Earnings Call Transcript - ITW Q2 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.

Karen Fletcher, Vice President of Investor Relations

Okay. Thank you, Julianne. Good morning, and welcome to ITW’s Second Quarter 2020 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 second quarter 2020 financial results and provide an update on our strategy for managing through the global pandemic. Slide 2 is a reminder that this presentation contains forward-looking statements. We refer you to the Company's 2019 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, 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, Chairman and CEO

Thank you, Karen, and good morning, everyone. Well, things are far from normal for any of us or our businesses at present. I’m extremely proud of how the ITW team is managing through the unprecedented and challenging circumstances brought about by the pandemic. I want to begin by sincerely thanking my ITW colleagues around the world for the effort, dedication, and selflessness that they continue to demonstrate daily in protecting the health and safety of their colleagues while continuing to serve our customers with excellence. As I have said many times, the power of the ITW business model and our decentralized entrepreneurial culture are never more valuable than during times of significant and rapid change. We are leveraging both to position the company to participate across a wide range of recovery scenarios while continuing to execute our long-term strategy to achieve and sustain ITW’s full potential performance. Over the last seven years, we have made significant progress in executing our strategy to take full advantage of our unique strengths to clearly establish ITW as one of the world's best-performing, highest-quality, and most respected industrial companies. In doing so, we are building a company that has both the enduring competitive advantages and the resiliency necessary to deliver consistent upper-tier performance in any economic environment. The resilience component of that equation is now being tested in ways that were hard for many of us to even imagine six to seven months ago. As evidenced by our second quarter results, this company and our team of over 45,000 dedicated professionals are rising to the challenge. In the second quarter, in the face of an unprecedented 29% decline in revenues, ITW delivered $449 million in operating income, $681 million in free cash flow, and operating margins of 17.5%. We leveraged our flexible cost structure to reduce operating expenses by more than $140 million without any centralized cost takeout mandate from corporate, while providing full compensation and benefit support to every ITW team member, sustaining investments in key long-term growth strategies, and positioning for full participation in the recovery. As we outlined during our first quarter earnings call, we have an integrated four-prong strategy for managing the company through the pandemic: protect and support our people, continue to serve our customers with excellence, maintain our financial strength and strategic optionality, and win the recovery. These four priorities comprise the central near-term planning and execution focus for the whole of ITW, and for every one of our operating divisions. We'll come back to them at the end of our presentation. But first, let me turn the call over to Michael, who will provide you with additional detail on our Q2 performance. Michael, over to you.

Michael Larsen, Senior Vice President and CFO

Okay. Thank you, Scott, and good morning everyone. Let’s turn to Slide 5. As Scott mentioned, priority number 3 for managing through the pandemic is to maintain ITW’s considerable financial strength, liquidity, and strategic optionality. In the second quarter, we did just that. Going forward, we will continue to live on that priority. As we leverage our strong financial foundation and resilient profitability profile to position ITW for maximum participation in the recovery. On our last earnings call, we shared our expectation for an unprecedented level of demand contraction due to the complete shutdown of wide swaths of the global economy. Indeed, organic revenues declined by an unprecedented 27%. As expected, automotive OEM and food equipment were the hardest hit segments. Other segments fared much better, providing another proof point for the benefit of ITW’s diversified high-quality business portfolio. At the enterprise level, total revenues declined 29% as organic revenues declined 27% while foreign currency and last year's divestitures further reduced revenues by about a point each. Nevertheless, our businesses still generated $449 million of operating income and delivered resilient operating margin performance of 17.5% with operating expenses down more than $140 million and enterprise initiatives contributing 100 basis points. Free cash flow was strong at $681 million, an increase of 12% year-over-year and representing 213% of net income. Q2 cash flow performance benefited from the delayed timing of U.S. income tax payments of $158 million, which were paid in the third quarter. Our divisions stepped up their credit monitoring and collection efforts early in the quarter, and as a result, our receivable performance has continued to remain in line with historical norms. Our balance sheet and our liquidity remained strong throughout the containment phase as we ended the quarter with $1.8 billion of cash on hand, essentially no short-term debt, no commercial paper, a $2.5 billion undrawn revolving credit facility, Tier 1 credit ratings, and total liquidity of more than $4.3 billion. ITW had more than enough financial strength and resilience to withstand the shock to the system that the global economy experienced in Q2. With that, please turn to Slide 6 for a retrospective look at second quarter revenue, starting with organic revenue by geography. As you can see, the demand contraction was global as North America declined 26%, Europe was down 37%, and Asia Pacific was down 7%. On a positive note, China was up 1% after being down 24% in Q1, as the early phase of their recovery began to take hold. On the right side of the slide, we're sharing average revenue per working day by month. As we move through the quarter and we compare it to last year, you can see that April was the bottom and then we experienced a sequential acceleration in May, and in June as the global economy began to reopen. This trend has continued in July.

Scott Santi, Chairman and CEO

Hi. Let’s start with your question on Europe specifically, which represented 25% of our sales in the quarter and saw its most significant decline year-over-year at 37%. By far, the most significant decline was in the automotive business, down 59%, followed by food equipment down 48%, and then construction down 28%. Regarding the dynamics for the second half of the year, we anticipate North America and Europe will both be down in the 10% to 15% range year-over-year. Asia Pacific and China, as noted, are expected to perform better than that, remaining flat or slightly positive. The trends we saw, sequentially in the second quarter were certainly encouraging; April was the bottom, with acceleration in May and June, and those positive trends have continued into July. However, it remains a complex and uncertain environment.

Andrew Kaplowitz, Analyst

Good morning, everyone. Hope everyone is well. Scott and Mike, maybe you can help us color on business conditions by region a little more. And China turning positive is encouraging, as you said. But for many companies in Q2, we saw some improvement, maybe a little faster in Europe. In the U.S., you guys were down a little bit more in Europe. So maybe you can talk about what held you down in Europe. And then you mentioned you were down about 20% in terms of average daily sales in June, and then you continued to see improvement in July. In terms of the reason for the decline, did you continue at the same rate of recovery as you saw by month in Q2 in July?

Michael Larsen, Senior Vice President and CFO

Well, I think, as you know we're not an auto company; we're really benefiting in Q2 from our high-quality, highly diversified portfolio. So we don't have to get the forecast 100% right in automotive because we know we're going to have offsets. We do expect a challenging second half in automotive certainly better than Q3.

Scott Santi, Chairman and CEO

I would add that we were very intentional about our response to the shutdowns. We made a conscious choice not to impair our ability to support our customers for when production resumes. While we could have mitigated some losses, our decision was to prioritize our customers' needs.

Jamie Cook, Analyst

Hi. Can you hear me? Okay? Okay, I guess just my first question. Can you just talk about any of the impact on auto food, as that was also the business that was hit harder? Can you just talk about the margin trajectories as we think about the second half of the year in that business?

Scott Santi, Chairman and CEO

Yes, we are looking at food equipment being down potentially about 25% in the second half. Even with that unprecedented decline, we expect that business to continue to be profitable. We expect margins to continue to improve from where they were in Q2 and to return to double-digit territory in Q3 and Q4.

Michael Larsen, Senior Vice President and CFO

In terms of market share, I want to emphasize that there are real opportunities for us. Our ability to continue to supply and deliver has led to significant new business generation. We saw over $100 million generated in the second quarter alone due to our consistent delivery capabilities.

Scott Santi, Chairman and CEO

In closing, on behalf of Michael and our entire executive leadership team, we offer our deepest thanks to our ITW colleagues around the world for their exceptional efforts and dedication, especially during this period of unprecedented circumstances and challenges. I have no doubt that the strength and resilience of ITW’s business model, along with our diversified high-quality business portfolio and our people, positions us extremely well to seize the opportunities and respond to the challenges that lie ahead.

Karen Fletcher, Vice President of Investor Relations

Okay, thank you, Scott. Julianne, let's open up the lines for questions.

Operator, Operator

Thank you. We'll pause for just a moment to compile the Q&A roster. Our first question comes from Andrew Kaplowitz from Citi. Your line is open.

Andrew Kaplowitz, Analyst

Good morning, everyone. Hope everyone is well.

Scott Santi, Chairman and CEO

Good morning.

Michael Larsen, Senior Vice President and CFO

Same to you, Andy. Thanks.

Andrew Kaplowitz, Analyst

Scott and Mike, maybe you can help us color on business conditions by region a little more. And China turning positive is encouraging, as you said. But for many companies in Q2, we saw some improvement maybe a little faster in Europe, in the U.S. you guys were down a little bit more in Europe. So maybe you can talk about what held you down in Europe. And then you mentioned you were down about 20% in terms of average daily sales in June, and then you continue to see improvement in July. In terms of the reason to decline did you continue at the same rate of recovery as you saw by month in Q2 in July?

Scott Santi, Chairman and CEO

Hi, so let’s start with your question on Europe, which represented 25% of our sales in the quarter and saw as you pointed out the most significant decline at 37%. By far, the most significant decline was in the automotive business down 59%, followed by food equipment down 48% and then construction down 28%. We’re anticipating that in the second half, North America and Europe will see declines in the 10% to 15% range, while Asia Pacific and China should be better than that, possibly even flat or slightly positive.

Michael Larsen, Senior Vice President and CFO

So, July has shown improvement sequentially from June. While it’s still uncertain, we remain focused on the long-term and believe we have the agility to respond quickly to changes in demand.

Scott Santi, Chairman and CEO

Overall, we have a strong diversified portfolio that helps us offset losses in one segment with gains in another. Our team is working diligently to ensure we can support all of our customers through this challenging time, and we’re optimistic about the recovery.

Jamie Cook, Analyst

Hi. Can you hear me? Okay?

Scott Santi, Chairman and CEO

Yes. Good morning, Jamie.

Jamie Cook, Analyst

Okay, I guess just my first question. Can you just talk about any of the question on auto food was also the business that was hit harder? So can you just talk about the margin trajectories as we think about the second half of the year in that business. And then I guess my follow-up question just is sort of on the market share opportunity. Can you talk about sort of early conversations with customers, if you think you'll be able to gain market share? And is that embedded, as you think about sort of the sales outlook for the back half of the year? Thanks.

Scott Santi, Chairman and CEO

Yes, so specific on food, we’ll probably be the hardest hit segment here in the second half of the year. We're looking at potentially being down somewhere around 25%. But even with that sort of unprecedented decline, we expect that business to continue to be profitable and for margins to continue improving and being back into double-digit territory in Q3 and Q4.

Michael Larsen, Senior Vice President and CFO

I think in terms of market share rather than talking about specific customers, I think I'd go back to the themes that Scott talked about the fact that we have a high degree of confidence that they are real market share opportunities and their discussions with customers that are taking place every day and every single one of our divisions as a result of that. We generated new business worth over $100 million in the second quarter, thanks to our ability to supply and deliver.

Scott Santi, Chairman and CEO

Yes, I think and I think the only thing I would add, Jamie, is that we aren't focusing so much on quick wins. We are looking for sustainable opportunities that align with our long-term strategy.

Scott Davis, Analyst

Hi, good morning, guys.

Scott Santi, Chairman and CEO

Good morning.

Michael Larsen, Senior Vice President and CFO

Good morning.

Scott Davis, Analyst

A couple of questions here, but Tests & Measurement margins were strong whether they're mixed any support on that mix, or is it restructuring that the guys are doing on a localized basis so it’s really quite remarkable to have mid-20s margins in a revenue environment like this?

Scott Santi, Chairman and CEO

Yes, I believe it's primarily about the ongoing execution of our enterprise initiatives that are making a significant impact. We achieved strong margins partly due to effective management of our operating expenses, which allowed us to implement considerable savings throughout the company.

Michael Larsen, Senior Vice President and CFO

We are essentially 100% open, and all of our divisions are serving customer needs at this point.

John Inch, Analyst

Thanks. Good morning, everyone. Michael, did July show an upward trend in average daily sales, even if it's not definitive? And are we both considering the possibility of channel restocking, considering the changes in the market and your expectations for the second half of the year?

Michael Larsen, Senior Vice President and CFO

So, the first part, July is up sequentially from June to answer your question. I think in terms of the channel, we really don't need to restock inventory, because we operate on a very short cycle— if they place the order with us, we're shipping it tomorrow.

Scott Santi, Chairman and CEO

Everything other than the structural costs that we have already planned to take out this year, those are structural savings. However, everything else is essentially temporary. These costs will come back as demand recovers.

Andy Casey, Analyst

Thanks a lot. Good morning, everybody. Within construction, you talked about U.S. non-residential down in Q2; Is it is it getting worse or is there really no change visible?

Michael Larsen, Senior Vice President and CFO

We don't expect a significant level of improvement on the commercial construction side here in the second half based on what we're seeing so far. The strong demand is really on the residential side through the home center channel, which is where we saw significant growth in Q2 and we do expect that to hold up fairly well in the near term.

Scott Santi, Chairman and CEO

We will remain intensely focused on keeping our workforce strong, maintaining our supply chains, and ensuring our customers' needs are met during this recovery.

Karen Fletcher, Vice President of Investor Relations

Okay, thank you, Scott. Julianne, let's open up the lines for questions.

Operator, Operator

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