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Illinois Tool Works Sees Margin Expansion and Earnings Growth

By Lee Samaha - Jul 26, 2017 at 9:58AM

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The industrial company's run of good results continues, but its revenue growth rate could slow in the third quarter.

Multi-industrial company Illinois Tool Works (ITW -1.34%) delivered another good quarter of earnings and raised full-year guidance across the board. It was a positive quarter for the company, driven by its automotive segment and recovery in some of its more cyclical segments (specifically welding, test and measurement, and electronics). That said, management served notice of a relative slowdown in the third quarter. Let's take a look at a busy second quarter for the company.

Illinois Tool Works second-quarter earnings: The raw numbers

Starting with the headline numbers from the quarter compared to guidance:

  • Organic revenue growth of 2.6% came in below the midpoint of the guidance range of 2%-4%.
  • GAAP EPS increased 16% to $1.65 and came in above the guidance range of $1.55-$1.69.

While sales growth was slightly disappointing, earnings were strong and contributed to the broad-based increase in full-year guidance as follows:

  • Full-year organic revenue growth still expected in the range of 2%-4% -- already an improvement on the 1.5%-3.5% range given at the start of the year. 
  • Full-year operating margin now seen at 24% compared to previous guidance for 23.5% plus.
  • Full-year GAAP EPS forecast to be in the range of $6.32-$6.52 compared to previous guidance of $6.20-$6.40.

However, the third-quarter guidance suggests a slowdown in growth, with management predicting organic growth of 1%-3% -- a range lower than full-year guidance. Moreover, guidance for GAAP EPS of $1.55-$1.66 implies growth in the range of 4.7% to 11.3%.

What happened in Illinois Tool Works' quarter

The best way to see what's going on with regard to the company's end markets is to look at organic revenue growth by segment. As you can see below, the more cyclical businesses like welding, test and measurement, and electronics are recovering as a consequence of the general pickup in industrial activity in 2017. It's a continuation of the positive trends established in the first quarter.

organic growth rate by segment

Data source: Illinois Tool Works presentations. Chart by author.

However, there are a couple of key points with regard to segment performance:

  • As you can see above, automotive original equipment manufacturer (OEM) revenue growth is slowing.
  • Although overall operating margin increased 120 basis points (100 basis points equals 1%) to 24.3% in the quarter, steel price increases contributed to an operating margin decline in the automotive OEM (25.8% to 22.3%) and construction (24.3% to 24%) segments.

Developing these two points, CFO Michael Larsen outlined that industry forecasts were calling for a 6% decline in domestic auto builds in the third quarter with a 2% decline in the fourth quarter. Consequently, the expected decline in auto builds is likely to impact Illinois Tool Works' overall growth rate.

In fact, Larsen outlined that that's why organic revenue growth rate for the third quarter is forecast to be 1%-3%, but he also forecast a pickup in the overall organic revenue growth rate in the fourth quarter, in line with the relatively better industry forecast for auto builds.

car production line

Auto build rates are the key to Illinois Tool Works' third quarter. Image source: Getty Images.

Turning to the issue of rising costs, management expects its so-called price/costs line item to strip 20 basis points to 40 basis points off full-year operating margin compared to a previous estimate for 10 basis points to 30 basis points -- a sign of rising costs.

Looking ahead

It was a good quarter for Illinois Tool Works, and management's full-year guidance implies continued margin expansion and earnings growth. That said, the anticipated dip in organic revenue growth in the third quarter -- caused by an expected decline in domestic auto builds -- may cause some near-term concern. No matter: Illinois Tool Works remains on track for a good year.

Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends Illinois Tool Works. The Motley Fool has a disclosure policy.

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