Illinois Tool Works (NYSE:ITW) unveiled a mixed set of second-quarter results that initially disappointed the market, and the stock is marked down a few percentage points as of this writing. However, there are a lot of things going on underneath the surface of the headline numbers. Let's take a closer look as I highlight the key points in the quarter.
Illinois Tool Works faces changes
Before diving into the results, here are a few bullet points on the headwinds and business changes affecting the results:
- The stronger U.S. dollar is trimming reported revenue and earnings.
- The company is in the middle of a five-year enterprise-strategy plan intended to narrow its business focus, simplify its business structure, and reduce costs through better strategic sourcing.
- Management continues to refer to a "soft capital spending environment," something that impacts the company, as a lot of its products are used in production activity.
With this context in place, here are the headline numbers:
- Revenue of $3.43 billion compared to analyst estimates of $3.45 billion, representing a revenue decline of 7.7% compared to the same quarter last year.
- Non-GAAP EPS of $1.30 compared to analyst estimates of $1.28, representing a 7% increase compared to a year ago.
As outlined above, currency effects are negatively impacting earnings. In fact, excluding the impact of currency, diluted EPS from continuing operations would have been 17% higher in the quarter. Moreover, EPS would have been up 18% in the first half had it not been for the negative impact from the stronger U.S. dollar.
Enterprise strategy plan
Meanwhile, the reported revenue decline is not really a big deal because the company is deliberately refocusing the business, and cutting back on its less-productive operations. Indeed, analysts have revenue declining 5.5% in 2015 only to bounce back with 3.4% growth in 2016. The things that really matter to the company's long-term plans are organic growth (coming from continuing operations), and margin expansion (evidence of productivity improvements).
Organic revenue growth came in at a disappointing 0.2% growth in the quarter compared to last year. Moreover, only three of its seven segments reported organic revenue growth in the quarter. It's a similar story with margin expansion, whereby total company operating margin expanded by 0.8% -- incidentally, this means operating income margin went from 20.5% in the same quarter last year to 21.3% in this year's second-quarter.
Weak capital spending environment
A breakout of segmental results reveals where the organic growth came from. As you can see in the chart, the company relied heavily on the automotive, food equipment, and construction products segments for its margin expansion. The interesting and slightly worrying point is that the segments most reliant on industrial capital spending -- test and measurement and electronics and welding -- were the weakest in the quarter.
A breakout of how operating income was generated in the quarter reveals the importance of the solidly performing automotive and food equipment segments.
While performance was uneven in the quarter, it's worth noting that management actually upgraded guidance for the full year. The updated EPS guidance range is now $5.07 to $5.23, up by $0.05 at the midpoint from previous guidance. The upgrade comes from better expectations for margin performance in 2015, with management stating on the earnings release: "Operating margin is projected to exceed 21 percent, an increase of more than 100 basis points year over year, largely driven by Enterprise Initiatives. The company expects this strong margin performance to offset modestly lower revenue expectations through the balance of the year."
It appears that the company is somewhat relying on a couple of its stronger segments, and an overall improvement in capital spending conditions. Time will tell.