Illinois Tool Works' (ITW) CEO Scott Santi on Q3 2016 Results - Earnings Call Transcript

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Illinois Tool Works, Inc. (NYSE:ITW)

Q3 2016 Earnings Conference Call

October 20, 2016 10:00 AM ET

Executives

Michael Larsen - SVP and Chief Financial Officer

Scott Santi - Chairman and CEO

Analysts

John Inch - Deutsche Bank

Joe Ritchie - Goldman Sachs

Scott Davis - Barclays

David Raso - Evercore ISI

Andy Kaplowitz - Citi

Nigel Coe - Morgan Stanley

Mig Dobre - Baird

Andy Casey - Wells Fargo

Ann Duignan - JPMorgan

Steven Fisher - UBS

Stephen Volkmann - Jefferies

Jamie Cook - Credit Suisse

Operator

Welcome and thank you all for standing by. At this time, all participants are in a listen-only mode. At the end of the presentation there will be a question-and-answer session. [Operator Instructions] Today’s call is being recorded. If you have any objections, you may disconnect at any point.

And I would like to turn the call now to your host Mr. Michael Larsen, Senior Vice President and Chief Financial Officer. Sir, you may begin.

Michael Larsen

Hi, thank you, Gary. And good morning and welcome to ITW’s third quarter 2016 conference call. I’m Michael Larsen, ITW’s Senior Vice President and CFO; and joining me this morning is our Chairman and CEO, Scott Santi.

During today’s call, we will discuss our third quarter 2016 financial results and update you on our 2016 earnings forecast.

Before we get to the results, let me remind you that this presentation contains our financial forecasts for the fourth quarter and full-year 2016, as well as other forward-looking statements identified on this slide. We refer you to the company’s 2015 Form 10-K and Form 10-Q for the second quarter of 2016 for more detail about important risks that could cause actual results to differ materially from our expectations.

Also, this presentation uses certain non-GAAP measures. And while we use very few non-GAAP measures a reconciliation of those non-GAAP measures to the most comparable GAAP measures is contained in the press release.

With that, I’ll turn the call over to Scott.

Scott Santi

Thanks, Michael, and good morning. In Q3 ITW delivered another quarter of high-quality earnings growth with record operating income, operating margin and return on invested capital performance.

In the quarter we generated 8% GAAP earnings per share growth, operating margin of 23.1% which if you exclude the 80 basis points of EF and CE acquisition dilution, it was 23.9% on an apples-to-apples basis. And after-tax return on invested capital came in at 23%.

The key driver of our performance continues to be the execution of our strategy. The third quarter marked the 12th quarter in a row that our enterprise strategy initiatives delivered more than 100 basis points of margin expansion.

In addition, we’re continuing to make good progress in executing our pivot to growth with six of our seven segments again delivering positive organic growth in Q3 despite a macro environment that obviously remains challenging.

Through the execution of our strategy, we have grown earnings per share by an average of 15% per year over the last four years with almost no help from the market environment. But we still have ways to before we are operating to our full potential. We look forward to providing an update on the work that we have ahead of us to deliver on ITW’s full-performance potential at our annual Investor Day in December.

With that I’ll turn the call over to Michael, who will provide you with more detail regarding our Q3 performance and our updated Q4 2016 forecast. Michael?

Michael Larsen

Thank you, Scott. ITW’s third quarter was another high-quality quarter with solid earnings growth, continued margin expansion and solid free cash flow.

EPS was up 8% to $1.50 slightly ahead of the mid-points of our guidance due to solid execution and the resulting better margin performance.

Total revenue was $3.5 billion up 4% and organic growth was 2% in-line with guidance. Overall demand was pretty steady state as we move through the quarter, and what continues to be a fairly challenging environment particularly on the capital equipment side. Nevertheless, six or seven segments delivered positive organic growth in key regions such as North America, Europe, Asia Pacific including China were all positive.

In my opinion, the highlight of this quarter was ITW’s record operating margin performance of 23.1% - 23.9% when you exclude EF&C, and all seven segments performing above 21%.

Operating income grew 6% to $808 million and after-tax return on invested capital improved to 140 basis points to 23%. Both of these performance metrics were all-time highs for ITW.

We invested more than $150 million in capital equipment, new products and projects to simplify our businesses.

Free cash flow of 101% on the income was a little lower than last year due to some quarterly timing but year-to-date we’re on track at 94% which compares to 96% at this point last year. We typically have a strong Q4 and we expect to finish the year above 100%.

In addition, we repurchased shares for $500 million and expect to complete this year’s program with another $500 million in Q4 bringing the total to $2 billion. Finally, as we saw in August, ITW announced a dividend increase of 18%.

So, overall, pretty straight-forward, good quarter as ITW continue to execute well and deliver strong results.

On slide 5, starting with the key drivers of our operating margin performance, the strong execution of our enterprise initiatives contributed 120 basis points. Price cost was slightly favorable. Volume leverage of 30 basis points was offset by a number of other items. And EF&C diluted margin 80 basis points, resulting in 23.1%, a record for the company and like I said 23.9% if you’re comparing to our long-term performance growth of 23% plus.

On page 6, really good operating performance across the seven segments, with all segments at or above 21% for the first time ever.

I wanted to point out that automotive OEM margins as expected were diluted 370 basis points by EF&C and that the core business is obviously still very strong at 25% plus. In construction, restructuring related to the simplification of our European manufacturing footprint created a drag of 190 basis points. The other segment numbers speak for themselves, really strong performance again this quarter.

Turning to the segment discussion and starting with our automotive OEM, a really good quarter on the top-line as organic revenue grew 7% due to strong penetration gains in every region.

In North America, 5% organic growth compares favorably to Auto-builds of 2% and that includes a 1% decline at the so called D3 where we have relatively higher content. Europe was up 5% with 700 basis points of penetration gains, as overall builds were down 2%. And China was up 40% with very significant penetration gains due to new product launches this quarter.

Also, you may recall that China was down 5% in this quarter last year making for relatively easy comparisons.

Food Equipment was up 1% organically with North America equipment up 3% due to a difficult year-over-year comparison. You may recall that in the third quarter last year, equipment was up 8%. International equipment was down 3% and service was up 1%.

Based on Q3 exit run rates and backlog and a more normalized comparison, we expect that Q4 organic growth rate to be more in line with recent trends, so continued solid demand in Food Equipment.

Also continued strong margin performance and 27.4% was the highest margin in the company this quarter. A good quarter for Test & Measurement in electronics as organic revenue grew 7% due primarily to an easy comparison. Last year in the third quarter of this segment was down 11%.

Electronics was up 13% and Test & Measurement was up 1% in what continues to be a fairly sluggish capital investment demand environment. However, the solid margin expansion is really encouraging and something we’ve talked about on this call before.

Margin improved 440 basis points to 21% with 190 basis points from enterprise initiatives and the balance primarily from volume leverage.

While the demand environment in welding is stable, it is still pretty challenging as evidenced by the 9% decline in year-over-year revenues. The decline breaks down as 4 points from oil and gas, 3 points from industrial, which is mostly heavy equipment related to agriculture, infrastructure and mining and then 2 points from commercial.

The brighter story; is on the margin front and as the welding team continues to do an excellent job managing the cost structure through this cycle by preserving our strong position in the marketplace and being ready to fully participate as things eventually turn around.

Despite peak-to-trough revenues being down about 20%, operating margin is 26.5% this quarter, which, is only 150 basis points below peak margins. In the third quarter, benefits from enterprise initiatives and the restructuring projects we talked about last quarter contributed 240 basis points to margin expansion.

As we said before our welding segment remains a good example of how resilient the ITW business model is across a wide range of economic scenarios.

Polymers & Fluids delivered another quarter of positive organic revenue growth of 1%. On a regional basis, international was up 3% and North America was down 1% mostly due to lower demand on the industrial MRO side of the business. Margin improved 200 basis points to 21% driven by initiatives and restructuring savings.

Demand in construction products held pretty steady this quarter as this segment grew 2% organically. Construction also had a challenging comparison to last year when North America was up 7%. This quarter, North America was up 1% as compared to down 1% in Q2, and this quarter commercial grew 5%, renovation and remodeling was up 4%, and residential was down slightly 1 point.

Asia-Pacific was up 2%, New York was pretty good up 2% but below the Q2 growth rates of 7% and 6% respectively. And we talked about the margins 24.5% in construction if you exclude the European simplification project this quarter.

Finally, specialty products, organic revenue was essentially flat with international up 3%, and North America down slightly. Our consumer packaging consumable businesses in this segment are growing solidly offset by weaker demand on the capital equipment side.

Good progress on the margin side with an increase of 210 basis points to 26.1% driven by 180 basis points from enterprise initiatives.

Turning to page 10, our updated guidance for 2016. As you saw this morning we’re raising the mid-point of our full-year EPS guidance and narrowing the range to 556 to 566 which represents 9% earnings growth at the mid-point.

As usual, we’re assuming current foreign exchange rates which given the recent strengthening of the dollar against the pound and the Euro creates a few pennies of currency translation headwind in the fourth quarter. As a result, this full-year guidance increased of the penny is essentially the $0.03 beep from the third quarter partially offset by $0.02 of additional currency translation headwind in the fourth quarter at today’s foreign exchange rates.

We expect full-year 2016 operating margin to be above 22.5%, a new full-year record for the company and up from 21.4% last year. Keep in mind that EF&C dilutes full-year margin by approximately 50 basis points. In other words, excluding EF&C, we would be talking about approximately 23% operating margin for the year.

For the fourth quarter, as usual, our forecast assumes Q3 exit run rates which equates to organic growth of zero to 2%. And embedded in that organic growth forecast is a steady state demand assumption that we feel is pretty reasonable in light of the relatively stable demand trends across our business portfolio in Q3.

We expect operating margin of approximately 21.5% which is greater than 22% when you exclude EF&C which compares to 20.7% in Q4 last year, so continued strong margin expansion in Q4.

Finally, EPS guidance is $1.31 to $1.41 which is, 11% earnings growth at the mid-point marking a pretty strong finish to the year.

So, that concludes our prepared remarks. And we’ll now open up the call to your questions.

Question-and-Answer Session

Operator

Thank you, sir, thank you speakers. [Operator Instructions]. Our first question, it’s from Mr. John Inch from Deutsche Bank. Your line is open sir.

John Inch

Thank you, good morning everyone. Guys, international Food Equipment softness I guess was consistent with Lennox’s comments. I’m wondering if we could get little more color on that what you’re seeing. I remember sort of the call or the commentary around restaurants which were softer I believe it was about, I think restaurants are about 15% of your mix maybe if you could just sort of put the international softness in the restaurant issue sort of into a context for us?

Michael Larsen

Yes, so John, I would just, I wouldn’t read too much into this quarter in Food Equipment, as you know the quarter trends can bounce around a little bit. I think if you look at the year-to-date numbers up in that 3% to 4% range we expect to end up in the same place in Q4 and for the full year.

I think Food Equipment more broadly we continue to see strength on the institutional side which is the majority of our business particularly in refrigeration and then on the scale side and the retail business but really nothing to be too concerned about in terms of the demand environment pretty stable as we went through the quarter and we’ll be back on trend in Q4.

John Inch

Okay. So, the international, you’re describing it more as a bullet versus some sort of beginning of a trend, is that a fair statement?

Michael Larsen

Yes, that’s correct.

John Inch

Okay. And then Test & Measurement and Electronics, I think some people don’t fully appreciate what’s in the Electronics segment. And I make the commentary in the context that 3M and others have experienced consumer electronics weakness. In their situation it’s all that conversion and Smartphone saturation. And I guess I’m wondering are you experiencing any kind of consumer softness within the confines of the umbrella of this Electronics up 13% organically?

Scott Santi

Our exposures there really have fallen into two buckets. One is and largely clean-room MRO collection of businesses, that’s a pretty steady Eddie business. And then the other piece which is where we saw some of the big driver of the year-on-year growth improvement was really on the Equipment side so we’re producing equipment that people use to produce circuit boards.

And that business again Michael talked about it was up somewhat in the quarter but also on a very low comp on the prior year. So I think we would not describe that business as being down significantly or being under pressure but it’s also I wouldn’t read a lot into the year-on-year growth number either.

John Inch

That’s fair. And then just lastly, you Auto strength in China, Michael you attributed to product launches. Is this a one-quarter phenomenon or are you gearing up to try and penetrate the China Auto sector, like, do this have more legs beyond the quarter I guess is what I’m wondering.

Michael Larsen

Yes, I think this has a lot more legs to it as we go forward and into next year and beyond. Obviously 40% - builds were up 20% plus. But in terms of kind of what the penetration gains can be, I think that’s directional, that’s where we would expect it to be going forward.

John Inch

And, that 2X numbers, is that what you’re saying?

Michael Larsen

Yes, I think that’s doable. Based on the new products and what’s in the pipeline yes.

John Inch

All right. Thanks very much. I appreciate it.

Operator

Thank you. And therefore next question is from Joe Ritchie from Goldman Sachs. The line is open, sir.

Joe Ritchie

Thanks, good morning guys.

Scott Santi

Good morning.

Joe Ritchie

In your next fundamental quarter maybe just focusing on Auto, since there seems to be a lot of concern out there right now giving potentially peaking Auto-builds and Ford’s comments about idling capacity. You mentioned in your prepared remarks that the D3 was down 1, but the out-growth in North America was still really strong. And so maybe just provide a little bit more color on where you’re seeing the out-growth and expectation longer-term to continue to outgrow Auto production?

Scott Santi

We’ve talked about this a number of times in the past. On the Auto business for us is one where we do have a reasonable amount of forward visibility typically two to three years. So we have, we feel very good about our pipeline of new content going on new vehicles. Certainly we will be impacted on a relative basis based on the overall build levels in the market but our ability to continue to outgrow whatever the market growth rate is. If it flattens out we would still expect it to be positive by 200 to 400 basis points.

And that’s pretty much a three-year kind of look. We’ve got some great backlogs and great programs in place and a lot of really compelling things we’re working on. So it’s an area that we are very bullish on, on a long-term basis.

Michael Larsen

And I would just add Joe, specifically to the D3 being down 1, the expectations is for them to be down again in Q4. And that’s fully embedded in our forecast. And I think similar to, in food you’ll see a growth rate in line with what we’ve done historically on the Auto side here in Q4.

Joe Ritchie

Got it. That’s helpful. And maybe touching base on the margins on Auto, I know you guys are under consistent pricing pressure but at the same time can - you really get a lot of production efficiency to help continue to grow margins in that segment.

Given that it’s longer-cycle, maybe have a little bit more visibility on Auto. I’m just curious, kind of compare and contract Auto versus welding because you’ve done such a great job at continuing to expand margins in your welding segment despite a roll-over in growth. I’m just curious how resilient you think your Auto margins can be if we do start to see a slowdown in Auto?

Scott Santi

The Auto margin still is largely about the value-add content we put in the products. So we have talked I think on a number of occasions of our business being very niche, very oriented around solving tough problems for our OEM customers. We’re not planning in the bumpers on whatever model car you’re talking about. We’re at an RFQ bidder, we’re problem solver.

So, from the standpoint of the overall margin performance in that business, it largely is a function of our discipline around the types of opportunities we’re going to engage yet with our customers and how well our skill-set matches up with what they need partner to do.

So, I think we’re in really good shape. These are typically longer-term, six-seven-year kinds of program. And certainly there are some commitments often embedded in terms of annual cost tick-up, those are fully baked in terms of our knowledge upfront. And we would work really hard on delivering value not only in the design of the actual solution but then on an ongoing basis continue to drive benefits for customers that also drive benefits for the company.

Joe Ritchie

Okay, fair enough. I’ll get back in queue. Thanks guys.

Operator

Thank you, sir. And for our next question, it’s from Scott Davis from Barclays. Your line is open.

Scott Davis

Hi, good morning guys. I’m trying to get a sense of when welding does come back, what type of margin structure we can expect and the question really here is that how much discretionary spend is being cut and things that you’re going to have to add back pretty quickly your investment spend or how you define it I guess. But just general spend that may have to come back that would indicate that maybe even margins don’t go up, when welding comes back but more flattish, just some color on that would be helpful?

Scott Santi

Your final comment would be very hard for me to see any scenario where that would be the case. We’ve, the teams in welding have done a really nice job of adjusting cost structure to the overall - current demand environment. But there is nothing. We’ve also been very clear and we’ve worked very hard on making sure that all of our, sort of important growth investments remains fully funded throughout this down-cycle.

So, it is largely a matter of lot of reapplication of 80/20, a lot of focus and prioritization, it’s not about cutting muscle it’s about adjusting the cost structures. So from a standpoint of how it looks on a go-forward basis, I would have a hard time seeing any scenario where the incremental margins on the recovery would be far outside of our traditional 30% to 35% bucket.

Scott Davis

Okay, that’s helpful. And then just as follow-on, if you think in terms of some normalization in welding sequentially. I mean, when do you think you’d be I know this is hard, but given that oil prices are back up over 50 in emerging markets, we’re getting a bit better and such, so do you get a sense of a book-to-bill in the 1.0 or little bit better range earlier in ‘17? Or do you still think it might be more of a mid-to-later?

Scott Santi

I’ll tell you what I would probably not want to give into the forecasting business here. It’s been we’re going up on eight quarters now, some pretty significant contraction. And we got to see it flatten out first, I would say from the standpoint of just sequential daily order rate demand transit has been pretty solid, pretty steady state for the last three or four quarters here. But it’s not - we’re assuming not seeing any signs of any pick up at this point. I would really hesitate to call a turn at some point in the future but we’re well positioned to participate in it when it happens. And I think we’re managing the business through this down-cycle pretty well.

Scott Davis

That’s fair. Thank you, guys. I appreciate it.

Operator

Thank you. And for our next question, it’s from David Raso from Evercore ISI. Your line is open.

David Raso

Thank you. Just first a broad question. Can you set the framework for December meeting, what we should be expecting organic growth, enterprise initiatives for next year?

Scott Santi

No.

Michael Larsen

We haven’t Dave, we haven’t even been through our full planning cycle yet for ‘17, so that happens in November and which is always our normal routine and then we come to December well-armed with pretty good view of what we think we got to be able to accomplish in the upcoming year.

David Raso

I mean, is it fair to say given next year is officially the last year of the enterprise initiatives that yes, there is a year left of that but the meeting is going pivot more, trying to focus on can you accelerate organic growth with internal initiatives I mean, is that the?

Scott Santi

Not necessarily.

David Raso

Not, okay, that’s interesting. When I think about the incremental margins you just put up, and kind of simplistically I think of it is as when you provide that organic margin change, this trade operating leverage that you provide right before any changes in variable margin overhead cost. The incremental margins were about 36%, and then obviously went higher when you added some of the enterprise initiatives.

Whatever you do provide an organic sales growth for ‘17 at that meeting. How should we be thinking about how you view your organic incremental margins right. Because we’re trying to pivot away from an internal how you can keep growing these margins 100 bps a year but at some point it just gets more challenging. What can you give us on organic and what kind of leverage do you expect, just to provide some framework?

Michael Larsen

Well, I think David, consistent with what we’ve said before and I think Scott just mentioned this, and when we’re talking about welding is, we would expect our incremental margins to continue to be in that 30% to 35% range.

Scott Santi

That’s the base rate, not.

Michael Larsen

That’s the base rate that does not include the enterprise initiatives, that’s correct yes.

David Raso

Most of the buckets right, whatever you think you can do on organically and obviously the pressure is on a little bit as we pivot away from the enterprise initiatives, how much can you get the ready-to-grow to show itself in fast-organic. But you still have another year of enterprise value and then again Scott, I do assume that the meeting will get some further, this progress on the idea of pivoting to the organic story?

And the capital allocation obviously you’re still generating strong cash. I assume we get some clarity on how to think about the next few years? Just, I mean, I know it’s hard to forecast, just the pivot from here the margin story internally to organic would always be the benefit of your strong cash flow and capital allocation. It is sort of an interesting moment for the stock’s evolution, right. I mean we’ll get more than just here is the ‘17 outlook. Is that fair?

Scott Santi

Yes.

David Raso

Okay, all right. Thank you very much. I appreciate it.

Operator

Thank you. And for our next question, it’s from Andy Kaplowitz from Citi. Your line is open.

Andy Kaplowitz

Hi, good morning guys. Scott, so with expected margin in Test & Measurement to improve as your enterprise initiatives continue to ramp up. Were you surprised by the speed of the margin ramp up? Is it really just new leadership this year taking a fresh look at the business and making more immediate changes than anything else? And if there is anything stopping Test & Measurement from being a mid-20% margin business, like your other businesses over time?

Scott Santi

Yes, the second answer - the answer to the second question is no. Great fundamentals in that business and I would say as with all of our seven businesses, they are in terms of the work they’ve done moving through, these enterprise strategy initiatives they all started in a different place, they all had their own level of work to be done and Test & Measurement’s case, there were recent progress in terms of outcome is not worthy but they’ve been doing things inside that haven’t necessarily showed up in terms of margin for the last six or eight quarters.

And so I’m very pleased with now what’s starting to show up and they’ve been on a pretty good track all the way long in terms of what they’ve been working on to get where they can be. And as you said, still have more room to go.

Andy Kaplowitz

Okay, that’s good Scott. And then just shifting to Construction, can you talk about what happened this quarter? You said BSS reduced margins by 190 basis points, but I would have thought that much of the simplification in that segment had already occurred. We know you’ve been trying to simplify your European Construction footprint for some time. But the level of BSS seems a little more out of the blue I guess than I would have thought.

Scott Santi

Well, it wasn’t necessarily out of the blue but there was, there are, from day one we knew that there was a lot to get down there, they’ve gone through a couple of cycles. And this particular project that has certainly, have visible impact on margin in Q1 was one that has been in the planning cycle for a while.

But it was among our most complex structures in the company if you go back to - I'm talking about European Construction. And so, we’ve talked in the past about not only the work we’ve been doing but the way we’ve been doing the work in terms of doing it in a methodical fashion in a way that doesn’t impair our ability to serve our customers and generate some reasonable incremental progress along the way.

So, while this was, this particular activity was known, we knew we were going to have to do it almost back to the beginning, it’s one where we also are now going to place from a standpoint of time and where we’re in a position to do it and do it in a way that doesn’t impact our ability to serve our customers in the region.

So, it wasn’t out of the blue from our standpoint by any stretch.

Andy Kaplowitz

Scott, does the headwind from this kind of quickly go away in terms of the margin difference?

Scott Santi

Yes.

Michael Larsen

Look at welding from last quarter, I mean, our restructuring, when it is, when it tends to be that constant in a segment, we’re doing it every quarter, we talked to you about the overall spend, it’s typically spread pretty evenly, we even talked about it, just part of how we operate.

But in the case of welding in Q2, we talked about some fairly sizeable actions and then look at the recovery in Q3 already in terms of margin from that. So in construction this is, the expense side of these, are front-end loaded based on the accounting rules. But the benefits ultimately start to show up maybe not fully in Q4 but certainly over the next three quarters or so.

Andy Kaplowitz

Okay, great. Appreciate it, guys.

Operator

Thank you. And for our next question it’s from Nigel Coe from Morgan Stanley. Your line is open, sir.

Nigel Coe

Yes, thanks. Good morning. I know you don’t provide quarterly guidance by segment, but just given the diversions that we saw this quarter I just wonder if you could maybe give us some help in terms of how you see the zero to 2% playing out in 4Q? I’m assuming that Auto tries to maintain 7%, but any commentary in terms of that spread would be helpful.

Michael Larsen

Yes, Nigel, as you know, we and as we said, our Q4 organic growth forecast is based on the Q3 exit run rates from a demand standpoint. And really what some of the deviations from that you see are really more comparison issue than anything else. And I think you asked about automotive, if you look at the year-to-date growth rate in that 4% to 5% range, that’s probably what you would expect to see given current run rates and given the comps here in the fourth quarter.

Nigel Coe

Okay. And then how does that look in 4Q?

Michael Larsen

How does it look in sorry?

Nigel Coe

How does that look in 4Q?

Michael Larsen

In Test & Measurement?

Nigel Coe

Exactly, yes.

Michael Larsen

Yes, I mean, I think Test & Measurement, the comparison is really to drive out the big 7% increase this quarter. That normalizes a little bit here in Q4, and I think you will see probably a year-over-year increase in Q4 that’s in the low-single digits in Test & Measurement. And it’s really driven by the continued sluggish demand for capital equipment which impacts the Test & Measurement side of that segment.

Nigel Coe

Right, right. Okay, great. And then, just a quick one on the impact of EFC in 4Q, you guided for 50 bps or thereabouts of dilution for the full year, suggests that the margin impact could be slightly greater in 4Q than 3Q. Is that correct, and if that is the case why would that be given I’ve expected most of the wipe downs have happened in the 3Q as opposed to 4Q?

Michael Larsen

Yes, I’m not sure how you got that Nigel I mean Q4 is going to look a lot like Q3 in terms of the EF&C impact. So you saw the margin dilution 80 basis points at the enterprise level. We’d expect the same here in Q4. Revenues in Q3, $117 million which is in line with what we expected and we expect something very similar to that here in the fourth quarter.

And then finally on the EPS side, consistent with what we said before, EPS neutral in the first six months here in the second half of ‘16 and then accretive, I would expect you to be accretive as we get into ‘17 and we have to go through the planning process as Scott said and then we’ll give you an update when we get to giving guidance for 2017.

Nigel Coe

Okay, I’ll leave it there. Thank you very much.

Scott Santi

All right. Thank you.

Operator

Thank you. And the next question is from Mig Dobre from Baird. Your line is open.

Mig Dobre

Yes, thank you. Good morning. If we can go back to Food Equipment, I’m looking at North America service and growth here over the past couple of quarters has slowed a bit after running at 4% to 5% for the last couple of years. I’m wondering if you can give us any color as to what’s going on here, what’s driving the slowdown?

Scott Santi

I wouldn’t say Mig it’s a slowdown, again if you go back and look, service in North America was up 4% in Q3 last year we’re up 2% this year, that’s pretty solid. But we’ve also talked about the fact that we think there is more potential here for organic growth, that’s probably closer to what we’re seeing at least on the equipment side.

Mig Dobre

I know, but I’m asking really about service. And it is a slowdown from the 4% to 5% that you’ve consistently put up since early 2014. And I guess my question is really going to this idea that we’re starting to see that restaurant sales have slowed here, and I’m wondering if that’s the driver or if it’s something else?

Scott Santi

No, that’s not it at all. I think if you go back and look I don’t think we’ve put up 4% to 5% in service since 2014. But I think going forward that’s not an unrealistic expectation. I mean, services is stable here, we talked about this last quarter, also little bit of PLS in some parts of the business.

But overall, kind of been this low single-digit is a pretty good way to think about the business on a go-forward basis, from a growth standpoint. And then obviously as you know this is a very profitable part of the business, more profitable than the equipment side.

Mig Dobre

All right. And then my follow up is back to Auto, looking at the core margin this quarter which was flattish on pretty good volume growth. I’m wondering if there is a bit of a mix issue there or anything else you would highlight.

Scott Santi

Yes, that’s exactly right. It’s really a product mix issue.

Mig Dobre

And how do we think about?

Scott Santi

So, I’m just saying Mig, 25.5% in automotive pretty solid margins and you’re right to point out that the volume leverage really here is the reason why I didn’t show up is the product mix issue.

Mig Dobre

Is this with us going forward into the fourth quarter?

Scott Santi

No.

Michael Larsen

It might be it’s hard to forecast to that level of detail. But what is going to be with us on a go-forward basis of these core margins, in the mid-20s.

Mig Dobre

Thank you.

Operator

Thank you. [Operator Instructions]. Our next question is from Andy Casey from Wells Fargo Securities. Your line is open.

Andy Casey

Thanks a lot. Good morning, everybody. Just another question on the Auto margin, could you define what the purchase accounting charges were in Q3, and are there any one-offs in Q4?

Michael Larsen

Yes, no, I think rather than go through the individual pieces here Andy I’d rather wait until we can give you the complete picture, also and include in that the guidance here for next year.

What I will tell you is that the business is actually performing a little bit better than what we thought from an operational standpoint. The operating margins are like where we thought they were going to be. There were no surprises from a purchase accounting standpoint. And like we said there was no EPS impact here in the quarter.

Scott Santi

In fact means that the charges basically ate up what the business earned in the last couple of quarters, yes.

Michael Larsen

That’s exactly right. So that’s the way to think about it. And we’ve talked about this Andy. When we give you guidance for ‘17, we’ll give a complete picture.

Andy Casey

Okay, thank you, Michael. And then the last one in Polymers & Fluids, within that, the 1% North America decline. Can you give any color on that, and update us on what’s going on in the Auto after market?

Michael Larsen

Yes, I think automotive aftermarket was pretty stable here again, flat to slightly positive. The decline is really tied to the maintenance, industrial MRO side of that business so industrial lubricants and consistent with what we’ve seen in prior quarters. That is still somewhat challenged, the industrial MRO side.

Andy Casey

Okay, thank you very much.

Operator

Thank you. And our next question is from Ann Duignan from JPMorgan. Your line is open.

Ann Duignan

Hi, good morning, everyone.

Scott Santi

Good morning.

Ann Duignan

Good morning, sorry about the delay. Can you talk a little bit about the fundamentals in European Construction, and by country or by region and then by application? And where are you seeing strength, are you seeing any slowdown in the U.K., etcetera? If you could just give us a little bit more color on what you’re seeing there, that would be great.

Michael Larsen

I think Europe was pretty good this quarter up 2%, pretty steady and really nothing unusual as we went through the quarter or nothing really material to point out on a country level. So pretty steady state, we feel pretty good about the demand levels, obviously up 2% and feel good about it going into Q4.

Ann Duignan

Okay, so no big changes in the U.K. versus some of the other regions?

Scott Santi

Not at this point.

Michael Larsen

No, I mean, overall U.K. as you know, our U.K. business overall, I’m not talking construction, it’s about 4% of sales and was actually positive in the quarter, like we talked about before the impact right now what we’re seeing is on the currency side moving on to translation side of things. But we haven’t seen anything other than that that’s worth mentioning.

Ann Duignan

And the FX, is that a net positive or a net negative? Are you exporting out of the U.K. or importing into the U.K.?

Scott Santi

We’re producing and selling in the U.K.

Michael Larsen

Yes, the impact is really on the translation side. So we are, we have run profitable businesses in the U.K. and when we bring those, we translate those, pound, British Pound, earnings into U.S. dollars, there is a headwind. And so that’s what we’re talking about.

Ann Duignan

Okay, I appreciate the color. And then just a little bit more color on the automotive sorry to keep coming back to automotive. But your comments that mix had an impact on the quarter. Can you just give us more color there, is that regional mix or mix of builds, and just a little bit more on how we should think about that going forward?

Michael Larsen

Yes, I mean, when we were talking about this product mix, I think in North America and so, our content for vehicle might be slightly different by product line and that’s really what we’re talking about.

Ann Duignan

So can I take that as there isn’t a huge difference in margins regionally?

Michael Larsen

Yes, that’s correct, yes.

Ann Duignan

Okay, that’s important. Thank you. I’ll get back in line.

Operator

Thank you. And our next question is from Steven Fisher from UBS. Your line is open.

Steven Fisher

Thanks, good morning. I think you made indirect reference to this, David Raso, but how is your visibility changing on winding down PLS activities? To what extent are you increasingly confident that 2016 is the last main year we’ll see it as a headwind?

Scott Santi

Well, I think what I would prefer to do is like to go through this planning cycle that we just talked about we will give you a good update on that in December. But I think before we do any speculating let our businesses run their plans for ‘17 through and then we’ll have a better picture there. Clearly at some point they will start lining down. I would also argue on the other side, we are - this is activity that is very healthy from the standpoint of profitability and focus.

So to the extent that there is continued activity there that we’re going to continue to continue to support it until we get all the stuff out of here that we think needs to go so we can really focus on in the highly profitable parts of our business that we think have long-term growth potential.

So, we’ll see what happens. I would expect it certainly things start to at least stabilize there if not start to slow down. But until we go through the actual details of what our businesses have in mind for next year, it’s hard to comment.

Steven Fisher

Okay. And then within your 35% or so incremental margin targets, how should we think about or how much of that is driven by pricing versus volume? As we look at slide 5, it looked like we had a negative volume impact there, so just trying to break that down if we could.

Michael Larsen

Yes, pricing is not a big margin driver for us here. Really the big margin driver is and has been I think Scott mentioned 12 quarters in a row of the enterprise initiatives, that’s really what’s driving the margin expansion. And the incremental margins, to go back and look historically that’s where the company has been for a very long time in that 30% to 35% range.

And really on the pricing side, all we’re trying to do is to offset some material cost inflation but it’s not the key driver of our growth or of our margin expansion.

Steven Fisher

Okay, thank you.

Operator

Thank you. [Operator Instructions]. Our next question is from Stephen Volkmann from Jefferies. Your line is open.

Stephen Volkmann

Hi, good morning. Most of my questions have been answered, but I think you said price cost was like 10 basis points or something in the quarter. I’m just curious if there’s anything interesting to talk about on either the price or the cost side, and how we think that’s going to look maybe in the fourth quarter? Does it actually turn negative, or whatever commentary you might have there? Thanks.

Michael Larsen

Yes, no there is really nothing interesting to report. I mean, like I think I said all we’re trying to do is offset to the extent that there is material cost inflation that’s we’re trying to offset that with price. We’ve been in this, 10 basis points to 20 basis points range for a number of quarters here, actually longer than that. And we expect to stay in that range on a go-forward basis.

Stephen Volkmann

Okay. I guess there’s a perception that some of these material costs are starting to go up. Are you seeing that and you’re just able to price for it, or is that not consistent with what you’re seeing?

Michael Larsen

We’re not seeing any material cost inflation at this point. And when we do we will react like I said, and do our best in the divisions to offset that with efficiency and with price.

Stephen Volkmann

I appreciate it, thanks.

Operator

Thank you. And for our last question for today we have Jamie Cook from Credit Suisse. Your line is open.

Jamie Cook

Hi, good morning. I just guess just two follow-up questions. One, in your prepared remarks you mentioned free cash flow. The free cash flow was a little light, and it sounded like there were some timing issues. Can you just talk around that sort of what the issues were and how much incremental that is to the fourth quarter?

And then second, I guess when I looked at your Construction revenues on an organic basis, it’s still up but obviously the increases are declining. So just a little color on your concern whether that market is turning at all in particular with the ABI data points that we’re getting out because commercial was also very strong within the Construction segment? Thanks.

Michael Larsen

So, I think on the free cash flow, like I said on a year-to-date basis we’re exactly what we were last year so there is, things can move around a little bit on a quarterly basis, for example, our CapEx number is up a little bit this quarter, but year-to-date it’s exactly in line with last year.

And then maybe some larger payments that go out in one quarter versus another, we fully expect we’ll be at above 100% for the year, which would imply a strong Q4, which seasonally that’s what we usually do. So, other than that, we feel very good about the free cash flow performance.

And on the construction side, I would just add, similar to what we said earlier, I mean, demand is pretty steady state. There are some comp issues that we’re dealing with but we feel good about the using current run rates to model the fourth quarter and we’re not expecting any big changes from where we are right now.

Jamie Cook

Okay, thanks. I’ll get back in queue.

Operator

Okay. That’s all for the questions sir.

Michael Larsen

Very good. Thank you very much. And have a great day.

Operator

That concludes today’s conference. Thank you all for joining. You may now disconnect.

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