Illinois Tool Works, Inc Q2 2009 Earnings Call Transcript

Transcripts

Illinois Tool Works, Inc. (NYSE:ITW) Q2 2009 Earnings Call July 22, 2009 2:00 PM ET

Executives

John Brooklier - Vice President of Investor Relations
Ron Kropp - Senior Vice President and Chief Financial Officer
David Speer - Chairman and Chief Operating Officer

Analysts

Terry Darling - Goldman Sachs
Deane Dray - FBR Capital Markets
Jamie Cook - Credit Suisse
Andy Casey - Wells Fargo Securities/Wachovia
Joel Tiss - Buckingham Research
Mark Koznarek - Cleveland Research
Daniel Dowd - Bernstein
Robert McCarthy - Robert W. Baird
Ben Elias - Stern Agee
Henry Kirn - UBS
Ann Duignan - JPMorgan

Operator

Welcome to the Illinois Tool Works second quarter 2009 Earnings Call. At this time all participants are in a listen only mode. (Operator Instructions) This conference is being recorded. If you have any objections you may disconnect at this time.

Now, I’ll turn the call over to your first host today, Mr. John Brooklier, Vice President of Investor Relations.

John Brooklier

Thank you. Good afternoon everybody and welcome to ITW’s second quarter 2009 conference call. As noted I am John Brooklier and with me today is our CEO David Speer and our CFO, Ron Kropp. Thanks for joining us today.

Now, let me turn the call over to David who will make some very brief remarks on what turned out to be better than expected quarter for us.

David Speer

Thank you, John. I am pleased to report that our recently concluded quarter represented improvement on a number of fronts, especially when you compare our second quarter to our first quarter 2009 results.

While base revenues were still significantly negative at minus 22% in the second quarter compared to 2008, our base revenues do appear to have stabilized. Sequentially base revenues in the second quarter were modestly better than the base revenues at minus 23.3% in the first quarter of the year. And we have now seen four consecutive months of reasonably stable base revenue performance.

Sequential operating margins significantly improved in the second quarter with margins at 9.9%. Excluding the impairment we experienced in the first quarter, our second quarter margins were 410 basis points better than our first quarter margins. Much of this improvement was due to the benefits of the restructuring programs that have been underway in the last several quarters.

Our second quarter earnings of $0.36 of share were significantly lower than the year ago period; they represent real improvement from the first quarter. Please note our earnings in the quarter were negatively impacted by discrete income tax charges and a higher than expected tax rate. As a result the Q2 earnings were reduced by $0.05 per share.

Our very strong free operating cash flow of $567 million was $213 million higher than the year ago period and represented a significant net income to free operating cash flow conversion rate of 321%. Our first half 2009 free operating cash flow totals $950 million. Our strong free cash flow year-to-date was largely been driven by a significant reductions in working capital.

And finally we are pleased with the upward trajectory of the company's operating margins and earnings. We remain mindful at the macroeconomic data and the worldwide end markets in aggregate remain weak. At best we expect minimal end market recovery in the second half of the year and into next year.

Now let me turn the call back over to John.

John Brooklier

Thanks David. Here is the agenda for today's call. Ron will join us shortly to cover Q2 financial highlights. I will then cover operating highlights for our reporting segments and then Ron will address our 2009 third quarter forecast.

Finally, we'll take your questions and as always we ask for your cooperation for the question and one follow-up question policy. We are targeting a one hour completion time for today's call.

First, lets cover some of the usual items please note that this conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including with our limitation, statements regarding operating performance, revenue growth, diluted income per share from continuing operations, restructuring expenses and related benefits, tax rates, end market conditions and the company’s related forecast. Important factors that could cause actual results to differ material from the company’s expectations are detailed in ITW’s Form 10-K for 2008.

And finally before we get to Ron, please note that the telephone playback for this conference call is 203-369-3416, no pass code necessary. Playback number will be available through 12 midnight of August 5, 2009. As always you can access our second quarter conference call PowerPoint presentation via the itw.com website.

Now, let me introduce Ron who will talk about 2009 financial highlights.

Ron Kropp

Thanks, John. Good afternoon everybody. Here are the key items for the second quarter. Revenue has decreased 26% due to significantly lower base revenues. Operating income was down 56% and margins of 9.9% were lower than last year by 670 basis points, but improved from the first quarter margins ex-impairment charge by 410 basis points.

Diluted income per share from continuing operations was $0.36, which was lower than last year by $0.65. Excluding the impact of the higher than expected tax rate of 34%, EPS would have been $0.41 which was the high end of our forecast range.

In spite of the significantly lower income, free operating cash flow was very strong at $567 million or $213 million higher than last year.

Now let’s go to the details of our operating results. Our 25.5% revenue decrease was primarily due to three factors. First, base revenues were down 22.2%, which was favorable by 70 basis points versus the first quarter. As David discussed, we continue to see weakness across our end markets and geographies. North American base revenues decreased 26.8%, which was 60 basis points more than the first quarter. International base revenues decreased 17.3%, which was an improvement of a 170 basis points from the first quarter.

Next, currency translation decreased revenues by 8.8%, which was unfavorable by a 160 basis points versus the first quarter negative currency effect. Lastly, acquisitions added 5.3% to revenue growth, which was 90 basis points lower than the first quarter acquisition impact. Operating margins for the second quarter of 9.9% were lower than last year by 670 basis points. The base business margins were lower by 400 basis points, primarily due to the lower sales volume.

However non-volume added items increased base margins by 310 basis points, as lower costs, as a result of restructuring programs and lower raw material costs had a favorable impact. In addition, acquisitions reduced margins by 80 basis points, translation diluted margins by 70 basis points and higher restructuring costs reduced margins by a 130 basis points.

Restructuring expense for the second quarter were $65 million, which was almost twice as much as the first quarter. When I turn it back over to John, he’ll provide more details on the operating results as he discusses the individual segments.

In the non-operating area, interest expense was higher by $7 million as a result of the higher interest rates and the long-term bonds issued in March. Other non-operating income and expense in the second quarter was unfavorable by $44 million, mainly due to a loss related to the venture capital investment and higher foreign exchange losses. The second quarter effective tax rate of 34% was higher than the forecasted rate 25% due to discreet charges related to German tax audits and the reclassification of the Decorative Surfaces segment back in the continued operations during the quarter. The higher tax rate reduced earnings by $0.05. The ongoing tax rate for the third quarter is expected to be in a range of 27.75% to 28.25%.

Turning to the balance sheet, total invested capital increased $218 million from the first quarter primarily due to currency translation as the US dollar weakened during the quarter versus our major currencies. Accounts receivable DSO was 63.5 days versus 63.2 at the end of the first quarter. Inventory months on hand was down to 1.9 at the end of the quarter versus 2.2 at the end of the first quarter.

Excluding the impact of translation, inventory levels reduced by more than $200 million during the second quarter. For the second quarter, capital expenditures were $57 million and depreciation was a $101 million.

ROIC declined to 8.6% versus 18.8% last year, largely as a result of the lower base business income. On the financing side, our debt decreased $839 million from the first quarter as strong free cash flow and proceeds from overseas repatriation we used to pay down commercial paper. As a result, our debt-to-capital ratio decreased to 28% in Q2 from 34% in Q1. Shares outstanding at June 30 were 499.7 million, note that the effective options typically adds 2 million shares to the dilutive share calculation.

Our cash position decreased $505 million in the second quarter as our free operating cash flow of $567 million were utilized for debt payments of $966 million, dividends of $155 million and acquisitions of $49 million.

Despite the lower income levels, we were able to generate strong free operating cash flow by reducing our working capital especially inventory.

Regarding acquisitions, we acquired five companies in the second quarter, which have annual revenues of $54 million. We have continued to see reduced level of activity in our acquisition pipeline.

I will now turn it back over to John, who will provide more details on the second quarter operating results.

John Brooklier

Thanks, Ron. Now, let’s review our second quarter highlights, starting with industrial packaging, segment revenues declined 35.9% and operating income fell 82.8% in Q2 versus the year ago period.

Operating margins of 3.5% were 970 basis points lower than the year earlier period, due to 710 basis points of margin dilution, 150 basis points of dilution related to translation. On a sequential basis, operating margins improved 400 basis points in Q2 versus Q1. The 35.9% decrease Q2 revenues consisted of minus 26.1% from base revenues, 0.8% from acquisitions and minus 10.6% from translation.

Moving to the next slide, industrial packaging segments Q2 base revenues of minus 26.1% was slightly more negative than base revenues of minus 24.5% in Q1. The modest sequential fall off in base revenues was largely attributable to negative industrial production rates in key geographies.

For example, US industrial production declined 15.2% in June 2009 versus a decrease of 14.6% in March 2009. Eurozone industrial production declined 16.8% in May 2009 versus a decrease of 18.5% in March 2009.

These important indexes along with ongoing weakness in key end market such as primary metals, construction related materials and manufacturing led to tap the demand for our industrial packaging consumables and equipment. As a result, total North American and international base revenues declined 31.9% and 27.3% respectively.

These metrics were slightly more negative in Q1, when North American base revenues declined 30.1% and international base revenues fell 24.4%.

In the Power Systems & Electronics segment in Q2, segment revenues declined 38.6% and operating income fell 57% versus the year ago period. Operating margins of 15.3% were 660 percentage points lower than the year earlier period with base margins accounting for 460 basis points of dilution and restructuring 120 basis points of dilution.

Excluding impairment in Q1 2009, operating margins improved 260 basis points. The 38.6% decrease in Q2 revenues consisted of minus 36.5% from base revenues, 2% from acquisitions and minus 4.1% from translation.

Some of the underlying data in the Power Systems & Electronics segment, we thought base revenues show a further signs of weakness in Q2 with base revenues at minus 36.5% in Q2 versus minus 31.9% in Q1.

The businesses in the segment largely are welding and PC board fabrication units are sensitive to both industrial production demand and CapEx spending. In welding total worldwide base revenues fell 37% in the quarter with North American base revenues down 41.3% and international base revenues down 26.4%.

PC board fabrication base revenues declined 59.2% in the quarter largely due to weak demand for consumer electronics products. The one bright spot in the segment continue to be ground support equipment units, which supply at the gate power units for airplanes at commercials and military airports. Base revenues grew 4% for these worldwide businesses in Q2.

Moving to the transportation segment. Q2 segment revenues fell 20.3% and operating income declined 75.6% versus the year ago period. An operating margins of 4.8% were 1100 basis points lower than the year ago period with base margins accounting for 670 basis points of dilution. The remainder of the margin dilution was almost equally split between translation, acquisitions and restructuring.

The better store gross in the segment is excluding impairment in Q1, 2009 operating margins improved 800 basis points in Q2 versus Q1. The 20.3% decrease of Q2 revenues consisted of minus 23.7% from base revenues, 12.7% from acquisitions and minus 9.4% from translation. The transportation segment’s base revenue improved notably in Q2 versus Q1. Segment base revenues declined 23.7% in the Q2 compared to a base revenue decrease of 35.5% in Q1. This improvement in base revenues was directly tied to significantly improved auto builds in Europe in Q2.

Our international automotive base revenues declined 22.5% in the second quarter versus the decrease of 44.1% in Q1. These improving numbers are result of builds of 4.1 million units in Q2 versus three million units in Q1, in part due to the cash-for-clunkers auto incentive program underway in Europe.

In North America, our base revenues fell 39.5% in Q2 versus the decline of 46.4% in Q1 as auto builds reached 1.8 million units in Q2 versus 1.7 million units in Q1.

On a year-over-year basis North American auto builds declined 49% in Q2 with Detroit three builds down 46% and the Detroit three break out is GM down 54%, Ford down 34% and Chrysler down 85%. New domestic builds declined 39% in Q2.

Finally in our auto aftermarket side of businesses base revenues declined only 12.7% in Q2, as consumers continued to utilize auto aftermarket service and appearance products, as part of the trend that consumers holding on to vehicles for longer periods of time.

Moving to food equipment segment, Q2 segment revenues declined 16.2% and operating income fell 20.7% versus the year ago period. Operating margins of 12.9% were 80 basis points lower than the year ago period, mainly due to 50 basis points of dilution related to restructuring activities. Base margins actually improved 20 basis points in the quarter.

Sequentially operating margins improved 260 basis points in Q2 versus Q1. The 16.2% decrease in Q2 revenues consisted of minus 8.5% from base revenues, 1.6% from acquisitions, and minus 9.3% from translation.

Food equipments base revenue performance improved modestly from Q2 to Q1. Base revenues were minus 8.5% in Q2 versus 9.2% in Q1 and the modest sequential improvement was due to better sales performance in North America. Specifically total North American food equipment base revenues declined 8.4% in Q2 compared to decline of 13.7% in Q1. Notably, institution equipment sales were down 13.2% in Q2 versus a decrease of 18.1% in Q1. Sales weakened internationally with food equipment base revenues decreasing 10.2% in Q2 versus the decline 5.5% in Q1.

Moving on to the construction product segment, Q2 revenues fell 34.5% and operating income declined 72.8%. Operating margins of 5.9% were 820 basis points lower than the year ago period mainly due to 570 basis points of base margin dilution and 210 basis points of dilution associated with translation. Sequentially, operating margins improved a substantial 910 basis points in Q2, versus Q1 as accumulative benefits of restructuring impacted the bottom line.

A 34.5% decrease in Q2 revenues consisted of minus 22.1% from base revenues, 0.7% from acquisitions and minus 13.1% from translation. The construction segments base revenue decline of 22.1% in Q2 was essentially in line with base revenue decrease of 21.2% in the preceding quarter.

We believe we witnessed signs of in market stabilization, both in North America and internationally during the quarter. In North America, base revenues fell 34% in Q2 versus a decline of 31% in Q1. And more notably, our residential units base revenues declined 43% in Q2 the same as in Q1, even as housing starts were down 48% in Q2 versus the year ago period. Sequentially, US housing starts in Q2 rose 1% versus Q1.

In the commercial sector, our base revenues declined 32.7% versus a decrease of 32% in Q1 and in the renovation category, base revenues fell 19.6% in Q2 versus a decline of 18% in Q1. Base revenues for international businesses declined 20.2% in Q2 versus a decrease of 19.7% in Q1. And European base revenues fell 30.2% and Asia Pacific base revenues fell a mere 2.5% in Q2. Both metrics were roughly in line with Q1 performance.

The next segment Polymers and Fluids, Q2 revenues fell 6.9% and operating income declined 46.1% versus the year ago period. Operating margins were 10.4% or 750 basis points fluids lower than the year-ago period mainly due to 310 basis points of dilution from acquisitions and a 190 basis points of dilution from restructuring.

Excluding impairment in Q1, operating margins improved 650 basis points in Q2 versus Q1. The 6.9% decrease in Q2 revenues consisted of minus 15.1% from base revenues. 19.2% from acquisitions, and minus 11% from translation.

For Polymers, the segment base revenue declined 15.1% in Q2 versus a decrease of 16.9% in Q1 as industrial production rates and MRO demand continued to be weak. This modest sequential improvement in base revenues was primarily a result of better performance from the international units within the segment.

In Fluids worldwide base revenues decreased 15.9% in Q2 versus a decrease of 19.9% in Q1. The International Fluids businesses saw base revenues decline only 11.2% in Q2 versus 16.4% in Q1. And the North American Fluid base revenues declined 22.9% in Q2 versus a decrease of 25.1% in Q1.

Worldwide Polymers base revenues fell 17.4% in Q2 versus a decline of approximately 18% in Q1 and International Polymers base revenues declined 7.9% in Q2 versus a decrease of 15.4% in Q1. North American base Polymers fell 28.6% in Q2 versus a decrease of 21.5% in Q1.

Moving on to our Decorative Surfaces segment, Q2 revenues declined 23.4% and operating income fell 27.2% versus the year ago period. Operating margins of 13.2% were healthy and were only 70 basis points lower than the year ago period. There is a 160 basis points of dilution from restructuring. Notably base margins improved 40 basis points on a year-over-year basis.

Sequentially operating margins improved to 110 basis points in Q2 versus Q1, and the 23.4% decline in Q2 revenues consisted of minus 16 from base revenues and minus 7.4 from translation.

As noted the Decorative Surfaces segment base revenues declined 16% in Q2 versus a base revenue decrease of 17.1% in Q1. The segments overall performance continues to benefit for its largely commercial construction mix and its ability to continue to take market share on a variety of worldwide high pressure laminate end markets.

The North American laminate businesses base revenues declined 20% in Q2, versus the base revenue decrease of 18.6% in Q1.

The Wilsonart business unit high definition laminate product continue to be attractively designed and price competitive alternatives to competitive natural and manufactured stone products. In fact there were a variety of HD premium products that were successfully launched in June of this year.

In Q2 international base revenues declined 11.6% versus the base revenue decrease of 13.2% in Q1. The base revenues from our French and Asian operations were week, while our UK units base revenues outperformed in the quarter.

Finally to our last segment all other; in Q2 segment revenues declined 18.2% and operating income fell 46% versus the year ago period. Operating margins of 13.2% were 680 basis points lower than the year ago period were 300 basis points of base margin dilution, and 230 basis points of dilution associated with restructuring.

Excluding impairment in Q1, operating margins were 180 basis points high in Q2 versus Q1. The 18.2% decline of revenues consisted of minus 20% from base revenues, 8.6% from acquisitions and minus 6.8% from translation.

As we noted earlier the All Other segment consist of four major reporting categories test and measurement; consumer packaging; finishing and industrial appliance products. The segment base revenues were modestly more negative in Q2 with base revenues decreasing 20% in Q2 versus the base revenue of decline of 18.9% in Q1.

Very quickly, in test and measurement worldwide base revenues declined 15.3% in Q2 versus the decrease of 13.2% in Q1. This modest fall off in base revenues, was the result of weakening CapEx spending in North America, Europe and to a lesser extend Asia.

Consumer packaging worldwide base revenues actually improved in Q2 versus the first quarter with base revenues declining 12.9% in Q2 versus the base revenue decrease of 15.2% in Q1. The Hi-Cone multipackaging can and bottle businesses and the zip bag receivable packaging businesses, led the way during the quarter.

In finishing, worldwide base revenues for these paint spray, systems and components fell 38.7% in Q2 versus a decrease of 24.1% in Q1. The sequential slowing was attributable to slow in manufacturing and CapEx spending in various geographies.

Finally industrial appliance worldwide base revenues were basically sequentially flat, as Q2 base revenues declined 26.9% versus the decrease of 27.8% in Q1. Declines in housing and renovation activity continued to pressure the appliance portion of this business.

Now, let me turn the call back over to Ron, who will briefly cover our third quarter forecast and related assumptions.

Ron Kropp

As a result of the ongoing broad based weakness, we have limited our long-term low visibility to our worldwide end market therefore, at this time we are limiting our forecast to just the third quarter of 2009.

For the third quarter, we are forecasting diluted income per share from continuing operations to be within a range of $0.39 to $0.51. The low end of this range is assumes to 26% decrease in total revenues from 2008 and the high end of the range assumes to 20% decrease. The midpoint of this EPS range of $0.45 would be 49% lower than 2008.

Given the economic situation, a more relevant comparison, maybe to the second quarter of 2009, third quarter 2009 forecasted revenue change from the second quarter of 2009 would be in a range of negative 1% to plus 4% and the third quarter forecasted EPS would be higher by 8% to 42%.

Other assumptions included in this forecast are exchange rates holding at current levels, restructuring cost of $30 million to $50 million for the third quarter, compared to $65 million in the second quarter, net non-operating expense in the range of $40 million to $45 million for the third quarter, and a tax rate range between 27.75% and 28.25% for the third quarter versus our tax rate in the second quarter of 34%.

I will now turn it back over to John for the Q&A.

John Brooklier

Thanks, Ron. Now we’ll open the call to questions and I’ll remind everybody once again we ask everybody to please honor our one question, one follow-up question request.

Question-and-Answer Session

Operator

Thank you. We’ll now begin the question and answer session. (Operator Instructions). Our first question comes from Terry Darling of Goldman Sachs

Terry Darling - Goldman Sachs

I am just trying to decipher what you are really telling us with the low end of 3Q guidance and if I take the low end of revenues and the high end of restructuring and the high ended tax, and kind to try to solve for what the detrimental margin assumption would have to be on a 2% sequential drop in revenues, its like a 60% detrimental, if I have got the math right. I’m just trying to figure out what would have to happen for that to actually occur, is there some pricing concern? Was there something in the second quarter that you know maybe feels little one-time? Any help on that for us?

David Speer

Well, I think if you look at the you know, the revenue range, first of all you have to understand that the third quarter has built into it the normal seasonal weaknesses that we expect to see in Europe is, that’s a heavy period of vacations, and in fact, we shut down. So that’s a sequential comparison. We expect the third quarter even on a normal basis is somewhere in the 5% range lower than our second quarter.

I think obviously the broad ranges lead to some different calculations that could lead you to look at comparisons such as what you've made given the broad range of activity. Clearly, the trends we saw with the margins in the second quarter improving to 9.9%, our base assumptions would have those margins north of 10% during the quarter and I think if you look at all ends of this, you know the range of earnings therefore before becomes much broader as Ron pointed out, it's a range of improvement over Q2 of 8% to 42%.

So obviously, a pretty broad range. So I think in terms of the math on the low end you could end up with I guess, a calculation I haven't done it that would have detrimentals like that, but I think the likelihood of detrimentals like that based on those revenue assumptions are remote.

Terry Darling - Goldman Sachs

That's helpful. And then if we go to the high end of the range just on the revenue discussion, which segments would you expect to be the driver, is that mainly transport or there are some other segments that you know are obviously uncertain at this point what will be most likely to be driving that kind of a sequential improvement?

David Speer

Well, I think if you look at the overall mix of businesses that Ron and John went through those details, you will see that a number of the businesses as indicated in my earlier comments, a number of the segments have stabilized, there are still some like the welding group in particular that we have continued to see some decline. So, I can't say that those businesses have bottomed, but the ones that clearly have been more stable and we would suggest at least that based on the data that we have at the moment that would look better in Q3 would certainly be transportation, construction to a lesser extent, food equipment.

So, I would say it's pretty broadly spread as the second quarter results show. The stability is I would say fairly broad at the moment with really only the welding organization to a lesser extent a little bit in food equipment, there was still some declines.

Terry Darling - Goldman Sachs

Okay. That's good and just lastly, David, the cash flow was very strong this quarter and the repair of the balance sheets happened sooner than we thought. What are the triggers that you are looking for in order to move back on to the offensive with the balance sheet? Presumably, it's not anywhere in the near term you do want to see things stabilize a little bit more but, if you could just help us understand how low you are willing to see that net debt-to-cap ratio go before you get back in the offensive here?

David Speer

Well, that the big variable is obviously acquisitions and acquisitions have been very light. So, I wouldn't expect to see a significant change, certainly not in the trajectory until we see a significant improvement in the acquisition activity. And we said since we provided guidance originally this year that we saw a weakening acquisition environment. And that we are comfortable, obviously storing cash and storing our credit capabilities for when that environment improves because we believe when it does there will be significant opportunities for the company. So, I don’t expect to see any change upward in that debt-to-cap, which I think was what your question was aimed at until we see a significant improvement in acquisition activity.

Operator

Your next question comes from Deane Dray with FBR Capital Markets. Sir, your line is open.

Deane Dray - FBR Capital Markets

It's been a while since we got to talk about Decorative Surfaces that it's back into the core business and one of the things that struck me on the results from the quarter is how skewed it is to the commercial construction markets and if we are at the beginnings of a significant downturn there, how badly do you think this business bears in as you start to see the fall off?

David Speer

Well, certainly, Deane as you know, it's been pointed out in your comment, the commercial markets are the most important segment overall for the company here for the Decorative Surfaces business is about 65% of their business is in commercial. Now it's not all commercial construction as in building per se, but it ends up in commercial buildings, commercial businesses.

So a fair amount of that is in retail store fixtures, case goods, items like that office furniture certainly is a portion of that. So a broad variety of end markets that end up in various commercial areas. What we have seen happen Deane, is that the advent of a lot of our newer product ranges in decorative surfaces, particularly the high definition series has helped us gain market penetration in some of those commercial markets where people are looking at using those premium laminated products as in some cases that trade down on a cost savings alternative to using other surface materials like natural stones or even engineered stone products.

So while the trajectory in commercial is down and certainly don’t think we have the same kind of trajectory in these businesses certainly. In Europe, it’s a much better balanced portfolio of businesses as it is in Asia, where it is primarily a commercial. However for a broader, even variety of end market activities and certainly in those markets, we have not seen the same kind of declines we have seen in the commercial markets here.

Deane Dray - FBR Capital Markets

That's very helpful. And just my follow-up, an earlier comment on power systems, I believe I heard you say you're not expecting to have seen that to have stabilized here. That’s one of ITW's more late-cycle businesses. If you just take us a tour geographically, what end markets you're seeing in the expectations on how power system fare?

John Brooklier

Well, I think what I said Deane was that we have not seen the stabilization, I described earlier stabilization is being three to four months of relatively consistent activity. We have not seen that overall in the Power Systems & Electronics businesses. Notably the welding businesses, we have seen more stability recently, but frankly only for a couple of months, so hard to call that yet.

The electronic segment, we have not seen any stability yet. Although we have an order book that is looking at least modestly better, too early to call any turn there. So, I’d expect that we will see some choppy numbers in Q3 in those markets and probably during the quarter, we may well be able to say that we have seen stabilization, but certainly entering the quarter, we can’t say that.

Operator

The next question comes from Jamie Cook with Credit Suisse. Your line is open.

Jamie Cook - Credit Suisse

First question, we saw another improvement in decremental margins in the second quarter versus the first quarter. Your margins of 9.9% were slightly better than, what I thought. So, I’m just wondering if you could comment on how you see margins trending towards the end of the year. Can we get to 12% rate or better given the second quarter performance and if there is any improvement on the decremental? Then David if you could just talk about how you’re thinking about auto production potentially in 2010, when you think about the US and Europe?

David

Sure, well it relates to decremental, Jamie. There were two primary drivers of good performance in the quarter. Certainly the impact of the restructuring, which we’ve been talking about now for several quarters, had a huge impact on the improvement. As we talked in our first quarter call, our efforts were really to get our businesses right size to a much lower market activity level that we’d anticipated when we started the year.

We spent $65 million in the second quarter on restructuring. We spent $35 million in the first quarter, nearly the same amount in the fourth quarter of last year. So, all and in the last three quarters, we spent $130 plus million in restructuring. We are now obviously beginning to see those benefits.

The second major factor was the positive impact on our price cost relationship. During the quarter, we had a positive impact of nearly 170 basis points on price cost and as you may recall, we were also signaling that we saw some recovery occurring there as cost began to mediate and the impact of price increases, particularly towards the end of last year began to come into play. So, those are very favorable, obviously.

Going forward, I’d expect that the strength of the restructuring, we will continue to see margins powered forward on those. We have not yet obviously seen all those benefits, certainly not all the benefits in the second quarter and to some extent even not those from the first.

So, clearly our expectation is without any significant improvement in revenues. That we would expect to see the margins climb certainly well into the double-digit territory in the next couple of quarters.

In terms of the auto build for next year, we really haven’t formed a view of exact numbers for next year in North America. If you look at the current assumptions for 2009 coming out of CSM, we are talking about an auto build somewhere around 7.8 million vehicles and I think from just our brief review in our long range plan discussions, our folks are probably looking at something between 8.5 to 9 million vehicles next year, but its very preliminary data at this point.

Don’t have any read on Europe yet. Although the European numbers that clearly the last half of the year would expect to be somewhere in the 8 million range in terms of the overall build, which is roughly in line with sequentially, what occurred in the second quarter. So, don’t have any read yet on the European build for 2010.

Operator

The next question comes from Andy Casey with Wells Fargo Securities.

Andy Casey - Wells Fargo Securities/Wachovia

First point, just trying to understand your consumable versus equipment split and packaging and power systems. Was there any improvement in the rate of change in Q2 versus Q1 due to among other things low rates of destocking?

David Speer

On the two sides, industrial packaging, no real significant change in either the equipment or the consumable profile. So you know the mix there again is a roughly 70-30, 70% consumables, 30% equipment in the industrial packaging, but no notable changes there. Although, I would say their businesses in that category have reached some reasonable level of stability over the last three or four months, but no notable change in mix between the two, if that was your question Andy?

On the power electronic side, we've seen better numbers on the consumables than we have on the equipment. Most of the decline is still been related to the equipment. The consumable volumes have actually stabilized in the last several months and certainly here in North America and in Asia, but the equipment volumes have been much more choppy in the power electronics business.

Andy Casey - Wells Fargo Securities/Wachovia

Okay. Thanks for that clarity. Then digging in the non-operating margin improvement contribution, out of the 310 basis points David I think you'd indicated about a 170 that was price cost benefit. Could you give a little color and overall on what the other roughly 140 was?

David Speer

I'm going to let Ron answer that for you Andy.

Ron Kropp

Yes. So total net volume impact is 310 basis points for base, 170 is price cost as you said. The other 140 is all related to cost reductions, and you know a large portion of that related to the benefits of restructuring where we reduced overhead and other manufacturing cost as a result of [four] restructuring projects. We also have a lot of ongoing cost reduction initiatives that don't involve restructuring, going on at various business units that have reduced the cost there, they have improved margins as well. The biggest segments that have restructuring benefits are power systems is one, also construction, [FEG] and polymers and fluids.

Andy Casey - Wells Fargo Securities/Wachovia

Okay and if I could follow-up on that just in some of the other companies that have reportedly had some inventory accounting benefit in the margins, did you guys see any of that?

Ron Kropp

No, not this quarter.

Operator

Your next question comes from Joel Tiss with Buckingham Research

Joel Tiss - Buckingham Research

I wonder if you can talk a little bit about the [snap back] in the packaging margins. Why is it that seems to be so tame versus what we're seeing in some of the other segments?

David Speer

You're talking about the improvement in margins?

Joel Tiss - Buckingham Research

Yes, the margins are getting a little bit better versus we've seen some pretty some harder snap backs in some other segments.

David Speer

Sure, while a large portion of the restructuring that is underway right now in the industrial packaging segment is international, so we've not yet the benefits of those restructuring projects As you may recall, Joel those take-- generally those restructuring projects internationally, the payback on them is more like 10 to 12 months. So while we have invested in those, we've yet to see any of the significant benefits yet. I would expect that over the next several quarters, we'll begin to see those trends change.

On the cost margin side, they have done reasonably well in terms of cost recovery but they have now begun to see cost increases particularly in their steel products. So some of that is mitigated, but we do expect to see albeit with more stable prices, a stronger margin improvement.

Joel Tiss - Buckingham Research

Okay. And also you mentioned a couple of segments that we should see some continued strength going into the rest of the year and into 2010 and you didn't really mention transport and it just seems like auto is snapping back harder than some of the areas. Is there anything below the surface there that we should know?

David Speer

No. I think what Ron was referring to, is where we have significant restructuring benefits coming forward. No, I think the transport business segment we should continue to see better margins. Obviously, the build rates for the rest of the year in the OEM auto businesses will be better clearly than what we saw in the first two quarters. And we've done a significant level of restructuring in those businesses. So, I would expect to see a very good margin improvement performance in those businesses.

Joel Tiss - Buckingham Research

Okay. And last quick one. Have you given us a free cash flow estimate for 2009?

David Speer

No, we have not.

John Brooklier

You know it's 950.

Ron Kropp

Yes I think the only thing we could say is that it's very strong in the first half. We've done a very good job in both the first and second quarter, reducing working capital receivables more in the first quarter inventory than the second. And so we've been generating a lot of free cash above and beyond our net income in the first half.

Yes, we still have opportunities there, but we won't see quite the impact of reducing the balance sheet as we did in the first half. So, it would be closer to a little bit more than one times net income as opposed to this quarter was 300 plus percent of net income for cash flow.

Operator

The next question comes from Mark Koznarek with Cleveland Research.

Mark Koznarek - Cleveland Research

You spoke a little bit about restructuring a little bit earlier, I just want to basically ask the question what have we got in for our $100 million now that we have spend year to date and what do you expect to get for the remainder in the second half?

And I know obviously the answer is 410 basis points of margin improvement you got so far in the second quarter. But how did that occur? Specifically can you give me an idea of what amount of headcount reduction is been undertaken? Or had there been facilities that have been shuttered to a material extent? Can you kind of quantify what you guys have actually done?

David Speer

Well, most of the restructuring charges and benefits are related to headcount. So, if you look across the spend, more than 80%, probably closer to 85% of it is related to reduction in personnel. I don’t have a precise number for the reduction for their first two quarters in terms of what were in those restructuring projects, but over the last four quarters, the overall work force has been reduced by something close to 7000 people overall.

So, somewhere in the 12% range, in terms of the overall headcount. In terms of the go forward look, clearly as we have moved in the second quarter to more international restructurings, the payback on those is longer.

So, the margin improvement profile is a bit slower on those, but nonetheless we would expect to see continued margin improvement on the basis of what we have already spent and as Ron highlighted in his earlier comments, we expect to spend somewhere in the $40 million range restructuring again in Q3.

So, I think the expectation is that we will continue to see margin improvement. If you look at the second quarter profile, the bulk of the margin improvement, more than two thirds of it came from the benefits we saw from restructuring project. So, we would expect that to continue.

Overall the restructuring projects, typically if you take the balance between our international and domestic restructuring projects, we typically are seeing paybacks that would be in the nine month range if you look at them cumulatively and benefits that are somewhere in the order of 1.2 to 1.3 times the cost. So, we had $100 million so far this year, if you just try to monetize that on an annualized basis, you’d see that being benefits of around $120 million to $125 million.

Mark Koznarek - Cleveland Research

Just of the year-to-date amount?

David Speer

Correct and you can apply the same math to the fourth quarter of last year for the 33 year or so, we spent there. So, it’s hard to put in precise quarterly buckets because it doesn’t blow, evenly some of those projects would have been approved towards the end of the quarter.

So, you can’t really precisely determine the lineup by quarter, but that’s roughly the way it works. You would see that in the impact in the second quarter. Obviously the full impact of what we were doing in the fourth quarter and a partial impact in the first quarter realized in our second quarter results.

Ron Kropp

A lot of those restructuring, it’s happening at the business unit level, that’s how we do it in our decentralized environment. So, there is a lot of different kinds of restructuring had been at all different times and you asked about shuttering plans, yes there are some of those, it is primarily headcount, but so there is a lot of different flavors of this spread throughout the world at all the various business units.

Mark Koznarek - Cleveland Research

Then we got you to walk out on the limb, asking about the future look for vehicle production, could I ask you about your outlook on housing starts and commercial construction, both domestic and international?

David Speer

We are going to start a new segment called forecasting and we are going to charge for these, if we are accurate, how is that? My view on the housing front is, we have obviously been bouncing around on the bottom. The housing numbers for June that just came out last Friday were modestly better than the once for May. They were up about 6%.

We have seen now about seven months of reasonable stability in the single family housing number. In fact the single family housing number in June was over 400,000. It’s pretty much in line with what we have been saying though. I think we’ll see a slow in modest recovery in the in the housing numbers.

I don't expect to see any significant improvement. I think by the end of the year, we'll probably be in a range of annualized activity of probably 550,000 to 600,000. I don't see any significant catalyst is going to change that number remarkably in 2010. So, while it will be sequentially better than what we seen and certainly as the month go on, we'll see improvements in the 6% to 7% range, like we did in June. I don't expect we're going to see a robust recovery in 2010 in housing. I think housing is at least to 2011 recovery in terms of significant improvement.

Commercial continues to fall the F.W. Dodge numbers for contracts rewarded are still down in the range of minus 50% in terms of square footage on those projects year-to-date. The activity levels across the major different segments are still down significantly. Office down 63%, retail stores down 58%, hotels down 57%, manufacturing 54%. So, there is a lot of damage still to be done or realized in the commercial construction markets because these are starts, equivalent to starts, which means that we're still trending down from buildings that are being completed that we are started in 2006, 2007.

So, I think we're going to continue to see a negative trajectory in the commercial markets. I would expect that the numbers next year won't be as bad as this year, but they will still be negative. I expect we'll still be a negative territory maybe in the mid-teens to low 20s.

Mark Koznarek - Cleveland Research

How about international?

David Speer

International, well there is no international industry. I’d expect that in Europe, we'll see as we've seen recently stability in a number of their commercial markets and that could possibly lead to some more positive comparisons next year. They have an opportunity to have some positive growth in commercial, albeit at modest in Europe.

The numbers in Asia clearly have moved upward particularly as related to infrastructure in markets like China. But again there is no one overall industry in terms of the international markets. But international markets are clearly be more favorable than those here in the US.

John Brooklier

And Mark, I would remind you that our international exposure on the commercial side is far bigger than it is on the North American side.

David Speer

Remember in construction 60% of the business is outside of North America.

Operator

Your next question comes from Daniel Dowd with Bernstein.

Daniel Dowd - Bernstein

Let me just turn to the acquisition pipeline for a minute. Are you seeing any differences in the willingness of sellers in key emerging markets that's different from what you are seeing in North America and Europe or is it pretty uniformly dismal everywhere?

David Speer

Well, that's that maybe hard if it too much flavor on Dan, because I don’t know, but I've got lot of data specifically on emerging markets. I can tell you I haven’t seen anybody flag anything for me that would indicate that they are significantly different.

Their markets have not been impacted to the same degree as the markets here in terms of the decline in both revenues and earnings. So, they are probably not in quite the same situation but nonetheless the multiples and the overall evaluations in those markets have also been impacted by the downturn. Particularly due to extent that businesses in the emerging markets are relying on exports to the developed markets.

So, I don’t really think there is much difference, but again I don’t have a lot of data to draw on. I can say that the pipeline for us is still above what it look liked before, the pipeline in terms of size is in the 300 million range. Not lot of new stuff flowing into the pipeline, but I can say that in the last probably four to six weeks I can see more activity and discussions going on around things it could end up going into a pipeline at some point, which is clearly different what we would have seen 90 days ago.

So maybe we're starting to see some early signs of the market adjusting to the realities of valuation which is really the primary issue here.

Daniel Dowd - Bernstein

All right. Well, lets assume then that the pipeline is pretty weak for the next 12 months or so. Where do you see your balance sheet ending up, this time next year?

David Speer

Well, I am not assuming its going to remain weak for 12 months but you can do your math on that. You saw the power of what we're able to do in the second quarter. Obviously as Ron pointed out a lot of that is based on significant reductions in working capital which is as things stabilize you won't see those reductions continuing to occur but certainly, if you'd look at where we are today in the 27%, 28% range, if we continue to see the kind of modest activity we're seeing we would clearly be in the low 20s I would guess. That's not what my expectation is, I really do expect the acquisition market to improve, probably not significantly in our numbers this year but I would expect by the fourth quarters of this year we would be talking about the different look at the pipeline than what we're seeing today.

Daniel Dowd - Bernstein

Okay. Is there a debt to equity at which you shift from debt reductions to a share buyback?

David Speer

There could be but we're certainly not. That's not on my radar screen right now.

Operator

The next question comes from Robert McCarthy with Robert W. Baird.