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Illinois Tool Works (NYSE:ITW)

Q1 2012 Earnings Call

April 24, 2012 10:00 am ET

Executives

John L. Brooklier - Vice President of Investor Relations

David B. Speer - Chairman and Chief Executive Officer

Ronald D. Kropp - Chief Financial officer and Senior Vice President

Analysts

Alan Fleming - Barclays Capital, Research Division

Robert Wertheimer - Vertical Research Partners Inc.

Jamie L. Cook - Crédit Suisse AG, Research Division

John G. Inch - BofA Merrill Lynch, Research Division

Ann P. Duignan - JP Morgan Chase & Co, Research Division

Deane M. Dray - Citigroup Inc, Research Division

Henry Kirn - UBS Investment Bank, Research Division

Andrew M. Casey - Wells Fargo Securities, LLC, Research Division

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

Nigel Coe - Morgan Stanley, Research Division

Operator

Welcome, and I would like to thank you all for holding. [Operator Instructions] Today's call is being recorded. If you have any objections, you may disconnect. I'd now like to turn with John Brooklier. Sir, you may begin.

John L. Brooklier

Thank you, Ed. Good morning, everyone, and welcome to our first quarter 2012 conference call. As is our normal practice, our CEO, David Speer; and CFO, Ron Kropp, have joined me to discuss our first quarter financial results, as well as our 2012 earnings forecast.

Here's the agenda for today's call. David will provide some brief commentary on 3 important long-term initiatives we have launched in the company, as well as discuss some first quarter highlights. Ron will then cover our Q1 financial results in much more detail. I'll come back and talk about our first quarter geographic and segment results, and then Ron will cover our 2012 Q2 and full year forecast. Finally, we will open the call to your questions. [Operator Instructions] We've scheduled one hour for today's call.

A couple of housekeeping items first. This presentation contains our financial forecast for 2012 second quarter and full year, as well as other forward-looking statements identified on Slide 2. We refer you to the company's 10-K for 2011 for more detail about the important risks that could cause actual results to differ materially from our expectations. Also, this presentation uses certain non-GAAP measures. Reconciliation of the non-GAAP measures to the most comparable GAAP measures is contained in the Appendix and also on our website at www.itw.com.

Finally, telephone replay for this conference call is (866) 365-2451. No pass code is necessary. Playback number will be available until 12 midnight on May 8, 2012.

Now let me introduce David Speer. David?

David B. Speer

Thank you, John. Before we address our first quarter results, let me make some brief comments on 3 very important long-term company initiatives that we've recently undertaken.

We've received a number of investor questions on these topics over the past few months, and we want to share with you what we can at this point. The 3 areas of focus include: our business structure simplification initiative, our strategic sourcing initiative and our portfolio management initiative.

First of all, our business structure simplification initiative will essentially result in generally larger-scale businesses within our decentralized operating structure. These are businesses, in most cases, with similar customers, markets and products where we can improve focus, while driving better operating efficiencies and lowering overhead costs. As this process unfolds, you should expect to see larger ITW businesses of roughly $100 million annual revenues. Internally, we're referring to this as our own 80/20 review of our business structure. We're excited about its long-term benefits for ITW, but we'll move cautiously to ensure we maintain our strong customer and market interfaces that have been a hallmark of our success.

Secondly, we have hired an experienced consultant to help us develop approaches to better leverage our opportunities for strategic sourcing initiatives across the company. We're in the later stages of gathering data, but we believe this ongoing initiative will add significant value in terms of how we purchase key raw materials such as steel, resins and chemicals, as well as services such as energy, transportation and logistics and other major cost categories.

Finally, our portfolio management initiative is built around our long-term strategy to divest assets that we no longer consider core and will allow us to focus on key core business opportunities, with strong growth and returns that will help us maximize our long-term returns.

The April sale of our $375 million finishing businesses to Graco is the most recent example of our commitment to proactive portfolio management. I would like to add that our management team and company are fully committed to all of these initiatives. These are multi-year programs that will enhance our decentralized operating structure. We expect the associated strategic benefits and savings from these initiatives will be significant, and we anticipate communicating some reasonable details around these initiatives before the end of 2012.

Now moving on to the first quarter. We believe we delivered very solid results, especially in light of the uneven macro environment. As you will see, our North American businesses produced strong results, while international businesses reflected slower market conditions, primarily in Europe and Asia.

It's worth noting that Europe end-market conditions have met our expectations for the first quarter. It's also notable that both our EPS performance and operating margins exceeded our expectations. Congratulations to our people for a job well done in the quarter.

Now let me turn it over to Ronald Kropp, who will discuss the recent quarter in greater detail. Ron?

Ronald D. Kropp

Thank you, David. Good morning, everyone. Here are the highlights for the first quarter.

Revenues increased 6.4% due to higher base revenues and acquisitions. Operating income was $705 million, which was higher than last year at $46 million, representing growth of 7%. Operating margins of 15.5% were 10 basis points higher compared to last year.

Diluted income per share from continuing operations was $0.97, which was at the high end of our forecast range of $0.89 to $0.97. On a GAAP basis, diluted earnings per share were $0.24 lower than last year, which included a onetime tax benefit of $0.33 related to a Q1 2001 Australian tax case. Excluding last year's tax benefit, Q1's earnings per share were higher than last year by $0.09, or 10.2%.

Finally, free operating cash flow was $239 million for the quarter. Now let's go to the components of our operating results.

Our 6.4% revenue increase was primarily due to the following factors: base revenues were up 3.2%, with North American base revenues increasing 6.6% and mixed international base revenues that were essentially flat overall. John will discuss the geographic mix in more detail later in the call.

Acquisitions net of divestitures added 4.4% to revenue growth, and currency translation decreased revenues by 1.3%. Operating margins for the first quarter of 15.5% were 10 basis points higher than Q1 2001 -- 2011. Base business margins increased 120 basis points, with higher sales volume contributing 80 basis points. The positive impact of non-volume items increased base margins by 40 basis points versus last year, primarily due to price cost favorability.

In addition, margins were lower by 60 basis points due to higher restructuring expenses versus last year, and the dilutive impact of acquisitions reduced margins by 50 basis points. The net margins from acquisitions, excluding amortization and other acquisition accounting, were 14.5%.

Looking at working capital and cash flow, accounts receivable DSO of 62 days was slightly higher than last year, and inventory months on hand was flat at 1.9 months. ROIC for the first quarter was 15.1%, which was 60 basis points lower than Q1 last year. Our ROIC continues to run at our 15% to 17% target range, which is significantly above our cost of capital of 9% to 10%.

For the first quarter, cash provided from operating activities was $323 million, with capital expenditures of $84 million, resulting in free operating cash flow of $239 million. This was $183 million better than Q1 of the prior year. As discussed in our January earnings call, we expect to generate more than $2 billion of free operating cash flow for 2012.

I would now like to make a few comments regarding our capital structure. First of all, our capital allocation priorities are as follows: our first priority for capital continues to be organic investments, especially related to our key growth platforms in emerging markets. Examples of organic investments include R&D spending, new CapEx projects such as additional manufacturing capacity in emerging markets and restructuring projects, which have long-term margin benefits.

Our next capital priority is dividends. We have a dividend policy of 30% to 45% of the trailing 2 years free operating cash flow. During the quarter, we paid dividends of $174 million.

Any excess capital after organic investments and dividends are used for external investments, either share repurchases or acquisitions. We evaluate the allocation between these investments based on the best risk-adjusted returns.

During Q1, we spent $474 million to repurchase 8.5 million shares. In addition, we utilized $481 million for acquisitions, led by the Brooks Instrument business and the test and measurement growth platform. Brooks has annualized revenues of $210 million.

Overall, during Q1, we returned over $600 million to our shareholders through share repurchases and dividends. As of the end of Q1, we have approximately $3.4 billion of authorized repurchases remaining under our buyback program.

Our debt levels increased $775 million during the quarter, with our debt-to-capital ratio at 32% and our debt-to-EBITDA at 1.4x. We have overseas cash of $1.3 billion and plenty of debt capacity to make additional investments.

We were pleased to complete the sale of our industrial finishing businesses to Graco on April 2 in a $650-million cash transaction. We estimate the pretax gain on the sale to be approximately $450 million, which we will record in the second quarter as part of discontinued operations. The finishing equipment businesses consist of paint spray systems and technologies for a variety of industrial end markets and applications around the world.

As we have said before, acquisitions will remain a key part of our growth strategy, but we will continue to selectively divest businesses that no longer fit our core platforms or our long-term growth and return objectives.

I will now turn it back over to John, who'll provide more details on the operating results as he discusses the results by geography and individual segment.

John L. Brooklier

Thank you, Ron. Before I get to the actual segment highlights, let me take a moment to review our Q1 geographic trends.

There was a not-so-surprising theme that emerged from our Q1 results. It's clear our North American businesses were the outperformers in the quarter, producing organic revenue growth of 7%.

I should note that Q1 industrial production levels in the United States were at mid-single digit levels during the quarter.

Given the mix of macro data we have seen from Europe and Asia Pacific in Q1, it's not surprising that our international organic revenues were essentially flat in the quarter. Organic revenues in Asia Pacific increased 3%, while Europe and South America showed modest declines in organic revenues.

As David noted earlier, while European organic revenues were modestly negative in Q1, our businesses in Europe largely performed at forecasted levels.

Now let me move to the segment data. As you'll note from our new slide presentation deck accompanying the conference call, we have all of our segment data essentially contained on one slide now, so my comments will relate to this particular slide.

In Transportation, this segment largely consists of our auto OEM businesses, with smaller revenue contributions from our auto aftermarket and truck remanufacturing business. Segment organic revenues grew 5.1% in Q1. For the biggest piece of the business, auto OEM, auto builds continue to be a key driver of revenue growth.

While worldwide auto builds grew 5% in the quarter versus a year-ago period, our worldwide auto businesses produced organic revenues of approximately 7% growth. We also delivered positive organic revenue growth for all 3 major regions: North America, Europe and Asia. And notably, even though European auto builds declined 4% in Q1, our organic revenues grew 6%. So while some of this outsized performance was due to favorable customer mix, it also exemplifies the strong product penetration we have contained within the auto OEM business.

In auto aftermarket, our worldwide organic revenues declined about 50 basis points in Q1, as warm weather impacted windshield wiper blades or our Rain-X brand. Now we encourage people to go out and buy as many windshield wiper blades as possible.

In our truck remanufacturing business, our organic revenues grew 7.4%, thanks to strong energy development activity in Canada and Western United States.

Moving to our Power Systems and Electronics segment, we continue to see very strong demand from our welding customers, while our electronics businesses experienced the reverse. Segment organic revenues grew roughly 7% in the quarter.

Covering welding first, our worldwide organic revenues grew a very strong 18.6%, with North American organic revenues increasing 19.9% and international organic revenues growing 15%. As in past quarters, strong demand from global heavy equipment manufacturers, such as Caterpillar and John Deere as well as energy projects, continue to drive welding's double-digit organic growth performance. They continue to have very, very good performance.

In electronics, the story was far less positive. Total electronic organic revenues declined roughly 10% as our businesses were hampered by weak worldwide consumer demand for products, as well as some destocking related to these products. The better news is that we continue to be involved in major capital equipment projects with Apple. This will help our financial results for our electronics businesses as the year progresses.

Moving to Industrial Packaging. Our businesses largely reflected industrial production trends in the major geographies. Put simply, North America was stronger and the rest of the world was weaker. Segment organic revenues grew approximately 2% in the quarter.

In aggregate, our total North American Industrial Packaging organic revenues grew 8.4%, while our total international Industrial Packaging organic revenues declined 2.4%.

In our Signode steel and plastic strapping equipment businesses, worldwide organic revenues declined 60 basis points in the quarter. And by geography, international organic revenues fell 3.6%, while North American organic revenues increased 4.8%. The better news was in our Protective and Stretch Packaging businesses, which grew organic revenues 9.5% and 6.1%, respectively.

Moving to Food Equipment. Equipment sales were strong in North America and weaker in Europe and the rest of the world. In total, segment organic revenues grew 1.6% in the quarter.

Moving to the North American part of Food Equipment, organic revenues grew roughly 7% in Q1, as equipment sales increased 6.9% and service sales grew 6.5%. Warewash and food machines for casual dining restaurants and supermarkets performed very well in the quarter. And the growth in service is largely attributable to productivity enhancements from our field technicians.

Once again, it was a different story internationally, where total organic revenues declined 3.8% in the quarter. International equipment sales declined 5.6%, largely due to weakness in cooking products for institutional customers in both France and Italy. Underlying this were project deferrals and lack of government spending, which impact the revenues. On a related note, international service organic revenues were essentially flat in the quarter.

Moving to our Construction segment, it was, once again, a tale of 2 geographies. Our Construction results were positive in North America and declined in Europe and the rest of the world. Please remember, though, that because our segment revenues are more weighted to international construction markets, segment revenues only grew roughly 1 point in the first quarter.

Total North American Construction organic revenues increased 8.4% in Q1, with the renovation and commercial categories growing 12% and 7.3%, respectively. For the residential category, our organic revenues grew 7% in Q1, and we continue to believe that 2012 housing starts will average approximately 700,000 units for the year and represent a firmer foundation for improved housing builds on a multi-year go-forward basis.

Moving to international, organic revenues declined 2.5% in the quarter, with European organic revenues decreasing 1.4% and Asia-Pacific declining almost 4%. Once again, while Europe grabs all the headlines, a bigger issue in Q1, international construction, was the weakening economic construction environment in Australia and New Zealand.

In our Polymers and Fluids segment, organic growth in polymers and hygiene was positive, while organic growth for fluids was negative. As a result, segment organic revenues grew approximately 2% in the quarter.

Very quickly, in polymers and hygiene, organic revenues were up 3.3% due to increased worldwide demand in both categories. Polymer organic revenues grew 4%, and hygiene organic revenues increased roughly 3%. In fluids, organic revenues declined 1.4% in the quarter, largely due to reduced sales for some of our MRO-related products and the impact of recession in Spain.

Moving to our other construction-related segment, Decorative Surfaces, we generated reasonably strong organic revenue performance from our businesses in an assortment of geographies. Segment organic revenues grew 4.3% in the quarter.

In North America, our Wilsonart high-pressure laminate business produced solid organic revenue growth of 4.4%, thanks to innovation and new product designs and ongoing penetration in commercial categories such as office furniture and retail outlets.

Internationally, our Decorative Surface business generated organic revenue growth of 4.3%. In Europe, our businesses in France and Germany contributed to organic growth. And in Asia Pacific, our Decorative Surfaces business in Thailand and China produced strong organic revenue increase.

So as you can see from this particular segment, just saying Europe's down on a more macro basis doesn't account for some of the activity we have in businesses where we can actually get good results in Europe. And I'll point you back to what we did on the auto area, where our European auto business actually outperformed build metrics there.

Finally, in our All Other segment, we had varying levels of contributions from our test and measurement, appliance and consumer packaging businesses. Segment organic revenues grew roughly 1% in the quarter.

In test and measurement, organic revenues were up 5% as CapEx spend for structural testing equipment cooled a bit in the quarter, especially on the international side. In appliance, organic revenues increased 7.1% due to better consumer demand in the North American appliance sector. We also increased our penetration with some of Whirlpool's top-load high-efficiency washer products.

And finally, in the consumer packaging area, organic revenues declined 1.6%, due to flat performance from our multi-pack businesses and a decline in our decorating businesses.

So at this point, I'll conclude my remarks, and I'll turn the call over to Ron, who will cover our 2012 forecast. Ron?

Ronald D. Kropp

Thanks, John. For the second quarter of 2012, we are forecasting diluted income per share from continuing operations to be within a range of $1.08 to $1.16. This range assumes an increase in total revenues of 3.5% to 6%. The midpoint of the Q2 diluted EPS range of $1.12 would represent a growth of 16% versus last year.

For the full year 2012, our forecasted EPS range for continuing operations is now $4.14 to $4.38. This range assumes a total revenue increase of 5% to 7%. The EPS midpoint of $4.26 would be 13% higher than 2011, excluding the Q1 2011 tax benefit of $0.33. This EPS midpoint is $0.12 higher than our previous forecast from January and is driven by the first quarter $0.04 outperformance, plus an $0.08 benefit from completed and forecasted share repurchases. In addition, the benefit of $0.03 from better-than-originally-expected base business performance is offset by higher projected restructuring costs, which took away $0.03.

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

John L. Brooklier

Thanks, Ron. Now we'll open the call to your questions. [Operator Instructions] We'll start the questioning now.

Question-and-Answer Session

Operator

[Operator Instructions] And our first one comes from Andy Kaplowitz.

Alan Fleming - Barclays Capital, Research Division

It's Alan Fleming standing in for Andy this morning. I wanted to ask you about your 2012 revenue outlook. It seems like you brought -- you did bring the top end of the range down a little bit. Wanted to see if that's more conservative, kind of given the uneven macro environment? Or are you seeing particular softness in some markets, if you could comment on that?

David B. Speer

Well, I think our comment would be -- what we've seen in the first quarter was clearly softer markets in Asia, and I think that's what we're really, as we look forward, are projecting forward. As John said earlier, the European performance was largely in line with what we expected. But I think the big delta from a geographic standpoint in our revised guidance is more about what we see happening in Asia, which has proven to be somewhat weaker in the beginning of the year than what we had anticipated. And at this time, we don't really see any catalyst that suggests it's going to get significantly stronger during the year.

Alan Fleming - Barclays Capital, Research Division

Okay, that's helpful. Wanted to ask one follow-up. What are you seeing in terms of price cost? Is there any change in your outlook from last quarter throughout the balance of the year? Are you seeing improved price costs? Do you still expect next quarter to be kind of the best quarter for price cost?

Ronald D. Kropp

So as we talked about when we put our guidance at the beginning of the year, we expected to have favorable price cost this year, assuming that raw materials kind of stayed where they were at. So in the first quarter, it was a little bit better than we expected. That's 40 basis points positive. And we're looking, as we look out at the rest of the year, that the full year would be a similar amount, 30% to 40% -- 30 to 40 basis points positive. From a raw materials side, it's a bit of a mixed bag. Resin has been up significantly, especially PET and polypropylene. Steel has been pretty stable. Stable -- flat to down in the quarter, but pretty stable from an outlook perspective as well. And chemicals has been up 3% to 5%.

Operator

Our next question comes from Rob Wertheimer.

Robert Wertheimer - Vertical Research Partners Inc.

It's Vertical Research Partners. Just a couple of quick questions. Is there any issue at all from the Evonik, the CDT resin, either directly in your products, or just indirectly on auto build that you've heard about yet?

John L. Brooklier

I'll take the question, Rob. We've checked with our auto people, and what they're telling us right now is that there's no impact on our business. We have very little to do with the actual nylon 12 that's actually part of, I think, principally, brake linings. So very little to do with us directly. Clearly, we would be more interested in what's going to happen in a non-direct way with OEMs and what it does to overall production. What we're hearing and what we're seeing currently is that the OEMs are getting together, and they're trying to get additional information, trying to source additional materials and doesn't seem to be any immediate impact. We believe there's enough inventory in the channel right now to handle this. But we'll keep you posted if we hear anything differently.

David B. Speer

Really about what happens to them and their production. Is not a material that we're using directly. But obviously, their extent to build vehicles will impact us if the shortage ends up cutting their production.

Robert Wertheimer - Vertical Research Partners Inc.

For sure. Okay. And then just a quick one on food service. I had the impression you'd lost a little bit of share, maybe falsely, but just confirm what we heard in the channel in the U.S. over the past year or 2. Have you -- are you gaining share? Or are you sort of up in line with the industry, you think, this quarter?

David B. Speer

Well, I think it depends on the segment. I mean, if you're looking at the institutional segment, which is a big segment for us, there's no question that it's been an uneven environment for the last several years, because a lot of those projects are funded by government sources, and the government funding has been uneven at best. So that's a category that's been quite volatile, if you will, from an equipment spend situation. I would say, in the casual dining category, I would not characterize what we've done or what our performance has been as a loss of any share. But I can tell you that as that category looks at equipment replacements and menu changes and so forth, it does impact how equipment rolls out in those categories. So it's not an even process. But I would say, overall, right now, I don't think I would characterize us having lost any significant share positions.

John L. Brooklier

Rob, I would point you back to the numbers I gave earlier when you talk about North America. Our North America organic revenues grew approximately 7% in the quarter, and both equipment and sales were up roughly 7%. So I think that...

David B. Speer

Which would have been our strongest quarter in some time.

John L. Brooklier

Yes, one of our better quarters. So I think that, that -- I think that our Food Equipment people are encouraged by what they see in Q1, and they're going to try to build on that.

Operator

Our next question will come from Jamie Cook.

Jamie L. Cook - Crédit Suisse AG, Research Division

Crédit Suisse. Two questions. One, on the lower, slightly lower sales forecast. Can you just talk about whether there's any change in your incremental margin assumptions with and without restructuring and acquisitions? And then I just guess, my second point, just in term -- questions, longer term in terms of your longer-term initiatives that you talked about in the beginning of the quarter and we're hearing more and more about. Can you just talk about sort of the latest and what you're thinking about potential divestitures? Are you willing to put a new number out there now that the finishing business is officially gone? I mean, a percent of assets at this point that you think you would potentially divest or are looking at for divestiture?

David B. Speer

Jamie, let me let Ron answer the beginning of your question, and I'll take the latter part.

Ronald D. Kropp

So the question on margins, incremental margins. So as you saw, we've taken down the overall revenue guidance a bit, but we've taken the overall earnings up in -- from a base business performance perspective, it's adding $0.03 per share. So we are getting some incremental margin benefit from the core businesses. The incrementals in the first quarter for the base businesses were 53%. So we had a very strong margin performance quarter from our base businesses. We expect to see very strong incrementals continue throughout the year. Overall, for the year, probably in the -- close to 40% for the full year in base business incremental. So that's certainly helpful. Offsetting that is obviously the increased restructuring. We've bumped that up a little bit, which took $0.03 out of the guidance.

Jamie L. Cook - Crédit Suisse AG, Research Division

And then just because I think last time, you were guiding more to like a 35% incremental versus the 40% on the base business, what's changed it? Is it the price feeling more comfortable with the price cost? Is it mix with more North America? I just want to make sure I understand the puts and takes.

Ronald D. Kropp

It's probably a little bit of price cost, but it's really just better performance. Better efficiencies, better cost reduction benefits, et cetera.

Jamie L. Cook - Crédit Suisse AG, Research Division

And then, I'm sorry, the last question, just on divestitures?

David B. Speer

Yes, on portfolio management, Jamie, what I would say is that as we've said over the last probably 1.5 to 2 years now, we're taking a lot more aggressive look at our own portfolio of businesses and being more proactive in looking at things that we consider to be core or non-core pieces long term. And as you pointed out, the finishing businesses that we sold to Graco in the first quarter -- or I should say in early April, were an indication of a set of businesses that we consider no longer core. And so we move forward to find the appropriate divestiture strategy for those. There are other businesses like that, that is part of our proactive portfolio management we'll consider. And undoubtedly, there'll be more activity. But at this stage, I wouldn't want to be in a position to quantify it because we're not far enough along to be able to talk about those things publicly. But we have an active program under way, and you can expect that there'll be other divestitures, as you'll see, come forward over the coming months and year.

Jamie L. Cook - Crédit Suisse AG, Research Division

Can I ask the question slightly differently then, relative to -- when we were talking about this, perhaps at the Analyst Day in December or even 6 months ago, is the amount of businesses potentially up for divestiture larger, while you don't want to put a percentage up? Or is it about the same?

David B. Speer

Well, if you look at the pattern here, I mean, the divestiture of the finishing business was truly a larger divestiture than the ones we had done prior. So there's no size range that was off limits, if you will. And I would say that based on what we've been looking at, the size range is probably somewhat larger than what we had seen in the past. In the past, if you go back, I think the time period from '06 to 2010, the average divestiture was more in the $50 million to $60 million range. And clearly, this was a $375 million divestiture. So I would say that the size of a potential divestiture will likely be somewhat larger going forward than what our past track record has been.

Operator

Our next question comes from John Inch.

John G. Inch - BofA Merrill Lynch, Research Division

Bank of America. First, on Construction. Now, I think, John Brooklier, you called out a softer construction Australia, New Zealand? Didn't that part of the world have some weather issues, though?

John L. Brooklier

Yes, there's been some weather issues, but we think it's a little bit more economically sensitive than that. And if you really look at what's going on in Australia, the economy is slowing. Some of the mineral-related exporting going on to China slowed a little bit as China slowed a little bit. So I would say the service side of the economy in Eastern Australia is certainly a lot slower, as is the Western side, where it's really more natural resources. That has slowed a bit, too. Overall, that's added up to a slower economy, which has impacted their housing market. I think housing -- it's probably one of the big key areas for them right now. That's somewhat way different.

John G. Inch - BofA Merrill Lynch, Research Division

So then if we back up of the Construction lens, if you will, and look at North America, you obviously, when you gave us the results right in the first quarter, how did that play out as the quarter progressed? And the question really comes down to, did you see or do you think you saw a bit of a pull forward because of the warm winter that we had, say, into December, January, February and -- I mean, the obvious question is was March much softer? Or has the trend still been pretty consistent?

David B. Speer

I think, John, what we've seen -- I mean, there's no question, the warm months of January through March pull some things forward. And I don't think it's going to change the trajectory of housing starts for the year. I think it gives a temporary sort of blip forward. The overall underlying dynamics still remain, with the inventory levels and housing prices the way they are. So while I think we saw some nice short-term momentum, I don't think that's something we expect to see sustained. There are some markets where the residential builds will begin to actually go up because of the local market conditions. Lack of available inventory or price points have actually started to rise. But I think it's still -- 2012, I think, is still a year to sort out for housing starts overall. But if you look at the overall numbers, we're expecting housing starts for the year to be closer to 700,000, which would be about a gain for the year in the mid-teens in housing starts. So it would be a nice welcome view to see that kind of a turn. But I wouldn't view the first quarter as a first data point that we could draw a line from and expect that rise to continue.

John G. Inch - BofA Merrill Lynch, Research Division

Yes. No, that makes sense. I think -- well, if your mid-teens growth rate holds, right, I think you did up 7% in resi in North America. That should actually get better as the year then progresses?

David B. Speer

Correct.

John G. Inch - BofA Merrill Lynch, Research Division

One last question on the simplification scaling up. You did, David, raise your guidance. You didn't just tighten the low end of the range. I'd always sort of been under the impression these initiatives were perhaps going to require a little bit of cost on ITW's part to -- for what -- for a variety of different potential things. Is that true? And is that in your numbers? Or is that -- a lot of this is still kind of in the fact-finding stage, and the more cost saves coupled with the cost spending or so forth is really about '13 versus '12.

David B. Speer

Well, I would say, John, it's both. But primarily, the costs that would be associated with some of these larger initiatives have not been fully represented in the guidance, because we don't have all the data yet. Some of it is represented in some of the restructuring that we've obviously put forward, which is higher than what we originally anticipated. But I think the best way to look at this is that we're still gathering the data, and there will be some investment involved in achieving some of what we think will be some significant savings along the way. And I expect that towards the latter part of the year, we'll have enough data to be comfortable giving some reasonable direction as to the size and significance of what we think will be happening. But it's a longer term sort of a process. So we're talking about things that would happen in 2013 largely and beyond with, I think, some reasonable quantification towards the end of this year.

Operator

Our next question will come from Ann Duignan.

Ann P. Duignan - JP Morgan Chase & Co, Research Division

It's Ann Duignan, JPMorgan. Just on the back of John's question. When I look at initiatives like strategic sourcing, I can't help but think that down the road, the consulting firm comes back and says, "Gee, now you need an ERP system. You need people analyzing data." How do you balance, David, investing in some of these initiatives in the near term versus kind of SG&A creep and centralization over the long term?

David B. Speer

Well, I think it's like any major initiative. You evaluate what you think the benefits are and, obviously, benefits of significance across the enterprise will require some level of investment and talent and resource. But we'll have to balance that in terms of what we think makes sense, where we think the biggest payoffs are and the ones that we think will drive the greatest benefits in the organization. So as we assess those, we have to determine what investments will be required to achieve what we think will be reasonable and significant savings. So hard to answer the question till we have more data. But clearly, we'll be in a position to be making more investment around that. And from a centralization standpoint, there's no question. We'll want to do more coordination around some of these larger areas of spend where we can be certain that we're taking advantage of our scale opportunities in a much more formal way than we'd done in the past.

Ronald D. Kropp

And I will add that, yes, we are -- we do feel the decentralized business model is the right model for us, and we're not changing that because of strategic sourcing. So the focus of the study has been how do we do a better job of approaching sourcing throughout the company in our decentralized operating model?

Ann P. Duignan - JP Morgan Chase & Co, Research Division

So we shouldn't be concerned that down the road you'd be building a new corporate headquarters somewhere?

Ronald D. Kropp

You've seen our old one, Ann.

David B. Speer

We might paint the existing one.

Ann P. Duignan - JP Morgan Chase & Co, Research Division

That's one of the things we love about you, so we don't want to -- that to change. But just on -- building on that a little bit, I know you said that you will communicate the cost and the benefits of all of these changes late in 2012. Can you just talk about -- I mean, that's a year of data analysis. Can you just talk about why it will take you till late 2012 to assess the opportunities and the costs?

David B. Speer

Well, because, I think, first of all, if we're going to give you any indications with numbers, you're going to want those numbers to be reasonably solid. And those numbers are going to involve, as you accurately pointed out in the beginning of your questions, some investment in both people and systems, and so we want to be certain that before we started signaling what we think some of the potential savings are here that we're pretty solid on what the approach is going to be and the time frame associated with that. So I don't think we're -- I don't think we're trying to hedge our bets. What we're trying to do is be thoughtful about what we communicate and what we think is realistic. And I think for us to digest that is going to take that kind of time.

Ronald D. Kropp

And also, as David said, these are multi-year, long-term initiatives. So as we figure out how to approach these major initiatives within the company, we want to make sure we do it the right way and make sure we -- at the same time we're doing all of this, continue to deliver on our results that you'd expect.

Ann P. Duignan - JP Morgan Chase & Co, Research Division

Okay. Well, I wish you guys luck, because I know it's kind of a cultural change. So we'll check in at the end of the year, I guess.

David B. Speer

Well, it is somewhat of a cultural change. But, Ann, as you know, you followed us a long time, we've been through several cultural nuance changes that have been successful, and I'm quite confident that we will be with this as well.

Operator

Our next question will come from Deane Dray.

Deane M. Dray - Citigroup Inc, Research Division

It's Deane Dray with Citi. David, I'd be interested in hearing more about your thoughts. We've discussed what are you thinking residential plays up, but how about the non-res cycle? Just in terms of the indicators that you think are important to ITW? What kind of visibility and how you think it plays out the balance of the year?

David B. Speer

You're talking about non-res here in the U.S.?

Deane M. Dray - Citigroup Inc, Research Division

Yes, first.

David B. Speer

Well, the data certainly from a start standpoint for commercial has finally begun to show some improvement numbers. Year-to-date, the commercial construction square footage boards is up 7%, with some notable categories, up that have been down for a while. Retail is up 28%; warehouses are up 20% -- 80%. So I think we're beginning to see the turn. However, it is still regional. There are some markets where we still have a lot of overbuilt and vacant space. The 2 big exceptions to improvement in commercial remain offices and education. So I'm of a view that we've begun to turn the corner, but I don't think we're going to see a breakout in commercial construction until probably sometime in 2013. But it would appear, based on the data, the numbers and the activity in some of the major markets, that we're quite close.

Deane M. Dray - Citigroup Inc, Research Division

And then how about outside the U.S.?

David B. Speer

Sorry?

Deane M. Dray - Citigroup Inc, Research Division

Outside the U.S.?

David B. Speer

Outside the U.S.? Well, that's a mixed bag. Europe, reasonable numbers in the north of Europe, in Germany and in France. A lot of the European commercial construction, as you know, still has government financing tied to it. So some of this is going to play out based on what happens with their budgets and how they view deficit spending. But Europe for us in the first quarter proved to be fairly good in commercial. So hard to get a long-term read based on what's going to happen with their budgets longer term. Clearly, the south of Europe is going to be troubled for some time. Spain and Italy and the public spending there around construction, that's going to be troubling for some time to come. The Asian construction numbers remain reasonable, and I think we'll continue to see some boost there, more around commercial than around residential.

Deane M. Dray - Citigroup Inc, Research Division

And then just on -- a business update on welding and -- we're back into some eye-popping numbers there. How much of that is true end-market demand? Or might there be some restocking going on?

David B. Speer

Well, there's probably some restocking going on. But frankly, the end-market demand in heavy equipment and the energy-related sectors, oil and gas, has been robust. And I mean, I can tell you that in some of our channels, particularly in North America, there's not a lot of stock in the channel. So it really is -- these are markets that are performing well and have what looks like a reasonable runway, at least for the next couple of quarters. The oil and gas, the energy-related infrastructure, will probably be longer than that. So I think we're still pretty -- we were obviously surprised by the strength overall of what we saw in Q1. But if you go back and look at Q3 and Q4 of last year, we were also surprised by the strength there. So I think these trends are trends that have some reasonably good legs to them for at least the next couple of quarters.

Operator

Our next question will come from Henry Kirn.

Henry Kirn - UBS Investment Bank, Research Division

It's UBS. Sorry to beat the initiative horse again, but what drove the decision to go forward today? What's different now versus 5 years ago or 2 years ago?

David B. Speer

Well, let's see. What's different now than 5 years ago, about $5 billion of acquisitions and a whole host of businesses that had really not participated in some of these larger-scale opportunities to see what kind of benefits might be available. It had been probably 8 to possibly 10 years since we had done something similar on a sourcing level. And most of that had been around 3 or 4 significant raw material categories. And as we begin to look across the total spend, it became apparent that there was more out there than just what we had looked at in the past, and that the size and scale of the company had changed enough that this really required a fresh look. I mean, an $18 billion company looking at this as opposed to an $11 billion company, I mean, obviously, there's some significantly different scale opportunities. So we thought it was time for a fresh look.

Henry Kirn - UBS Investment Bank, Research Division

That's helpful. And then on electronics, how much did the destocking hurt the segment results? And how much more is left on destocking?

David B. Speer

Oh, that's a hard one because a lot of the electronics is related to consumer products, and it's hard to get a read on how much of it is channel destocking. But certainly a significant portion of that has been. This has been a volatile market for some time, up and down. I mean, we were talking about that as being a tough market for us in 2010. And in the first quarter of 2011, we were comping things that were above 50%. So, hard to say with that market. It is, clearly, a volatile market and -- we're talking about cell phones, PDAs, computers, so you've got a mix of different products. Flat-screen TVS. I mean, you've got a lot of different consumer products in there with different demand cycles right now. So we expect that that's going to still be volatile for a while.

John L. Brooklier

Henry, I think we believe that the larger level of destocking took place in Q4 or later last year. And there was some element of destocking into Q1. But again, to David's point, it's very hard to get precision around those numbers. But I think on a -- conceptually, we think more of the destocking has probably taken place.

Operator

Our next question will come from Andy Casey.

Andrew M. Casey - Wells Fargo Securities, LLC, Research Division

A couple of quick questions, a lot has been covered. What was the end-of-quarter share count?

Ronald D. Kropp

I'm not sure I have that handy.

David B. Speer

40-something. 40...

Ronald D. Kropp

45, I think, is what comes to mind. But we can follow up with you later on that number.

John L. Brooklier

We'll look at that number for you, Andy.

Andrew M. Casey - Wells Fargo Securities, LLC, Research Division

And then I guess I'm searching for a little bit more granularity on the international construction markets. Was there any heartbeat as the quarter progressed in those markets, Europe and Australia specifically?

David B. Speer

Well, Europe performed actually reasonably well. But as I said earlier, it's a tale of 2 stories, the northern part of Europe versus the southern. I think the one that was the weakest, that probably told the story for us, was Australia. And I think John talked about that earlier, some of the economic issues there, the housing market has slowed significantly. The economy there is slowing significantly. And they have some currency translation issues down there as well as they're buying a lot of their imported goods in U.S. dollars. So that's probably the one that -- Australia is probably the one that caught us with the biggest surprise. And in the retail segment down there where we have reasonable presence, this is where we expect to see some pretty good retail activity. And that just hasn't picked up at this stage.

Andrew M. Casey - Wells Fargo Securities, LLC, Research Division

And then just one last one, a question on the strategy. When other companies have talked about starting transformations, strategic pricing is typically discussed. I wouldn't imagine that you're a multiple-of-cost-type business, but is that part of what you're investigating? Or is it all strategic sourcing?

David B. Speer

Let me understand the question. Strategic pricing versus?

Andrew M. Casey - Wells Fargo Securities, LLC, Research Division

No. When you go after the strategic sourcing and try to leverage what you have, just steps that are taken to make sure that you don't have any price leakage?

David B. Speer

Oh, yes. That is definitely part of what we're talking about, yes. And that is linked to some of the work that we're doing on the commercial side that we're able to bring back together on the sourcing side. So yes, I would expect that we're going to see some changes coming out of that as well. As you know, we have a number of global platforms where we already do a fair amount of strategic pricing across the platforms. Automotive is certainly an example of that, as is appliance, and certainly across some of our welding markets as well. But yes, that's clearly something that has opportunity with it.

Ronald D. Kropp

And also, a benefit of the business simplification initiative, when we have scaled up businesses that are larger, we have a better opportunity for coordinated pricing across bigger businesses.

Operator

Our next question comes from Ajay Kejriwal.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

Ajay, FBR Capital Markets. Thanks for providing the color on longer-term initiatives. And maybe just to follow up on the scale up of businesses, could you maybe talk about what that could mean in terms of combining businesses? I thought I heard $100 million average revenues. Does that mean the number of subsidiaries get cut in half? Is that something that could happen over the next couple of years?

David B. Speer

Clearly, it means that the number of business units will be fewer. And as I said in my comments in the beginning, the ones that would be consolidated are largely ones where they have similar customers, markets and products already. But it would -- yes, it would result in fewer business units and, obviously, better operating efficiencies inside those business units and lower overhead costs. So, hard to predict exactly how many business units, how many fewer business units, but it would be a significant number. If you look at the average business units that we had in average business unit size that we had in 2010, it would have been closer to $30 million. So if you just take that math and look at a $100 million, it would suggest perhaps 2/3 less business units. And we're not far enough along to predict that because we're not doing it just as a math exercise, but there will be a significant reduction in individual business units as we've called them. And a lot of those services and approaches will be consolidated under one umbrella in those cases.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

Good, that's helpful. And then on strategic sourcing, I thought you mentioned steel, resin, chemicals, a couple other items. Maybe if you can talk about the total buy or the spend that you're looking to target? And any sense on the size of the opportunity there? I know it's very, very early, but...

Ronald D. Kropp

Yes. I think, certainly, as we've said, when we raise a -- start getting into some specifics around numbers and benefits towards the end of the year, that will be part of what we talk about. Not ready to get into that at this point.

David B. Speer

But as you can imagine, I mean, the size is significant in terms of the spend in these categories. But as Ron says, until we've got better data, we really don't want to get too far ahead of ourselves and communicate data here that is premature. But it's -- these numbers are big, obviously.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

And you're looking at the total spend across these broad categories you've mentioned?

David B. Speer

Yes. We're looking at total spend.

Operator

Our next question will come from Nigel Coe.

Nigel Coe - Morgan Stanley, Research Division

Yes, Nigel Coe from Morgan Stanley. Just wanted to kind of dig into what you're just talking about. Taking down the number of business units by, let say, 2/3, can you just maybe remind us what level of G&A overhead you have in each of these operating companies, be it finance, HR, et cetera? And then maybe if you could then talk about, as you go through this process, where you see the opportunities in terms of gross margin versus SG&A overhead?

Ronald D. Kropp

On the first question, the typical business unit is run as a stand-alone business, which means it has a general manager, a controller, typically HR support, and any -- the other functional disciplines you would need to run a business. They typically would have a stand-alone system, although, in some cases, we do have business units that shares systems across multiple business units, especially when they're located in the same general area. So that's the kind of the SG&A profile of a business. We have generally been pretty efficient at running, so these are pretty lean overhead structures. If you look at our overall overhead levels versus our peers, we certainly compare favorably. But as we scale up, there certainly will be some opportunities to leverage some of these overhead functions across a bigger business unit and, therefore, result in some cost reductions.

Nigel Coe - Morgan Stanley, Research Division

Right. I mean, I look at your SG&A as a portion of sales, it's about 18% or thereabouts. It's pretty -- compares very favorably to your peers. But I'm wondering, as you drive joint procurements, do you think it's more of an opportunity on procurement versus G&A? Or do you think the 2 are pretty even?

Ronald D. Kropp

Yes. Again, it's hard to say. I mean, I think there's big opportunities in both. And certainly, as we move through this and figure out how to approach this in detail, and we'll be ready to share that with you towards the end of the year.

David B. Speer

I think we'll clearly see significant opportunities in both.

Nigel Coe - Morgan Stanley, Research Division

Okay, that's clear. And then just quickly on the -- coming back to the portfolio. I mean, I don't know. I mean -- that there are obviously some numbers out there in the market in terms of what you could do in terms of proportion of sales. But how do you feel about reallocating the capital? Because, let's say you've realized $3 billion to $4 billion of proceeds from this process, I mean, do you wish to replace that with more of an emphasis in acquisitions versus buybacks? Or is that to be decided?

Ronald D. Kropp

Well, certainly, to be decided, right? I mean, we haven't -- we don't have that kind of capital to put to use right now. And as -- if we did, we'd have to go through our capital allocation strategy and figure out how we utilize that. So we've, I think, clearly laid out our capital allocation priorities. In fact, we've got a slide in the deck today that lays that out. Organic investments is our first priority, then dividends, and then external investments. And external investments, share repurchase versus acquisitions, is really based on the specific opportunities at a point in time and which of those has the best risk-adjusted return. So, for instance, in the finishing sale, we have some proceeds from the finishing divestiture, we intend to use those to repurchase shares. That's one of the reasons that our share repurchase forecast went up for the year.

John L. Brooklier

I think we will end it there with that question and answer. We want to thank everybody for joining us on today's call, and we look forward to speaking to you at some future point in time. Thank you very much.

Operator

At this time, that will conclude today's conference. You may disconnect, and thank you for your attendance.

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