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Illinois Tool Works Inc. (NYSE:ITW)

Q3 2009 Earnings Call

October 20, 2009; 2:00 pm ET

Executives

Ron Kropp - Chief Financial Officer & Senior Vice President

David Speer - Chairman of the Board & Chief Executive Officer

John Brooklier - Vice President of Investor Relations

Analysts

Dean Dray - FBR Capital Markets

John Inch - Merrill Lynch

Eli Lustgarten - Longbow Research

Henry Kirn - UBS

David Raso – ISI

Jamie Cook - Credit Suisse

Andy Casey - Wells Fargo Securities

Daniel Dowd - Bernstein

Ann Duignan - J.P. Morgan

Walter Liptak - Barrington Research

Operator

Welcome to the Illinois Tool Works third quarter 2009 earnings conference call. At this time, all participants are in a listen-only mode. (Operator Instructions). This conference is being recorded. If you have any objections please disconnect at this time.

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

John Brooklier

Thank you Amy good afternoon everyone and welcome to our third quarter conference call. As noted I am John Brooklier, ITW’s Investor Relations Officer and with me today is our CEO, David Speer and our CFO, Ron Kropp. Thanks for joining us.

Let me now turn today’s call over to David who will make some brief introductory remarks on what turned out to be another strong operating performance for us. David.

David Speer

Thank you John. You are right, the third quarter did turn out to be better than expected on a number of fronts. Our total company base revenues improved sequentially as base revenues declined 17.9% in quarter three versus a decrease of 22.2% in quarter two. Some of this improvement our base revenues was due to a modest pickup of activity and several discrete end markets, such as North American Auto and the residential housing markets.

A very strong quarter three operating margins of 13.5% were 360 basis points higher than our second quarter operating margins and our quarter three margins were 770 basis points higher than our comparative Q1 operating margins. It’s clear that our ongoing restructuring activities have had a positive impact on our numbers.

I would like to thank and congratulate our Operating Managers around the world for stepping up to the plate and rightsizing their businesses based on the demands of their local customers and end markets.

Our third quarter free operating cash flow was a very strong $516 million, thanks in large part to our improved operating earnings, and working capital reductions. This represents a free cash flow to net income conversion rate of 171% for the quarter and for the year our pre-operating cash flow totaled nearly $1.5 billion or an impressive conversion rate of 333%. Let me now 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 Q3 financial highlights, I’ll then cover operating highlights for our reporting segments and Ron will address our 2009 fourth quarter forecast.

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

Let me cover a couple 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 without limitations, statements regarding operating performance, revenue growth, diluted income per share from continuing operations, restructuring expenses and related benefits, tax rate and market conditions and the company’s related forecasts. Please consult our 10K for additional information on this forward-looking statements.

Finally, the telephone playback for this conference call is 203-369-1074. No pass code is necessary.

Now let me turn the call over to Ron who will comment on that Q3, 2009 financial highlights.

Ron Kropp

Good afternoon everybody. Here are the highlights for the third quarter. Revenues decreased 20% due to lower-base revenues, but showed improvement from the second quarter revenue decline of 26%. Operating income was down 28%, margins of 13.5% were lower than last year by a 150 basis points, but improved this from the second quarter margins by 360 basis points.

Diluted income per share were $0.60, which was lower than last year by $0.29, excluding the impact of a $12 million impairment charge and the higher than expected tax rate of 32.5% EPS would have been a $0.66. Our previously forecasted range was $0.48 to $0.56 per share. Free operating cash flow continue to be very strong at $516 million or a 171% of net income.

Now let’s go to the components of our operating results. Our 19.8% revenue decrease was primarily due to three factors. First, base revenues were down 17.9% which was favorable by 430 basis points versus the second quarter. As David mentioned, we have seen a modest pick up in certain end markets, such as, North American Auto and Housing. North American base revenues decreased 21.6% which was 520 basis points better than the second quarter.

International base revenues decreased 13.8% which was an improvement of 350 basis points from the second quarter. Next, currency translation decreased revenues by 5.6% which was favorable by 320 basis points versus the second quarter negative currency effect.

Lastly, acquisitions added 3.6% to revenue growth, which was a 170 basis points lower than the second quarter acquisition impact. Operating margins for the third quarter of 13.5% were lower than last year by 150 basis points. The base business margins were actually higher by 20 basis points as the unfavorable impact had a lower sales volume was more than offset by non-volume items. Non-volume items increased base margins by 580 basis points, which was favorable versus the second quarter non-volume effect by 270 basis points.

Included in the non-volume impact for the third quarter were the following items. We had a favorable price cost effect that improved margins by 260 basis points. Lower cost as a result of our restructuring programs had a favorable impact of 160 basis points. And that other miscellaneous favorable one time adjustments such as, items related to inventory reserves, life insurance investments and benefit accruals improved margins by 90 basis points.

In addition, acquisitions reduced margins by 40 basis points, translation diluted margins by 30 basis points, higher restructuring expense reduced margins by 70 basis points and a goodwill impairment charge had a negative 30 basis point impact.

Starting this quarter, we have changed our annual goodwill testing period from the first quarter to the third quarter and we had a minimal impairment charge related to one business.

When I turn it back over to John he will provide more details on the operating results that he discuss at the individual segments. In the non-operating area, interest expense was higher by 7 million as a result of the higher interest rates and a long-term bond to be issued in March.

Other non-operating income and expense in the third quarter was unfavorable by 6 million mainly due to higher foreign exchange losses.

The third quarter effective tax rate of 32.5% was higher than the forecasted rate of 28% and reduced earnings by $0.04 per share. The higher rate was a result of discrete charges including, non-deductible goodwill impairment and a higher ongoing rate due to higher pre-tax income. The ongoing tax rate for the fourth quarter is expected to be in the range of 29.25% to 29.75%.

Turning to the balance sheet, total invested capital decreased a $110 million from the second quarter as the continued reductions in operating working capital were partially offset by increases related to currency translation.

Accounts receivable DSO improved to 60.6 days versus 63.5 at the end of the second quarter. Inventory months on hand was 1.8 at the end of the quarter versus 1.9 at the end of last quarter, excluding the effect of translation, inventory levels were reduced by almost a $100 million during the third quarter, and by more than $500 million year-to-date.

For the third quarter, CapEx was $53 million and depreciation was $89 million. ROIC declined to 12.7% versus 16.2% last year, largely as a result of the lower base business income, but significantly improved from the second quarter ROIC of 8.6%.

On the financing side, our debt decreased $99 million from second quarter, a strong free cash flow was used to pay off commercial paper. As a result our debt to capital ratio decreased to 36% in Q3 from 28% in Q2.

Shares outstanding at September 30th were $500.9 million. Note that the effective options typically adds about $2 million shares to dilutive share calculations. Our cash position increased $327 million in the third quarter as our free operating cash flow of $516 million was utilized for debt repayments of a $105 million and dividends of a $155 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 two companies in the third quarter, which have annual revenues of $6 million, although we have seen a low level of acquisition activity so far this year, an acquisition pipeline for the fourth quarter looks a little better, with more than $200 million in acquired revenues.

I will now turn it back over to John who will provide more detail on the segment operating results.

John Brooklier

Thank you Ron. Now, let’s review our third quarter segment highlights, we’ll start with industrial packaging where segment revenues declined 29.5% and operating income fell 52% in Q3 versus the year ago period.

Operating margins of 7.6% were 360 basis points lower than the year ago period. But sequentially, Q3 operating margins improved 410 basis points compared to Q2. The 29.5% decline in revenues consisted of the following, minus 23.3% from base revenues, 0.9% contribution from acquisitions and minus 7.1% from translation.

Moving to the next slide, industrial packaging base revenue actually showed modest signs of improvement in Q3 versus Q2. In Q3 base revenues fell 23.3% compared to a Q2 base revenue decline of 26.1%. Clearly, underlying fundamental such as industrial production in the US and in Europe have shown some signs of modest improvement as the year have progressed, and these trends have helped our industrial packaging businesses somewhat.

For example, our total North American industrial packaging business has declined 27% in Q3 versus a decrease of nearly 32% in Q2, and likewise our total international industrial packaging business has decreased 25% in Q3 versus a decline of 27.3% in Q2. Small improvements, but the numbers appear to be moving in the right direction.

Moving to the power system and electronic segment, in Q3 segment revenues decreased 34.6% and operating income fell 41.2% versus the year ago period. The good news is, well, a strong Q3 operating margins of 17.2% were 200 basis points lower than the year ago period, they were sequentially higher. Operating margins in Q3 were a 190 basis points higher than Q2. The 34.6% decrease in revenues consisted of minus 34.2% from base revenues, a contribution of 2.4% from acquisitions and minus 2.8% from translation.

There appeared to be a bottoming in terms of the segments base revenues’ performance. Base revenues declined 34.2% in Q3 versus a base revenue decrease of 36.5% in Q2. Our worldwide welding business has produced a base revenue decline of 36.2% in Q3, which was modestly better than their Q2 performance.

North American welding base revenues declined 40% while international welding base revenues fell approximately 27% in Q3. Remember that the welding businesses are sensitive to both industrial production and CapEx spending as well as activity in the commercial construction sector. And as a result, we expect our welding businesses to be among on the last of our businesses to recover.

The big improvement in the segment was the PC board fabrication businesses, which saw base revenues decline 42.3% in Q3 versus a base revenue decrease of 59.2% in Q2.

Moving to transportation, Q3 segment revenues declined 7% and operating income fell 17% versus the year ago period. Those numbers represent dramatic improvement from Q2 and segment revenues decreased 20.3% and operating income declined 75.6%. The even better story was the ongoing margin improvement in the segment. Well, margins of 10.5% in Q3 were a 130 basis points lower than the year ago period, those Q3 margins were 570 basis points higher than Q2.

The 7% decline in revenues consisted of minus 7.9% for base revenues, a contribution of 7.5% from acquisitions and minus 6.6% from translation.

Moving to the next slide. There is a simple reason for better Q3 base revenue performance in the segment and it's simply more auto builds. Base revenues in the segment moved to minus 7.9% in Q3 from base revenue decline of a 23.7% in Q2.

North American automotive base revenues declined 14.3% in Q3 versus the base revenue decrease of nearly 40% in Q2. And this improvement was directly linked to a dramatic increase in North American auto builds largely associated with the Cash for Clunkers incentive program. Specifically North American auto builds moved from 1.8 million units in Q2 to 2.4 million units in Q3. And Detroit three accounted for approximately two thirds of this auto build increase with new domestic auto builds accounting for the remaining part of the growth.

Notably four had the best build improvement in the quarter producing 500,000 vehicles or 15% more cars from the year ago period. We are expecting North American builds of roughly 2.5 million total units in Q4. On the international side, automotive based revenues declined 4.7% in Q3 versus a base revenue decrease of 22.5% in Q2. Well, European auto based auto builds slightly declined from 4 million units in Q2 to 3.9 million units in Q3. An auto build rate of approximately 4 plus million units per quarter looks sustainable in Q4 and into the next year.

Moving to food equipment, Q3 segment revenues declined 10.2% and operating income decreased 5.1% versus the year ago period. Like most all of our segments that represents quarter-over-quarter improvement of results as Q2 revenues fell 16.2% and operating income declined nearly 21%.

Margins also improved, Q3 margins of 17.2% were not only 90 basis points higher than the year ago period, but 430 basis points higher than Q2. The 10.2% decline in revenues consisted of minus 6.3% from base revenues, a contribution of 1.6% from acquisitions and minus 5.5% impact from translation.

Food equipments improvement and base revenues from Q2 to Q3 was essentially driven by relatively strong performance from our service business. This worldwide service business, which accounts for 35% of the total segment revenues at flat based revenues in Q3 versus the year ago period when service numbers were very strong. And the Q3 ’09 service performance was better than Q2 ’09 where base revenues declined 1.1%.

Geographically, our international businesses also showed modest improvement. International food equipment base revenues declined 4.9% in Q3 versus a base revenue decrease of 10.2% in Q2. North American food equipment base revenues fell 8% in Q3 versus the base revenue decline of 8.4% in Q2 as customers continue to delay equipment purchases.

Moving to construction, Q3 segment revenues declined 23.3% and operating income fell 41.7% versus the year ago period. That’s considerably stronger performance in Q2 and revenues were down 34.5% and operating income declined 72.8%.

Operating margins also improved sequentially as Q3 margins of 10.9% were 500 basis points higher in Q2. The 23.3% decline of revenue is consisted of minus 16.5% from base revenues, contribution of 0.9% from acquisitions and minus 7.8% impact from translation.

The construction segments base revenues’ decline of 16.5% in Q3 was in accrual versus Q2 and base revenues fell 22.1%. The sequential improvement in base revenues in the quarter was largely due to better housing activity in the US, and better international construction activity.

In North America, our residential base revenues decline approximately 30% in Q3 versus a decline of approximately 43% in Q2, and that’s largely due to housing starts in Q3 which on a seasonally adjusted basis totaled nearly 600,000 unit, that would represent approximately a 100,000 more units than what we saw in Q2.

Internationally, our total construction base revenue has declined 13.2% in Q3 versus a decrease of 20.2% in Q2 with Europe down 22% and Asia Pacific flat in the quarter.

In the Polymers and fluids segment Q3 revenues fell 16.8% on operating income decline 9.7% versus a year ago period. More importantly, operating margins improved a 130 basis points to 15.8% in Q3 compared to the year ago period. As important Q3 margins were sequentially 540 basis points higher than Q2 operating margins, a 16.8% decline in revenues consisted of minus 13.9% from base revenues, the contribution of 4.4% from acquisitions, and minus 7.2% impact from translation.

In Polymers and fluids base revenue has declined 13.9% in Q3 versus the base revenue decrease of 15.1% in Q2. The mode of sequential improvement was largely due to improving trends for our worldwide fluids businesses which produced the base revenue decline abruptly 12% in Q3 versus a base revenue decrease of approximately 16% in Q2.

Some of this pick up of was due to increased demand for MRL products and international North American end markets. The worldwide polymers saw a slight, more modest improvement as base revenues moved to minus 16.8% Q3 versus minus 17.1% in Q2. While our North American polymer businesses in particular we are still grappling with weak industrial end markets in Q3 it appears that the vast majority of inventory destocking has seized and modest restocking should take place in both Q4 and beyond.

Under the decorative surfaces segment, Q3 revenues declined 20.2% while operating income grew 1.9% versus a year ago period. Operating margins of 10.9% in Q3 were actually 230 basis points higher than a year ago period, and that's mainly due to the benefits of a pension adjustment after deciding to move from discontinued operations back into continuing operations. The 20.2% decline in revenues consisted of minus 15.6% for base revenues and minus 4.5% from translation.

The deck surfaces segments base revenues declined 15.6% in Q3 and that was modestly better than Q2, given this segment exposure to North America and commercial construction it’s not surprising that North American laminate (ph) base revenues declined 20.6% in Q3. The better news for us is internationally, where base revenues fell only 10.7% in the quarter, and we continued to get better performance from our business in the UK.

Finally, our all other segment Q3 revenues declined 15.1% and operating income fell 28.4% versus the year ago period. That's better than Q2 when revenue was decreased to 18.2% and operating income declined 46%. Notably, operating margins of 16.5% in Q3 were 330 basis points higher than Q2. The 15.1% decrease on revenues consisted of minus 18.9% from base revenues, contribution of 7.9% from acquisitions and minus 4.1% impact from translation.

The sequential improvement of base revenues from Q2 to Q3 was largely due to better numbers from our consumer packaging and industrial appliance businesses. Our consumer packaging businesses base revenues declined a 11.7% in Q3, which represents the modest improvement versus Q2. And our industrial client base revenue has declined 21.8% in Q3 which represents another sequential improvement versus Q2, this was primarily related to a modest pick up in US housing starts in the quarter.

On the flip side, our Test and Measuring businesses, base revenues went more negative in the Q3 versus Q2 as worldwide CapEx spending continues to be soft.

That concludes my remarks in this segment so now let me turn it back over to Ron who will address the fourth quarter 2009 forecast.

Ron Kropp

For the fourth quarter we are forecasting diluted income per share from continuing operations to be within a range of $0.54 to $0.66 per share. The low end of this range assumes an 11% decrease and total revenues versus 2008 and the high end of the range assumes a 5% decrease.

The midpoint of the CPS range of $0.60 would be 2% higher in Q4, 2008. In comparison to the third quarter of 2009, the fourth quarter forecasted revenue change would in a range of negative 1% to positive 5%, even though the midpoint of the range assumes that revenue will increase 2% from the third quarter, the forecasted EPS midpoint of $0.60 is expected to be flat versus the third quarter due to a number of other components.

On the positive side, no fourth quarter impairments is expected and a lower tax rate of 29.5% versus the third quarter rate of 32.5% would each add $0.025 to EPS. In addition, further incremental benefits of our restructuring programs would add between $0.02 and $0.03 to the fourth quarter.

Offsetting these favorable items are several unfavorable items that will impact the fourth quarter as follows. The favorable third quarter one time adjustments for inventory reserves and corporate items that I previously mentioned were between $0.04 and $0.05 per share, and are not expected to be repeated in the fourth quarter.

Also, expected fourth quarter changes and mix and other miscellaneous operating, non operating items would reduce Q4 EPS by $0.04 to $0.05, and finally the price cost effect is expected to be less favorable in the fourth quarter resulting in lower income of $0.03 to $0.05 per share.

Other assumptions including this forecast are exchange rates holding at current levels, restructuring cost of 25 to $40 million for the fourth quarter, which compared to $31 million in the third quarter. Net non operating expense in the range of $35 to $45 million for the fourth quarter, and a tax rate of range between 29.25% and 29.75% for the fourth quarter.

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

Question-And-Answer Session

John Brooklier

Thank you Ron, we are prepared now to take questions. I will remind everybody we ask everybody to please honor our one question one follow up question.

Operator

(Operator Instructions) Your first question comes from Dean Dray - FBR Capital Markets.

Dean Dray - FBR Capital Markets

Dave you knew the day would finally come where you would be on the call saying that North American Auto and North American Rezzi would be the brighter spots to call out in that quarter, didn’t you?

David Speer

I did know that, that would happen some day, I wasn’t sure when.

Dean Dray - FBR Capital Markets

All right, but that doesn’t count as my question. So I really like to drill down a bit on auto if we could, because I know we had a Cash for Clunkers impact here, but just give us a sense of what has changed competitively during the downturn. I mean, you made comments a couple of quarters back that some of your competitors, because of their liquidity issues that you were getting increased share and customers were coming to you.

So, after the dust settles here how has ITW’s auto business improved market share, may be geographic mix, may be some new products or new platforms, but just give us the state of the union in auto as you come out of this.

David Speer

Yes, well certainly, you know the build in North America in the quarter up over 30%; obviously that’s the biggest variable in Q3 versus Q2. The European auto bill was actually relatively flat from Q2 to Q3, so not much impact there.

Clearly, the mix of vehicles and our penetration rates in the North America have continued to improve which allowed us to outperform the market and we are seeing obviously the leverage that we talked about. In earlier calls when we get any volume in these businesses, there’s significant leverage on the margin side.

So, in our penetration as we’ve talked about for the last several years in North America it has been primarily focused on the new domestics has continued to serve us well. We’ve got good growth content, both in the current bill schedules and in the year ahead as we look at new platforms coming on with new content for us.

So, we continue to be optimistic as we see these bill rates now begin to improve. Much of our market penetration gains over the last year had been lost in the direct decline in the bill numbers themselves. So as these bills begin improve you’ll see the benefit of our increased content per vehicle overall are going up.

Again, much of that in North America’s queue to the new domestics, at the same time our international businesses, particularly those in Asia, are performing well, and we are well positioned now in a number of new end markets with new vehicle producers like Cherry, like Tata, like Brilliant and others, that they are going to be significant factories in the Asian car build ahead.

Our biggest growth relationship in the last two years has been with Hyundai and Kia and that continues to play out strongly. So I think as we have been saying that, I think for the last, a year or so, we are well positioned with the key global auto builders and now we are starting to see some actual numbers reflect as bills go up and you can begin to see it in our performance metrics.

Dean Dray - FBR Capital Markets

Okay, that’s very helpful and then just as a follow up, I want to make sure I heard it correctly. Was that $6 million in acquired revenues for the quarter has that ever happened before, that low?

David Speer

I don’t know, you did hear it right. $6 million was the number and I don’t know that I would recall certainly any quarter that was lower than that. So yes, it was not much happening, two small deals, two small distributorships that really hardly would count if we weren’t scoring all of our acquisitions.

The better news is that the fourth quarter does in fact have about $200 million of activity and so, I think we’ll see a much better quarter in the fourth quarter and I think as I’ve said in the number of my comments more recently, I think we are beginning to see at least some early signs that the environment may in fact start to show some improvement as particularly as salaries begin to adjust to the new realities of their business performance and their earnings.

Operator

Your next question comes from John Inch - Merrill Lynch.

John Inch - Merrill Lynch

May be this question is for Ron. I just wanted to understand the puts and takes in the fourth quarter. So it kind of looks like you has got a little bit of a wash between the mix and the pricing effect and I guess the inventory reserves versus the other tailwinds.

We are calculating possibly up to $0.15 of sequential earnings per share benefit from currency at the dollar euro rate, is there something else we are missing, firstly, do you agree with that, do you agree with that exchange rate calc and then is there something else that’s may be embedded here as to why you wouldn’t be seeing a higher sequential guide forecast for the fourth quarter.

Ron Kropp

Yes, the currency number that we have is definitely not that high, it’s $0.15. May be helpful of take it from the third quarter EPS of 60 to midpoint of the fourth with the puts and takes. So, included in the 60 is an impairment charge in the third quarter of $0.025, so if you ad that back, also the tax rate of 29.5 versus 32.5 is another $0.025. So that get you to $0.65 kind of on a normalized basis without some of these other things.

Then you have the other higher revenues which will add somewhere between, $0.03 and $0.04 around the midpoint, that’s favorable and then also favorable would be $0.02 to $0.03 of incremental restructuring benefits above and beyond what we saw in the third quarter.

Offsetting those items, you have the kind of the third quarter one-off adjustments, the inventory adjustments and the other corporate adjustments that’s $0.04 or $0.05 negative in the fourth and then other miscellaneous things mix some non-operating stuff that’s also $0.04 to $0.05, and then reduced price cost impact which is expected to be $0.03 to $0.05. So, all those puts and takes that I get you from, to go from 60 to 60, but there’s always a lot of components in there.

John Inch - Merrill Lynch

Would you have it that in currency Ron? I mean, currency based on exchange isn’t it at least $0.10 plus.

David Speer

Remember our currency John, our currency is assumed in this forecast remaining current levels, current levels for us is the end of Q3 internationally and as you may recall our Q3 International ends in August. We haven’t projected anything forward as we never do with the currency, we [peg it] the end of the International quarter, and so any change from that, obviously be reflected in the core two numbers, but we haven’t reflected anything different than that here. It is neutral in our forecast is the way to look at it.

John Inch - Merrill Lynch

Right, but since August it’s helped, I think is the way I think about it.

Ron Kropp

Incrementally.

David Speer

Again our forecast doesn’t include any change in currency since the end of August, that’s our, traditionally we use the end of the quarter, and we talk about currency as being a stable on this, so obviously if currency remains above that rate, then we’ll certainly see a favorable impact of that in our earnings, but it’s certainly not reflected in this.

John Inch - Merrill Lynch

Now, that makes sense. So as a follow up, some company have been, they have suspended variable comp or bonuses or other aspects of compensation that may have to just purely for competitive reasons regardless of any coming back next year. Does that dynamic held at ITW and UC, let’s assume things don’t materially change, would you envision any kind of compensation headwinds again just to retain key employees or that sort of thing that are material?

David Speer

No, I do not.

Operator

Your next question comes from Eli Lustgarten – Longbow.

Eli Lustgarten - Longbow Research

Just for clarification, currency was negative in the quarter, about negative 7% in operating income?

Ron Kropp

Yes, 6.9% in operating income. Yes.

Eli Lustgarten - Longbow Research

Yes, so it was a negative effect in the quarter, so it would be given a negative and a swing quarter to quarter but it was actually positive in the fourth quarter, wasn’t it?

Ron Kropp

Yes.

Eli Lustgarten - Longbow Research

Okay, so that would be a biggest link. Can we talk about, you gave us the state of the union in automotives, so we do it for construction, because that’s the other part, which doesn’t have to say Cash for Clunkers kind of thing, [inaudible] sort of still going down with probably what we got, would you give some idea, how we should look at construction not only for the fourth quarter, but in 2010.

Ron Kropp

Sure, Eli I think as you look at construction first let’s remember a couple of important elements that 60% of our construction business is outside of North America, the components that are here about 5% of the overall is tied residential construction. Residential construction housing starts, as John pointed out, have approached 600,000. They have been fairly consistent overall for the last four months.

However, if you look at single family numbers, which I think are stronger indicator because multifamily numbers included in there are always fairly choppy. The single family trend has moved upward consistently for the last nine months from 360,000 to 500,000 and that’s from January through September.

So, we are in fact beginning to see early signs of a modest recovery in the in-housing market. We have not developed a view of 2010 yet for housing, but I would expect to see continued modest improvement is these housing numbers going forward. So it’s clear, as I think we have said in the last two calls, we think that the housing markets bottomed, but I think the recovery is long and slow recovery based on number of factors in the market, real estate price is still dropping, foreclosure is still high, etcetera.

Eli Lustgarten - Longbow Research

What percent of your sales are related to North American housing that we are talking about?

Ron Kropp

5%.

Eli Lustgarten - Longbow Research

5%. So it’s a very small piece.

Ron Kropp

Correct.

Ron Kropp

5% of total company, right.

Eli Lustgarten - Longbow Research

Of total company.

Ron Kropp

Correct, Yes.

Eli Lustgarten - Longbow Research

Not just the construction side.

Ron Kropp

That’s correct total company.

Eli Lustgarten - Longbow Research

Total company.

Ron Kropp

Right.

Eli Lustgarten - Longbow Research

Within the construction sector how much would you guess is residential North America?

David Speer

Within the North American piece it’s about 50%

Eli Lustgarten - Longbow Research

Could you tell us what are you seeing in non-res constructions, and what kind of decline, negative decline, you could expect over the next 12 months versus where we are now? Does it stabilize or...?

David Speer

I’m sorry, are you talking about housing again now?

Eli Lustgarten - Longbow Research

Commercial.

David Speer

In the commercial front it’s a completely different story. I mean obviously what we track most closely in commercial is square footage awards, the doc numbers and year to date those numbers are down 48% on a square footage basis, and they continue to show decline, although the rated decline in the last three months has been less than in the beginning of the year. We are still seeing accumulative number for the year down nearly 15%.

So, we are definitely seeing a continued trend downward and I think it’s across all of the major building categories in commercial construction. So, even in hospital and healthcare we are seeing declines in the 20% range. So, I expect we are going to see that continue through the end of the year, and probably even in the next year which means that most of our businesses are early cycle in commercial construction that is involved in building the structure or the frame of the buildings.

So, I expect that will be early indicators when we see things start to turn, but it will take these construction award value to start rising for that to be a strong signal on the commercial side.

Operator

Your next question comes from Henry Kirn - UBS.

Henry Kirn - UBS

Could you talk a little bit about to what extend, and in which segments are we stocking benefits of your businesses?

David Speer

Well, that’s a hard one to measure. Across our North American businesses 90 plus percent of what we sell in North America are sold through some form of distribution, and certainly we saw major de-stocking going on. I can’t say that we’ve seen significant restocking occur. However I believe that as things continue to stabilize and people begin to get a little more comfortable with the trajectory of the end markets and economies, we will start to see some modest level of restocking begin.

But I would say at this point we haven’t been able to put a finite number on that, and I suspect it’s probably early for us to be seeing much of that so far, since we really in most of these markets have only begun to see bottoms.

Certainly an exception to that would be in the auto business, where there has been a dramatic uptick in production, and we’ve see that obviously flow through. But there is not much inventory in that system anyway. So, I wouldn’t say that we have seen any dramatic restocking occur at this stage.

Henry Kirn - UBS

As we go through the upside, could you talk a little bit about how you think about the cost base today and if we were to see an uptick whether you would need to add cost to be able to support the advantage?

David Speer

Yes, I think from a capacity standpoint, I think we are in good shape to be able to handle a reasonable uptick in demand. Most of our businesses have somewhere between 15% to 20% excess capacity at today’s operating rates. So we can have a fairly good upturn without having to add any significant labor overhead. I think the bigger variable for us is probably looking what happens with input cost, with commodity costs.

We have seen some early indications of some modest movement in steel pricing and some on some plastic resin. So, I think probably in the near term it’s probably cost pressures are going to be more around input cost and they are around a labor overheads.

Operator

Your next question comes from David Raso - ISI.

David Raso – ISI

Regarding core growth, which of the segments have you expected first to see positive year over year core growth and what?

David Speer

Well, I think if you talked about in terms of the over all portfolio, I mean certainly what we are seeing in the transportation segment based on where we have been we would expect to obviously see that based on the trends that are coming, now I have some pretty low numbers.

In the general industrial categories, it’s probably more about what we are going see in overall industrial production number. So as those begin to trend up we will see that reflected. I think our food equipment business clearly, we’ve seen that already in some markets, particularly internationally. The service volumes have held up well.

I think the equipment sales look like they have bottomed, but I would expect we begin to see that from an institutional standpoint probably earlier in the cycle, certainly the later cycle of business is like welding and testing measurement, I think they are ways away from obviously being able to see where those bottoms might turn for us.

David Raso – ISI

The reason I ask, the businesses have really caused the first quarter ’09 margin to really [clap] unlike ITW, industrial packaging, transportation and construction. Now, it looks link transportation and construction might potentially be positive core growth at this quarter, fourth quarter. Then the margins have already come back aggressively already.

So I am just trying to think, can I extrapolate the base margins for transportation already above 15, constructions back in double digit as well. Is it largely upward and onwards from here with those margins getting back to where they were at their previous levels, or is there anything that I should be a little bit more cautious with those margins, because they have really come back aggressively in just two quarters.

David Speer

Yes, they have David, but I think your sort of direction with your question or with your modeling if you will is accurate. I mean certainly the businesses are positioned to return, if you will to the kind of traditional earnings power that they have had. The operating margins as you have pointed out have improved nicely in both those segments.

You may recall that both of those segments were the earliest ones down. So the first quarter of ’09 were fairly miserable quarters in both auto and housing, and while we tool additional restructuring efforts, much of the restructuring we did actually occurred before the benefits which are now obviously accruing.

But, certainly when you look at the auto build numbers, conservative numbers for next year in the $9.5 to $10 million range are up significantly from the 8.2 or 8.3 we’ll bill this year, and certainly I would expect the housing numbers to continue to move up modestly, probably somewhere in the 700,000 range.

So, if you use those kind of numbers certainly we are going to continue to see strong incrementals in both of those businesses on the upside, certainly in the 40 plus percent range.

David Raso – ISI

If one of you should have any angst about going into ’10 is how quickly does the price versus cost change? Can you give us a little indication on (NYSE:A) what do you think ’09 full year price versus cost will be for the company, and obviously across a lot of divisions you are generalizing. But do you have a number for price versus cost for ’09? And how are you thinking about pricing for ’10.

I mean there are enough indications in commodity prices that you don’t want to fall behind. I recall last time maybe you were a little slow to capture some of the incremental cost years ago. So are we thinking a little more proactively this time about pushing the needle on pricing next year or no?

David Speer

Yes. David I think we were slow. If you go back to the ’06-07 timeframe we were slow, primarily because of the multiple price increases or cost increases that we got. In that timeframe steel is an example, we were getting cost increases every month. So, we had a hard time getting ahead of those cost increases and as a result on a sequential basis we proved we had some big headwinds.

I can’t give you a number for the full year, but obviously we had a significant positive impact. This quarter 260 or 270 basis points, we were about a 170 basis points last quarter, but frankly that’s been on the back of strong price increases that have occurred since a year ago period and on the basis that a number of those commodity costs for at least the first two quarters went down. They have stabilized now and in fact in some cases we are looking at some modest increases or some modest headwind.

So, as I think about 2010, I think about it as a more normalized price cost environment where any kind of commodity increases we get we are going to have to stay on top of and find ways to pass those along, but I am not expecting significant input cost changes for 2010. I think we will see some movement up but it think it will be much more manageable than what we saw heading into this downturn.

Operator

Your next question comes from Jamie Cook - Credit Suisse.

Jamie Cook - Credit Suisse

First, I was just wondering if you could give a little more color specifically in what you are seeing in your across the board from some of the other industrial companies, it sounds like this could have been trending better than people’s expectations or things could stabilize there. So your thoughts there on how we come out of it? And the just on industrial packaging what you are seeing on the equipment versus consumable thought?

David Speer

Yes, Jamie we have been saying I think now for probably four or five months that we have seen the European numbers respond somewhat better than what we had originally expected. Clearly, the European markets did not drop as far as the US markets, and in fact in some cases those markets have begun to show signs of recovery, in fact even I had some of the US markets.

So, as we pointed out in our base number, our base assumptions, the international Q3 numbers were down 13.8% versus the North American, which was down 21.6%, so a pretty big delta there, recognizing that 75% of our international numbers are coming out of the European region, you can see that we have seen better performance out of those markets than what we clearly have here.

The auto business there responded much more quickly to the downturn and in fact the downturn in auto in Europe was really very sharp decline that lasted for about two quarters. They are back on to a $4 million piece in the third quarter and a $4.5 plus million piece in the fourth quarter. So those are examples of some markets that have responded much earlier.

The construction numbers there have not been down as much, the residential numbers have been challenged at a number of markets there, but the commercial numbers have not been down anywhere near what we have seen here in North America.

So I think to your question the recovery maybe somewhat earlier, but probably more importantly is the decline was not nearly as great in a number of these end markets is what we have seen in North America.

Jamie Cook - Credit Suisse

But any country specifically, I am assuming southern Europe we are hearing southern is much weaker and Germany and France stronger, I’m just trying to get more granular.

David Speer

Yes, Germany and France has certainly been stronger. The housing market, if you look at construction certainly Spain and Ireland have been in terrible shape, and probably will be for a while they are vastly overbuilt, but if you look the car production numbers are pretty well spread across all the European automakers. So all of them have participated in their version of Cash for Clunkers have been very successful. So, all the car companies in France, Germany, Italy have all participated in that.

The overall manufacturing industrial production numbers have improved better in France and Germany than they have in the rest of Europe, those are also the strongest industrial market. So, I think we have seen clearly a different sort of drum beat over there than what we have seen in North America.

Jamie Cook - Credit Suisse

And then sorry, just last one, industrial packaging equipment versus consumable.

David Speer

Yes, well, the consumable volume is obviously on a sequential basis shown some modest improvement. The mix in that business is still about 70%, consumable is 30% equipment. The equipment side is still down close to 40% on a year-to-date basis and the consumable volumes in the most recent quarter are down in the mid 20s. So better than what we saw in Q2, but still some fairly significant headwinds in terms of activities.

Operator

Your next question comes from Andy Casey - Wells Fargo Securities.

Andy Casey - Wells Fargo Securities

I wanted to look at cash deployment on acquisitions you already touched on improved Q4 pipeline. Just from broader standpoint, how are you looking at the current environment as a time to increase your exposure to higher growth regions when developing economy seem to be recovering well, North America kind of stabilizes and the US dollar is generally weakening. Are those evaluations already moving away from where you would be comfortable?

David Speer

Are you talking about from acquisition perspective Andy?

Andy Casey - Wells Fargo Securities

Yes.

David Speer

Yes. No, I think largely the issue with acquisitions has been really around sellers not wanting to sell at the bottom of the market and in many cases not having adjusted their expectations to the fact that their businesses have been impacted by this downturn as well as others, and a significant earnings decline along with the fact that the market multiples for businesses has in fact declined.

So, if you have got somebody using map from 2007-2008, early 2008 evaluations, I mean we are talking about pretty significant reductions in what those businesses would yield today. Probably, to put it in perspective, prices today that would be 40% to 50% of what they would have been in late 2007. So I think that’s probably the biggest a single factor.

On the International front, in terms of looking at acquisitions and opportunities, we are just as active there. I think the Asian region continues to be a challenging region to do acquisitions going forward. In many cases, certainly in China it’s based on the complexion of the businesses and how new they are, what market access they bring, etcetera, but we are working hard in that regard in the International front.

The last couple of years more than 60% of our acquired revenues have been outside of North America. So we continue to focus on those faster growing developing market regions, but I wouldn’t say that there is any different overall issue in the acquisition environment in the international markets, perhaps the Chinese market excluded where there is other issues there, but most of the markets are still adjusting to the fact that some of those expectations have remained inflated.

Operator

Your next question comes from Daniel Dowd - Bernstein.

Daniel Dowd - Bernstein

One last follow-up about acquisition. So, part of the thesis on acquisitions have been that private equity firms would likely be seeking liquidity by selling some of the companies that they might have bought through the past sub cycle, and obviously we haven’t seen that. What do you think is driving that, and is it possible for that thesis to come back or is that kind of just dead?

David Speer

No I don’t think that pieces of dead. I think what we have said, at least from our perspective is, we think that it will in fact happen and I think that going forward I would expect to see a fair amount of that begin to show itself in 2010.

When you look at the number of assets in the spaces that we have had an interest in, over the last three or four years the private equity was able to transact at significantly higher evaluations than us, and also the age of those portfolios and the financing arrangements that were made when those deals were done.

I mean a lot of those factors would indicate that just based on the level of financing, and the fact that a lot of that financing was longer term with not a lot of covenants and much of that financing is coming due or coming up for renewal. In other cases these are assets that have been held for four or five years, they have also been impacted by this downturn.

So I think you are going to begin to see a natural unwinding of some of these assets. Clearly, on the new front they are not the same factor, they don’t have the same advantages they had on newer deals that they had over the past three or four years, but I certainly would expect to see, and we have seen some early indications of that with some increase we see in the market that we would expect to see that play out.

I don’t know it’s going to be a dramatic rise that we are going to see in one quarter, but I think as we look into 2010 that I would imagine by the mid year of next year we are going to be able to talk about that more discretely with actual examples.

Daniel Dowd - Bernstein

One last thing. So, many of the companies in the sector have been disproportionately doing their cost cutting in high cost, high tax markets. Your models has always been very different, right proximity to the customer and therefore it wasn’t really about moving your manufacturing to places where it was less expensive.

Can you confirm that that’s still the case that your cost cutting has been relatively evenly spread across the markets you are in or are you actually seeing a real systematic trend of moving your cost from higher cost locations to lower cost locations?

David Speer

Our business model and footprint really remains the same. Our cost reductions have largely been done inside of the existing business structure. You are very accurate in pointing out that our preference and approach has long been to put our manufacturing activities where the market is and that remains one changed.

I will say that there are some sectors where our customers have moved or are moving more capacity and obviously we will follow them, again putting our factory where their production is going to be, but no wholesale changes in terms of a re-look.

Remember direct labor cost represents, in most of our products under 7% of the cost of the product. So that’s not the most important factor. It’s much more important that we are close to the customer. Logistics costs, freight and duties are much more compelling cost factors than direct labor.

Tax obviously is an issue, variable tax rates, but frankly tax rates in the end we have to look at tax rates as it relates to the overall business proposition, not just based on what people are doing in the near term in terms of comparables. If there is a significant change in tax rate obviously that’s a factor we have to look at, but it’s not been at least thus far anything that’s driven any different decision process for us.

Operator

Your next question comes from Ann Duignan - J.P. Morgan.

Ann Duignan - J.P. Morgan

Can we dig a little bit deeper into the pricing and performance this quarter, where exactly are you getting pricing and some of the recent PPI data which those industry level, but suggest that pricing compression is upon us and in welding actually it turned negative last month. So, can you just give us a bit of color on where exactly you are seeing pricing power and where you expect to see most pressure?

David Speer

Yes, well remember Ann, that these comparisons on price cost are compared to the prior quarter a year ago. So we have had price increases that were put in place since then, and in some cases cost that have decreased which has increased the spread. So, it’s a combination of factors.

I would not want to give you the impression that we have had a wholesale group of price increases in the last quarter because that’s not the case. What we are seeing is the overall impact of the change in price cost, third quarter this year to third quarter of last year, but most of those price moves were made probably six months ago or so.

On the cost side we saw some cost declines that occurred earlier in the year and we were, due to our purchasing power, able to get better pricing than most of the industry. So while we had to give some price back it wasn’t as much in most cases as our cost went down.

I would tell you though that going forward, as Ron pointed out in one of his factors for the fourth quarter, we don’t see those same kind of spreads recurring because the fourth quarter of last year is a different set of comparables in terms of price cost and we are also now beginning to see early signs of some of the cost headwinds, that we would expect to see as you have seen announcements around steel, paper board and plastic resins as examples of where we are going to start to see some cost increases.

Ann Duignan - J.P. Morgan

Cost decreases we have seen to-date I am assuming that those are mostly oil base related?

David Speer

Well, we saw some on steel on the first half of the year, certainly some of the steel. But, yes, a lot of it has been plastics and chemicals, which are oil derived products, yes.

Ann Duignan - J.P. Morgan

Just switching back a little bit on restructuring, how much of your restructuring spend that you have done is on permanent cost reduction versus headcount reductions or back office headcount reductions that one might consider as semi variable. Given how decentralized you are, have you taken much structural cost cut, i.e., closed factories, shut the lights our.

David Speer

Yes, I mean it’s a combination. Obviously the biggest factor in our restructuring cost, about 85% of it’s related to people. If you look at the headcounts the large proportion of those people are going to be in our direct labor force. The next biggest category being the period overhead category and then some in the SG&A, but clearly we have closed some factories, we have downsized some factories, we have retired some equipment. But largely it has been more about having the right sized organization.

So, the difference I think as we look going forward is that in a modest recovery scenario, which is what we foresee, we don’t see any significant cost additions having put back into the cost base on any near term basis. So, I don’t think this is something where we would expect these were one time reductions and they will come back as soon as volume has increased.

Ann Duignan - J.P. Morgan

But they will come back at some point when volume is increased.

David Speer

Well, they will, but not at the same rate they came out. Because in many cases we have been able to accelerate productivity improvements and sort of reshape our footprint in a lot of these different factories as well. So, they will come back, yes, but they won’t come back with the same rate that they came out.

Ann Duignan - J.P. Morgan

Okay. Can you quantify the number of facilities that you have actually shutdown?

David Speer

It would be, I don’t know, probably 10 to 12 facilities but the best way to think about it is that we spent counting the fourth quarter of last year and what we project to spend the full year of this year somewhere around $200 million and 85% of that is head count related. So it’s not about facilities in terms of dollar impact as much as it is about the head count. We will take one more question

Operator

Your final question comes from Walt Liptak - Barrington Research.

Walter Liptak - Barrington Research

I want to ask you about, a one a quick one on that charge sheet that you have been decorating, the pension charge, how much was that?

Ron Kropp

Yes. So, well it was a charge in the last year in the third quarter related to a pension curtailment charge, when decorative services became a discontinued operation. When we reconsolidated back in the second quarter we restated last year’s number. So it’s a comparable issue, third quarter of this year versus third quarter of last year, it’s about $12 million.

Walter Liptak - Barrington Research

$12 million okay. Then, the welding, you talk about, being life cycle and that it’s going to be one of the last to recover, but I was thinking about automotive as being kind of a key welded product and things like pipelines and I think you had a big China business now. Wouldn’t some of those aspects within your welding business be recovering?

David Speer

Yes. I mean certainly some of those end markets are. Auto is not a huge market for us for our welding businesses. We don’t have a lot of content in the auto industry per se, but certainly the oil and gas business have been, in Asia in particular, continued to grow for us.

But overall if you look at the North American business remember this is a business that the welding group is 70% North American centric and the mix in our business is 70% equipment 30% consumables. So it’s a very different mix in that regard, and general industrial manufacturing activities, heavy equipment, steel construction all down big time in North America.

So, it’s really on the strength of that and how people feel about their equipment purchases which drives sort of the capital side of this. So as expected we saw a much more dramatic decline in equipment than we did in the consumable volume.

Walter Liptak - Barrington Research

Okay. Has CAT talked to you about their power up program and you mentioning mobile equipment, and are you seeing increased, are you ramping up the supply chain for more production next year?

David Speer

Well certainly we are familiar with CAT’s power up program. We understand the concept and we are positioned to execute against that program as I think many are, but we would love to see the upside of their forecast come true and we are ready to participate.

Walter Liptak - Barrington Research

Just last one on welding. Can you talk about market share in North America or Europe, has it gotten more competitive and mentioned pricing, are you still getting pricing in the welding industry?

Ron Kropp

We haven’t had any recent pricing increases in welding. Again, most of the price increase that we talked about in the price cost was increase that occurred at the tail end of last year, maybe some in the early part of this year, but really nothing significant since then.

The competitive environment remains challenging. Obviously in this kind of a market downturn, it’s a very aggressive marketing environment from a competition standpoint. So, we are out there slugging it out like everybody else is trying to maintain our position and hopefully find ways where we can grow it, but it’s a challenging market environment when you see your equipment volumes and the activity levels drop in the 50% range.

David Speer

We want to thank everybody for joining us on today’s call, and we look forward to talking to everybody again. Thank you.

Operator

This concludes today’s conference. Thank you for your participation, you may disconnect at this time.

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Source: Illinois Tool Works Inc. Q3 2009 Earnings Call Transcript.
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