Illinois Tool Works Inc. (ITW) Q2 2018 Earnings Report, Transcript and Summary

Welcome, and thank you for joining ITW's 2018 Second Quarter Earnings Call. [Operator Instructions]. Today's conference is being recorded. If you have any objections, you may disconnect at this time. I will now turn the call over to Karen Fletcher, Vice President of Investor Relations. You may begin.

Thanks, Brandon. Good morning, and welcome to ITW's Second Quarter 2018 Conference Call. I'm joined by our Chairman and CEO, Scott Santi; along with Senior Vice President and CFO, Michael Larsen. During today's call, we'll discuss second quarter financial results and update you on the outlook for the remainder of 2018. Before we get to the results, let me remind you that this presentation contains our financial forecast for the third quarter and full year 2018 as well as other forward-looking statements identified on this slide. We refer you to the company's 2017 Form 10-K and subsequently filed Form 10-Qs for more detail about important risks that could cause actual results to differ materially from our expectations. Also, this presentation uses certain non-GAAP measures, and a reconciliation of those measures to the most comparable GAAP measures is contained in the press release. I will now turn the call over to our Chairman and CEO, Scott Santi. Scott?

Thank you, Karen, and good morning. ITW delivered another strong quarter, with revenue up 7% and organic growth of 4%. EPS of $1.97 was up 17% versus prior year and ahead of our expectations despite a $0.03 currency headwind versus the prior guidance. And that's a translation headwind. If you exclude the benefit from a legal settlement we received in the second quarter of last year, EPS was up 19% year-on-year. We delivered strong results on all key financial metrics, including operating income of $932 million, up 9%; operating margin of 24.3%, up 50 basis points; and after-tax ROIC at 28.7%, up 440 basis points. Underlying demand trends remained strong as evidenced by all 7 business segments in major geographies, delivering positive organic growth in the quarter. In particular, CapEx-related demand continued to spur strong organic growth in our Test & Measurement and Electronics and our Welding segments. And we saw improving growth momentum in Food Equipment, with growth 120 basis points higher sequentially versus Q1. Overall, the company delivered 4% organic growth despite 40 basis points of unfavorable impact from North American auto builds, which ended up being down 3% year-over-year versus an IHS forecast heading into the quarter that they would be up 3%. And in addition, we had 70 basis points of Product Line Simplification in the quarter. Michael will share more on -- more details a little later in the call. Overall, our teams are working to offset raw material cost increases on an ongoing basis, and through the first half, we have offset the impact of those raw material cost increases on a dollar-for-dollar basis. And we continue, despite the rising raw material cost environment, to expand margins. Continued progress in implementing our Enterprise Initiatives contributed 110 basis points margin benefit in Q2 and in the first half as our business teams continued to apply our proprietary business model to deliver solid growth with best-in-class margins and returns. Looking ahead, we have adjusted our full year guidance to account for current foreign exchange rates, which, at the current levels, present roughly a 12% impact to the second half compared to the end of Q1 when we last updated guidance. We expect to deliver 15% EPS growth for the full year as we continue to execute well, accelerate organic growth and expand margins. We are well positioned to deliver continued strong results as we enter the second half of the year. And with that, I'll now turn the call over to Michael for more detail on the quarter. Michael?

Thanks, Scott. Organic revenue growth of 4% was up more than 100 basis points sequentially, and we're seeing good growth momentum across our business portfolio and in every major geography. Product Line Simplification in the quarter reduced organic growth by 70 basis points, and softer North American auto builds versus the industry forecast heading into the quarter was a 40 basis points drag on our overall organic growth rate. We add those back, we would have been right around 5% organic growth. By segment, Welding led the way as demand continued to accelerate, delivering 13% organic growth; followed by Test & Measurement and Electronics and Specialty both up 4%. Scott mentioned good sequential growth momentum in our Food Equipment business, and this was particularly evident in our North America foodservice equipment side with growth of 13% in Q2 following 7% in Q1 and a positive outlook for the second half. Earnings per share of $1.97 were $0.02 above the $1.95 midpoint of our guidance despite a $0.03 unfavorable currency translation impact. Operating margins was strong at 24.3%, up 50 basis points year-over-year, excluding the prior year legal settlement, and up 20 basis points sequentially. Free cash flow was really good at $533 million, up 38% versus prior year. And we repurchased 500 million of our shares this quarter for a total of $1 billion in the first half of 2018. Moving to Chart #4 and operating margin. Like I said, strong margin performance as operating margin continued to improve sequentially and year-over-year. Operating margin of 24.3% was up 50 basis points versus prior year when excluding last year's benefit from a legal settlement. Similar to Q1, strong execution by our teams of Enterprise Initiatives contributed 110 basis points of margin improvement. And volume leverage from higher organic growth added another 70 basis points in the quarter. Pricing actions continue across the company as we execute on our strategy to cover raw material cost inflation with price adjustments on a dollar-for-dollar basis. I'll cover this and tariffs in more detail on Slide 10. Finally, we continue to invest in CapEx and people to support and further accelerate our long-term growth strategies. These growth investments amounted to 60 basis points. Turning to Chart #5 for a look at our first half performance. We delivered strong performance with revenue up 7%, organic growth of 3% and earnings per share up 20%. All segments and major geographies contributed positive organic growth. Across the board, there was excellent operational execution with continued margin improvement as operating margin improved 70 basis points in the first half with Enterprise Initiatives, again, contributing 110 basis points. Pricing actions offset cost increases on a dollar-for-dollar basis. And we just completed the most profitable first half in the company's history and have really good growth and margin momentum heading into the second half. Let's move on to Chart #6 and segment performance. Table on the left summarizes organic growth by segment for first and second quarter. And you can see the good growth momentum we're building, with 5 out of 7 segments improving sequentially. Overall, organic growth was 4% in Q2, which, as I mentioned, includes PLS initiative impact of 70 basis points. We remain confident that we will deliver 3% to 4% organic growth in Q3 and for the full year based on current run rates. The table also shows segment operating margins for the first and second quarters with strong margin performance across the board as all segments improved sequentially, except auto where pricing actions take a little longer to take hold. Now moving to the right side of the chart and an overview of our Automotive business. Organic growth was 3%, up from 1% in Q1. Looking at the regions, our North America growth of 2% was 5 percentage points above builds, which were actually down 3% in the quarter. You'll remember that on our last earnings call, I shared that the Q2 North American build forecast from IHS was up 3%. Had North American builds been at the original forecast, our total segment growth rate would have been 1.5 percentage points higher, well above 4%. China organic growth continues to be very strong at plus 17%, 8 points above builds. And Europe was up 3%, 1 point below builds, mostly on mix and PLS in the region. Overall, in Automotive, PLS had roughly a 4 percentage point impact to organic growth in Q2. Finally, if you look across these 3 major regions, our weighted average penetration was about 250 basis points above the build rate. Margin expanded by 20 basis points, with Enterprise Initiatives and new product penetration offsetting cost inflation in the quarter. Looking ahead, we expect organic growth around 3% in the second half, with margins holding steady. Moving on to Chart #7. Food Equipment organic revenue was up 2%, and on a very positive note, we continue to see a strong recovery in institutional sales, particularly in education, as foodservice equipment sales were up 13% in the quarter, partially offset by decline in retail. Operating margin of 25.4% was up 80 basis points sequentially but down year-over-year due to slightly higher restructuring in Europe this quarter versus prior year and unfavorable product mix, partially offset by the benefits from Enterprise Initiatives. Price/cost did not have a significant margin impact in Food Equipment. Looking forward, we expect the Food Equipment segment to accelerate organic growth and expand margins in the second half. Test & Measurement and Electronics organic revenue was up 4%; once again, particularly strong performance driven by strong CapEx spending in Test & Measurement, which was up 7%. Electronics was flat this quarter, primarily due to timing of large equipment orders in electronic assembly. Operating margin improved by 160 basis points to 23.5%. Now Chart #8. Welding's organic growth rate continued to accelerate in Q2, and the backlog for the second half is looking very good. Organic growth was 13%, with global equipment up 15% and consumables up 11%. North America was up 17% with strong demand across all end markets, including oil and gas. Margin expanded by 210 basis points to 29.3%. Polymers & Fluids, organic growth was 1% and operating margin was essentially flat despite significant cost increases tied to chemicals, silicone and resins. Chart 9. Construction delivered 2% organic growth in the quarter with North American growth of 2%, European growth of 4% and flat in Asia Pacific. 6% growth in North America residential was partially offset by declining commercial construction where we were impacted by a onetime wedge anchor product issue. Excluding this issue, commercial construction was down 5%. This segment also had a 1 percentage point impact from PLS initiatives in the quarter. Specialty organic growth was up 4% this quarter, driven by strong equipment sales that were up 23%. Operating margin was essentially flat at 28.1%. Moving on to Chart #10 with an update on raw material costs and tariffs. As we've talked about before, we continue to execute our strategy to cover cost inflation with pricing actions on a dollar-for-dollar basis. We've done that year-to-date and expect to do the same in the second half. For perspective, full year projected cost inflation, including tariff impact, represents approximately 3% of our total spend. As many of you know, our model is to source and produce where we sell. And this approach helps significantly mitigate the risk associated with tariffs. By our estimate, the impact of tariffs represent about 10% to 15% of our total projected cost inflation in 2018. In addition, only 2% of ITW's material spend is sourced from China. Our "produce where we sell" model and the very limited cross-border movement of raw materials and products certainly helps mitigate the impact from tariffs. The bottom line for ITW is that the combination of continued progress on organic growth, which is underway right now, coupled with the strength and resiliency of our business model and our high-quality business portfolio and the excellent operation execution of our teams who are delivering over 100 basis points in Enterprise Initiatives, will drive continued margin expansion and strong earnings growth in 2018. Our guidance midpoint reflects margin expansion of about 80 basis points this year, following 70 basis points realized in the first half. Let's go to Chart #11 and 2018 guidance. As mentioned, we see strength in demand trends across our segments and continued strong margin expansion from Enterprise Initiatives with clear line of sight to projects and activities that will contribute at least another 100 basis points of margin improvement again this year. While we expect raw material cost inflation to continue to impact margins in the second half, we're confident that we will offset those cost increases with price actions on a dollar-for-dollar basis, so there is no negative impact to earnings. The price/cost impact to margin is reflected in our updated operating margin guidance of 24% to 25%. Again, this is strictly a margin percentage point impact, not an earnings impact. As we always do, we've updated guidance for foreign exchange rates as we sit here today, which has a $0.12 impact in the second half versus the exchange rates in place at the time we updated guidance at the end of last quarter. As a result, for the full year 2018, we're adjusting the EPS guidance midpoint by $0.10 and expect earnings in the range of $7.50 to $7.70 per share, which represents 15% EPS growth at the midpoint versus the $6.59 underlying earnings per share in 2017. On the top line, currency is expected to be a 1 percentage point impact in Q3 and Q4 versus prior year quarters. With respect to cash, we expect free cash flow conversion to be 100% of net income or better. Through the first half, we repurchased $1 billion of our shares and now expect to repurchase an additional $500 million in the second half. As a reminder, subject to board approval in August, we plan to significantly raise our dividend as we increase ITW's dividend payout ratio to 50% of free cash flow. Today, we're also providing guidance for Q3, a range of $1.80 to $1.90 per share versus $1.71 in the third quarter 2017. As a reminder, we had a $0.14 benefit in the third quarter last year from a legal settlement. Finally, we expect organic growth of 3% to 4% based on current run rates. So to wrap up, we continue to see positive underlying demand trends across our businesses. We're well positioned to continue to deliver strong margin expansion and earnings growth in 2018. On price/cost, we continue to execute well on an effective strategy and the impact is manageable. Our guidance today reflects solid organic growth with best-in-class margins and returns, including 15% year-over-year earnings growth and strong cash flows. All in, another strong year supported by our performance at the halfway mark and our confidence in ITW's ability to continue to execute at a high level through the balance of 2018. Karen, back to you.

Thanks, Michael. Brandon, let's go ahead and open up the lines for questions.

And our first question is from Andrew Kaplowitz with Citi.

Scott or Michael, this question is going to be a bit nitpicky because we know that you have still very high margin, but it seems like there has just been a little more volatility in some of your segments' margins over the last couple quarters, arguably outside of price versus cost. So if you look at Food Equipment, you guys talked about it, but down 100 basis points year-over-year this quarter after being down last quarter. And at the company level, you cited 60 basis points of growth, investments, other, which you said was an investment in people but maybe a surprise, at least to us. You did mention more PLS in Food Equipment. Are you having to do more PLS than you thought or the investment in people you've mentioned at the company as a whole? And do you think this increased level of noise will diminish moving forward?

So there was a lot there, Andy, but I think the bottom line is that we are very close to executing the plan that we laid out at the beginning of the year. Really, the only delta that's meaningful is the price/cost equation, and that's just the margin percentage impact that we talked about. In terms of overall organic growth, margin expansion from Enterprise Initiatives continue in every segment. They're broad-based. We're not done on the Enterprise Initiatives. More to come in the second half and beyond that. So you're pointing out Food Equipment. Like I mentioned, we had slightly higher restructuring in Europe here in the quarter, about 40 basis points. And the balance really is a product mix item in Q2. But like we also said, in Food Equipment specifically, we expect, just based on the orders, the run rate, continued progress here in the back half on organic growth as well as margin expansion. On PLS, we are running at about 70 basis points here in Q2, similar to what we did in Q1. And as you know, that is completely consistent with the way we run our businesses and are really an integral part of our 80/20 operating system. And very briefly, what it does is positions us for continued acceleration in organic growth with better margins and returns. So it's absolutely the right thing to do for a little bit of headwind on the top line here in the short term.

Michael, could I just have you clarify the 60 basis points of growth investment still? Was that sort of in the plan? And you talked about adding people, where are you adding people or at least you said investment in people?

Yes. So we've seen, if you look at the details, an increase in overall levels of investment really to support and further accelerate the organic growth rate. You've seen that now 4 years in a row. We're making progress on the organic growth rate up 4% here in Q2. So a portion of it is CapEx-related as well as new products. And then people is really investment in talent that can support everything we need to do to further accelerate our organic growth rate as well as continue to execute well on our Enterprise Initiatives.

Got it. If I could just shift gears briefly and ask you about organic growth. Last quarter, you said that you thought all of your segments would have better organic growth in Q2 than Q1. We see Test & Measurement and Construction had a little bit lower organic growth. I think you explained Construction well with the commercial construction issue in the quarter. In Test & Measurement, looks like Electronics slowed down a bit. So maybe you can talk about that segment in particular.

It's really not that significant, Andy. I mean, we -- Electronics business was flat in the quarter, really based on some timing, as I think I mentioned, on some large equipment orders. If you were to adjust for that, that's -- Electronics would have been up 4%. And then the Construction item I talked about, if you adjust for that, the Construction business would have been up in that 3% to 4% range.

So no changes to either segment for the year in terms of overall balance, would you say?

They're all, I'd say, pretty close. We talked about Automotive. We have a fairly, hopefully, conservative assumption here at 3% for the balance of the year. And then we continue to see acceleration in Welding and, hopefully, some good progress also on Food Equipment.

Our next question is from Joe Ritchie with Goldman Sachs.

So my first question, maybe just focusing on the growth investments again. I just want to understand that a little bit better. I guess if -- you guys have obviously done a great job the last few years driving strong margin expansion, good cost control. I guess the -- if you look at this line item, I think some folks will say perhaps you guys got too close to the bone and now have to reinvest in either people or CapEx. So maybe talk about that a little bit on your -- where you think you are today from a growth perspective and the investment that you need to make in the second half of the year and maybe even into 2019.

Yes, Joe, nothing -- if you look back over the last 5 years, we have continued to invest in organic growth and everything that we need to do to support an acceleration in our organic growth rates. So there's really nothing significantly different. We are seeing a -- an increase in our CapEx spend here really to support our customers, which were growing at a fairly rapid rate. So I -- and if you look at it, 60 basis points is not really that meaningful, that big a number on a dollar basis. It just happens to be something that we call out here on the margin walk.

Well, and what I would add is that we have -- we're trying to be more transparent in terms of how we're investing in growth. This is not a new item this quarter. This is something we've been doing for the last 5 years. The presentation is a little different, but ultimately, these investments had been ongoing for the last 5 years. They're embedded, and when we talk about 35% long-term incrementals, those growth investments are embedded in that number. So it is not a new item that just happened this quarter. These investments have been going on for the last 5 years. We've changed the presentation a bit just to reflect, given some of what we heard about, "Are you investing enough in growth given the kind of margin and progress that you've made over the last 5 years?" So these are -- this isn't a new item. This is -- these are investments that have been taking place consistently over the last 5 years.

Got it. That's helpful clarification, Scott. If I can maybe turn the conversation a little bit to organic growth and specifically just focus on Auto for a second. I know you've got 3% baked in for the back half. But I think this is the first quarter we've seen you guys actually under-pace global auto builds. And so maybe just talk a little bit more about what happened there specifically this quarter, that would be helpful.

Yes, it's pretty straightforward. I mean, the global build number includes geographies where we do not have a presence or do not have a significant presence. So if you look at places like Brazil, India, even in Japan, for example. So the right way to look at this is really on a geographic basis, which is the way we laid it out in the slides and described it. And you can see North America, up 5 points of penetration gains there; in China, 8 points; Europe, some mix, and PLS activities there were slightly below. And like I said, on a weighted average basis, we are at 250 basis points, in that 2 to 4 percentage point range that we've been in for the last 4, 5 years. And based on all the projects that we booked already, we expect to remain in that range in the future.

Okay. And, Michael, maybe one last one. The share buyback and the repatriation, I may have missed it, but did you guys give an update on how far along you are with repatriating the $2 billion that you expected this year?

Yes. So we made some really good progress. We are slightly above $2 billion year-to-date and ahead of schedule. So the obvious question is, how are you going to allocate that repatriation, those cash -- those funds that have been repatriated, the little over $2 billion. So we've reduced our short-term debt about $900 million. Our share repurchases, we just took it up, the target for the year, by $500 million. We've got a dividend increase coming. If you pencil that out, that's about a $200 million increase for the year. And then we have slightly more cash on hand here in the near term. And as you know, we have some maturities coming up in the first half of '19. So really good progress. I'm very pleased with the fact that we were able to accelerate those plans and bring the funds back to the U.S.

Our next question is from Ross Gilardi with Bank of America Merrill Lynch.

I'm just trying to understand the reduction to the margin outlook a little bit better. I mean, you seem to be moving forward on the Enterprise Initiatives and you continue to say you'll offset raw material costs dollar-for-dollar. So what has actually changed on a margin standpoint?

Well, I think we're through the first half here, and we are updating the margin guidance now for our current view of how price/cost, again, only from a margin percentage standpoint, will impact our overall operating margins for the year. It's -- again, it's not an impact to EPS, which does not what -- you're not seeing that, you're not hearing that from us today. It's purely just a reflection of what we've seen year-to-date on price/cost and our expectations for the balance of the year. I want to just point out, we're still -- year-to-date, we've expanded margins 70 basis points for the full year. With our updated guidance here, we expect at the midpoint to expand margins 80 basis points. So that's really the only driver here, Ross.

Okay. So just to be clear, the reduction to the margin outlook is purely -- is for price/cost. The reduction to the EPS outlook is for FX.

That is correct.

Correct.

Okay. And just back on autos. I mean, are you seeing any signs of disruption? I mean, obviously, Daimler was complaining about the trade war already having an impact on U.S. auto exports to China. And you've seen some other announcements from various auto companies. Anything going on there that you feel like is impacting your business? And can you clarify a little bit more about these tariffs making up 10% to 15% of your raw material inflation? Where specifically in the portfolio is that showing up?

Yes. So I think, Ross, the short answer to your question is we've not seen anything with our customers. It might be a little too early to tell. There's still some movement around what these tariffs may or may not be and for how long they may be in place. So and again, we are a "produce where we sell" company, and the impact from tariffs is significantly mitigated by that. In terms of the overall tariff impact, it's -- as a result of that, fairly small, 10% to 15% of what we project for the full year will come from tariffs. The majority of that is really related to metals, so steel and aluminum, which was the first round of tariffs. And then the China tariffs will pretty -- I'd say pretty broad-based across the portfolio but pretty small impact overall from that -- from the Section 301 tariffs.

Our next question is from David Raso with Evercore ISI.

Maybe I missed it, the price/cost drag on margins, what is the number now for the year? And then also if you can give us some insight on 3Q and 4Q.

Yes. We're in that -- consistent with the first half, 60 to 70 basis points range is what we're projecting at this point.

For each quarter?

And that's the 3% price recovery on the 3% in place.

Correct.

So little margin...

But again, the cadence is similar? Third quarter, fourth quarter year-over-year drag is similar for both [indiscernible]...

Yes, it's similar. You could -- yes, it's the same assumption for Q3 and for Q4.

The reason I ask, when I try to get to the EPS for the third quarter, the fourth quarter, you seem to be implying for the third quarter the operating margins, even adjusting for the year-ago legal settlement, the margins are flattish to down a bit. But you then need, for the fourth quarter, margins to grow over 100 basis points. And I do see the organic implied is a little faster in the fourth quarter, about 4%; third quarter, 3.5%. So maybe that explains it. But I was kind of hoping to hear on -- maybe making the guide seem easier, that the third quarter drag on price/cost was greater in the fourth quarter. There's some relief, right, some of the pricing actions take hold and the margin drag becomes a lot less. If that's not the case, can you explain why the margins in the third quarter were flat to down, but fourth quarter, they pop back up year-over-year?

Yes. So we don't give margin guidance for Q3 and Q4, but the price/cost impact is modeled or estimated to be the same in Q3 and Q4. The big delta -- and I don't -- not knowing your model specifically, and so what you have to factor in is really currency. So if you look at the impact from currency in the second half of the year is negative on a year-over-year basis versus being positive in the first half. So I don't know how you've updated your model for that, but that's really the main driver here in the back half of the year.

Okay. We can take it offline. And on Auto, when you gave the second half organic, at least the quick numbers that I ran, it implies the full year organic went down about 200 basis points. But the offsets, the other segments, the -- I mean, I would assume Welding was a big piece of it. But to make up for the 200 bps lower on Auto, I mean, ideally, if you can give us like you gave us that for the first quarter, maybe a full year organic sales number for each segment, how you're thinking about it or just...

Yes. So I'm not sure I can do that for you, David. But like I said, I think we adjusted the outlook for Auto. I think we've seen the IHS forecast may not be the most -- haven't been the most reliable data point year-to-date. And so we've put in a 3% growth rate for the back half for Auto. The acceleration really is Welding, and then like I mentioned, some improvement in Food Equipment. Those are the big ones. There's a couple of other puts and takes here, but that's really the -- those are the big drivers.

Our next question is from Steve Volkmann with Jefferies.

Maybe just a couple of clarifications. The -- Michael, the PLS headwind in the second half same as first half. And the cadence question as well is sort of 3Q, 4Q the same?

Yes. I would -- the same for the second half as the first half, so right around 70 basis points.

And again, 3Q, 4Q pretty similar?

Yes.

Okay, great. And then just with respect to the remaining $500 million of repo, is that -- should we spread that evenly over the third and fourth quarters?

I think from a planning perspective, that's probably a good way to do it.

Okay. And then my final one, just quickly again, is on this price/cost thing. Is it your goal to just cover the dollar-for-dollar and leave it at that? Or do we think there will come a point once all the pricing is kind of through the system and everything kind of renormalizes, say, 2019, will you get back the margin as well as the dollars? Or do we just leave it at the dollars and move on?

No, I think you're raising a really good point. In the near term, what we're doing is covering dollar-for-dollar. But eventually, when we get ahead of this, this will be a positive to margins at some point. When -- we're always operating a little bit of a lag here. We see the cost increases come through. We react on pricing. And we're still, I would say, in a little bit of a catch-up mode, but we will absolutely get ahead of costs here at some point.

There's roughly a one-quarter lag on average in terms of cost versus price response.

Right.

And so the dollar-for-dollar, if I can say it a slightly different way, that coverage is factoring in that lag. So we're still able to cover -- minimize the EPS impact in the near term. But should the cost increases stop tomorrow, then those pricing actions will continue to carry through and have a positive impact beyond the dollar-for-dollar.

Correct, yes.

Our next question is from Mig Dobre with Baird.

Just looking to clarify a comment you made on Food. As I understood it, it was Welding and Food organic expectations that ticked up to offset Auto. And I guess I'm wondering here what the thinking is because your prior guidance talked about 2% to 3% growth. Even towards the low end of your full year guidance, that would imply pretty significant acceleration in the back half versus what you've done in the front half of this year. Is there enough in your backlog or visibility to where we could be thinking that this -- that, that can grow north of 4% organically in the back half?

Are you talking about Food Equipment?

Yes, I am.

Yes. So we've got a number of things going on there. One is you saw the acceleration on the institutional side and the really strong backlog going into the second half as well as you're going to get some benefits from pricing and a number of new product launches in the back half of the year.

Okay. So this is more sort of internally driven rather than end market-driven, that's what you're saying.

Well, I think the foodservice side is certainly improving. We don't expect the retail side to improve. And then if you just look at the comps on a year-over-year basis, they also are going to be a tailwind here in the second half.

Okay. And then if I may go back to this question on growth investments that you've broken out in \guidance. Obviously, a new way to present this, but I guess, from my standpoint, when I'm looking at this bridge here, you typically talk about Enterprise Initiatives as well as volume, price/cost and so on. I'm looking at this and I'm interpreting this as incremental investments that are essentially offsetting Enterprise Initiatives at this point. If that's wrong, why is it wrong? And what should we expect for this growth investment drag to be going forward?

So first of all, I wouldn't necessarily extrapolate from Q2 and assume that we're going to have 60 basis points every quarter going forward. I do -- I think Scott explained very well why we're calling it out. But it also would not be a good assumption to think that the 60 basis points offset the Enterprise Initiatives. So I think really the way to think about this is unchanged relative to what we've done in prior years, which is core incrementals in a normal macro environment in that 35% range, plus the Enterprise Initiatives on top of that. That's really the way to think about this. And that's how you -- that really supports what we've been saying for a while now is that we expect margins to continue to improve from here.

But if that is the case and growth was included in Enterprise Initiatives previously -- I don't know. To me, as I read this table, something seems to be materially different, and I guess I'll just leave it at that.

Well, we can take it offline. I don't think you're interpreting what we're saying and what's on the chart correctly.

Our next question is from Ann Duignan with JPMorgan.

Can we talk a little bit more about the negative mix in your PLS model that you mentioned? What specifically is that? And how should we think about that toward the back half of this year?

Well, that's really mixed with -- at this point, it becomes in terms of -- by OEM as well as by model. And so I would not read too much into that. There was -- again, it's one quarter. If you look at it historically, these penetration numbers can move around quite a bit, depending on when models kind of roll off and when new models kick in. The main driver here in terms of being slightly below the builds was really the PLS work that the team is doing.

Okay. So it's not, as we might appear, the loss of a platform or the loss of an OEM customer?

No. The penetrate -- obviously, as what Michael said, the penetration numbers on a quarter -- 1-quarter basis are not good gauges. The annual numbers absolutely are. And what -- we will continue to deliver penetration gains in Europe on a full year basis this year. But things do jump around, as Michael said, in a quarter based on when a model is going up, when a new model is being launched and some of the supply chain work behind the scenes that goes on in preparing for that.

Sure. I appreciate that. And then another point of clarification. On the commercial construction side, I think you said you had a product issue. Can you talk about that and what that means and what the outlook is for the commercial construction side for the back half?

Yes. So commercial construction has kind of been flattish for a while now. We were down slightly, I think I said down 5%. When you exclude this onetime event, really limited to North America with our wedge anchor product resulting in some returns, if you adjust for that onetime event here in the quarter, Construction would have been up 3% in commercial.

Okay. And then the wedge anchor problems, can you talk about those? It's sort of uncharacteristic for ITW to have quality issues, but [indiscernible].

Yes, I know. We had some inaccurate labeling on the packaging, and we had to correct for that.

Okay. So not a product quality issue?

No.

Our next question is from Andy Casey with Wells Fargo Securities.

On Auto OEM, you mentioned second half expected to be 3% organic growth. Could you help us understand how you may be treating the impact of what appeared to be a North American supply chain disruption, not for you specifically but would have impacted some of your customers? I'm wondering how you're treating that in the outlook. Are you just extrapolating Q2 as is? Or are you including...

No. Yes, we have -- so you're right. There were some issues in Q1 that we talked about last time. There were some issues in Q2. Not specific to us, and that may be one of the reasons why the IHS forecast was off. IHS calls for North America specifically for significantly higher growth here in Q3 and Q4. We took a conservative approach here and risk-adjusted those numbers and put in a 3% growth rate for Automotive in the back half. Hopefully, that turns out to be a conservative assumption, but that's kind of what we have in our guidance today.

Okay. And then I guess another round at the growth investments. You mentioned CapEx comments. Are you seeing any market segments where production may have been constrained and may offer restock opportunities in the future? I'm just trying to understand the CapEx part of it.

No. I think it's just part of our -- as these businesses grow, we continue to invest in CapEx. We've done that for 5 years and even beyond that. I mean, typically, CapEx for us as a percentage of sales is right around 2%. And as sales grow, the CapEx numbers go up, and that's really all that you're seeing here. Again, this is to continue to support our customers with best-in-class quality and service on a global basis. And I really wouldn't read as much into it as the time we spent on it today.

Okay. And then one last one on it. You mentioned -- or you cautioned against extrapolating the 60 basis points. Was that more lumpy in the quarter than what you'll be seeing in the second half?

On the growth investments? Yes, I think this can be a little circumstantial to the quarter. I think we will continue to lean in on these investments that we need to make to further support and accelerate organic growth as well as continue to expand margins, core margins in our businesses. So this is ongoing. I think we called it out this time. And given the reaction today, we may not call it out in the future. We'll have to see. But this is an ongoing thing. It's not a response to anything specific. We are fully invested here. We're fortunate that even these investments -- by fully funding every good project inside the company, they only consume 25% of our operating cash flow. So we're not constrained. We'll continue to invest. And we wanted to highlight that today, and that's what you're seeing on that side.

Our next question is from Steven Fisher with UBS.

When I look at the European auto build outperformance of your business versus the market, it's really been moderating since the -- going back to the second quarter of last year with obviously the flip to negative this quarter. So has that been mix in that trend down all along for the last year? And then what kind of gives you the visibility to that inflecting back positively in the second half?

Well, I think in Automotive, and this is not a European comment, this is a global comment, we are fortunate that we have visibility 2.5, 3 years out based on the projects we've sold already. So we know what our content per vehicle growth is going to be on new model launches. We know what's rolling off. There can be some mix as these 2, those are the big variables, kind of play out, but we're highly confident that we'll continue to outperform in Europe and on a global basis in that 2 to 4 percentage point range above the global auto build numbers. And that's really on -- the way to look at this is what Scott said is really on an annual basis. On a quarterly basis, it can move around a little bit. But absolutely nothing has changed in terms of our confidence in our visibility to continue to do that on a go-forward basis.

But that outperformance is basically 0 for the first half, so the second half would have to inflect positively. It sounds like you do have that visibility in Europe right now?

Well, again, I mean, we can talk about Europe offline. I mean, I think if you look at this on a global basis, we had 2 percentage points of penetration in the first quarter. We just did 2.5% above the weighted average, and nothing has changed.

Okay. And then shifting over to the commercial construction, just to make sure I heard all the numbers right. The minus 5% on commercial, that was excluding the anchor wedge product issue?

Yes. We would have been down 15% -- we're down 15%. We would have been 5% if it wasn't for this onetime item.

Okay. And I think it was down 2% in the first quarter. So where generally are you seeing sort of incremental weakness? Or is that just a comparison issue between Q1 and Q2 year-over-year?

I would think that's really more of a rounding issue. Commercial is about 20% of our Construction business. And the performance of that segment is really driven much more by the continued growth on the residential and the renovation side.

Of the Construction business, not the commercial.

Okay. So maybe just one quick clarification. Did your short-term debt go up a lot in the quarter? And I thought you said when you were talking about repatriation, you were talking about reducing short-term debt.

Yes, that's correct. So that's a reclassification of the maturities that I talked about that are coming due in the first half of '19. So we have some March and April maturities, $1.35 billion. And that -- because we're within 12 months, that slips into the short-term debt category, that's why. If you look at the long-term debt, we're down by the same number.

Our next question is from Nicole DeBlase with Deutsche Bank.

So I guess just first question around the price/cost issue. If you could kind of talk a little bit about from a segment perspective where that has the most impact. I know you kind of said it's not happening -- or it's not a significant issue within Food Equipment, but it would be helpful to know where it is.

Yes. So the largest impact is really in the Automotive segment where it can take a little bit longer for price actions, new products to offset those cost increases. Everywhere else, we're positive on a year-to-date basis.

Okay, got it. That's really helpful. And then the other question. Just looking at Welding margins, the incrementals were really strong this quarter. I think they were like 44%, clearly above what you tend to target. Just thinking about like the outlook into the second half of the year, is that level of margin expansion or incrementals sustainable into the second half? And I guess a little bit of just what's driving the strength.

Yes. No, I think this is frankly typical for what we're seeing in Welding with this type of organic growth. So those are -- that's a reasonable assumption for incrementals for the back half of the year.

Our next question is from Nathan Jones with Stifel.

A bit of a more philosophical question on the impact of some of the -- all the uncertainty in trade and that kind of thing. I would have thought you guys would maybe start seeing some impact on your customers' CapEx spending as all of this uncertainty weighs on their investment decisions. Maybe that led to some of the under build in Auto OEM. Instron was still pretty good. Just any kind of commentary you guys have, what you're hearing out there in the market in terms of, are customers still confident in the economic outlook here? Are you seeing any kind of weakening in just the way people are thinking about the economy going forward?

No, we've not seen that, Nathan. I mean, I think if you look at the segments most exposed to business investment, CapEx cycle, Welding, Test & Measurement, we continue to see. And the equipment side of Specialty continued to see accelerating demand. So we have not seen any impact from a demand standpoint.

Polymers & Fluids and Specialty Products both seem to have relatively flat kind of margins here. I figure there's probably a bit more oil impacting that. Is that something that you should be -- we should be expecting to see a little improvement in that as you catch up a bit more in pricing with the, I guess, more recent history of cost increases going through there?

I think in the near term, there certainly, as you point out, some chemicals, so silicones, specifically resins, are putting some pressure on. But as -- once we work through that, those segments are going to continue to expand margins.

Okay. And then just one housekeeping one. You had the other income line pick up fairly significantly in this quarter. Can you talk about what drove that up? And do you forecast the number for that in your model? Or is it just a 0 in your guidance?

Well, there's always some puts and takes. I mean, it can move around a little bit on a quarterly basis. The majority of what's in that bucket is really interest income. And so linked to some of the repatriation we talked about, we saw a pretty significant increase in the other income bucket. We do include an assumption in the guidance, and we also do for the back half, which is right around current levels. But like I said, it can move around a little bit on a quarter-by-quarter basis.

Our last question is from Jeffrey Sprague with Vertical Research Partners.

Just a couple of things here. First, just on Welding. I'd love to get a little more color there. I guess no good deed goes unpunished, right? You talked about Welding today. But if you could give us a little bit of color on where you're seeing the most strength and if there's any indication that customers are perhaps pre-buying. And I ask that in the spirit, Lincoln, for example, has raised price 3 times in the last 6 or 7 months, right? We're chasing price up pretty rapidly in this business. Do you see any unusual customer behavior in the channel as a result of that?

We really haven't. I mean, I think to give you a little bit more color, overall, Welding up 13%, with Equipment up 15%, Consumables moving up double-digit. And then North America is really the key driver of the business, which represents 80% of our sales. We talked about the industrial side before, so that would be heavy equipment, auto up really strong, more than 20%, and the commercial side continues in the high single digits this quarter. I know you're a big offshore guy. We have not seen a pickup in offshore, but overall, oil and gas was up 7% here in the quarter, which is certainly encouraging.

Great, that's helpful. And then just on Auto real quick. With this European testing logjam, I'm not sure if you're familiar with that, but the WLTP, do you see any disproportionate negative seasonality in your Auto business in Q3 as part of your back half guide?

In Europe specifically?

In Europe specifically, yes.

Yes, no, we have not seen that.

And then just one last one for me. Just on the Test & Measurement/Electronics, maybe Electronics a little bit more specifically. There is a lot of pressure and noise in just kind of the whole electronics supply chain, semi CapEx, et cetera, particularly rippling through Asia. Do you have visibility on what the back half looks like in that business? Maybe a little extra color there would be helpful.

Yes. I think the -- for Electronics, the back half looks good, similar to what we were seeing in the first half. We do have a little bit of semi exposure in that business, which may be going through a little bit of a slowdown in the near term but then is expected to pick back up in Q4. Not enough to really move the needle for us, but overall, the team feels really good going into the second half here.

Okay. I think that brings us to the top of the hour. Thanks, everybody. And if you have follow-up questions, I'm available. That concludes our call.

All right. Thanks, everybody.

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