Illinois Tool Works Inc. (ITW) Earnings Call Transcript & Summary

Good morning. My name is Kona Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to ITW's third quarter earnings conference call. [Operator Instructions] Erin Linnihan, Vice President of Investor Relations, you begin your conference.

[Audio Gap] President and CFO, Michael Larsen. During today's call, we will discuss ITW's third quarter 2026 financial results and provide guidance for full year 2026. Slide 2 is a reminder that this presentation contains forward-looking statements. Please refer to the company's 2025 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 President and CEO, Chris O'Herlihy. Chris?

Thank you, Erin, and good morning, everyone. As you saw in our press release this morning, the ITW team delivered another quarter of strong operational and financial performance. Our third quarter highlights include organic growth of 4% and or 5% excluding the impact of the tornado event at 1 of our welding locations. Our top line was fueled by another meaningful increase in customer-backed innovation, and we are raising our full year CBA projection to 3% plus. Operating margin expanded 40 basis points to 27.8% and operating income increased 6%, marking a new quarterly record for ITW. GAAP EPS exceeded our estimates and increased 7% to $3. Demand momentum this quarter continued to accelerate in our 2 CapEx-related segments at the organic growth of 16% in Test & Measurement and Electronics and 7% in welding or 15% excluding the tornado event. In addition, Polymers & Fluids grew 8% due to robust contributions from both market share gains and new products. Beyond capitalizing on favorable market conditions, we continue to make meaningful progress on our long-term organic growth agenda across all segments. On that note, I'm very encouraged by our customer-back innovation progress which so far this year has contributed more than 3% to revenue growth compared to 2.4% in 2025. As I mentioned, we are now projecting that CBI will exceed 3% for the full year which is the single biggest catalyst for achieving our enterprise goal of sustained high-quality organic growth of 4% or higher. Our performance year-to-date offers another proof point that disciplined execution on our next phase enterprise strategy priorities is yielding strong results, positioning us very well for 2027 and putting us firmly on track to achieve our 2030 performance goals. Before I transition to the bottom line, let me spend just a minute on the unfortunate tornado event that we mentioned on our call in July which damaged 2 of our welding facilities and reduced our revenues by about $40 million or 1 percentage point in the third quarter. I am pleased to say that our colleagues were all safe and the team did an outstanding job quickly and safely restoring operations and taking care of customers. Our swift recovery starts a great demonstration of our ability to read and react a key proof point of the value of ITW's decentralized entrepreneurial culture. With welding order growth running well ahead of revenue, we expect welding to return to strong growth again in the fourth quarter and carried good momentum into next year. On the bottom line, the ITW team continued to execute at a high level with Enterprise Initiatives contributing 130 basis points to our operating margin. And in a very dynamic inflationary environment, our teams continue to respond decisively and effectively. Overall, price/cost was favorable in the third quarter. But as you can see, in a few segments such as automotive OEM and construction products, we have some catching up to do. Turning to capital allocation. In the quarter, we raised our dividend 7% marking our 63rd consecutive year of dividend increases. In the first 3 quarters of the year, we have returned $2.7 billion to shareholders through share repurchases and dividends. In terms of our outlook, we are raising our full year GAAP EPS guidance by $0.05 to a new midpoint of $11.50, reflecting 10% year-over-year growth. This marks our third guidance increase of the year. Looking ahead to 2027 and with [indiscernible] have developed our annual plans, yes, demand momentum continues to build across several of our end markets, notably in Welding and Test & Measurement and Electronics. In addition, we are exiting this year with CBI already at 3% plus. We would expect another meaningful contribution from our enterprise initiatives and incremental margins in the 40%-plus range. Our long-term performance framework, 4% plus organic growth and 30% operating margins by 2030 is very much intact and remains well within our reach. In conclusion, I want to thank our dedicated HW colleagues around the world. And this quarter, in particular, the welding folks in Appleton, Wisconsin for their dedication to serving our customers and executing our strategy with excellence. With that, I'll hand the call over to Michael to walk you through the segment details and updated full year outlook. Michael?

Thank you, Chris, and good morning, everyone. Starting with the top line. Total revenue grew 4.4%, driven by 3.8% organic growth, a 0.3% contribution from foreign currency translation and 0.3% from an acquisition. Excluding the tornado event in Welding, our organic growth rate would have been approximately 4.8%. Importantly, order growth continued to accelerate in both welding and Test & Measurement and Electronics and demand remained strong in polymers and fluids. Moving to the bottom line. Operating margin expanded by 40 basis points year-over-year to 27.8% with another solid 130 basis points contribution from enterprise initiatives. Sequentially, margins improved 110 basis points from Q2. In the quarter, price increases and other actions offset higher raw material costs in dollar and margin terms. Those favorable drivers were partially offset by inflation in other areas such as employee-related costs. Free cash flow was $851 million or 100% of net income. And on a year-to-date basis, free cash flow grew 9% to more than $2 billion or 82% of net income. Finally, GAAP EPS was $3, an increase of 7% despite a headwind of about $0.10 from a higher tax rate of 24.4% compared to 21.8% last year. Overall, a strong quarter operationally and financially and with significant positive momentum going forward. Turning to Slide 4. From a regional perspective, organic growth was up 6% in our largest region, North America. Asia Pacific was up 3%, with China down 2%, primarily due to a tough comparison of plus 10% and Europe was flat. Moving to the segment highlights, starting with Automotive OEM. Organic revenue was down 2% against a tough comparison last year of plus 5%. In Q3, North America was down 1%, Europe down 7% and China was down 1%. In the quarter, we meaningfully outperformed build rates in both North America and China, while Europe was impacted by unfavorable customer mix and product line simplification. For the full year, we expect to outperform builds and remain well positioned to continue to execute on our long-term growth opportunities such as EV growth in China. Operating margin was down 170 basis points, primarily due to resin inflation, and the resulting price cost timing lag, which was partially offset by favorable enterprise initiatives. As usual, we expect to recover the price cost impact over time helped by new product launches, and we remain on track to achieve our longer-term margin targets for the segment. Turning to Slide 5. Food Equipment organic revenue grew 1% overall as service strength of plus 5%, helped offset a 2% decline in equipment, which marked a notable sequential improvement from the mid-single-digit equipment declines in the first half. Regionally, North America was down 3% due to soft but sequentially improving institutional demand in areas such as K-12, which are impacted by a decline in funding levels, partially offset by high single-digit growth in areas such as retail. On a positive note, international again delivered strong growth, up 5% in the quarter. Operating margin improved 60 basis points to 29.8%. Looking ahead, with North America orders up mid-single digits this quarter, we are now projecting year-over-year organic growth in the low single digits and operating margin expansion in Q4. Test & Measurement and Electronics had another outstanding quarter with 16% organic growth, led by a 31% surge in electronics, which represents approximately 40% of the segment. Test & Measurement was up 8%, driven primarily by semiconductor demand, with general industrial order activity also beginning to pick up. The 2 main drivers of the strong growth that we're seeing in this segment are first our electronic assembly businesses, which serve the printed circuit board industry and second, our semiconductor-related businesses, which serve the chip manufacturing industry. Staying invested in our strategic growth initiatives in those businesses through the cycle has positioned us to take full advantage of the significant growth opportunities that remain ahead as orders continue to outpace revenue growth by a wide margin. Operating margin expanded by 330 basis points to 28.7%, primarily as a result of strong operating leverage. Moving on to Slide 6. Welding was obviously impacted by the tornado event in the quarter, but still managed to deliver a remarkably resilient top and bottom line results including 7% organic growth, which would have been 15%, excluding the tornado event. Equipment revenue grew 5% as orders continue to surge across most end markets and consumables grew double digit driven by both market tailwinds and strong new product adoption. North America, which represents 85% of the Welding segment was up 8% with broad-based growth across both industrial and commercial markets as demand momentum continued to strengthen in end markets such as infrastructure, energy, aerospace, defense and semiconductors. On the bottom line, the loss of operating income associated with the tornado event was offset by business interruption insurance, which favorably impacted margins. Looking ahead, we expect welding margins to return to the typical best-in-class levels. In Polymers & Fluids, organic growth reached 8% and driven by strength across most end markets with strong traction on CBI and continued market share gains. Organic growth was 6% in automotive aftermarket while organic growth of 12% in polymers and 9% of fluids was supported by robust momentum in general industrial and biopharma markets. Operating margin expanded 280 basis points to 31.3%. Turning to Slide 7. In our most interest rate sensitive segment, Construction Products organic growth was down 1% compared to end markets, which we estimate were down in the mid-single digits. North America was flat, Europe was down 2% and Australia and New Zealand was up 1%. While residential innovation in North America was down 2% commercial construction, which represents about 15% of the region, was up 19% due to strong demand in areas such as data center construction. Operating margin was down 170 basis points to 29.9% due primarily to near-term price cost headwinds. Specialty Products organic growth was down 1%, which includes the impact of 130 basis points of product line simplification, primarily in the appliance components business. North America grew 3% on solid demand for consumer packaging, offset by an 8% decline in international markets, which had a tough comparison of 7%. Operating margin was down 90 basis points to 31.4%. With that, let's turn to Slide 8 for an update on our full year guidance. Overall, we are carrying significant positive momentum forward and are well positioned to continue to deliver strong operational and financial performance in the fourth quarter and beyond. Starting with the top line and per our usual process, our guidance is based on current levels of demand, adjusted for typical seasonality and prevailing foreign exchange rates. As a result, our organic growth projection remains 3% to 4% for the full year despite the Q3 tornado event, which implies organic growth of 5% plus in Q4. Sequentially, revenues grew 1% to 2% from Q3 despite 2 fewer shipping days in Q4. We're raising total revenue growth guidance by 50 basis points to 4.5% to 5.5% to account for current foreign exchange rates. On the bottom line, our operating margin guidance remains unchanged at 26.5% to 27.5% and we expect Q4 margins in the mid- to high 27s, similar to Q3, which would mark a significant improvement year-over-year. Enterprise initiatives remain the primary margin driver and are expected to contribute more than 100 basis points. For the full year, we're estimating that price cost will be favorable on a margin -- on an income basis and about neutral to margins in what remains a very dynamic environment. Factoring in our strong third quarter results, we are raising our GAAP EPS gains by $0.05 to a narrowed range of $11.45 to $11.55 with a new midpoint of $11.50, representing 10% year-over-year growth. The projected effective tax rate remains unchanged at 23% to 24%, free cash flow conversion is projected to be approximately 100% of net income, with full year share repurchases of approximately $1.5 billion. Considering some of the unique challenges we had to deal with this quarter. We're pleased with our performance and especially the strong momentum across the company. Combined with our best-in-class margins and our disciplined operational execution, we remain well positioned to deliver differentiated financial performance in 2026 and beyond. With that, I'll turn the call back over to Erin.

Thank you, Michael. Conor, will you please open the queue for questions.

[Operator Instructions] Your first question comes from the line of Jamie Cook with Truth Securities.

I guess 2 questions. First, just on the price cost in the quarter. I think originally, you had said it would have been a headwind. You expected a headwind of 30 bps, and it sounds like it was better than that? Just if you could quantify that? And then I guess my second question, it sounds like there's opportunities within automotive and construction for margins to improve. Just it sounds like there's like a pricing lag there. Can you talk to what pricing actions that you're taking and when we should see that start to hit the bottom line?

Yes. Let's start with price/cost. And if we look back to Q3 our pricing actions largely came through as planned. And like everyone else, we continue to see a lot of inflation in raw material costs, such as resin, chemicals, steel, electronic components kind of in that 4% to 5% range. Price cost was modestly favorable in the third quarter. And given the dynamic environment, we don't really want to provide a whole lot more detail than that. What we can say is that for the full year, we also expect the margin impact to be about neutral for the full year. Just given the very kind of dynamic conditions here, we're going to refrain from providing more detail on Q3 and Q4 and quantifying specifically the basis points. Now looking ahead to 2027, what we've talked about in the past is still the case that we expect conditions to normalize here in 2027, which typically is a 10 to 20 basis points tailwind to margins from price cost. So that's kind of the base assumption for 2027. So a little bit of near-term headwind, and we expect to get through that over the next -- by year-end and next year then would be a more kind of normal environment? And then maybe on the automotive OEM margins, Chris, if you wanted to comment?

Yes. So I would say in both auto and construction, we are busily recovering price right now. But I think in both cases, we think about margins in -- across all 7 agents particularly with auto for a second, the primary drivers of auto margins are enterprise initiatives and higher-margin innovation. And we are making great progress on those, both in auto and construction. We see those standing into next year.

Okay. Sorry. And one follow-up. Obviously, Chris, congratulations. It seems like we're getting some good traction on SBI. It's trending ahead of your expectations besides auto, what are the big -- where are you seeing the biggest benefits? And should we assume that momentum improves -- continues to improve into 2027?

Yes, you should assume it continues to improve. What I would say is that just to refresh in terms of how we think about this, what's captured in our CBI numbers, incremental revenue growth over a 3-year period net of cannibalization. So on that basis, you need to keep refilling the pipeline with new projects. So it can be a little lumpy from quarter-to-quarter, but what's evident is that the work that we've done over the past 2, 3 years, have really resulted in this step change from what was 1% 5 years ago to 2% 2 years ago to a 3% contribution level right now. And we would expect, given the improvements in innovation practice across the company, as you surmised, this number to incrementally improve from here on a year-over-year basis going forward. And as we've said, the most actionable and sustainable way that we drive organic growth over the long term is CBI. So we're pretty encouraged what this means for organic growth.

The next question is from Andy Kaplowitz of Citigroup.

Michael, I know you generally have short cycle businesses, but you obviously went '26 with relatively strong organic revenue growth. And I would imagine you have some backlog in your CapEx focused businesses now. So how does that position you when you about 27%. Chris, I think you sounded pretty confident regarding being you're beating that 4% or better algorithm that you have. But maybe you can elaborate on any puts and takes. I know you talked about CBI to JV, but anything else? And maybe you can elaborate on if you do have backlog in these CapEx businesses?

So we do have a little bit more backlog than usual, but we're talking about months years of backlog. So just as a reminder, we're still very much a short-cycle business. Part of that is because of our 80/20 operating system, which allows us to take orders today, ship them tomorrow and then replenish the inventory the next day. So there's no incentive for customers to place orders significantly ahead of when they need them. So as we kind of -- that said, obviously, with what we've seen on side of the business, particularly in Welding and Test & Measurement electronics. We are carrying a little bit more backlog than usual. We actually saw to complete the picture, it's a little bit of a backlog increase also in the Food Equipment business here going into the fourth quarter. And so all of that bodes really well for this 5% plus organic growth number that's implied in our guidance for 2026. And maybe more importantly, as we go into 2027, not so much the backlog, but just the underlying momentum that we're seeing in these businesses, the feedback we're getting from customers, the new products that are coming through at significantly higher margins. Now, as Chris said, at 3% plus CDI contribution. And 3% plus in the segments, we just talked about Welding and Test & Measurement is you could surmise that it's significantly higher than 3 in those segments. So those really have a lot of momentum going into 2027.

Yes. I would just add to that, Andy, that as Michael indicated, strong order intake, higher than revenue growth for both Test & Measurement and Welding in the quarter. What's also encouraging is that welding and test and measurement that the growth is pretty broad-based. So think about welding very strong growth, not just on the industrial side in areas like energy, aerospace, construction fabrication and so on, but also on the commercial side on small fab. Similarly with Test & Measurement, obviously, semi has been strong for a little while now. But we're now starting to see a real make pick up on industrial side of the business as well in areas like Instron. So even though we don't forecast cycles, they would certainly say that the current order activity and the feedback to Michael's point, that we're getting from our customers gives us some good confidence going into 2027.

And then I think 8% organic growth in Polymers & Fluids is the strongest growth you've had in last few years in that segment. So I know you mentioned market share gains, strength in general industrial and biopharma, but maybe you could give us a little more color on the sustainability of that growth for that segment .

Sure. So polymers & fluids has been building for a little while now. And certainly some gains, but also, I think, some real nice progress on CBA above-average contribution CBA in that segment, but broad-based across all 3 platforms of automotive aftermarket, polymers and fluids I would say, polymers, in particular, be well positioned in very high-growth markets, pretty sophisticated adhesive bonding applications. I think electronics, electric vehicles and then similarly on the fluids business, so we're having some real success on the biopharma space. So I think what this all says, Andy, is that it really highlights the fact that this segment is really well positioned to be a 4% plus grower for the enterprise on a sustained basis going forward.

And I would just add, Andy, as you think about this from a modeling standpoint, the comparison does get quite a bit tougher here in the fourth quarter. So Q4 last year. As Chris said, this has been going on for a while, was up -- the segment was up 5% organic. And so the Q4 growth rate might not be starting with an 8, is kind of what I'm trying to tell you here.