Good morning. My name is David, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the ITW second quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there'll be a question-and-answer session.
If you'd like to ask a question during this time, simply press the star key followed by the number one on your telephone keypad. If you'd like to withdraw your question, press star one once again. For those participating in the Q&A, you'll have the opportunity to ask one question and, if needed, one follow-up question. Thank you. Karen Fletcher, Vice President of Investor Relations, you may begin your conference.
Thank you, David. Good morning, and welcome to ITW second quarter 2022 conference call. I'm joined by our Chairman and CEO, E. Scott Santi, and Senior Vice President and CFO, Michael M. Larsen. During today's call, we will discuss ITW second quarter financial results and update our guidance for full year 2022.
Slide two, is a reminder that this presentation contains forward-looking statements. We refer you to the company's 2021 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 three, and it's now my pleasure to turn the call over to our Chairman and CEO, E. Scott Santi.
Thank you, Karen, and good morning, everyone. The ITW team delivered another quarter of strong operational execution and financial performance with organic growth of 10.4%, operating margin of 23.1%, after-tax return on invested capital of 27.8% and GAAP EPS of $2.37. In the second quarter, we saw continued strong demand across our portfolio.
Supported by our 80/20 front-to-back driven operational capabilities, our teams continued to do an exceptional job of delivering for our customers and aggressively executing our Win the Recovery strategy to accelerate profitable market penetration and organic growth. As a result of our advantaged operational execution and delivery performance, we are being rewarded with meaningful additional share by our customers, as evidenced by our 10.5% organic growth in the first half of this year.
While input cost inflation and supply chain issues remain challenging, we did see some stabilization on both fronts in Q2. In fact, for the first time in two years, price cost margin dilution headwind improved sequentially from -250 basis points in Q1 to -160 basis points in Q2 as our businesses continued to do an excellent job of adjusting price to offset input cost inflation and the pace and magnitude of input cost increases moderated somewhat. Importantly, our teams delivered these strong operational and financial results while continuing to drive meaningful progress on the execution of our long-term enterprise strategy, and they delivered another 90 basis points of margin improvement from enterprise initiatives in the quarter.
Based on our first half results and projecting current demand and supply rates through the balance of the year, we are maintaining our guidance for full year 2022 with organic growth of 8.5% at the midpoint, margins in the range of 24%-25% and GAAP EPS of $9.20 at the midpoint, which would be an all-time record for the company.
Excluding one-time tax items in both years, this represents EPS growth of 12%. While the near-term environment remains challenging and the global macro is certainly uncertain, ITW remains strongly positioned to continue to deliver differentiated performance for our shareholders, differentiated service to our customers, and continued progress on our path to ITW's full potential performance through the back half of the year and beyond. With that, I'll turn the call over to Michael, who will provide more detail on the quarter and our full-year outlook. Michael.
Thank you, Scott, and good morning, everyone. In Q2, quarterly revenue grew 9% and exceeded $4 billion for the first time since 2012, with strong organic growth of 10.4%. The MTS acquisition contributed 3% to revenue. Foreign currency translation was a 4% headwind. Despite $0.10 of year-over-year EPS headwind from foreign currency translation and $0.05 of higher restructuring expense, GAAP EPS was $2.37, the second highest quarterly EPS ever.
By geography, North America grew 14% and international grew 6%, with 6% growth in Europe and 3% growth in Asia Pacific. China organic revenue was down 4%, and we estimate that the China lockdowns reduced our organic growth rate by about 1 percentage point at the enterprise level, which we fully expect to recover in the second half.
Operating margin was 23.1%, with operating leverage of 200 basis points and 90 basis points of enterprise initiatives. Margin headwinds included 50 basis points each from the MTS acquisition and higher restructuring expense related to 80/20 front-to-back projects. The margin dilution impact from price cost was 160 basis points.
Free cash flow was $420 million, an increase of 69% versus Q1. We remain committed to intentional working capital investments to support growth, mitigate supply chain risk, and sustain service levels for our key customers. The routine resolution of a U.S. tax audit resulted in a one-time tax benefit of $0.16. As you may recall, Q2 last year had a $0.35 one-time tax benefit.
As a result, our Q2 tax rate this year was 18.3% as compared to 10.1% last year. Excluding these one-time tax benefits, the effective tax rate was 23.9% this year and 23% last year. Please turn to slide four, with a look at price costs and the beginning of the improvement trend on margin dilution that Scott mentioned.
Thanks to our business's decisive price actions throughout this inflationary cycle, we have stayed ahead of inflation on a dollar- for- dollar basis. The seemingly endless barrage of cost increases over the last 12 months appear to have leveled off, such that we are beginning to recover the margin dilution impact. Based on all known costs and price increases, this positive trend is projected to continue such that the margin impact is expected to be neutral in the second half.
Throughout this two-year inflationary cycle, while we have more than covered cost increases on a dollar- for- dollar basis, we have absorbed as much as 250 basis points of margin dilution impact. As raw material cost inflation begins to moderate on a year-over-year basis, we are confident that we're gonna recover this margin impact, hopefully starting in 2023.
Moving on to the segments, Automotive OEM delivered solid organic growth of 6%, with 18% growth in North America. Europe was down about 1%, and China was down 11%. At this point, and consistent with our prior guidance, we do not expect a meaningful improvement in the chip shortage situation impacting auto production until 2023. In effect, our guidance assumes that automotive production remains around current levels for the second half.
While we are getting positive signals from several of our customers in terms of preparing for a Q3 and Q4 ramp up in auto production, we are taking a more conservative approach to our guidance per our usual process. Even with revenue around current levels, keep in mind that the year-over-year comps ease in the second half, which sets the Automotive OEM segment up as a meaningful contributor to the overall organic growth rate of the enterprise through the balance of the year.
Operating margin was 17% when excluding 270 basis points of 80/20 front-to-back restructuring impact this quarter. As supply chain issues get resolved down the road and auto production ramps up, we're confident that we'll see some strong organic growth rates for an extended period of time and a return to the segment's historic margin rates in the low to mid-20s.
Let's turn to slide five, for food equipment, which led the way this quarter with an organic growth rate of 25%. Record quarterly revenues of $614 million, and operating margin of 24.7%. North America grew 27% with double-digit growth in every major category and end market. Both restaurants and institutions were up around 40%, and retail growth was in the mid-teens.
International revenue grew 23%, with Europe up 25% and Asia Pacific up 11%. Orders remain very strong in this segment. Test & Measurement and Electronics revenue grew 15% with organic growth of 1%, which as you know, is uncharacteristically low for this segment and entirely due to the timing of a large equipment order from an electronics customer in Q2 last year.
Adjusted for that order, segment organic growth would have been about 7%, which is a more accurate representation of how strong the order intake is. Test & Measurement organic growth was 8%, with continued strong demand for CapEx, as evidenced by Instron instrument growth of 5%, as well as continued strength in semiconductor-related end markets.
Moving to slide six. On another positive note, welding's organic growth was also strong at +22%, with equipment up 24% and consumables up 19%. Industrial grew 29%, and the commercial business was up 19%. North America, which is about 80% of our sales, grew 25%. Oil and gas was up 8%. Sequentially from Q1, revenue was up 8% with continued strong order intake. Operating margin improved 80 basis points to 29.3%.
Polymers & Fluids grew 10% organically, with polymers up 25% on continued strength in MRO and heavy industry applications. Automotive aftermarket was up 4%, and fluids grew 3%. On a geographic basis, North America grew 8% and international was up 13%. While sequential revenue grew from Q1, we did see some slowing demand in our automotive aftermarket business as consumers are dealing with rising inflation and gas prices.
On to slide seven. Construction delivered strong organic growth of 15%, with continued strength in North America, which was up 29%. U.S. residential grew 34%, and commercial was up 20%. While Europe and Australia and New Zealand were up 5% and 4% respectively, the international businesses started to show some signs of slowing in their order rates towards the end of the quarter.
Specialty was the only segment that didn't grow, with organic revenue down 2% as supply chain constraints caused a delay in the delivery of some larger international equipment orders that are now on track for the second half. On a geographic basis, North America was up 5%, while international was down 13%.
Okay, let's turn to slide eight for an update on our full year 2022 guidance, which remains unchanged. Per our usual process, our guidance is based on our actual results year to date and a projection of current levels of demand through the balance of the year. As a result, our organic growth projection of 7%-10% remains unchanged. The acquisition of MTS is projected to add 3% to revenue.
Based on current foreign exchange rates, the headwind from foreign currency translation is now 4% versus a prior expectation of 1.5%. We are maintaining our full-year GAAP EPS guidance range of $9-$9.40. Compared to our prior guidance on May 3rd, the one-time favorable tax benefit of $0.16 in Q2 is offset by $0.20 of additional EPS headwind from foreign exchange, which is now embedded in the outlook.
Our operating margin guidance is unchanged at 24%-25% with about 100 basis points contribution from enterprise initiatives. Price-cost margin dilution impact is unchanged at 100 basis points, which implies that the second half margin dilution impact is about neutral as compared to 200 basis points of headwind in the first half.
Finally, there's no change to free cash flow generation or share repurchases of $1.5 billion. Our tax rate for the full year is expected to be in the range of 22%-23%. We've often talked about the fact that ITW is a company that can deliver top-tier results in any environment, and this year is no exception.
We're obviously not immune to the macro challenges and uncertainties that may lie ahead, but we remain confident that ITW is very well-positioned to continue to deliver differentiated best-in-class performance as we leverage our diversified high-quality business portfolio, the competitive strength of ITW's proprietary business model, and our team's proven ability to execute at a very high level in any environment. With that, Karen, I'll turn it back to you.
Okay. Thanks, Michael. David, let's open up the lines for questions, please.
Thank you. At this time, I'd like to remind everyone in order to ask a question, press star, then the number one on your telephone keypad. As a reminder for those participating in the Q&A, you'll have the opportunity to ask one question, and if needed, one follow-up question. We'll pause for just a moment to compile the Q&A roster. We'll take our first question from Andrew Kaplowitz with Citi. Your line is now open.
Hey, good morning, everyone.
Andrew.
Scott or Mike, could you give us a little more color on underlying demand trends you're seeing in your more consumer versus capital goods businesses? I know you mentioned just tough comparison in electronics, some slowing in auto aftermarket, but, you know, obviously we all have increased focus on macro slowdown. Are you seeing signs of moderating demand, or is consumer demand still holding up?
Go ahead.
Oh, go ahead.
Go ahead.
I was gonna say, I think Michael told you exactly where we're seeing it, which is a couple of pockets. One is the auto aftermarket business for reasons that are pretty logical related to gas prices and, you know, consumers' discretionary spending in that arena. The other is our international construction businesses that we did see a little bit of a pullback. Those two businesses combined represent, I think, less than 15% of the company's overall revenues. For the other 85%, we see things remaining very strong.
It's helpful, Scott. Then Michael, I think you had talked about 200 basis points of price cost impacting in Q2, and I think it read out at 160. Maybe you can give us a little more color on how you're thinking. I know you said neutral for the second half of the year, but obviously commodity prices have come down pretty significantly lately. How long does it take for that to read through? Then is there maybe some upside to that second half neutral forecast?
Well, I think I explained to Andrew kinda how we do this. I mean, based on all the known price and cost increases as we sit here today, we expect.
Decreases. I don't know.
Decreases in certain cases. All of those things are cost decreases. All of those things are baked into our assumption today. When you project that in a pretty mechanical calculation, so there's no assumption here that things get better or worse, it's based on what we know today, that margin dilution impact is essentially neutral here in the second half of the year. That's how you get that 200 basis points swing in the second half of the year relative to the first half of the year.
I tried. Appreciate it, Michael.
Next we'll go to Tami Zakaria with JP Morgan. Your line's open.
Hi. Good morning. Thanks for taking my questions. Just a quick follow-up on what you said earlier. I think you mentioned some weakness in international construction end markets. Is that focused on both resi and non-resi for you?
Yeah. The biggest positions we have in both of those markets is by far residential. I think they mostly speak to what's going on in those markets, in the residential side in both Europe and Australia.
Yeah. I would just add to that, I mean, we're also seeing a lot of strength in other parts of the company. While less than 15% may be experiencing a little bit of a slowdown, you know, some of the other segments, Food Equipment, Welding, Test & Measurement and Electronics, are off to a really strong start here in Q3.
If you just look at our July numbers, overall for the company, on a year-over-year basis, we're up 18%. That is the highest monthly organic growth rate that we've seen all year. Sequentially from June, we are up in July, where typically we are down, and actually five of seven segments are growing double digits. There's a lot of strength in other parts of the company that, at least for the month of July, are offsetting some of the slowing we've seen in the parts of the company that we've talked about.
Got it. That is super helpful color. Along the same lines, has your expectations for overall organic growth in Europe changed since the beginning of the year? The reason I ask, it seems like some people are thinking Europe would be in a recession in the back half. Does that alter your expectation for the region in the near term?
I think we are pretty close to where we were on our last call, which I think we said we expect kind of low single digit type growth rates in Europe, based again on current run rates. As you know, we're not you know assuming any change in the macro other than kind of what we're seeing today.
You know, we are in Europe, I should say, we are hearing some positive signals, like I said in the script, from our automotive customers in terms of potential ramp up in production here in September and in Q4. Likewise, that's not baked into our guidance as we sit here today. I hope you get the sense there's a lot of puts and takes across the company, and overall we're on track to a really strong second half for the company.
Absolutely. Great. Thank you so much.
Sure.
Okay. Next we'll go to Jeff Sprague with Vertical Research. Your line is now open.
Hey, thanks. Good morning. Before my question.
Good morning, Jeff.
Can we just clarify, Michael, interesting color on July. Thanks for that. When you say in July, the 85% that's not under pressure is up 18%, or the total company is up 18%?
The total company. Yeah. On an equalized basis.
What?
The total company is up 18% here in July.
Well, that's interesting and surprising. Good to hear. I'm just curious on Welding. You know, I would have guessed perhaps that you know, seeing that stronger number in Welding, that maybe oil and gas would have been stronger than up 8%. It sounds like it must have been pretty broad-based strength across most of the markets that you can kind of see into. But maybe you could give a little bit of color there, what's going on in welding, both from a vertical market standpoint and any color on what's going on maybe in the channels.
Yeah, I mean, as you know, 80% of our business is North America, and that's where the strength was, up 25%. Really, you know, you heard equipment up 24%, consumables up 19%, strength in industrial and commercial. Then the international side was up 8%, and that's where our primary oil and gas exposure resides. Europe was up 20%, and then the China business was down, which was the lockdowns again, so down about 6%.
We, like I said earlier, are fully expecting to recover that here in the back half of the year. But a lot of strength in the North America business for sure. I would be remiss if I didn't point out the margin performance of north of 29% operating margin. A really strong quarter for the welding business. Q3 is looking really good so far.
Just maybe a little additional color. The real strength there in Q2 was the industrial side. I think, Jeff, part of your question was related to the channel, and that's not a product, a category of products that typically is inventoried in a significant degree at the channel. These are, you know, larger, more complex products, machines and systems and that are typically sold into end users for specific projects. There's not a lot of channel inventory at any point on those products.
Great. I appreciate the color. Thanks, guys.
Sure.
Next we'll go to Scott Davis with Melius Research. Your line is now open.
Good morning, everybody.
Morning, Scott.
Just to be clear, guys, I know you don't disclose price explicitly, but is price still going up, net realized price still going up?
We are still. There is a lag here, as you know, from the time we see the cost increases to the price is being realized. That is somewhere between one to two quarters, and we are still in catch up mode here in the second half of the year. Obviously on a margin basis, we talked about that, and also on a dollar basis.
Okay. That's what I thought. Just wanted to clarify.
Yeah.
I know, you know, obviously the FX has a translation impact, but it can have a trade impact. Can you remind us what businesses you are doing much exporting?
We do almost.
Yeah, sorry. Sorry to cut you off, Scott, and let you finish your question. I was just gonna say, we are producing locally to sell locally. We do very little cross-border commerce, either on the input side or the export side. You know, there's a little bit here and there, but less than 5% of our revenue overall.
Yeah. It's something like 2% of our imports are, you know, from China. I mean, it's really de minimis. We produce where we sell company. Our suppliers are local. Our customers are local.
Our exposure is largely translation. We are sourcing in the same currency that we are producing and selling in the vast majority of cases.
Right.
All right. Helpful. I'll pass it on. Good luck. Thank you.
Thank you.
Okay. Next we'll go to Joseph O'Dea with Wells Fargo. Your line's open.
Hi. Good morning. Thanks for taking my questions. I wanted to start on the consumer and sort of the less than 15%, that you were talking about. I think you've talked previously where maybe over half of revenue kind of broadly tied to consumer. Can you help kind of segment that a little bit in terms of where you might have consumer exposure that would be a little bit more tied to something like overall consumer confidence, and where you would have exposures that are a little bit more maybe durable in terms of demand trends and not as tied to what we would think about as sort of pressures related to a broad consumer slowdown?
Yeah, I think, Joseph, we really highlighted the two big ones, which is construction, residential, and then the automotive aftermarket business.
The other one maybe that I would add is in our specialty business, we do a fair amount of consumer packaging. Beverages and resealable closures for things like cheese and other food products that I think have generally proven to be pretty resilient during times of economic contraction. Consumer staples, basically.
Got it. On supply chain, I mean, the PMI yesterday for July, I mean, still showing very extended lead times. I think you talked about stabilization, but I'm assuming that means exactly that, not that things are getting better. Can you talk about, you know, sort of any visibility that you have into timing of supply chain starting to improve a little bit from a point of stabilization?
You know, what I would say overall is we have no visibility to any improvement. We are not planning on it. I'm sure that it will get better at some point. I think our business has been very resilient in terms of working their way through, you know, various issues and challenges and, computer chips that.
Yeah.
You know, you name it. We are finding a way to serve our customers, and that's, you know, that remains, I think, the posture that we have. Until it changes, we're not changing what we're doing. You know, I think we're on it, but it's still not easy.
I appreciate it. Thanks.
Next we'll go to Stephen Volkmann with Jefferies. Your line's open.
Hi. Good morning, guys. I was wondering maybe if we could just go back to the price cost margin dilution chart. I'm assuming there's some sort of a linear relationship here, and that 3Q is probably still a small headwind and the exit rate at 4Q is probably a tailwind. Is that a reasonable expectation?
I think, as we sit here today, I think that's a reasonable expectation, yes.
Michael, I'm trying to think a little bit further into 2023 and just rather than think about volumes, that they'll be whatever they are, but you're gonna have a few things kind of moving here in terms of sort of price cost and then dilution from MTS and some of the restructuring that you've done. Any way to start to think about what incremental margins in 2023 might look like, sort of when all is said and done?
Yeah. I think you're right, Stephen. There is a lot going on. What I can tell you is that as we kind of peel back the onion on our incrementals, so adjusting for all the things you just talked about, MTS, restructuring, and price cost, we are right back at our core incremental margins, in that 35% range, right now, and we wouldn't expect anything different, in 2023. Obviously, we haven't done the planning yet, but, that's kind of long term, what you should expect from us is incrementals in that 35% range.
Great. That's helpful. Thank you, guys.
Sure.
Next, we'll go to Mircea Dobre with Baird. Your line's open.
Yeah, thanks for taking the question.
Hey, Migs.
You know, I've been doing this for a while, but my name is always butchered on these earnings calls, so I'm used to it. Maybe to kind of follow up on Steve's question here, thinking about 2023, I'm curious, as you're looking at the amount of pricing that you had to put through this year, is there a good way to think about the carryover that's gonna go into 2023 relative to 2022 from a top line perspective, contribution to the top line?
I think it's a little too early, Migs. I mean, clearly there will be some carryover, but to try and quantify that right now for you, I don't think would be helpful.
We've got to get into our planning process, which is really, you know, we're talking about November-ish before we'll have a reasonable view on that, and I think that's the appropriate time.
Yeah. I mean, I think the only thing I would point back to is what I said in this prepared remarks is that if you add up the price cost margin dilution impact during this cycle, over, you know, this year and last year of about 250 basis points. The expectation is that, as things begin to normalize, we will recover that margin impact over time. Now, how exactly that will play out and the timing around that is not entirely clear as we sit here today, but I think it's reasonable to assume that some of that impact will be in 2023.
Okay. I guess if I may follow up on this, I'm trying to probe a little bit about your degree of confidence that the business overall will be able to outgrow industrial production as we're thinking 2023 and beyond. This has been a big topic, right, over the past few years. You talked about winning the recovery and investing through the downturn. I'm curious if you can maybe update us a little bit on your degree of confidence that we can continue to see outgrowth.
Well, I don't know exactly what I can do to reassure you other than to tell you that it continues to be the number one dominant priority of every member of ITW from China to Europe to North America to South America. It is, you know, certainly we think we've got a terrific opportunity going forward. We have done a lot of things in terms of investing and positioning ourselves to execute on it, and the proof will be in the pudding. You know. It's already happening.
Yeah, I agree with that, Mig. I mean, I think if you look at the results we've put up so far, and granted there's some recovery in here, but last year organic was up 12%. The first half is up 10% of this, you know, organic this year. I think relative to peers, we're certainly closing the gap compared to where we were kind of just a few years ago. I think yes, the proof will be in the organic growth rate numbers that we're gonna put up. But I also will tell you there is a high degree of confidence that we are making significant progress. Lots more to do, but certainly we are headed in the right direction here for sure.
All right. Thank you.
We'll take our final question from Julian Mitchell with Barclays. Your line's open.
Julian?
Go ahead, Julian. Your line's open. Julian Mitchell, your line's open.
Hello.
Maybe on mute. There we go.
Sorry about that. Good morning. Just wanted to clarify on the margin outlook, because I suppose the margin rate or the margin guide for the year implies, you know, the fourth quarter margins are maybe up, you know, 300-400 basis points year-over-year or something. Just wanted to confirm that that's roughly the right way to think about the back half guide, and maybe what are the main drivers of that big fourth quarter margin uplift.
Yeah, I mean, the big driver for the second half here is what we just talked about, which is 200 basis points of price cost margin dilution impact in the first half that's not projected to repeat in the second half. That's probably the biggest driver. I think you also have to factor in if you just take our current revenues and project those into Q3 and Q4, because the comps are easing on a year-over-year basis, we'll be putting up some meaningful organic growth rates with all the operating leverage and the incrementals that are returning to something a lot closer to our historical incrementals in the back half of the year. Those are kind of the big drivers here. Less price-cost margin headwind and significant organic growth year-over-year with more normal incremental margins in that 35% maybe plus range for the back half of the year.
I understand. Thank you. Then just to follow up on free cash flow, I think your sort of 90% odd conversion guide for the year on free cash, you know, that implies, I think, sort of 50% growth in the free cash year-over-year in the second half. Just, you know, help us understand, you know, how do you get that monstrous sort of free cash flow expansion? Is there just a massive sort of inventory destock because, you know, supply chains are easing? Maybe just any color around that because it is a big move for a sort of.
Yeah. It's
Big company.
It's a little bigger than usual. I mean, as you know, historically, our second half cash flows are always significantly higher than the first half. It's a little bit more this time. You know, we've talked about the fact that we've been very intentional in terms of our working capital investments to support the growth that we're seeing, you know, double-digit growth at the top line, mitigate supply chain risk, which is still a reality, and then sustain the service levels for our customers. So we will carry whatever inventory we need to do those things.
If you look at our months on hand, we're running right around three months on hand, and we really only need a slight improvement in that, in the months on hand to get to those free cash flow numbers. As we sit here today, we do have a line of sight to a ramp-up in the second half. Like I said, we think it's a smart use of this balance sheet, you know, to support everything we're trying to do from an organic growth standpoint by taking care of our customers.
I will say this, if we come in at the low end of the range, it won't change anything in terms of our capital allocation plans for the year. We'll still do the buyback. We'll still do, obviously investments. We'll still do the dividend. There's really no trade-off here. Obviously we you know we'd like to hit that free cash flow number, and we have line of sight to doing that, for the back half of the year. We're obviously aware that it's a little bit more of a ramp than what we normally have, so.
Understood. Thank you very much.
All right. Thanks, Julian.
This concludes today's conference call. You may now disconnect.