Another quarter brings another set of earnings from Illinois Tool Works (NYSE:ITW) in which the underlying improvements due to its five-year enterprise strategy plan are hidden by deteriorating end markets. In short, management reduced earnings guidance to account for a weaker economy, but its ongoing initiatives continue to make progress -- possibly setting the company up for strong growth given a pickup in the industrial economy. Let's take a closer look at the earnings.
Illinois Tool Works: Third-quarter results
Reported revenue declined 9.2%, but since the company is restructuring, it's more useful to focus on the 1.7% decline in organic revenue. However, EPS increased 9% aided by an 180-basis-point year-over-year increase -- where 100 basis points, or bp, equals a 1% move -- in operating margin to 22.7%. Indeed, on the earnings release management highlighted that, excluding currency effects, EPS was up 18%.
It's an impressive performance given the revenue declines, and management attributed 110 bp of the operating margin increase to its enterprise initiatives -- evidence that the company is helping itself in a difficult environment.
What happened with Illinois Tool Works this quarter
Delving into the details, the revenue decline is symptomatic of the weakness the company is seeing in some of its more cyclical end markets like welding and electronics. As you can see in the chart below, the organic revenue declines in test and measurement as well as electronics, polymers, and fluid, and welding are being accompanied by margin declines in these product lines.
In a sense, the company's third quarter mirrors the tone set by Alcoa's (NYSE:AA) outlook in its third-quarter earnings presentation. Alcoa left its full-year outlook for the construction and automotive markets largely unchanged for North America and Europe. Indeed, Illinois Tool Works reported 7% growth in North America construction sales and 5% growth in North America automotive original equipment sales -- EMEA automotive original equipment sales were up 12%.
However, just as China and emerging markets were the biggest losers in Alcoa's outlook, so Illinois Tool Works reported an 8% decline in China sales and a 7% decline in Brazil. Moreover, as you can see in the chart above, the highly cyclical and industrial-facing areas like welding and electronics are seeing deterioration globally. The consumer-facing areas, such as automotive and food, did relatively better.
What management had to say
Management's focus is on continued execution of its enterprise strategy and it sought to highlight the company's performance in dealing with tough markets. On the earnings release, CEO Scott Santi highlighted "new all-time records for operating margin and after-tax return on invested capital. ... In addition, free cash flow conversion was very strong at 126 percent."
On a more negative note, guidance for full-year organic revenue growth was taken down for the third quarter in a row. Management started the year expecting 2.5% to 3% full-year organic growth, only to cut guidance to 1% to 2% in the first-quarter presentation, then to "approximately 1%" in the second quarter, and finally to "down 1% to flat" in the current quarter.
In addition, the midpoint of full-year EPS guidance was reduced by $0.05, leaving the updated EPS range at $5.05 to $5.15, and management forecasts that free cash flow conversion from net income will exceed 100% for the full year, implying more than $5.10 in free cash flow.
All told, it was a good earnings report under the circumstances of a weakening industrial environment. The company continues to expand margin overall, but the more cyclical industrial-product lines are coming under pressure. Going forward, it's hard not to see more pressure unless the global economy improves.
However, the company's margin and free cash flow improvements are putting it in a good position to recover strongly given any sustained recovery in some of its end markets. Management is executing well.
Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends Illinois Tool Works. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.