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Illinois Tool Works Inc. (NYSE:ITW)

Q1 2010 Earnings Call

April 20, 2010 2:00 am ET

Executives

John Brooklier – VP IR

David Speer – CEO

Ron Kropp – SVP & CFO

Analysts

John Inch – BofA/Merrill Lynch

Jamie Cook - Credit Suisse

Terry Darling – Goldman Sachs

Henry Kirn - UBS

Eli Lustgarten - Longbow Research

Mark Koznarek – Cleveland Research

Ann Duignan - JPMorgan

Robert Wertheimer – Morgan Stanley

Robert McCarthy – Robert W. Baird

Unspecified Analyst

Andy Casey - Wells Fargo

Operator

Welcome to the Illinois Tool Works first quarter 2010 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 our first quarter 2010 conference call. With me today on today’s call is CEO, David Speer and our CFO, Ron Kropp. Thanks for joining us on the call.

I’ll now turn the call over to David, who will make some brief remarks on our very strong first quarter operating performance and our updated 2010 guidance.

David Speer

Thank you John, as noted we posted very strong first quarter operating results in a number of key categories. Our first quarter revenues increased 14.6% versus a year ago, with total base company revenues growing 7.5%.

Notably we had nearly equal base revenue growth contributions from our North American and international businesses, with North American based revenues up 7.1% and international based revenues increasing 8% in the quarter.

A number of our segments produced solid base revenue gains in the quarter, our transportation segment grew base revenues 32%, thanks to the significant ramp up in the first quarter auto builds in both North America and in Europe.

Our industrial packaging segment and our power systems and electronics segment both saw base revenue growth in the 11% range during the quarter. And our polymers and fluids segment produced base revenue growth of 8% during the quarter.

We believe the stronger base revenue growth in these segments highlights an improvement in consumer buying patterns as well as a pick up in industrial production and underlying end market activity.

We posted very strong operating margins of 13.4% in the quarter. This represented margin growth of 1050 basis points versus our reported results from the year ago period. When you exclude the impact of our 2009 first quarter impairment, our first quarter 2010 operating margins would have been 760 basis points higher than the first quarter of 2009.

Its important to note this dramatically higher margin growth was a result of our business units’ ability to achieve significant leverage on increased revenues, thanks to lower overhead manufacturing costs due to our restructuring programs.

Finally our 2010 second quarter and full year forecasts reflect a more bullish view of worldwide economic and end market growth for the remainder of the year. While we have learned over the years that a forecast is still a forecast, we have a growing sense of optimism that the business environment will continue to improve as the year progresses.

Now back to John.

John Brooklier

Thanks David, here is the agenda for today’s call. Ron will join us shortly to talk about Q1 2010 financial highlights, I will then cover Q1 operating highlights for our eight reporting segments, Ron will then detail our Q2 and full year earnings forecast. Finally we will take your questions.

First let’s cover our mandatory 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 net income per share from continuing operations, restructuring expenses and related benefits, tax rates, end market conditions and the company’s related 2010 forecasts.

Finally the telephone playback for this conference call is 203-369-3795 and no pass code is necessary. The telephone replay is available through midnight of May 4, 2010. One other reminder, our webcast power point presentation accompanying this call is available on our www.itw.com website.

Now here’s Ron Kropp who will comment on our 2010 first quarter financial highlights.

Ron Kropp

Thanks John, good afternoon everyone. Here are the key items for the first quarter, revenues increased 15% due to higher base revenues and currency translation, and significantly improved from the fourth quarter revenue decline of 5%.

Operating income was $484 million which was higher than last year by $393 million. Margins of 13.4% were higher than last year by 10.5 percentage points. Diluted income per share was $0.58 which was higher than last year by $0.60 and above our most recent EPS guidance of $0.48 to $0.56 primarily due to stronger base business results especially in March.

Also included in the EPS for this year was the previously disclosed $0.04 per share tax charge related to the new healthcare bill. Included in last year’s EPS was an impairment charge which reduced earnings by $0.17 and discrete tax adjustments which reduced earnings by $0.06.

Finally free operating cash flow was $219 million. Now let’s go to the components of our operating results, our 14.6% revenue increase was primarily due to three factors. First, base revenues were up 7.5% which was favorable by 17.5 percentage points versus the fourth quarter base decline of 10%.

As David mentioned we have seen solid revenue gains worldwide led by the transportation, industrial packaging, power systems and polymers and fluids segments. North American base revenues increased 7.1% and international base revenues increased 8% in the first quarter which were significant improvements from the fourth quarter declines of 10.9% and 9.0% respectively.

Next, currency translation increased revenues by 5.4% which was favorable by 210 basis points versus the fourth quarter currency benefit. Lastly acquisitions added 2% to revenue growth which was 30 basis points higher than the fourth quarter acquisition impact.

Operating margins for the first quarter of 13.4% were higher than last year by 10.5 percentage points and higher than fourth quarter margins by 70 basis points. The base business margins were higher by 810 basis points due to both the favorable impact of the higher sales volume and the positive impact of non-volume items.

Included in the non-volume items are the following items, lower costs as a result of restructuring programs, plus 200 basis points; favorable price cost effect, plus 70 basis points; inventory adjustments related to costing and obsolescence reserves, plus 160 basis points. In addition margins were higher by 270 basis points due to last year’s impairment charge of $90 million.

Also acquisitions reduced margins by 20 basis and translation diluted margins by 30 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, interest expense increased by $13 million in the first quarter as a result of the bond issuance in late 2009 of March. Other non operating income and expense was favorable by $0 million mainly due to higher income from investments.

The first quarter effective tax rate of 33.9% was higher as a result of the unfavorable discrete tax adjustment of $22 million related to the new healthcare bill. Excluding this adjustment the effective tax rate would have been 29%.

The tax rate is forecasted to be in a range of 28.75% to 29.25% for the second quarter and 29.75% to 30.25% for the full year.

Turning to the balance sheet total invested capital decreased $171 million from the fourth quarter primarily due to unfavorable currency translation partially offset by higher inventory levels. Accounts receivable DSO was 61.2 days versus 59.7 days at the end of the fourth quarter. Inventory months on hand was 1.8 at the end of the quarter versus 1.9 at the end of last year.

For the first quarter capital expenditures were $61 million and depreciation was $84 million. ROIC for the first quarter excluding the discrete tax adjustment increased to 13% versus 5% last year excluding last year’s impairment and tax charges.

On the financing side our debt level was essentially the same as the fourth quarter and debt to capital remains stable at 26%. Cash on the balance sheet increased to $1.4 billion from $1.3 billion at the end of the fourth quarter.

Our cash position increased $99 million in the first quarter as our free operating cash flow of $219 million and short-term debt proceeds of $112 million were utilized for acquisitions of $28 million and dividends of $155 million.

Regarding acquisitions we acquired four companies in the first quarter which have annual revenues of $26 million. Our current forecast for full year 2010 is acquired revenues of $300 to $500 million which includes a $62 million auto aftermarket business which closed in early April.

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

John Brooklier

Thank you Ron, now let’s review our first quarter segment highlights, starting with transportation Q1 2010 total segment revenues increased 35.6% versus the year ago period. Base revenues grew a very healthy 32% compared to the year earlier period and notably Q1 operating margins of 13.7% were 1810 basis points higher than the year earlier period but 130 basis points lower than Q4 2009 operating margins.

The large Q1 increase in segment base revenue growth was due to continued high levels of auto builds in both North America and Europe. In North America Q110 auto builds of $2.9 million were substantially higher than the Q109 builds of $1.7 million.

And Detroit 3 and new domestic OEM’s both participated in these big year over year production increases. The European auto builds totaled $4.2 million in the first quarter of 2010 versus a build of three million units a year ago. We continue to believe that auto builds will stay strong throughout the year and we are now forecasting full year 2010 auto builds of 11.2 million units for North American OEM’s and 16.5 million units for Europe.

In our auto aftermarket group Q110 base revenue grew a modest 0.6% on a year over year basis reflecting the slight uptick in miles driven and consumer spending in this category. Moving to industrial packaging total segment Q1 revenues grew 21% versus a year ago period. Q1 base revenues totaled 10.9% growth compared to the year earlier period.

Q1 operating margins of 9.8% were 1040 basis points higher than the year earlier period and 250 basis points higher than the Q409 operating margins. Industrial packaging base revenues continue to show improvement in the first quarter of 2010 with base revenue growth of 10.9% compared to the year earlier period.

Recent macro data including improving industrial production activity in the US underpinned better financial results for a number of our North American industrial packaging business units. Notably our total North American industrial packaging base revenues increased 19.8% in Q1 with the [inaudible] strapping volume increases accounting for significant majority of the growth.

Total international industrial packaging base revenues were up 2.5% in the quarter versus the year ago. Moving to food equipment, total segment Q1 revenues were modestly negative on a year over year basis. Q1 base revenues declined 5.2% due to the expected slow equipment sales. Even with slower negative revenues however, Q1 operating margins of 11.8% were 150 basis points higher than the year ago period, but 220 basis points lower than Q409 operating margins.

Food equipment’s Q1 base revenue declined to 5.2% was directly tied to slow equipment sales in the quarter. As we said in Q409 worldwide customers continue to delay equipment purchases and that has impacted both our North American and international businesses.

Total North America food equipment base revenues declined 2.7% in the quarter with the new project side of the business accounting for most of that decline. As you would expect the replacement side of the business was stronger in the quarter.

Once again the strongest performer in the segment was the North America service business which produced Q1 base revenue growth of 1% versus a year ago period. Total international food equipment base revenues decreased 7% in the quarter as both Europe and Asia saw pushback from institutional customers on equipment orders.

Moving to power systems and electronics, the total segment Q1 revenues grew 13.7% versus a year ago period. Base revenues total 10.7% growth in the quarter compared to the year earlier period. The substantially stronger Q1 operating margins of 20.8% were 1440 basis points higher than year ago period and 620 basis points higher than Q409 operating margins.

The segment’s Q1 base revenue growth of 10.7% was largely attributable to our PC board fabrication businesses. These units which provide solder and in OEM and manufacturing equipment to worldwide consumer electronics customers produced a Q1 base revenue increase of 89.4% versus the year ago period.

Clearly the surge in demand for a variety of consumer electronic products including phones, portable computers, and PDA’s have spurred on business group growth. In the welding related portion of this segment Q1 worldwide welding base revenues declined 1.4% versus the year ago period.

However that is substantially better performance than Q409 when worldwide welding base revenues fell nearly 25% on a year over year basis. The sequential improvement from Q409 to Q110 was led by North American welding which produced Q1 base revenue growth of 1.7% versus the prior year period. Internationally Q1 welding base revenues declined 8.4% compared to the year ago period.

The next segment construction products, total segment Q1 revenues grew 14.2% versus the year ago period. Base revenues however only increased 0.5% in the quarter compared to the year earlier period. Even so, Q1 operating margins of 6.9% were 1010 basis points higher than the year ago period but 300 basis points lower than Q409 operating margins.

The segment’s Q1 base revenue growth of less than 1% directly reflects sequentially better financial performance but still relatively tepid end market demand in both North America and internationally. In North America total construction base revenues declined 2% in Q1 versus the year ago period.

Our North American residential businesses saw base revenues grow 7.6% in Q1 thanks to better housing start data. In Q1 housing starts averaged 617,000 units versus housing starts that were largely in the 550,000 range for the second half of 2009. However the renovation and commercial construction businesses both produced base revenue declines of 6% compared to the year ago period.

Internationally Q1 base revenues increased 1.1% versus the year earlier period with Asia Pacific base revenues growing 4.3% and European base revenues declining 0.9%. In the polymers and fluids segment total revenues grew 18.3% versus the year ago period. Base revenues increased 7.6% on a year over year basis as the fluid side of the business showed substantial improvement.

Notably Q1 operating margins of 12.5% were dramatically higher than Q109 but 110 basis points lower than Q409 operating margins. The segment’s Q1 base revenue growth of 7.6% was largely driven by our worldwide fluids businesses. Base revenues for the worldwide fluids businesses grew 13.9% in Q1 with international businesses increasing 15.1% and North American base revenues growing 11.5%.

Growth in the fluids category was mainly due to increased worldwide demand for both MRO aerosol products as well as personal hygiene products. The worldwide polymers businesses also showed improvement in Q1 with base revenues growing 4.7%. International polymers base revenues increased 6.1% while North American base revenues were essentially flat year over year.

Decorative surfaces total segment Q1 revenues grew 1.5% versus the year ago period. Base revenues in Q1 declined 2.6% as the segment’s North America commercial construction revenue concentration continued to impact results. As a result Q1 operating margins of 9.5% were 260 basis points lower than the year ago period but 10 basis points higher than Q409 operating margins.

While the decorative surfaces base revenue sequentially improved from a decline of 10.3% in Q409 to a base revenue decrease of 2.6% in Q110 the overall segment continues to be constrained by its North American commercial construction mix. Commercial construction activity industries all show ongoing weakness in the US based commercial construction projects.

Base revenues for the North American [inaudible] laminate business declined 2.6% in Q1 versus the year ago period. On the international side base revenues fell 2.5% in the quarter compared to the year earlier period.

And finally in our all other segment Q1 revenues grew 11.4% versus a year ago. Base revenues in Q1 increased 2.6% with short cycle consumer related businesses leading the way. Very strong Q1 operating margins of 16.8% were 560 basis points higher than the year ago period and 190 basis points higher than Q409 operating margins.

The segment’s year over year base revenue increase of 2.6% was due to the improved performance of our consumer related businesses. Most notably our industrial appliance base revenues grew 12.9% in Q1 versus the year ago with most of that growth emanating from energy efficiency initiatives in the appliance sector.

Consumer packaging base revenues grew 4.2% in Q1. While our more CapEx related businesses, the business has showed sequential improvement Q409 to Q1 they were still faced with weaker demand for equipment sales. Most notably our worldwide custom measurements base revenues declined 7.5% in Q1 versus the year ago period.

Now let me turn it back over to Ron who will cover our 2010 second quarter and full year forecast.

Ron Kropp

For the second quarter of 2010 we are forecasting diluted income per share from continuing operations to be within a range of $0.74 to $0.86. The low end of this range assumes a 15% increase in total revenues versus 2009 and the high end of the range assumes a 19% increase. The mid point of this EPS range of $0.80 would be 122% higher than Q2 2009.

For the full year our forecasted EPS range is now $2.72 to $3.08 based on higher total revenues of 10% to 14%. The mid point of the EPS range of $2.90 would be 50% higher than 2009. This new EPS forecast is a significant increase from the forecast range we provided in January of $2.43 to $2.93 and reflects our more optimistic view of the business environment and our ability to continue to generate solid operating margins.

Other assumptions included in this forecast are exchange rates holding at current levels, acquired revenues between $300 and $500 million, restructuring costs of $50 to $80 million for the year, and as I mentioned earlier a tax rate range between 28.75% and 29.25% for the second quarter and 29.75% to 30.25% for the full year.

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

John Brooklier

This concludes our formal part of our presentation, we’ll now open the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of John Inch – BofA/Merrill Lynch

John Inch – BofA/Merrill Lynch

Could we talk a little bit about M&A, I see you didn’t raise the expected contribution target this year. If you look at sort of industry bid/ask spreads things have narrowed considerably. You are obviously very strong acquirers. What do you see in terms of your current pipeline, I think you have this secondary pipeline, maybe where could there be upside based on your activity levels and what areas are you looking.

David Speer

First of all as you know we don’t adjust the pipeline until we’ve actually closed deals so if you follow what we said about Q1 and Ron noted in his comment we closed a deal early in April of about $60-some million so year to date we’re about $90 million in revenues closed.

So at this stage we wouldn’t obviously raise the range but obviously as our experience based on deals going forward would rise we would look at that range. I can tell you that the pipeline has strengthened since the end of the year. The pipeline today is about $600 million in size, so its up some $200 million since the end of the year.

I would expect that what we have in the pipeline that is scheduled to close over the next 45 days or so that we would likely be in a position before the end of the second quarter to make some upward revision in the range for acquisitions.

We are beginning to see some change obviously in the bid and ask if you will, the spread, but I can also tell you that there are a number of factors that are occurring from a private equity perspective that have also driven valuations up relatively quickly, so, there’s a number of things going on but I would say that we certainly see an improving environment and I would expect that as the year progresses the pipeline will continue to strengthen.

John Inch – BofA/Merrill Lynch

If you look to the mid 2000, you completed sort a billion to two billion of revenue from deals, could you maybe just contrast today’s environment with that period and are we, do you foresee a scenario where we build back to those types of levels and if not why, or perhaps maybe exceed them, just a little bit more color in terms of where you think we are relative to the future runway. Its less to do with this quarter, next quarter, its more just where are we heading with all of this as you take a look at the landscape.

David Speer

Yes, I think we’re clearly headed back to that same kind of trajectory that you referenced that we had from 2006 to 2008. I think we’re coming off of a very significant trough that occurred actually beginning in the latter part of 2008 into 2009 as business conditions weakened and as it became less and less a very conducive environment for acquisitions, but I certainly see that the trends are upward. Certainly the capabilities from our balance sheet standpoint and certainly our interests are there so I certainly see us returning to that kind of activity level again where I would expect that we’d be routinely looking at acquisitions that are in that 7% to 8% of our annualized revenues which would put you in the billion dollar plus range on a normalized basis.

So I think we’re at the beginning of what I would expect to be an upsurge in the cycle as it impacts our acquisition activity.

Operator

Your next question comes from the line of Jamie Cook - Credit Suisse

Jamie Cook - Credit Suisse

Two questions, one just trying to get a feel for you talked about I think material costs, price you had a benefit of 70 bps in the quarter, how do you see that playing out for the full year and whether or not we’ve gone out with more aggressive price increases in the back half and just the competitive response to that. And I guess just a follow-up question to that is should we view, how do you think about margins in the remaining nine months of the year. Should we continue to see sort of modest sequential improvement or whether there’s anything in terms of seasonality or material cost price risk that I should be thinking about.

David Speer

A couple of things, first of all on the price/cost side yes, you accurately noted we had a 70 basis point favorable impact. By our projections going forward that’s over. We have clearly seen raw material price increases some of which we will offset with already initiated price increases as well, but I would expect that as we move forward its going to be the sort of the more traditional range where we have some cost increases that we don’t recoup necessarily in line with the price increases, that don’t necessary recoup in line with all the cost increases.

I would expect for the balance of the year we’re probably going to bounce around between maybe minus 50 to minus 100 basis points per quarter but a pretty normal level of activity and that’s really what we’ve built into our sort of future look forward.

The price increases that we’ve seen or cost increases we’ve seen have largely come from the steel and plastic categories and they have moved up clearly at the end of the quarter and into what we’re seeing in the early part of the second quarter so, I expect that we’ll be in that kind of sort of market for the next several quarters anyway.

On the margin side I would just remind everyone that our strongest quarter is in fact the second quarter so the margins that we’re projecting for the second quarter are sequentially better than what we’d expect in the second half of the year on a percentage basis.

The change in margin profile I think solidified significantly in the first quarter as we saw with the strong incrementals and I would expect that if you look at our mid point numbers for Q2 and you extend those through to the implied ranges for the balance of the year, we would expect our margins for the year to end up in the 14% to 15% range so obviously trending up from the 13.4% in Q1.

Jamie Cook - Credit Suisse

And then the competitors response to price increases, are people being rational or are they being aggressive, just what you’re seeing in general.

David Speer

Well I don’t know that we have a lot of data to be able to talk definitively about competitive response, but I know that our early moves on price have not met with anything other than the normal kind of resistance, so I don’t think there’s any notable data on competitors that would suggest that people aren’t expecting to recoup price based on cost increases.

Operator

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

Terry Darling – Goldman Sachs

I wonder if we could talk a little bit about the drivers of the sequential revenue improvement that’s implied by the second quarter guidance, which segments is that coming from and if you think about the high and the low end of the range on guidance, kind of where the big swing factors could be again from a segment perspective.

David Speer

Well I think we expect obviously as John and Ron pointed out in their comments, we’ve raised our guidance in the transportation segment significantly based on what we see is a significantly better auto build. The number now for us is 11.2 million for the year. That’s up from 10.5 which was revised up from 10 and the same on the international side in Europe the auto build now is projected in the 16.9 range, up from just over 16.

So that’s probably individually the strongest driver. Continued strengthening in the industrial packaging area, certainly you saw the numbers that John spoke about particularly obviously on the consumable side. We haven’t seen any significant rebound in equipment yet, but strong demand in consumables, almost a 20% increase here in North America in Q1.

So those are two of the more significant I would say drivers on the upside. If you look at our revised guidance however for the year you’ll note that while we improved our earnings guidance, we did not change the revenue range so our expectation is still that we’re going to see base revenue for the year in the 8% range and that the real driver here in earnings improvement is going to be the incremental performance and stronger performance as a result of the cost controls that we’ve had put in place.

So I think the offset to the stronger guidance in transportation and industrial packaging is still a lag in what we see happening in some of the equipment businesses. So I think all in, we’re talking about a stronger margin profile based on what we see as better incrementals through the cost controls we’ve had in place but not a significant change in our revenue outlook for the year.

Terry Darling – Goldman Sachs

And two points of clarification on that first you did talk about being more optimistic about the economic environment and so perhaps you’re really suggesting maybe there is more upside here to the full year guidance to the extent that you do get a little bit more volume and secondly in terms of the better margins then driving the full year guidance move doesn’t sound like its price/cost. Is it either you’re finding greater benefits from the restructuring you did last year, or maybe you can just clarify where within the margin levers you’re feeling better there.

David Speer

Yes I think largely the margin levers is we’re getting more benefit in the restructuring that we did last year than what we had projected. I mean that’s probably 80% of it. I would say that price/cost I would describe the price/cost environment that we outlook now for the balance of the year as being sort of a normalized environment where there is some negative sort of headwind but its relatively narrow.

We certainly will not see the benefits that we saw for the last three quarters in the price/cost equation but I think its largely the incrementals are being driven by better benefits or higher benefits if you will than what we had anticipated in our restructuring activities last year.

Relative to the optimism I would suggest that the optimism, we had built optimism into our original guidance in terms of what we saw happening with revenues. I think we can confirm after the first quarter we came in slightly above our mid point on base revenue growth in Q1 and I think our base revenue growth, if you run the numbers for the balance of the year would suggest that we’re up in low double-digits in Q2 and in the 6.5% to 7% range for the second half of the year.

So, if we get revenue strength beyond that we’ll certainly have much improved results from our guidance but I think the note is we’re really projecting similar revenues to our original guidance but stronger incrementals which leads to higher margins.

Terry Darling – Goldman Sachs

The geographic profile of your $600 million M&A pipeline, can you give us a feel for that.

David Speer

I don’t have the exact makeup but it would be probably slightly tilted towards international revenues at the moment.

Operator

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

Henry Kirn - UBS

Wondering if you could chat a little bit about what you saw from the demand in March versus the rest of the quarter.

David Speer

Well obviously the March numbers were quite strong. In fact if you look at the differences between the numbers that we had put out in our mid March release covering the first two months versus what happened in March, it was significant change upward, base business up more than 12% in March which is obviously a strong indication of the improvement that we saw in that month.

We saw some of that building obviously heading into March but obviously clarified across a pretty broad range of businesses as John and Ron noted in their comments, but yes, March was a strong month.

Henry Kirn - UBS

And I guess could you talk a little bit about how we should think about working capital as we go through the rest of the year.

David Speer

Well the big swing in cash flow if you will compared to Q1 of last year was really the build in receivables which you would expect to come as a result of increased revenues. There was not much change in inventory in terms of the overall inventory dollars but certainly as the year progresses and we look at rates in the second quarter of base business growth in the 10%-plus range we’ll start to see inventory build as well.

So I would expect to see some modest gains in both inventory and then certainly as you look at receivables, the sales volumes for the coming quarters are higher than they were for Q1 so you’ll see some rise in obviously working capital as we look at the balance of the year.

Ron Kropp

I think what you should expect to see going back to more historical levels of DSO and months on hand so, typically months on hand is 1.9 to 2, DSO is between 60 and 61, 62.

Operator

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

Eli Lustgarten - Longbow Research

Brilliant quarter, couple of questions, one by the way, I hope you can post the presentation on the website, at least I can’t find it. Power systems and electronics had a phenomenal margin with the welding business still flat on its back, can you give us an idea of the [inaudible] was great, sustainability particularly the margin side of this business, are you expecting welding, do you have some guidance on what’s going on the welding business the next couple of quarters and will consumables hold margins, can you give us some idea of what’s going on there.

David Speer

Well obviously as you pointed out the margins were impressive. I’d say the biggest single lever in the quarter was the significant improvement in the PC board businesses because they had been a huge drag on margins. Certainly the margins in welding are impressive and they have remained high. The consumable margins are strong in that business. The mix is still tilted towards largely equipment in our welding businesses, it still represents about 70% of the welding group if you will.

So I think the real swing in Q1 in terms of margin improvement would be really related to what changed in terms of the electronics sub segment there and the strong improvement in the order volumes both on the consumables side as well as the equipment side and the equipment side continues to build.

The backlog there continues to build as John pointed out in his comments, the strong response or rebound in consumer electronics has been one of the stronger drivers there and some of that product also ends up in the automotive segment and that’s also had a contributing factor as well.

Eli Lustgarten - Longbow Research

So you’re expecting these margins to be sustainable for the most of the year at this point.

David Speer

Yes, if you look at the growth rates we’re looking at across this segment for the balance of the year the answer is yes.

Ron Kropp

If you look at the prior year margins of 60.4% that includes an impairment charge that had an impact of 5.7% so that’s also driving part of this. Historically this segment’s margins are in the 20% range.

Eli Lustgarten - Longbow Research

And to be there without welding is quite impressive. Can you talk are you seeing any of this [inaudible] effect, can you talk about what’s going on in inventory in the chain and is there any chance, any way that a lot of this is just restocking and rebuilding the pipeline from the big [defamation] last year.

David Speer

There’s no question that I think certainly in March I would expect that at least some of this had something to do with restocking in some segments. Its hard to get an exact handle on that but I would think that it would have had some impact. Some of the segments that have begun to rebound the inventory levels were very low, so any kind of increased activity level is going to require at least some rebuilding of inventory to a reasonable level.

I think that’s clearly the case in parts of our industrial packaging businesses. We have not seen that to any significant extent in any of our equipment businesses yet, but the transportation segment I would not say that there was much of an inventory build there. Most of that occurred in the latter half of last year. The volumes from Q4 to Q1 change in auto build was not significant.

In fact it went down in Europe, it was up modestly here. So I think the restocking if you will is probably begun to occur at least in some segments but its hard to get a handle on it. Certainly not as significant as what we saw in the destocking.

John Brooklier

Point of clarification, the power point presentation was not posted. You were correct so our apologies. Everybody on the call, the power point presentation should be posted within the next five minutes.

Operator

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

Mark Koznarek – Cleveland Research

Question about the transportation margin performance in the quarter because if you look at revenues I’m comparing it versus fourth quarter so just sequentially revenues were about flat but with a margin down 130 basis points or so, was there something unusual going on here in the first quarter.

David Speer

I think the change in margins in Q1 in transportation, remember this is a segment that’s got automotive aftermarket in it as well as a truck related aftermarket business. And so the margins certainly in the truck related business were down, that would have had somewhat of a negative impact.

And we had probably the strongest incrementals in the automotive OEM business in Q4 so I think you’ve probably got a combination of several things.

Ron Kropp

Also on the non volume area we had some pickups in inventory related things, things like LIFO in the fourth quarter in this segment.

Mark Koznarek – Cleveland Research

So then given that we’re at a sort of a run rate for North American manufacturing any way these margins would be pretty much good for the remainder of the year, do you expect anything different as we get to the full year annual.

David Speer

Are you talking about the transportation segment or automotive.

Mark Koznarek – Cleveland Research

Transportation segment.

David Speer

Transportation segment I would expect these margins to actually improve through the year.

Mark Koznarek – Cleveland Research

Question about the earlier comment about price versus cost, it seems like you’re pretty direct saying you think that’s going to be negative, a headwind 50 to 100 basis points and yet it seems like across a lot of the manufacturing economy there’s a lot of price increases being put in place right now to the final customers and lead times are beginning to stretch in several categories and it seems like buyers are on the margin becoming less price sensitive and more focused on availability. And I’m wondering why ITW isn’t adopting a more aggressive posture with regard to price improvement in the latter half of the year.

David Speer

Well I wouldn’t describe our posture as passive, I think what I’m describing it is we’ve had price increases, we’ll continue to have price increases, the delta is largely related to timing. You never get price increases perfectly in line with cost increase from a timing standpoint so its really the lag effect of how long it takes to get a price increase actually through the system while you have already incurred cost increases.

So, I would describe this as a very normal sort of an environment and if in fact costs or price increases, if we figure that we can go higher on some of these than we can we certainly will, we certainly look at the market and we look at the cost profile and what we think is reasonable but I wouldn’t read anything negative into my comment.

That’s sort of a typical price/cost environment and its really based more on a lag than anything else. And remember we’re coming off of three extremely strong quarters of a big delta between price and cost, so, we’ve recognized a lot of this improvement already in our current margin profile.

Ron Kropp

And part of the reason for this sense of strong performance there over the last three quarters is as costs have come down our prices have not come down as much so we’ve been able to hold price over the last year.

Mark Koznarek – Cleveland Research

And then just a final little detail here, the outlook for tax for the full year, the [50%], that would include this Medicare charge in there.

Ron Kropp

That’s correct, that includes the 33.9% rate from the first quarter.

David Speer

And that’s really the reason that the rate for the year has changed, its related to that.

Operator

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

Ann Duignan - JPMorgan

Can you talk a little bit about your commercial construction business and they seem to be holding up better than the market itself, can you just talk about what’s going on in those specific businesses and is there worse to come or is it those segments that are kind of holding you to be more conservative on your revenue outlook. Could you just give us some color on those.

David Speer

Well obviously the commercial segment as you know from the Dodge data on contracts awarded continue to be significantly negative. Was negative all of last year. Negative into the mid 40’s last year for the year on start related data on a square footage basis, its still year to date commercial square footage down nearly a third.

So we haven’t seen any significant improvement in the market levels. Obviously what we built into our original guidance was not for a rebound in commercial construction. I think we are performing somewhat better in the market. I think some of it has to do with our short supply lines. I think some of it also has to do that in some of our commercial construction businesses we do have a component of some MRO activity that helps.

But overall while its down 6% versus some significant declines in start activity obviously we’re pleased with the performance in that kind of a market environment but I wouldn’t read anything too significant into it.

Ann Duignan - JPMorgan

And on the food service side would you expect to see further declines just given that your food service business is highly institutional and maybe tied more to state and local budgets. What do you think, do you think you’re at the bottom in that business.

David Speer

I think we’re probably near the bottom but I wouldn’t call it a bottom yet until we actually see some inflection point. I think its as John pointed out in his earlier comments, the main downfall or the main shortfall in North America as an example was the project related activity. That’s almost exclusively new construction. So the replacement activity I think has flattened out. We’ll see over the next quarter what happens.

So if we’re not at the bottom, I would expect we’re reasonably close. The bid activity, the quote activity is reasonable which is obviously a precursor to any significant improvement in ordering activity so too early to say it’s the bottom but probably based on where we are, not far away.

Ann Duignan - JPMorgan

And then just a quick follow-up on the margin, I think you said that by year end you’d expect to be at 14% to 15% margins—

David Speer

I think if you look at the implied guidance for the second half of the year along with the 2Q guidance at the mid point it comes out between 14% and 15% margins.

Ann Duignan - JPMorgan

And assuming when you give us that guidance you’re baking in roughly $400 million of acquisitions at lower margins.

David Speer

Yes, correct, $400 million of acquisitions with almost no significant margin impact.

Operator

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

Robert Wertheimer – Morgan Stanley

I had a couple of questions, first is just on financial distress in the supply chain, I’m wondering if you’re seeing any share gains, I know its tough to measure from competitors who are struggling to get financing in the growing up cycle and maybe if that’s tough to answer if you’re seeing more situations of distress in the potential acquisition pipeline.

David Speer

I would say on the supply chain side we probably in some markets seen some modest benefit as a result of some supply chain disruption. There’s no question that some players in the supply chains in some markets cut back to the point where they have not been able to respond to any significant upswings.

I think in other cases our businesses are positioned with much shorter lead time profiles and that’s a lot more comfortable for people to deal with in what is still somewhat of an uncertain environment in terms of the demand profile over the next several quarters.

So I think we clearly have benefited from that. We know we have in construction, we know we have in auto, we know we have in industrial packaging so, I don’t think there’s any question that we’ve been the benefactor of that at least at some level.

I think as it relates to the M&A environment I don’t know that I could say anything definitively there other than the fact that some of deals that have started to emerge of size have emerged with multiples that remind me more of 2007 than 2008 which would indicate that there’s a shift in thinking at least from how some people are looking at valuing some of these larger size deals both public and private.

So its hard to get a read on that environment. It has not had much impact on our pipeline or the pricing, but I tell you there’s a few deals we’ve looked at that did not get into our price line because the pricing was clearly outside of anything we thought was comfortable.

Robert Wertheimer – Morgan Stanley

I know you’ve kind of asked and answered this but I was surprised not to see the revenue outlook go up given how bullish you sound. I don’t know if it’s a fair question or not but are you more comfortable with the revenue outlook now than you were last time you spoke to us.

David Speer

I don’t know, maybe I sounded too much like a bear before but I would say that what I’m reflecting, what we’re reflecting here in our change in guidance is based largely on the strength of what we saw incrementals much better performance in incrementals largely as a result of more benefits coming out of the restructuring that we did.

When you do the restructuring you try to peg the benefits as closely as you can but you really don’t get a full view until things really begin to take off and you see the incremental impact and obviously its stronger than what we had projected.

I think in terms of the markets, the market is playing out at this stage about what we had expected. Some markets performing better, like transportation and industrial packaging, and some somewhat slower like custom measurement and the industrial packaging equipment business. So I don’t think there’s any dramatic change in what our expectations are.

The second half of the year remember we’re going against obviously stronger comps from the second half of 2009 so no real change in the demand profile, I think perhaps the more optimism is based on we have a pretty strong sense now of where our cost profile stands and what we think we can generate with what now looks, we think to be a reasonably good look at revenue forecast for the year.

Operator

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

Robert McCarthy – Robert W. Baird

What specifically is included in your second quarter revenue forecast in terms of base business growth.

David Speer

Its about 11%, the mid point for the second quarter base business.

Robert McCarthy – Robert W. Baird

And in a world where nothing ever meets exactly meets forecast, you’ve identified some businesses that were stronger in the first quarter, nothing that is running a bit behind earlier expectations.

David Speer

I would say the equipment businesses, our test and measurement group which is in the all other category along with even some of our welding equipment and some of our industrial packaging equipment. So what we’ve seen with the businesses that are more CapEx related that there really has not been a significant rebound in order profiles there.

Replacement volumes are starting to build but new equipment orders are not. And capital budgets appear to be increased but they’re not being spent yet. So those would be the ones that I would highlight as sort of a category businesses that are probably somewhat weaker than what we would have expected which means I think in some of those equipment businesses we now don’t expect any real improvement in the demand profile until probably the second half of the year.

Robert McCarthy – Robert W. Baird

And then related to that focusing in a little more closely on industrial packaging you made the comment that you really didn’t see any improvement in the equipment side of the business in the quarter but my memory is that there had been some improvement in February, maybe it didn’t follow through in March and I would think that what you’re really looking for there is a pickup in general industrial to tell you that something is fundamentally changed in the economy and I wonder how far away from that we are.

David Speer

What I would say is we had a very strong March in industrial packaging led by the consumable volume which as you know is the first precursor to any improvement in the marketplace and certainly would be a precursor to any improvement in equipment activity so it’s a strong reflection that in fact capacity utilization across these customers is going up.

They’re utilizing the capacity at the rate that drove demand up. Some of that was probably a modest level of restocking but a 20% increase in consumable volume here in North America, that’s a pretty good indication that we have finally seen I would think a significant inflection point upward on the demand side there.

I would expect that that would mean that over the next quarter or so we’ll start to see an improvement in the equipment profile. The quote activity has improved but it hasn’t resulted in orders and shipments that would allow me to say that that part of the business is sort of back on track.

Operator

Your next question is a follow-up from the line of John Inch – BofA/Merrill Lynch

John Inch – BofA/Merrill Lynch

Just as a follow-up currency was a little bit more of a contributor to the top line than we had thought this quarter, given the dollar what are you baking in for translation headwinds over the course of the rest of the year.

Ron Kropp

Remember the currency changed quite a bit last year so we’re comparing to the prior year. It will have lots of a contribution in the second quarter in the 3% to 4% range, about flat in the third quarter, and down negative two to negative three in the fourth based on current exchange rates.

David Speer

Remember current exchange rates for us are end of February.

John Inch – BofA/Merrill Lynch

So end of February and I’m assuming if you wanted to drive EPS you just simply multiply by the corporate average margin, is that fair how you do it.

Ron Kropp

Yes, that works.

John Inch – BofA/Merrill Lynch

So then I just want to, can you remind me, why are your Asia Pacific construction businesses still really sluggish. I know you’ve got a [inaudible] to Australia but aren’t those economies doing much better and maybe you could comment broadly on what you saw in China in the quarter and maybe any business activity specifically like welding or something like that.

David Speer

Well certainly as it relates to construction, you’re right, we have a reasonably strong presence in Australia and New Zealand, in our construction businesses, and the first quarter is traditionally a relatively weak quarter there. Remember its got December and January which is the big vacation months certainly down under.

So, that’s not expected to be very strong. I don’t have the exact granular numbers for China in construction but I suspect they would have been modestly in the double-digits.

John Inch – BofA/Merrill Lynch

What about China overall, do you have any color in terms of your businesses overall.

David Speer

Certainly you see a solid rebound in China for the quarter revenues up in the 37% range, but I think what I would suggest that we’ve seen a couple of businesses with strong improvement, those were the ones that were beaten way down in the first part of last year, first quarter of last year, you may recall we had a big decline in several of our businesses related to the electronics segments, both in the power electronics segment and then some in our polymers and fluids segment where we have some other businesses concentrated there.

That’s probably been the biggest single element there in terms of rebound. Some modest pickup in overall export activity but I think the most notable one would be the electronics segment.

John Inch – BofA/Merrill Lynch

You said revenues were up 37% in China in the first quarter.

David Speer

Correct.

John Inch – BofA/Merrill Lynch

And then what did your welding business do in China and maybe you could just talk a little bit about that and the outlook.

David Speer

I don’t know that I have specific data on welding down double-digits, modest double-digits in welding in China primarily on the basis of the major decline in ship building, the energy infrastructure business has still held up well but the ship building business which was still good through the first quarter of last year obviously has declined and that’s been the big headwind in welding in China.

Operator

Your next question comes from the line of Unspecified Analyst

Unspecified Analyst

I just have a quick one, I’ll make it fast for you, the second quarter margins are they based on your guidance are they going to be the high spot for the year or do you think that you can continue to make progress as we move through the year.

Ron Kropp

Consistent with where we normally run, the second quarter is our strongest quarter and so we expect the margins to be the highest in the second quarter in the 15% to 16% range.

David Speer

Remember the third quarter has got significant vacation period in there for Europe and obviously the fourth quarter is lower quarter of activity levels.

Unspecified Analyst

And is there a chance for some more pricing as we move through the year or that remains to be seen.

David Speer

I think that remains to be seen. Obviously as I’ve described earlier we’re in a price/cost environment that I would call relatively normal. If there’s an opportunity to recoup price more quickly that may have some impact but it will probably take at least a quarter for us to sort of understand.

First of all understand how significant these cost increases are and how long they’re going to stick if you will and certainly how quickly we’re able to respond from a price standpoint but I wouldn’t place a lot of credence in any significant change in prices going forward, not that we’re going to get any significant gain.

Operator

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

Andy Casey - Wells Fargo

Couple of follow-ups, one is to an earlier question on international, you gave China revenue increase could you give us the same for Europe.

Ron Kropp

Its around 3%.

Andy Casey - Wells Fargo

And then on the PC board fabrication business the positive 89.4 that you saw in the quarter clearly that is not a sustainable number, what do you think, is that more first half loaded that type of comp and then it flattens out in the second half or just more moderate revenue growth as we go forward.

David Speer

Well certainly we don’t expect 89% going forward, that’s for sure. Remember that was the worst quarter of the year last year so things did begin to improve by Q3 and Q4 in those businesses so, I certainly wouldn’t expect that. I think the kind of demand profile we’d expect probably overall in that related business is somewhere in the 20% to 25% range for the year.

Clearly its impacted by both equipment volume and consumables. The equipment component is about 70% of that volume so a lot of that’s going to have to do with change in technology, some of the newer devices that are being sold and they require newer equipment.

In addition to that obviously higher volumes require more consumables so I would expect that the demand profile for the year is probably in the 20% to 25% range.

Ron Kropp

And if you look at the comps, that segment was down more than 50% in both the first and second quarter, got better in the third last year and was only down 14% in the fourth.

John Brooklier

Thanks everybody for joining us on the call and we look forward to talking to everybody again, have a good day.

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