. And then can you give us an update on the longevity of enterprise initiatives? ITW continues to I think we might begin to get a little spoiled here that it could last indefinitely. So how are you thinking about enterprise strategy in '23?

Michael Larsen, Senior Vice President and CFO

Well, we are in the tenth year now. We are approaching $1.5 billion in structural cost savings from enterprise initiatives. When we rolled up the plans here in November and checked back in, we were really encouraged by what we saw in ongoing projects. That’s likely going to continue as we apply these methodologies to a more differentiated portfolio. The enterprise strategy isn't going away soon.

Scott Santi, Chairman and CEO

So, to provide a perspective, I think one of the real strengths of our operating methodology and business model is that there's always room to get better. The model serves as the core tool for our divisions to identify and prioritize opportunities to improve. I don't see that stopping for quite a while.

Unidentified Analyst, Analyst

You have Sabrina Abrams on for Andrew Obin. So, first on the margin guide, does the 70 bps to 170 bps of year-over-year expansion include the 100 bps of enterprise initiatives? Is this a conservative approach?

Michael Larsen, Senior Vice President and CFO

Yes, it does include that. I think it would be helpful to talk about the elements that contribute to margin improvement year-over-year. If we just ended 2022 at operating margins of about 24%, you should expect volume leverage of about 50 to 100 basis points of positive contribution to margins year-over-year, plus the enterprise initiatives, plus some progress on price/cost, with the offset being wage and inflation impacts. Overall, I would say our forecast of 100 basis points of margin improvement on a year-over-year basis is a solid number.

Unidentified Company Speaker, Analyst

Got it. That's helpful. China was strong in Auto OEM in Q4. What's incorporated in your guide for China reopening next year?

Michael Larsen, Senior Vice President and CFO

Most of our regions are kind of in that mid-single digits for the year. China is projected to be a little bit higher than that, primarily driven by the Automotive business, which we are focused on expanding market share and penetration gains.

Jeff Sprague, Analyst

Thank you. Good morning, everyone. Solid results. Just back to enterprise, I've often thought of it as reflecting a trade-off between margin and growth. It does seem that the organic growth is greater than it had historically. Can you comment on that?

Scott Santi, Chairman and CEO

First of all, thank you for noticing. Our efforts have shifted over the last decade. We focused on operational improvements, and now, with stronger operations, we're able to focus more on growth opportunities. We have a lot of energy devoted to growth because of operational positioning, which is reflected in our recent performance.

Stephen Volkmann, Analyst

Good morning, guys. Most of my questions have been answered. A couple of quick follow-ups. Is there a portion of your portfolio where you would expect to give back price once lower energy and transportation costs work their way through?

Michael Larsen, Senior Vice President and CFO

We have a very small portion of our overall portfolio where the pricing is indexed to raw materials, around 5% of our total revenue. For everything else, we expect to maintain our premium given our differentiated nature and quality of our products. Well, regarding our M&A pipeline, organic growth is our priority. We continue looking for high-quality acquisitions that enhance long-term growth potential and improve margins. MTS was an example of an acquisition that checked all the boxes.

Scott Santi, Chairman and CEO

We're focusing on acquiring good businesses to help them become great businesses. In uncertain economic environments, these good businesses are generally not looking to sell, so potential M&A opportunities might be less than usual this year.

Dan Donner, Analyst

Excellent. Thank you. The Food Equipment business has been a standout for you. Can you comment on the cohesive presentation of the business and your investments in the category?

Michael Larsen, Senior Vice President and CFO

We haven't really changed our strategy over the last five years. We've continued to invest in differentiated products. The team has been putting up great numbers as a result of executing on their strategy. They are gaining market share and reporting strong numbers, including on the margin side.

Joe O'Dea, Analyst

Good morning. Thanks for taking my question. I wanted to start with the 300 basis points of outgrowth versus the proxy group over the last couple of years. Can you talk to attribution of that?

Scott Santi, Chairman and CEO

There's no way to break this apart precisely. What I can say is that we are consistently outperforming our peers. The data shows we are growing our segments at higher rates than their respective peers, and that’s what matters most.

Julian Mitchell, Analyst

Good morning and thanks for squeezing me in. Maybe I just wanted to circle back to the organic sales growth guide. Can you help us understand the step down at the 4% growth guide versus the most recent quarter?

Michael Larsen, Senior Vice President and CFO

It's all in the comparisons year-over-year. Q1 starts out lower and then we kind of improve from there. Nothing baked in for acceleration or deceleration. We've accounted for current levels of demand risk-adjusted for the areas where we're seeing weakening demand.

Julian Mitchell, Analyst

That makes sense, thank you. And within Construction products, how are you thinking about the three big pieces: residential new build, residential replacement, and commercial?

Michael Larsen, Senior Vice President and CFO

The big driver is the housing market, specifically new housing, which is about 80% of our business in North America. We have seen some slowing here but it’s important to note that the commercial side has been performing well, even amidst challenges in the market.

Operator, Operator

Thank you for participating in today's conference call. All lines may disconnect at this time.