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Illinois Tool Works Inc. (NYSE:ITW)

Q4 2009 Earnings Call

January 27, 2010 2:00 pm ET

Executives

John Brooklier – VP IR

David Speer – CEO

Ron Kropp – SVP & CFO

Analysts

Jamie Cook - Credit Suisse

Henry Kirn - UBS

Terry Darling – Goldman Sachs

Unspecified Analyst

Deane Dray - FBR Capital Markets

Mark Koznarek – Cleveland Research

Robert Wertheimer – Morgan Stanley

Eli Lustgarten - Longbow Research

Shannon O’Callaghan – Barclays Capital

Ann Duignan - JPMorgan

Andy Casey - Wells Fargo

Robert McCarthy – Robert W. Baird

Operator

Welcome to the Illinois Tool Works fourth quarter 2009 earnings conference call. (Operator Instructions). I would now like to turn the meeting over, Mr. John Brooklier, Vice President of Investor Relations. Sir, you may begin.

John Brooklier

Good afternoon everyone and welcome to ITW’s fourth quarter 2009 conference call. 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 on the call.

Let me now turn today’s call over to David who will make some brief remarks on our strong fourth quarter operating performance.

David Speer

Thank you John, our 2009 fourth quarter financial performance was very good, particularly when viewed against the modest improvements we saw in our worldwide end markets during the quarter. While its clear the easier Q4 2009 comparisons versus the prior year period helped this quarter we continue to be encouraged by the improvement in US and European industrial production and ISM forecast data as well as the uptick in certain worldwide end markets.

Here are some noteworthy Q4 developments which have good implications for 2010. Our base revenues improved sequentially but base revenues declined 10% in Q4 compared to the Q4 of 2008. That compares favorably to our total company base revenue decrease of 17.9% in the third quarter of 2009 versus the year earlier period.

Some of the sequential improvement was clearly tied to easier comparables in the Q4 period versus the year ago. But we continue to see real improvement in discrete markets, most notably worldwide automotive. Our worldwide automotive base revenues grew 8.8% in the quarter versus a base revenue decline of 9.7% in the third quarter.

As you’ll hear later the dramatic improvement in base revenue growth was driven by a significant increase in auto builds in Europe and in North America in Q4 versus Q3 and also significant additional penetration gains.

While our strong company performance in Q4 yielded operating margins of 12.7%, 120 basis points higher than Q4 2008, though there were modestly below our Q3 margins but in line with our expectations. In any event we believe we’re well positioned for margin expansion in 2010. Its clear our restructuring expenditures of $161 million for the full year have allowed us to respond to local market conditions as we right size the company.

Finally our free operating cash flow numbers remained strong during the quarter and as a result our free operating cash flow for the year totaled $1.9 billion. That represents a free operating cash flow to net income conversion rate of 201% for the full year.

Now let me turn the call back over to John.

John Brooklier

Thank you David, here is the agenda for today’s call, Ron will join us shortly to cover the Q4 2009 financial highlights. I will then address Q4 2009 operating highlights by reporting segment. Ron will then return to detail our Q1 2010 and full year 2010 earnings forecast. And finally we will take your questions.

First let’s cover the usual housekeeping 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 rates, end market conditions and the company’s 2010 forecasts. For more information on this forward-looking statement, please consult our 10-K for 2008.

Finally the telephone playback for this conference call is 402-220-3450. No passcode is necessary. The telephone replay is available through midnight of February 10. One other note, as per our custom our webcast power point presentation that accompanies this call is available on our www.itw.com website.

Now here’s Ron Kropp who will comment on our Q4 2009 financial highlights.

Ron Kropp

Thanks John, good afternoon everyone. Here are the key items for the fourth quarter, revenues decreased 5% due to lower base revenues but showed improvement from the third quarter revenue decline of 20%.

Sequentially fourth quarter revenues were higher than the third quarter by 5%. Operating income was up 4.8% and margins of 12.7% were higher than last year by 120 basis points. Diluted income per share was $0.98 which was higher than last year by $0.39 primarily due to favorable discrete tax items recorded in the quarter of $187 million or $0.37 per share.

Excluding the impact of these tax items EPS would have been $0.61. Finally free operating cash flow continued to be very strong at $434 million. Now let’s go to the components of our operating results, our 5% revenue decrease was primarily due to three factors.

First, base revenues were down 10% which was favorable by 790 basis points versus the third quarter. As David mentioned we have seen a modest pickup in certain end markets such as worldwide automotive OEMs. North American base revenues decreased 10.9% which was 10.7 percentage points better than the third quarter decline.

International base revenues decreased 9% which was an improvement of 480 basis points from the third quarter. Next, currency translation increased revenues by 3.3% which was unfavorable by 890 basis points versus the third quarter negative currency effect.

Lastly acquisitions added 1.7% to revenue growth which was 190 basis points lower than the third quarter acquisition impact. Operating margins for the fourth quarter of 12.7% were higher than last year by 120 basis points. The base business margins were higher by 160 basis points as the unfavorable impact of the lower sales volume was more than offset by non-volume items.

Non-volume items increased base margins by 490 basis points which is favorable versus the third quarter non-volume impact by 90 basis points. Included in non-volume impact for the fourth quarter were the following items.

Favorable price cost effect, plus 170 basis points; lower cost as a result of restructuring programs during the year, plus 140 basis points; miscellaneous one-time adjustments such as inventory reserves, life insurance investments and other corporate items, plus 80 basis points.

In addition acquisitions reduced margins by 20 basis points and translation diluted margins by 10 basis points. 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, other non-operating income expense in the fourth quarter was favorable by $21 million mainly due to higher income from investments. The fourth quarter effective tax rate was negative 13%, as a result of discrete tax adjustments of $187 million in the quarter primarily related to a favorable German tax settlement of $77 million and additional foreign tax credits of $86 million which were recorded as a result of a legal entity restructuring.

For the full year the effective tax rate was 20.1%. The tax rate for 2010 is forecasted to be in the range of 28.75% to 29.25%. For the full year revenues decreased 19% and operating income was 45% lower. Income from continuing operations of $1.93 was $1.31 lower than last year. However as a result of significant reductions in operating working capital during the year free operating cash flow was very strong at $1.9 billion or more than 200% of net income.

Our 18.8% full year revenue decrease was primarily due to base revenues being down 18.4%. The revenue contributions from acquisitions were essentially offset by the negative currency impact. For the full year North American base revenues decreased 21.6% and international base revenues were down 14.9%.

Full year operating margins of 10% were lower than 2008 by 460 basis points. The base business margins were lower by 220 basis points, acquisitions reduced margins by 60 basis points, and higher impairment and restructuring charges reduced margins 70 basis points each.

Turning to the balance sheet total invested capital increased $392 million from the third quarter primarily due to favorable currency translation and acquisitions. Operating working capital was essentially flat.

Accounts receivable DSO improved to 59.7 days versus 60.6 days at the end of the third quarter. Inventory months on hand was 1.7 at the end of the quarter versus 1.8 at the end of last quarter. Excluding the impact of translation and acquisition, inventory levels were reduced by almost $50 million during the fourth quarter and by almost $600 million year to date.

For the fourth quarter capital expenditures were $73 million and depreciation was $94 million. ROIC for the fourth quarter excluding the discrete tax adjustments increased to 13.9% versus 12.3% last year largely as a result of the lower invested capital and higher base business income.

On the financing side our debt increased slightly by $192 million from the third quarter and debt to capital remains stable at 26%. Cash on the balance sheet increased to $1.3 billion from $943 million at the end of the third quarter.

The increase in our cash position of $376 million in the fourth quarter was due to our free operating cash flow of $434 million being utilized for acquisitions of $163 million and dividends of $155 million. Regarding acquisitions, we acquired seven companies in the fourth quarter which have annual revenues of $155 million.

The biggest acquisition in the quarter was Hartness International which provides conveyor systems and line integration and automation for the beverage and food industries. For the year we acquired 20 businesses with $290 million of annualized revenues as the M&A environment remained weak throughout the year.

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

John Brooklier

Thank you Ron, now let’s review our fourth quarter segment highlights, we’ll begin with transportation. The Q4 2009 segment revenues grew, I emphasize grew, 9.6% and operating income dramatically increased more than 430% versus the year ago period.

By comparison Q3 2009 revenues fell 7% and operating income decreased 17% versus Q3 2008. Most notably operating margins of 15% in Q4 were 1190 basis points higher than the year ago period and 450 basis points higher than Q3 2009.

The 9.6% increase in Q4 revenues consisted of 6.3% for base revenue minus 0.3% from acquisitions and 3.7% from translation. Moving to the next slide, there’s a very simple explanation for better Q4 base revenue performance in the transportation segment and that increased auto builds.

The sequential improvement in segment base revenues from a decline of 7.9% in Q3 to growth of 6.3% in Q4 was directly tied to significantly higher levels of auto builds in Europe and North America in the quarter. Notably worldwide automotive OEM based revenues improved from a decrease of 9.7% in Q3 to growth of 8.8% in Q4.

European auto builds jumped from 3.9 million units in the third quarter to a very robust 5.1 million units in Q4. This 31% increase in sequential builds was attributable to virtually all of the European OEMs increasing production, with PW group, PSA group, Renault, Fiat, and Ford group leading the way.

In North America Q4 auto builds of 2.7 million units were a 364,000 units higher than Q3 production rates. The Q3 to Q4 ramp up in North American auto builds was due to Detroit Three and the new domestics increasing production 16% and 15% respectively.

In our auto aftermarket business Q4 2009 base revenues declined 3% versus the year ago period. That’s slightly better than what we saw in Q3 and was attributable to an increase in miles driven and a modest uptick in consumer spending in this category.

Moving to the next segment, industrial packaging revenues declined 9.9% and operating income fell 5.3% in Q4 versus the year earlier period. By comparison Q3 2009 revenues decreased 29.5% and operating income fell 52% in Q3.

Fourth quarter 2009 operating margins of 7.3% were 40 basis points higher than the year ago period and base business contributed 120 basis points to operating margins in the quarter. The 9.9% decline in Q4 revenues consisted of minus 16.3% from base revenues, 2.3% from acquisitions, and 4% from translation.

Industrial packaging’s base revenues continue to show improvement as 2009 progressed with base revenues decreasing 16.3% in Q4 2009 compared to a base revenue decline of 23.3% in Q3 2009. Its clear that underlying macro data especially improving industrial production data from the US and Europe has helped the industrial base businesses somewhat in the segment.

Notably total North American industrial packaging base revenues declined 12.4% in Q4 compared to a base revenue decrease of 27% in Q3. Total international industrial packaging base revenues fell 19.4% in the fourth quarter versus the base revenue decline of 25% in Q3 2009.

Moving to food equipment, segment revenues decreased 9.8% and operating income fell 22.6% in Q4 versus the year ago period. By comparison Q3 2009 revenues declined 10.2% and operating income fell 5.1% versus Q3 2008.

Fourth quarter 2009 operating margins of 14% were 240 basis points lower than Q4 2008 and the 9.8% decline in Q4 revenues consisted of minus 12.5% from base revenues, 0.6% from acquisitions, and 2.2% from translation.

Food equipment’s Q4 performance was clearly impacted by soft equipment sales. Worldwide customers continued to delay equipment purchases especially those customers in the United States. As a result total segment base revenues declined 12.5% in Q4 versus a base revenues decrease of 6.3% in Q3.

North America food equipment base revenues declined 14.6% in Q4 with equipment sales down approximately 20%. The better news was that the North American service portion of the business declined only 0.8% in the quarter and that compares to a performance of essentially flat in Q3 2009.

Internationally base revenues declined 10.5% in Q4 as demand for equipment in both Europe and Asia weakened but was better than what we experienced in the US.

Moving to power systems and electronics in Q4 segment revenues decreased 17.9% and operating income declined 23.1% versus the year ago period. By comparison Q3 revenues fell 34.6% and operating income declined 41.2% versus the year ago period.

Fourth quarter operating margins of 14.6% were 100 basis points lower than the year ago period. However base business contributed 120 basis points of growth to operating margins in Q4. The 17.9% decline in the fourth quarter revenues consisted of minus 21.6% from base revenues, 2.2% from acquisitions and 1.5% from translation.

Moving to the next slide, the segments base revenue decline of 21.6% in Q4 compared favorably with the base revenues decrease of 34.2% in Q3. Worldwide welding’s base revenues declined 24.9% in Q4 and that consisted of North American welding down 25.6% and international welding down 23.5%.

While its clear that the welding numbers became less negative as 2009 progressed please recall that the welding businesses are tied to CapEx spending as well as activity in the commercial construction sector. As a result we expect our welding businesses especially the equipment-oriented parts of the business to be among the last of the ITW businesses to recover as we move through 2010 and beyond.

Another significant contributor to improvement in the segment was the performance of our PC board fabrication businesses. Base revenues declined 14.5% in Q4 as demand for our consumer electronics improved. By comparison the PC board businesses base revenues fell 42.3% in Q3 2009.

In the construction products segment revenues grew 4% and operating income increased 13.5% in Q4 versus the year ago period. By comparison Q3 2009 revenues declined 23.3% and operating income fell 41.7% versus the year ago period.

Operating margins of 9.9% were 90 basis points higher than Q4 2008 with base business contributing 40 basis points in the quarter. The 4% increase in Q4 revenues consisted of minus 5.5% from base revenues, 0.8% from acquisitions, and 8.8% from translation.

The construction products segment base revenues decline of 5.5% in Q4 was a significant improvement from Q3 when base revenues fell 16.5%. The sequential improvement in base revenues was primarily due to easier new housing comparisons from Q4 2008 and improvement in the international construction businesses.

In North America our residential base revenues declined 7.2% in Q4 versus a decrease of 30.4% in Q3. Housing starts averaged 554,000 units in Q4 versus 658,000 starts in Q4 2008 and that represents a 16% decrease.

Base revenues for our North American renovation and commercial construction businesses declined 2.3% and 13.5% respectively. Both numbers represented improvement from Q3 2009. internationally our total construction base revenues declined 4.2% in Q4 with Europe down 8.9% led by Australia and New Zealand, Asia Pacific base revenues grew 2.4% in the quarter.

Moving to polymers and fluids segment revenues declined 1.2% while operating income grew 18.7% in Q4 versus the year ago period. By comparison Q3 2009 revenues fell 16.8% and operating income decreased 9.7% versus Q3 2008.

Operating margins of 13.6% improved 230 basis points versus the year earlier period with base business contributing 190 basis points in the quarter. The 1.2% decline in Q4 revenues consisted minus 4.7% from base revenues, 1.1% from acquisitions, and 2.5% from translation.

The improving financial performance for polymers and fluids in Q4 was largely driven by growing end market demand for worldwide fluid products. As noted total segment base revenues declined 4.7% in the quarter but base revenues for the worldwide fluid businesses actually grew 0.6% in Q4 with North America up 4.2% and international down 1%.

Growth in the fluids category was mainly due to increased demand in North America for personal hygiene products as well as MRO aerosol products largely used by manufacturers. Base revenues for the worldwide polymers declined 6.9% in Q4 with North America down 14.8% and international down 4.4%.

Exposure to end markets such as general, industrial, and construction dampened the performance of polymers businesses in Q4.

Moving to decorative surfaces segment revenues declined 7.2% and operating income fell 30.1% in Q4 versus the year ago period. By comparison revenues decreased 20.2% and operating income increased 1.9% versus Q3 2008.

Please note that the Q3 2009 income comparison was helped by negative pension plan adjustments in Q3 2008. Operating margins of 9.4% were 310 basis points lower than the year ago period. The 7.2% decline in Q4 consisted of minus 10.3% from base revenues, and 3.1% from transaction.

While the decorative surfaces base revenues improved from minus 15.6% in Q3 to minus 10.3% in Q4, the underlying impact of very weak North American commercial construction activities continue to constrain the segment’s financial results.

Its important to note that in 2009 North America accounted for 56% of segment revenues, and more than half of the North American exposure directly relates to commercial construction. For the Dodge Index we frequently quote US commercial construction square footage activity declined 46% for full year 2009 versus 2008.

Not surprisingly base revenues for North America laminate products fell 15.9% in Q4 versus the year ago period. Internationally the news is a little bit better, as overall construction environment in Europe and Asia Pacific outperformed North America. As a result international base revenues declined 3.5% in Q4 versus year ago period.

Finally in the all other segment Q4 revenues declined 5.5% and operating income decreased 9.4% in Q4 versus the year ago period and by comparison Q3 2009 revenues fell 15.1% and operating income declined 28.4% from Q3 2008.

Order operating margins of 14.9% were 60 basis points lower than the year ago period and the 5.5% decrease in Q4 revenues consisted of minus 11.9% from base revenues, 4.4% from acquisitions, and 2% from translation.

The segment’s Q4 year over year base revenues decline of 11.9% compared favorably with the base revenue decrease of 18.9% in Q3. Most notably the industrial/appliance base revenues declined a mere 2.6% in Q4 versus the year ago period with the most improvement coming from US energy efficiency initiatives in the appliance sector.

Base revenues for the consumer packaging area fell 8.5% in Q4 2009 versus the year earlier period as consumer spending was still soft in the quarter. Our more CapEx driven businesses showed less improvement in the quarter. For example test and measurements base revenues declined 13% in Q4 versus the year ago period as customers delayed equipment orders as they weighed better economic fundamentals.

Now let me turn the call back over to Ron who will cover our 2010 forecast.

Ron Kropp

Thanks John, during the first part of 2009 you may recall that due to the uncertainty in the world economies we decided to discontinued full year guidance and only provide guidance one year out. Since things have now become more stable, we’ve decided to reinstate full year’s earnings guidance for 2010.

For the first quarter of 2010 we are forecasting diluted income per share from continuing operations to be within a range of $0.48 to $0.60. The low end of this range assumes a 14% increase in total revenues versus 2009 and the high end of the range assumes an 18% increase.

The midpoint of this EPS range of $0.54 per share would be 157% higher than pro forma Q1 2009 and pro forma excludes the impact of impairment and discrete tax charges that happened in the first quarter of 2009.

For the full year our forecasted EPS range is $2.43 to $2.93 per share, based on higher total revenues of between 10% and 14%. The midpoint of the EPS range of $2.68 would be 39% higher than 2009.

Other assumptions included in this forecast are exchange rates holding at current levels, acquired revenues between $300 million and $500 million for the year, restructuring costs of $50 to $100 million for the year, and a tax rate range between 28.75% and 29.25%, both the first quarter and the full year.

Now back to John for the Q&A.

John Brooklier

Thank you Ron, we’ll now open the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Jamie Cook - Credit Suisse

Jamie Cook - Credit Suisse

Just a couple of questions as I look at the guidance I recognize its still an uncertain economic environment out there but I guess I just look at the guidance and I’m trying to figure out the implied incrementals I think are somewhere in the 20 to 40 I think, a lower range than I would have anticipated. Even if I look at Q4 and you back out tax and you multiply by four gets us to the low end so I’m just sort of, the top line to me seems about where I thought, but the pull through on the bottom line is a little disappointing relative to what I thought so I’m just trying to figure out what the main drivers are, is it material cost price, headwinds versus 2009 that seem to benefit, I’m just trying to get a better understanding why we’re not getting more pull through on the bottom line.

David Speer

I think we are, certainly as you accurately point out the revenue forecast were much in line with what we talked about in our investor day in New York in December in that 6% to 8% range for base businesses. I think the incrementals as Ron can comment on, I think are much stronger that what you’re alluding to in the numbers you’ve cited.

Certainly there are some one-offs that have occurred certainly in the third quarter on the inventory reserve category most notably and also price cost. Price cost was very favorable for us for most of 2009 and we do not see that same favorability occurring in 2010 as the price increases and the cost increases or decreases have lapsed now on a comparable period.

So, I think we’re looking at a relatively stable price cost environment meaning that we’re not going to see the same kind of favorable benefits that we saw flowing through but if you look at the low end of our guidance we’re still talking about margins in the 13% range for the year and at the high end about 14% and clearly incrementals that I think you’ll find are more in the 40 to 50% range.

Ron Kropp

If you look at margins and the midpoint of that 13 to 14-plus range, you’re talking in the mid 13% versus 10% for 2009 so you’re talking about 350 basis points in total and a lot of that increase is going to come from the base businesses but really that’s based on the revenue growth. The non-volume related impacts we’ve had for instance in the fourth quarter was 490 basis points, price cost and restructuring benefits etc.

We’re not going to see those kinds of contributions to margins year on year as we have. We will see continued restructuring benefits although not at the same level as we’ve seen say in the fourth quarter but price cost definitely will not be a positive contributor and its more likely to be a negative contributor to margins as we go forward.

Also acquisitions will as usual have a dilutive impact on margins probably in the 2 to 4% range, negative 0.2, negative 0.4 and we will have some pick up in margins from lower restructuring costs all in but still we’re talking about a $50 to $100 million spend in restructuring costs for 2010.

David Speer

At the midpoint the incrementals are in the mid 40’s.

Jamie Cook - Credit Suisse

But I guess even so I would historically I think you have done a little better than that coming out.

David Speer

I think that’s very much in line with what we’ve been talking about. Our traditional incremental margins are in the 30 to 35% range. I think we said coming out of this we expected to be in the 40 to 50% range and certainly our guidance represents that.

Jamie Cook - Credit Suisse

And then last when you think about acquisition pipeline for the year, still seems like we’re, seems like on the lower end of what we expected, can you just give a little more color on what’s going on there.

David Speer

I think as you know we look at the acquisition pipeline as we develop these projections and certainly our look at the pipeline now while we have seen improvement in the pipeline over the last three or four months, its still modest by comparison to what we’d expect as the year unfolds. But that’s what it is today and that’s how we strike that guidance.

I would expect that if the acquisition M&A environment improves, as I would hope that it would as buyers and sellers are coming closer together on the pricing realities, that in fact we’ll see a better year than that but at the moment based on our current pipeline that’s how we strike that number for acquisitions. Again you know we adjust that quarterly so it would be my hope that as the year unfolds and we see a better acquisition environment we’ll see that range go up.

Operator

Your next question comes from the line of Henry Kirn - UBS

Henry Kirn - UBS

Could you talk a little bit about what you see as the big swing factors between the high end and the low end of your guidance, the relatively wide range there.

David Speer

The high and the low, between those ranges, its really going to be driven primarily by the ranges of our base businesses at 65 to 8%. Obviously any improvement in base businesses beyond that is going to have a very strong incremental impact but I think if you look at the overall impact of acquisitions and translation that’s how you obviously develop the overall range for the year of 10 to 14%.

But the big variable in there in terms of upside would clearly be stronger end market performance and recovery. As we’ve highlighted we expect in most of these markets relatively modest recovery by comparison I think to what some have said about some of these end markets. As an example we have the North American auto market performing in the 10 to 10.5 million range. There are estimates out there now that are in the 10.8 to 11 million range.

So if in fact auto builds as an example were at that level we’d certainly see stronger revenue performance and therefore stronger earnings performance. Same with housing starts and same with European recovery etc. so, our base revenue range is 6 to 8% is really what’s driving the range if you will in terms of earnings guidance along with the assumptions that Ron talked about in terms of tax and acquisitions and restructuring costs.

John Brooklier

I would also add that if you look at the year and you start to see our more longer cycle CapEx businesses recover I think that would be suggestive of something that’s probably going to be midpoint to higher in the range. But I think that would be, you’d probably want to track our power systems and our test and measurement and to a lesser degree our food equipment which is equipment that’s probably not a classic CapEx spend.

Henry Kirn - UBS

And is it possible to talk a little bit about what you’re seeing by geography and maybe your economic expectations by geographic regions.

David Speer

I think they’re pretty much in line with what we’ve been talking about and that is sort of modest recovery. If we look at GDP growth and industrial production growth here in the US next year, we’d expect to see that somewhere in the 2 to 2.5% range, industrial production slightly higher probably closer to 3%. The number is about 100 basis points less than that in Europe. That’s pretty much been what the trends have shown us for the last several quarters.

Steady sequential improvement but still coming off of obviously some pretty low bases. The China market is obviously rebounded strongly. The other southeastern Asian markets have rebounded more slowly but all in I would say the kind of GDP and industrial production numbers we’re expecting globally are in that 3% range.

Operator

Your next question comes from the line of Terry Darling – Goldman Sachs

Terry Darling – Goldman Sachs

Wondering if you could maybe give us a bit of a bridge between Q4 2009 and Q1 2010 I think at midpoint and you’re looking at revenues down 3% sequentially, probably some seasonality in there and then it looks like decrimentals of 44% but maybe take us through the big moving pieces 4Q versus 1Q.

Ron Kropp

Obviously there’s a normal seasonality in our 4Q to 1Q sequential and that’s partly driven by our international businesses having November 30 year-end so the month of December is actually in the first quarter on the international side. So we’re down, the base revenue is down as corresponding to that.

So that’s really the biggest driver. Some of the other drivers we did have some corporate adjustments, they were favorable in the fourth quarter not quite as favorable as they were in the third. That won’t repeat and clearly the tax part of it is a significant piece that won’t repeat or we don’t expect to repeat in the first quarter. So those are the bigger pieces of it.

David Speer

The top line changes between Q4 and Q1 on a sequential basis though, are actually more favorable to what we normally see so Ron has pointed out that Q1 is typically a weaker quarter for us than Q4 and again Q1 internationally represents December, January and February and certainly December and January are two of the weaker months in the international calendar.

Terry Darling – Goldman Sachs

And then I’m wondering if you might put a finer point quantifying what you are assuming for price of raw material in 2010. I think you indicated you are now assuming that that’s slightly negative but wonder if you could give us what the price assumption is and maybe what the raw material inflation assumption is.

David Speer

It’s a pretty narrow range built into the forecast, a range of basically plus or minus 30 basis points which basically is about normal, mimics a normal environment. We’ll see some cost increases offset by some price increases and timing will dictate how far on either side of that we might be.

That’s based on input from our business units and what they’ve seen happening recently. That is for the last quarter or so and what they’re projecting going into 2010 is going to happen with some of their commodity costs and so far that seems to be reasonably accurate.

Just to put it in perspective in Q3 we had 260 basis points of positive price cost that narrowed to 170 basis points in Q4 and we would expect that to be very small positive in Q1.

Terry Darling – Goldman Sachs

And then lastly the base revenue assumption up 6 to 8 as you said pretty consistent with the analyst meeting in December I’m wondering if you could just talk about the segments and what if anything has changed in there. I think you talked about transportation, obviously its going to be way above that, I think you talked about decorative with a non-res exposure still being negative in 2010 but maybe just talk through the segments around the 6 to 8 range.

David Speer

I think largely the data we gave you in December still holds. We’ve not really changed any of our views of some of these key end markets. What I think I had said in an earlier comment was there are now projections as an example for North American auto build that have it closer to 11 million. Our forecast is in the 10.5 range so if it comes in at 11 certainly we’ll see stronger performance. But we haven’t seen anything yet that would suggest we should modify any of our market outlooks for the year.

So as an example we still have the housing market in the 670, 675 range as opposed to what an HB and a few others have come out with which are above 700 so we really haven’t changed our view of how we see these end markets at the moment. Certainly as the year unfolds we’ll stay close to that and if we see changes we’ll certainly let you know what those are but at the moment the end market activities that we highlighted in early December are still largely what we’re using at the moment.

Operator

Your next question comes from the line of Unspecified Analyst

Unspecified Analyst

My question is on inventories and I wonder if there was any trends that you could perceive either in your business or from customers running their business for cash going into December and then getting inventory build here in January.

David Speer

I can’t say that we’ve really seen anything definitive that would tell us whether that was really a significant phenomenon. We have clearly seen some inventory pipeline begin to build in some markets in areas where it had been run almost dry if you will, but I wouldn’t say that we necessarily saw any specific unusual activity in December.

That’s sort have been a phenomenon we’ve seen over the last three or four months. It clearly has had somewhat of a positive impact but wouldn’t say that I expect any big consequences if you will in January in Q1 as a result.

Unspecified Analyst

Do you have any numbers yet for January.

David Speer

No.

Unspecified Analyst

And if I could follow-up with the acquisition, you’re assuming $300 to $500 million of acquired sales is there a profit number that you’ve put to that acquired sales number, is that in your guidance.

David Speer

Well yes we do build something into our guidance around it, I think as Ron said earlier its largely dilutive and at $400 million at the midpoint it’s a relatively diminimous number. But we do put the impact of that in our guidance yes.

Ron Kropp

Especially in the first year there is extraordinary amortization charges that really dilute the income contribution.

Operator

Your next question comes from the line of Deane Dray - FBR Capital Markets

Deane Dray - FBR Capital Markets

Question on the food equipment business this quarter and it looks like that was one of the softer spots and would be interested in hearing any color as what was unique about this quarter. I know sometimes seasonally you’ll talk about rebates and bundling programs that customers may be engaged in, just want to know how that played out this quarter.

David Speer

I don’t know that I can make a whole lot of definitive comments around that, clearly a lot of the larger buyers typically have some level of purchase rebate programs which generally impacts their purchases in Q4. I can tell you we did not see that same level of activity this year largely because a lot of those rebate levels were such that very few would have been able to qualify with incremental purchases in Q4.

I think there is some impact there certainly because normally we’d expect to see some [inaudible] around that basis, I think that probably the best sort of overall comment on Q4 in the equipment side is that customers have pulled back on some orders and are really waiting to see how things unfold and I expect that as you know in many of those markets we deal through a distribution channel and certainly the distributors are going to want to feel more positive about the projections into 2010 before they look at rebuilding inventories to any significant level.

So I think there’s some impact of that. The end market activity levels seem to be pointing in the right direction in terms of activity levels at food outlets and restaurants moving upward, I would expect that ultimately that’s going to lead to an improvement in equipment sales.

So, I think as John pointed out earlier I think that’s something we would expect to see as an early indicator. The service business has held up well which still gives us a strong look into the end markets and the activity levels so I think we’re probably close to an inflection point on the equipment side but we’ll have to see that unfolds in the first quarter.

Deane Dray - FBR Capital Markets

And then a follow-up question regarding the rebuilding of the pipeline of potential M&A, and can you tell us what’s different this time as you rebuild the pipeline. I know it comes from the field, its not a headquarters driven acquisition list, but how might it look in terms of valuation, geographies, at one time you were trying to ratchet up the potential internal growth a couple percentage points, what types of businesses, but how do you expect that pipeline to refill.

David Speer

Well I would expect the pipeline to refill much like it was as it headed down in terms of activity levels, the areas that we had the strongest activity levels in heading into this downturn were in the food equipment area, the test and measurement area, the welding space, and our polymers and fluids businesses. Those were the four that were the most active and I’d expect that as the pipeline rebuilds, we’re going to continue to see activities in those areas.

As those are areas that continue to be of strong interest and are globally fragmented that allow us I think some significant opportunities going forward. The pipeline given the dramatic decline in the pipeline over the last 18 months it will take time to rebuild. I think what we saw in the fourth quarter was our best quarter of the year in terms of activity in terms of deals closed.

And we’ve also seen the pipeline now begin to show some positive momentum in terms of rebuilding. But we’re talking about it at a level that is significantly below what it was 18 months ago, so 18 months ago we were talking about a pipeline that we could measure in the 1.2 to 1.3 billion range, we’re talking about a pipeline now that we’re measuring in the 300 or 400 million range and that’s got four or five months of visibility.

So its better than it was three months ago but still not strong enough for us to put a bigger number into our guidance at the moment.

Deane Dray - FBR Capital Markets

And implied valuations for this.

David Speer

Not a lot of change in valuation, slightly below one times revenue is what the experience base was in 2009 and I don’t think and when we look at the pipeline we see much difference in what we’d expect at least going into 2010.

Operator

Your next question comes from the line of Mark Koznarek – Cleveland Research

Mark Koznarek – Cleveland Research

The question here about the restructuring actions in 2009 and the benefits that are going to be delivered in 2010, it looks like just the absence of the lower restructuring costs are about a 50 basis points improvement and then how much do you expect to get in actual year over year benefits from productivity or whatever.

David Speer

I think as we think about the incrementals on that, I’ll let Ron comment on some of the changes in the non-volume which is where we’ve been seeing the improvements all year, that’s where the restructuring benefits would be flowing in the margin line today. I think if we look at the overall volume of restructuring in 2009 at about 160 million, that generally drives somewhere around 25% more in terms of benefits so somewhere in the 200-plus million range in overall benefits, not all of which would have been realized during 2009.

Generally it takes about six months to realize the benefits in our North American restructuring and closer to a year in the international side. So we still have some flow through coming in 2010 certainly for those restructuring projects and given that most of the restructuring, the heavy volume of restructuring was in Q2 and Q3, we would expect that by mid year that those comparables will be pretty much back in line.

Ron Kropp

The way we look at it is in the base business margins, we try to call out in the non-volume area how much is the restructuring benefit and so we’ve seen that benefit going down a bit as we’ve gone from the third quarter when it was 160 basis points, 140 in the fourth and it will be less than that in 2010, probably in the 100 basis point range for the full year primarily as David said in the first half of the year.

And so that 100 that you’re talking about includes both less restructuring cost and the flow through benefits from the actions.

David Speer

Actually that would be of the incrementals so it would be more like, in total, 140, 150.

Mark Koznarek – Cleveland Research

And then the North America versus international do you expect and appreciable difference in the revenue trends next year between the 10 to 14, adjusted for currency of course.

David Speer

Well as you know we had much stronger declines this year, I think our overall base revenues this year in North America were down in the 21%-plus range and international about 15 so I would expect that as the year unfolds particularly around some of the key end markets here in North America that we’ll see the growth rates in North America trend above the growth rates we see in the international markets, at least the European markets for sure.

Mark Koznarek – Cleveland Research

And that should have a positive impact on margin in terms—

David Speer

Well generally our margins in North America are somewhat higher than those in international. That’s not true in all segments but it is in most, so yes I would expect that on the basis of stronger revenue mix we would see that, in fact that’s reflected in the guidance that we’ve prepared.

Operator

Your next question comes from the line of Robert Wertheimer – Morgan Stanley

Robert Wertheimer – Morgan Stanley

I hate to beat a dead horse but I wanted to circle back to acquisitions M&A again, the M&A activity has sort of picked up dramatically across the sector and a little less dramatically for you so I wanted to ask if not in the formal pipeline if the conversations have picked up in a dramatic way or whether the increase in the pipeline would just gradual, is mirrored in the less formal conversations you’re having.

David Speer

I think what you’re asking is what’s the pre-pipeline activity, we count pipeline as things that are actually being worked on that are somewhere beyond the letter of interest stage all the way up to due diligence. So the activity pre-pipeline has certainly picked up in the last six months and most notably in the last three so there’s a lot more activity going on, a lot more discussions under way particularly in a number of cases with deals that we’re under discussions when the market really tanked in late 2008.

So I think, I’m encouraged by the level of activity and I’m encouraged by what our people are telling us but as we strike our acquisition numbers for the year we look at what’s actually in our pipeline when we develop that so, if the precursor activity in the pipeline is an indication of what we would expect then we will likely be in a position to do better than what we’ve put in the guidance here but we’re not at a point to be able to say that given its not in the pipeline yet.

Robert Wertheimer – Morgan Stanley

And then the balance sheet question, deferred income taxes went from around 81 million last quarter to 670 million this quarter, I’m not sure I understand that one, if you could just explain it.

Ron Kropp

The biggest piece of that is I talked about this tax benefit of $85 million related to foreign tax credits related to a legal entity transaction during the quarter and as a result of that we’re recording significant foreign tax credit assets that will carry forward on a go forward basis and utilize.

So that’s the biggest piece of it. Some of the other things that had an impact on that, the settlement of the German tax audit also increased tax assets as well.

Robert Wertheimer – Morgan Stanley

Will that flow to the income statement and is it embedded in guidance.

Ron Kropp

Both of those things went through the income statement this quarter so that’s why its having an impact on the balance sheet. So from a cash perspective the cash will be realized on a go forward basis. It will not impact the P&L as we realize the cash.

Operator

Your next question comes from the line of Eli Lustgarten - Longbow Research

Eli Lustgarten - Longbow Research

If we could go back to the forecast for 2010 in December I guess you had a 9.5 million to 10 million forecast for North America auto and the industry was 10, 10.5 and that’s gone up and you’ve gone up a bit, can you give us what your European is, is there any other area that you’ve actually that much because that is a material change in forecast that you have in the North American auto build.

John Brooklier

If you look at the European auto builds we basically said it was going to be somewhere around 16 million at our meeting in December and I don’t think that’s going to change appreciably.

David Speer

The current CSM data for Europe is still in that range. I think its actually at 15.9 at the moment.

Eli Lustgarten - Longbow Research

I’m just saying you changed your automotive North America by 5%, is there any other place that you’ve changed your outlook, that’s the only one that—

David Speer

That’s really the only significant change and we’re still at that level, we’re still below what some of the newer estimates are at 11 million but that’s the only one of any note that we’ve changed since December.

Eli Lustgarten - Longbow Research

And can you give us some insight on what other income will look like or anything like that because that’s been one of the wildcards that we have to go through in the quarter.

Ron Kropp

I would estimate that its reasonably close to what it was this year, probably in the 160 to 200 expense range including interest. Interest is the biggest piece of that.

Eli Lustgarten - Longbow Research

So no real change in that number.

Operator

Your next question comes from the line of Shannon O’Callaghan – Barclays Capital

Shannon O’Callaghan – Barclays Capital

On the miscellaneous items that you mentioned in the quarter what was the total benefit from those on a margin basis for the full year in 2009.

Ron Kropp

I’m not sure I have that number, I know for the quarter the benefit on the margin side, inventory related items were about 50 basis points positive, other corporate reserve type items were about 30 basis points positive.

Shannon O’Callaghan – Barclays Capital

And when you’re thinking about that non-volume related next year, you’re sort of saying plus or minus on price costs, restructuring, is a fairly big tailwind, is this item negative, it seems like net net you’d have some non-volume negatives. What’s the total non-volume assumption for next year for margins and what are the components in that for miscellaneous.

Ron Kropp

We don’t have the details of the various components specifically, but in total the non-volume will have very little impact in the midpoint of our range. Obviously when you range the price cost it will have different impacts, but its about flat in the midpoint.

Shannon O’Callaghan – Barclays Capital

Just last one, SG&A kind of jumped up sequentially, was there anything unusual in that.

Ron Kropp

The biggest items in that first of all you have the impact of the international fourth quarter having a bigger contribution because they’re basically a lot of the businesses are shut down the month of August and therefore have very little SG&A cost, so that’s one impact.

Also translation had a fairly significant impact both on revenues and on related cost. And acquisitions also had an impact.

Operator

Your next question comes from the line of Ann Duignan - JPMorgan

Ann Duignan - JPMorgan

I just wanted to take a step back on the restructuring charges for 2010 for a moment, we’re fairly long into this downturn and you’re beginning to see some of your end markets pick back up, just a little bit surprised that you’d have such a large amount of continuing restructuring going into 2010, can you just give us some color on what [inaudible] still require restructuring, what kind of restructuring, and I think last quarter you said you had closed a total of 10 to 12 facilities, can you just update us on the total fixed cost pickup versus [semi] variable.

David Speer

First of all $50 million is about our traditional range so in a normal year we’re in that $40 to $50 million range so if you think about $50 million that sort of describes the normal restructuring environment. Part of that designated towards base businesses, part dedicated towards acquisitions. The $100 million would be reflective of if we don’t see a rebound particularly in some of the later cycle businesses we may well spend more restructuring dollars in 2010 so the range is broader than what it would normally be.

And its based on just a little bit of uncertainty around some of those later cycle businesses and what might unfold with them. Relative to actual complete facility closings, no real change since our last discussion. Most of our restructuring dollars have been spent at actually right sizing facilities not actually closing them. So that’s really what we saw more of occurring during the fourth quarter and certainly the early indications of what we’ve seen in the pipeline of restructuring are largely in line with that as well.

Ann Duignan - JPMorgan

And this is traditionally, [inaudible] but you might have less visibility on obviously welding, which are the ones and what are some of your concerns.

David Speer

Its really only a question of when do these markets really start to turn and at what capacity levels will we need to be operating as those markets turn around. So its really I think based more on the level of uncertainty because we haven’t seen some of those markets have not hit trough yet or in some cases they may have hit the trough but we haven’t seen any significant improvement yet in capital spending.

So I think its our err or caution if you will that says we’ll have to see what unfolds in those markets but clearly if they respond earlier and stronger then I would expect we’d be spending a lot less in restructuring.

Operator

Your next question comes from the line of Andy Casey - Wells Fargo

Andy Casey - Wells Fargo

I wanted to go back to some of the trends that you’re seeing in distribution type businesses specifically in industrial packaging are you seeing any significant improvement in the consumable side of that yet.

David Speer

Well the consumable volumes clearly have trended up since the troughs that we saw at the beginning of 2009, but I wouldn’t say that we’re seeing any great burst of activity. Equipment side continues to be depressed which is clearly an indication that people are not replacing equipment nor are they adding capacity which is not unexpected given the environment. The consumable volumes have in fact improved but I would not say that we’re at a point yet where in the number of their end markets that we could say we expect to see any strong improvements.

Most of what we built into the industrial packaging outlook and what we’ve seen is again steady sequential improvement but this is one of the businesses that was impacted the greatest by the downturn given some of their core end markets like the metals markets, the construction building materials markets, the general industrial markets.

So they’ve been really in a pretty deep state of decline in many of their end markets here for the last almost 18 months. But the consumable volumes have shown better activity on a sequential basis. I would expect that we’re going to continue to see that as we trend forward. Its probably not in our estimate until sometime after mid year until we really start to see any improvement in equipment volume.

Andy Casey - Wells Fargo

And then while overall price net of cost was good, are you seeing any pockets where its still seeing any competitive pressure.

David Speer

Not as much competitive pressure as what we’re seeing probably around cost increases which might indicate or dictate later what we might have to do on the price side. We had some early indications of increases that we talked about in December around steel and plastics, some of those have abated, some of those are beginning to materialize, but at lower levels so I would not describe what we’re seeing right now is anything that is particularly onerous.

There are plenty of concerns as an example with oil at $80.00 plus a barrel are we really going to see plastic prices rise more dramatically than what people have indicated. That’s all speculation. I think I would describe the price cost environment as we see it in 2010 as more of a normalized environment where there will be some cost increases and we’ll have to offset those with a combination of price and productivity and its sort of the normal operating mode.

So, unless there’s some dramatic changes in the demand level which might drive prices up or costs up higher, but I don’t expect we’re going to see as much volatility as we saw say in 2007 and 2008.

Operator

Your final question comes from the line of Robert McCarthy – Robert W. Baird

Robert McCarthy – Robert W. Baird

The first thing I wanted to ask you about is just the general posture towards forecasting you’ve reinstated your full year guidance now, you’re forecasting 6 to 8 organically with I think and investor production forecast that’s a lot like what we experienced in 2004 when you came out of the funk period with an 8.5% organic, so is there something different, we’re also talking about back then 25% incremental so, have you sacrificed some organic growth early part of the cycle to get more pop or are you just trying to not get the timing wrong here.

David Speer

Obviously we’re coming out of a period of great uncertainty. We can’t say in a number of end markets that they’ve turned the corner yet so obviously there’s some of that uncertainty built into how we look at the year unfolding. Clearly the incremental as we’ve already pointed out are going to be strong on a comparable basis.

I don’t know that I could really compare what we’re talking about in 2010 to what happened in 2004 but I would certainly expect that as things materialize and these markets do strengthen there’s no doubt in my mind we’re going to see incrementals here much stronger than what we saw in 2004.

I think the variable for us when do some of these later cycle markets really begin to respond. I don’t think the trajectory of growth is going to be nearly as dramatic in 2010 as it was in 2004 so I think there are some differences but all in, I think we feel comfortable with where we’re positioned and we’d be happy to have the opportunity for revenues in our end markets to exceed the 6 to 8% range that we’ve got here.

And if they do we’re certainly going to respond with some very strong incrementals. But at the moment although we’re reinstating annual guidance as you pointed out, I would still describe visibility in end markets in terms of the overall impact in some of these markets is not great still so hard for us to make a call on how strong and when some of these markets will actually begin to show some real growth.

Robert McCarthy – Robert W. Baird

The other thing I wanted to ask about was the, and this came up once before, the business you have that seems to have lost the most momentum in the fourth quarter which is the food equipment business, as you point out there’s a channel there, I wonder if you’ve got any information that you can share with us about maybe inventory levels in the channel, what might be happening with used equipment, are prices down there significantly perhaps, you forecast up for 2010 led by service, but I’d be interested in what kind of a split you’re imbedded in the 2 to 4 for the year that you talked about in December between service and equipment since service is the smaller business.

David Speer

Well service overall represents about 35% of the segment, that’s both in North America and internationally so its pretty consistent and certainly the overall revenue base of 2 to 4% would imply that probably mid year is when we’d begin to see the equipment business improve and I think on a go forward basis we expect that the normal sort of service revenues grow in that same kind of range but I think this is more mid year in terms of the equipment growth opportunities.

So, I think we’re at a point where I can’t explain necessarily in great detail some of the questions you asked about inventory in the pipeline or other factors on used equipment and so forth, that’s clearly something that we’re looking at and hopefully get better insights into. But I don’t think there’s anything unusual in what we would expect to see unfold here except that again we wouldn’t expect to see significant demand change on the equipment side until perhaps midyear.

So the first half of the year I expect will still have equipment businesses that will be maybe down slightly to flattish on a comparable basis, remember this is a business that performed fairly well the first part of 2009 but I expect that by mid year we’ll start to see the equipment revenues begin to rise and the service revenues typically operate in a range of 2 to 4% which is what we’ve imbedded in the forecast for 2010.

Robert McCarthy – Robert W. Baird

This is a business that you believe was impacted last year by destocking in the channel right.

David Speer

Yes, we do. But the destocking in this business is probably not at the same level as we would have seen in some other businesses but it would have been certainly a factor probably in the Q1, Q2 timeframe.

Robert McCarthy – Robert W. Baird

What happens to employment at ITW in 2010 if your forecast is at the high end of your organic range.

David Speer

I would expect to see a modest increase in total headcount. Most of our businesses are sized to handle the range and forecast that we’ve already provided without making any significant additions and I would expect that would be the case overall. Obviously that may vary by individual business or segment if the growth rates are stronger but overall I’d expect even at the high end of our range at 8% base business growth there’d be modest increases in employment.

John Brooklier

I want to thank everyone for joining us and we’ll be talking to you later. Thank you very much and have a good day.

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Source: Illinois Tool Works Inc. Q4 2009 Earnings Call Transcript
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