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Edited Transcript of ITW earnings conference call or presentation 24-Oct-18 2:00pm GMT

Q3 2018 Illinois Tool Works Inc Earnings Call

GLENVIEW Oct 26, 2018 (Thomson StreetEvents) -- Edited Transcript of Illinois Tool Works Inc earnings conference call or presentation Wednesday, October 24, 2018 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* E. Scott Santi

Illinois Tool Works Inc. - Chairman, President & CEO

* Karen A. Fletcher

Illinois Tool Works Inc. - VP of IR

* Michael M. Larsen

Illinois Tool Works Inc. - Senior VP & CFO

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Conference Call Participants

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* Andrew Alec Kaplowitz

Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head

* Andrew Millard Casey

Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst

* Ann P. Duignan

JP Morgan Chase & Co, Research Division - MD

* Jamie Lyn Cook

Crédit Suisse AG, Research Division - MD, Sector Head of United States Capital Goods Research, and Analyst

* Joel Gifford Tiss

BMO Capital Markets Equity Research - MD & Senior Research Analyst

* John George Inch

Gordon Haskett Research Advisors - MD & Senior Analyst of Multi-Industrials

* Joseph Alfred Ritchie

Goldman Sachs Group Inc., Research Division - VP & Lead Multi-Industry Analyst

* Joshua Charles Pokrzywinski

Morgan Stanley, Research Division - Equity Analyst

* Nicole Sheree DeBlase

Deutsche Bank AG, Research Division - Director & Lead Analyst

* Ross Paul Gilardi

BofA Merrill Lynch, Research Division - Director

* Stephen Edward Volkmann

Jefferies LLC, Research Division - Equity Analyst

* Steven Fisher

UBS Investment Bank, Research Division - Executive Director and Senior Analyst

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Presentation

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Operator [1]

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Hello, and welcome to ITW's 2018 Third Quarter Earnings Call. My name is Ian, and I will be your events specialist today. (Operator Instructions) Please note that today's conference is being recorded. (Operator Instructions) It is now my pleasure to turn today's program over to Karen Fletcher, Vice President of Investor Relations. Karen, the floor is yours.

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Karen A. Fletcher, Illinois Tool Works Inc. - VP of IR [2]

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Okay. Thank you, Ian. Good morning, and welcome to ITW's Third Quarter 2018 Conference Call. I'm joined by our Chairman and CEO, Scott Santi; along with Senior Vice President and CFO, Michael Larsen. During today's call, we will discuss third quarter financial results and provide guidance for the fourth quarter. Slide #2 is a reminder that this presentation contains our financial forecast for the fourth quarter and full year 2018 as well as other forward-looking statements identified on this slide. We refer you to the company's 2017 Form 10-K and subsequently filed Form 10-Qs 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 a reconciliation of those measures to the most comparable GAAP measures is contained in the press release. Turning to Slide 3. Today, we're announcing the date and location for ITW's Investor Day. We hope you can join us on Friday, December 7, in New York City, at which time we'll provide updates on our long-term strategy as well as guidance for 2019. If you plan to attend, we ask that you please register on our investor website.

Moving on to Slide 4. As a reminder, in the third quarter of 2017, we disclosed an $80 million favorable legal settlement. This table summarizes key financial measures on a GAAP basis and on an adjusted basis that excludes the legal settlement. Going forward in our presentation this morning, our comments and variances exclude the legal settlement. I will now turn the call over to our Chairman and CEO, Scott Santi.

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [3]

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Thanks, Karen, and good morning, everyone. The ITW team delivered a solid quarter, with 11% earnings growth and EPS at the high end of our guidance range. We improved operating margin by 30 basis points to 24.6%, and increased free cash flow by 17%. In the quarter, pricing actions more than offset material cost inflation on a dollar-for-dollar basis, and price/cost-related margin percentage dilution showed sequential improvement versus the second quarter. In Q3, we delivered on our earnings commitment with top-tier margins and returns, despite more challenging end-market conditions than we anticipated as we headed into the quarter in a few places. North America remains solid, with 4% organic growth while demand in international markets was mixed as auto production in Europe and China and demand levels in several international markets served by our Specialty Products and Polymers & Fluids segments softened.

Michael will walk you through the details in a few minutes, but at a high level, the pullback in auto production in Europe and China and the softening that we saw in the 2 segments I mentioned internationally negatively impacted the company's overall organic growth rate by approximately 2 percentage points in Q3 versus what it would have been had demand in those sectors stayed even with second quarter run rates. In addition, and as expected, ongoing Product Line Simplification activities reduced organic growth by 70 basis points in the quarter. Our proprietary business model continues to generate strong free cash flow, with 116% conversion in the quarter, supporting our ability to raise our dividend 28% to an annualized $4 a share, and repurchased $500 million of our shares in the third quarter. While we expect that near-term market challenges will continue into the fourth quarter, we're narrowing our guidance range and reaffirming the midpoint of our 2018 EPS guidance at $7.60 per share, which represents 15% growth. Our ability to deliver consistent strong results across a wide range of economic and end-market scenarios is a direct reflection of the resilience of our high-quality diversified business portfolio. The strength of ITW's proprietary business model and our team's focused execution of ITW's long-term strategy. Before I turn the call over to Michael to provide more detail on the quarter, I'd like to again thank our more than 50,000 ITW colleagues around the world for their efforts in executing our strategy and serving our customers with excellence each and every day. Michael, over to you.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [4]

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Thanks, Scott. Let's recap some of the highlights on Slide 5. Year-over-year earnings growth in the quarter was 11%, or 13% excluding $0.03 of unfavorable currency translation impact. Despite the more challenging end-market conditions in a few places that Scott talked about, we delivered earnings per share of $1.90 at the high end of our guidance range. Organic revenue growth increased a solid 4% in North America, offset by a 1% decline in Europe and a 2% decline in Asia Pacific. China was down 2% in the quarter, but we remain on track for mid-single-digit growth in 2018 after being up 13% last year. Operating margin was 24.6%, an improvement of 30 basis points year-over-year and versus the second quarter. I will go into more detail on margin on the next slide. After-tax return on invested capital was 28%, an improvement of 400 basis points, resulting primarily from the new U.S. tax rules and regulations. The effective tax rate in the quarter was 23.7% due to a net discrete tax benefit of $15 million in the quarter. Free cash flow was strong at $743 million, an increase of 17% and in the quarter, we repurchased $500 million of our shares and raised our annual dividend 28%.

Moving to Slide 6 and operating margin. Operating margin at 24.6% was a new record when we exclude favorable legal settlement last year. Our strong execution on Enterprise Initiatives continue to contribute in a meaningful way with 100 basis points in the quarter. Our price actions are catching up to raw material cost inflation as price/cost margin dilution impact in the third quarter improved to 60 basis points from 70 basis points in the second quarter. And in addition, price more than offset raw material costs on a dollar-for-dollar basis this quarter. The other line includes a numbers of puts and takes. Year-over-year improvements in growth investment impact and in line with our normal run rate this quarter has a 30 basis point impact to margin. All in, operating margin expanded by 30 basis points in the quarter to 24.6%.

I'm going to spend some time on the left side of Slide 7 to provide additional color on the organic growth performance relative to our expectations heading into the third quarter. It comes down to 3 key drivers, all of them related to international end markets that collectively reduced our organic growth rate by 2 percentage points. The first one is our international Automotive OEM business as both European and Chinese auto production came in lower than expected. European auto production declined 5% in the quarter, following 4% growth in the second quarter. Based on what we're hearing, this was due primarily to the new emission regulations that went into effect in the quarter and lower exports to China.

Overall, this change in builds led to a 6% decline in our auto business in Europe, following 3% growth in the second quarter. Auto production in China was down 4% following 11% growth in the second quarter. This change appears to be more related to overall consumer sentiment and the availability of financing. As a result, our China business, which was up 12% in the first half, was flat. We experienced some softness in a few international end markets served by Polymers & Fluids segment, specifically in Europe, additives for Automotive Aftermarket and reagents experienced lower demand as did our Polymers & Fluids division in Brazil. Overall, the international component of our Polymers & Fluids segment declined 5% in Q3, in contrast with our North American business, which was up a solid 3%. Finally, the international component of our Specialty Products segment was down 7% after being down 2% in Q2.

There was significant PLS activity this quarter in addition to demand declines versus Q2 levels in 3 divisions: marketing and coating; graphics, primarily for sports apparel; and appliance components. That said, as you can see from the left of the slide, there's some bright spots too internationally. Welding accelerated to 12% growth with a solid recovery in oil and gas after 1% growth in Q2. Test & Measurement and Electronics and Food Equipment both had sequential organic growth increases of 2 full percentage points.

Let's walk through each segment for additional color, starting with Automotive OEM on the right side of the slide. Overall, organic growth was flat, with builds down about 3% for North America, Europe and China combined. North America was strong, up 7%, 5 percentage points ahead of builds, with solid penetration gains. As I mentioned, Europe was down 6%, in line with builds, and China was flat versus builds down 4%. We continue to generate solid penetration gains with European Auto OEM customers. However, inventory reductions to adjust for lower forecasted build rates offset these penetration gains resulting in our revenues essentially declining in line with European auto rates in Q3. Despite some of the price challenges in the Automotive segment that we've discussed in prior calls, Automotive was able to hold margins on a year-over-year basis. And if it wasn't for higher restructuring expense related to acquisition innovation, margins would actually have improved year-over-year. Moving on to Slide 8. Food Equipment was a bright spot, with organic revenue growth of 4% as overall demand continued to accelerate from the first half of the year. North America overall was up 4%, with equipment up 6% and up 10%, excluding the retail sector, which remains challenging due to lower customer investment and a tough comp from a major national rollout in 2017. We saw particular strength on the institutional side, up in the mid-teens, as health care was up 20%-plus and education and lodging were both up 10%-plus. International was also solid, up 3% on equipment and up 4% on service. Operating margin of 26.6% was up more than 100 basis points sequentially from Q2, and down slightly year-over-year due to unfavorable product mix. Test & Measurement and Electronics organic revenue was up 3%. Test & Measurement was strong, up 7%, with Instron up double digits. Electronics slowed slightly due to lower demand in end markets related to solar and consumer electronics, while semiconductor remained fairly stable. Operating margin improved by 60 basis points to 24.7%, a new record for the segment.

On Slide 9. Welding had another strong quarter, with 10% organic growth and really strong performance across-the-board. Global equipment grew 12% and consumables were up 9%. By region, North America was up 10% and international growth was up 12%. Industrial business and oil and gas were both up double-digit, and the commercial business grew in the high single digits. Margin expanded by 160 basis points to 28.2%. As we discussed, Polymers & Fluids organic growth was down 1 point, despite solid 2% growth in North America. New product launches in auto aftermarket contributed to organic growth, and margin gains in North America. Operating margin improved by more than 100 basis points.

Turning to Slide 10. Construction delivered 1% organic growth in the quarter, as Europe led the way with 4% organic growth. North America was essentially flat with residential down 1 point on a tough comparison and inventory destocking. Recall that residential was up 7% in the third quarter last year. Underlying demand in residential remains solid as the business is up 4% on a year-to-date basis, and the outlook for Q4 looks in line with that growth rate. Commercial was solid too, up 5%, and operating margin improved 40 basis points. As we talked about, in Specialty, organic growth slowed on the international side. And there are also some real bright spots with 5% in consumer packaging, up 6% year-to-date and 7% growth in packaging equipment. Overall, packaging equipment is up 12% year-to-date. On a year-to-date basis, the segment is about flat, which was also our outlook for the year as the comps are challenging in Q4. Moving on to Slide 11, with an update on raw material costs and tariffs. We continue to make good progress on price/cost as our ongoing price actions are catching up to raw material cost inflation, as pricing dollars are ahead of costs dollars in a meaningful way and the margin dilution impact is stabilizing. We continue to view the tariff impact as manageable and are adjusting pricing as necessary to offset the approximately $30 million impact in 2018. As we talked about in the last call, our exposure significantly mitigated by our produce what we sell strategy and the fact that only 2% of ITW spend is sourced from China.

For 2019, we estimate the impact of tariffs at around $60 million, which is based on all announced tariffs and tariff increases as well as any carryover from 2018. And we continue to expect our pricing actions will continue to offset raw material cost inflation, including tariff impact, on a dollar-for-dollar basis. Let's go to Slide 12 and guidance. We remain on track to deliver our full year EPS guidance midpoint of $7.60, despite some of the challenges we've talked about today. Our midpoint represents 15% earnings growth year-over-year, and as you saw, we narrowed the EPS range to $7.55 to $7.65 per share.

In 2018, as we have for the last 5-plus years, we will continue to expand our already best-in-class operating margins, returns on capital and free cash flows. For the year, we expect revenue growth of 3% to 4%, with organic growth of 2% to 3% and operating margins in the 24% to 25% range.

Enterprise Initiatives contributed more than 100 basis points again this year. We are planning to repurchase approximately $2 billion of our own shares in 2018, and our tax rate for the year is expected to be in the 25% range. Our Q4 EPS guidance is $1.78 to $1.88, up 8% year-over-year, with organic growth in the 1% to 2% range based on current levels of demand. Looking forward, we remain well positioned to continue to deliver differentiated results across a wide range of macroeconomic and end-market scenarios as we leverage our diversified high-quality business portfolio, the strength of ITW's proprietary business model and our team's ability to execute. We hope to see many of you at our Investor Day on December 7. And that time we'll discuss the details of our Finish the Job agenda as we work to get the remainder of our divisions to their full potential in terms of organic growth and continue to improve on our best-in-class operating margins, returns on capital and free cash flow over the next 2 years. Karen, back to you.

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Karen A. Fletcher, Illinois Tool Works Inc. - VP of IR [5]

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Okay. Thanks, Michael. Ian, let's go ahead and open up the lines for questions.

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Questions and Answers

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Operator [1]

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Your first question comes from the line of Joe Ritchie, Goldman Sachs.

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Joseph Alfred Ritchie, Goldman Sachs Group Inc., Research Division - VP & Lead Multi-Industry Analyst [2]

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Maybe just kind of starting out, just a clarification on the Auto OEM growth. So some organic growth is down 5% this quarter. However when I do the regional builds, the plus 7 North America; minus 6%, Europe; flat, China. Something just -- I don't know, the math isn't really working out for me. I was a bit curious, are you guys disproportionately greater in Europe than you are in North America? I thought North America was a larger geography?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [3]

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So I don't know what data you are looking at, Joe. We are overweight in North America, followed by Europe and then China.

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Joseph Alfred Ritchie, Goldman Sachs Group Inc., Research Division - VP & Lead Multi-Industry Analyst [4]

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Okay. Yes, and okay. Maybe I can follow-up offline, just that the minus 5 number versus the regional build looks a little bit odd. I guess, maybe just sticking with organic growth for a second. If you think about the fourth quarter, 1% to 2%, pretty similar to 3Q. But the comps get tougher on a 2-year basis. I guess, just from an underlying perspective, what do you guys expect to be better in 4Q versus 3Q?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [5]

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Yes. So we just hit $1.90 EPS. The midpoint for Q4 is $1.83. The revenue is expected to be fairly similar at current levels of demand. The mix is going to be a little bit better by segment. So some of our higher margin businesses such as Food, Specialty Products should improve and Construction and even Polymers & Fluids, their growth rate should improve in Q4 relative to Q3, offset by auto, which is really, at this point, one of the lower margin businesses inside the company. So we also -- so that's really on the revenue side, 1% to 2% organic. We expect to expand margins year-over-year as we've done every quarter this year. Price/cost turned positive on a dollar basis in Q3 versus neutral for the first half. Currency headwinds is a little bit lower in Q4 than in Q3. The share count is a little bit lower, the tax rates is a little difficult to call. There's some new guidance expected here in Q4. But overall, we've got a solid path here to our guidance, and I maybe just point to our track record over the last 5 years.

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Joseph Alfred Ritchie, Goldman Sachs Group Inc., Research Division - VP & Lead Multi-Industry Analyst [6]

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Okay. And then just maybe specifically on organic growth for Auto OEM in the fourth quarter. Are you expecting that to improve at all in 4Q versus 3Q?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [7]

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If anything, we expect it to get a little bit worse than Q3.

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Operator [8]

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Your next question comes from the line of Ann Duignan, JPMorgan.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [9]

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Just taking your comments there on revenue Q4 versus Q3 and knowing the way that you guys guide kind of at your current run rate, that would imply that 2019 revenue would come in around $14.4 billion, if I just took Q4 and multiplied it by 4.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [10]

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In 2018, Ann, or you said '19? You mean '18?

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [11]

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Well, I was going to start looking at 2019 because you'll guide to that in December. But my point being that, that would be well below your long-term target of 3% to 5% organic growth. I mean, is that -- am I missing something? Or is that the way we should be thinking about it, that the fourth quarter run-rate will be what you build off of for organic growth for next year? Or is there anything new or different?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [12]

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We're going through our planning process right now. And so we'll update you in December in terms of our view on kind of a go-forward basis. But beyond the macro, we are working on as we have been for the last 5 years, repositioning of our businesses really on 2 levels as we've talked about for a while now. One is that we've had a lot of work to do in terms of operational excellence, we apply 80/20. And once we get there, positioning those businesses to leveraging their growth potential, realizing their organic growth potential. We're today, at about 50% there in terms of the divisions that I would say have -- are operating sort of within their range of potential both on the standpoint of 80/20 and from the standpoint of their organic growth, where the combined organic growth year-to-date of those 51% of our divisions is about 7.5% year-to-date. So part of our growth for next year is certainly -- beyond the macro, is the continued improvement in the underlying performance of those other 49% of our businesses. We're going through the planning process right now. So there's a number of different things beyond the macro that are going to affect our organic growth rate, but I think we're pretty encouraged by the progress that we've generated of the -- in the 50% of the divisions that are largely there. And as I said, 7.5% year-to-date, on a combined basis, is pretty good and speaks a lot to the potential to continue to move down that path at the entire company level.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [13]

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Okay. That's useful color. I didn't realize there were so many still to be realized, just with the potential. And just to follow up on, you noted that in Food Equipment margin was down on mix. Is that because it was more equipment and less service? Is that the right way to think about that? And then what's the outlook there for the mix?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [14]

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It's really more related to what's going on in the retail side of the business being down in a pretty significant way.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [15]

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Okay. And the outlook there for retail continued weakness?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [16]

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And certainly in the mid-near term, we don't expect any improvement on the retail side here through Q4. I think when you look at the balance of the year, the momentum going into Q4 in food specifically looks good. We expect a slight improvement in the growth rate in Q4 relative to Q3. And I just point to margins, you're right. The mix did have an impact on a year-over-year basis. Sequentially, they were up over 100 basis points.

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Operator [17]

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Our next question comes from the line of Andrew Kaplowitz, Citi.

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Andrew Alec Kaplowitz, Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head [18]

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Starting with Michael. Can you give us a more color into your margin performance in terms of the sustainability of that performance into 2019? I know you'll talk about this more in December, but if I look at the core enterprise strategy, tailwind was still solid, volume was a little less of a tailwind, but the other headwind was half of what it was last quarter. I know you didn't break out build this time. Price versus cost is a little better. So as you look at 2019, do you have decent visibility at this point that enterprise strategy could still be a 50 to 100 basis point tailwind? You already talked about price versus cost and that other doesn't creep back up, so you still see good margin expansion next year.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [19]

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Yes. I think -- and it's a little early here. We haven't gone through the plans for 2019 yet. Just on Other specifically, this is kind of our normal run rate. If go back and look where it's in that 20 to 30 basis points range, maybe move around a little bit but I think that's a pretty safe assumption on a go-forward basis. At our Investor Day, we'll lay out specifically the Finish the Job agenda, and what we're trying to accomplish over the next 2 years, including continued margin expansion. And as we've said in the past, we certainly expect a positive impact from the Enterprise Initiatives next year. But I can't give you the number as we sit here, simply because we haven't gone through the plans. We haven't looked at the project and the activities and the carryover that will get us to a solid number for 2019.

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [20]

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But we'll lay it out in December.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [21]

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Right.

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Andrew Alec Kaplowitz, Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head [22]

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Okay, Michael, that's helpful. And just the comment that you just made about 50% of the businesses still have potential for pivot to growth. I guess, my understanding was that 2018 was pivotal year for you guys in terms of this pivot to growth. And when we think about what growth is going to come in at for this year, it's probably going to be less than 2017. And again, I know that some of the markets have turned down, but when you look at businesses like Construction or Specialty Products, Polymers & Fluids, how much of the "weakness" is maybe that these businesses aren't performing yet to the potential that they can versus just simple market weakness?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [23]

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Well, it's certainly some of both. I think the -- what I can tell you is, inside the company, this is not a sector issue in terms of Polymers & Fluids versus Automotive or any of our other segments. This 87 divisions that operate inside in each of those 7 segments. And we're at about 51%, as I said earlier, in terms of businesses that are both operating at level of excellence that they're capable of from an operational standpoint, application of 80/20 and are driving organic growth at a range that is within what we believe their potential is. And the other 50%, we've got more work to do, and this is -- and those are pretty equally spread across all 7 segments, so there's no particular tilt. I certainly expect that we would have put some better overall progress on the board had we not had auto pullback, like it's pulling back in the second half of the year, it's been our fastest-growing segment. So we're giving up a little bit in the near term, but our focus is on getting this company to its full potential. We think we've got about 2 years left to run in terms of getting all the way there. I don't want to steal the story from December but that's what Mike was alluding to and we've got plenty more room to go in both from an operational margin standpoint. And certainly, we've got to get the other 49% of our divisions moving faster on organic. And it's not that they have under-executed, but they started from further back, they have had more work to do to get there. And I think the plan at this point is to lay that out in some pretty specific detail at the December Investor Day, so you'll have a good view of what we think and make sure there are no gaps and what the processes will look like in the next couple of years to do it.

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Andrew Alec Kaplowitz, Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head [24]

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Scott, real simply, do you think that 2019, you could have actually outperformance versus market than '18? Is that sort of the plan as we sit here today?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [25]

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I think it gives us a chance to run through all the operating plans. We're right in the middle of that process now. I don't mean to be evasive at all, but I think December Investor day is in December for a reason, because it gives us a chance to go through in detail. What I would say is, we will have a plan for of the 49% of our divisions that are not there yet, how many of them we're going to get there in '19 and what kind of help that's going to provide.

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Operator [26]

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Your next question comes from the line of Ross Gilardi, Bank of America Merrill Lynch.

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Ross Paul Gilardi, BofA Merrill Lynch, Research Division - Director [27]

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Just curious, how are you going to think about the IHS forecast into next year's initial guide for auto? I mean, they continue to forecast 12% -- 2% global production growth, in '19, I believe. I mean, with China up 4%, and the U.S. kind of flattish, Europe up a little bit. You can't help but wonder obviously if there's downward bias based on all the profit warnings we're seeing in the global auto space. So are you going to abandon pegging your outlook to IHS and take a more conservative approach or how are you thinking about that?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [28]

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Well, I think it's certainly for the last couple of quarters, the fact that the backward looks IHS compared to what production actually was is pretty good. The forward looks have not been so good, so obviously we're going think -- we'll probably take a more ITW specific view based on our own experiences as we think about '19 for auto.

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Ross Paul Gilardi, BofA Merrill Lynch, Research Division - Director [29]

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And then in Test & Measurement, I think last quarter, you had attributed some of the slowdown in organic to delivery timing. But the organic seemed to slow down even further. Was there an underlying slowdown than that was stronger than expected in any of your business? And there certainly seems to be a lot of negative headlines on semis. You said your semi-related business was stable. So could you still have a softening there still ahead of you or are you just positioned in part of the market that's going to be immune from some of these broader pressures?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [30]

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No, I think semi, as we said, was fairly stable here in Q3, which means positive growth, although at a lower rate than what we've seen in the first half of the year. That was what we expected. We do expect it to slow a little bit further here in Q4, and that's included in our guidance. The other thing to keep in mind for Test & Measurement, is you're running up against a difficult comp here in Q4. On a year-over-year basis, that segment was up 9% last year. And even though Test & Measurement was up 7%, with a lot of strength in Instron here in Q3, the growth rate here year-over-year is probably going to slow a little bit, just based on the comp. But the underlying demand trends in Test & Measurement and Electronics broadly are very solid.

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Ross Paul Gilardi, BofA Merrill Lynch, Research Division - Director [31]

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And just the last one, on Polymers & Fluids. I think some of the global peers in that market seem to be getting squeezed pretty hard by raw material cost, but your margins actually surprised to the upside. Is there cost pressure still on to come in that segment? Or do you think you've just adjusted prices faster than everybody else?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [32]

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I can't really comment for everybody else. I can tell you what we're doing. We are seeing a fair amount of cost pressure. Other than auto, it's the second highest in terms of price/cost impact. But they've done a great job, really reacting on the pricing side and more than offsetting those cost increases on a dollar-for-dollar basis.

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [33]

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And we're -- as we said before, we don't hedge, so we have been incurring those costs as they are happening.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [34]

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Yes, I think that's a good point. I mean relative to others, and this is true and we explained it a little bit that not just on raw materials, but also on currency. Because we do not hedge currency and raw material cost, maybe they show up faster at ITW and gives our businesses a real-time view of what's going on, and then they can react maybe faster on the pricing side. So...

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Operator [35]

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Your next question comes from the line of John Inch, Gordon Haskett.

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John George Inch, Gordon Haskett Research Advisors - MD & Senior Analyst of Multi-Industrials [36]

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Going back, Michael, to the semi exposure, can you just remind us how much of Test & Measurement and Electronics is semi? And I think to that last question, is there something about the nature of your exposure that's allowed you to outperform?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [37]

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It's about $200 million. I can't really comment specifically on why we're outperforming. Like I said, we've certainly benefited from strong growth over a long period of time. The growth rate slowed a little bit here in Q3, as expected. And we expect it to slow a little bit further here in Q4. How that compares to everybody else, I'm not sure I can give you a good view.

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John George Inch, Gordon Haskett Research Advisors - MD & Senior Analyst of Multi-Industrials [38]

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No, no. That's fine. So autos globally, you guys continue to outperform in North America and China. Last couple of quarters, you've had slightly below build average results in Europe. And I'm wondering, is that tied to the WLTP emission stuff with respect to your portfolio, are you positioned? Like are you doing some PLS work there? What maybe or may not be going on in Europe?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [39]

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Yes. I think, John, it's more related to the fact that sort of inventory levels are sort of getting adjusted to the lower build rates. We have a lot of confidence based on new programs that we've added and are continuing to add that we are still getting penetration gains in Europe, and it's just a matter of those are being offset by our customers pulling inventory down. The requirements are less because they're producing less. You'll see it positive -- back to positive certainly over the next couple of quarters depending on how the overall production rates go.

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John George Inch, Gordon Haskett Research Advisors - MD & Senior Analyst of Multi-Industrials [40]

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Yes. No, that makes sense. Maybe one more. And so thinking about Polymers & Fluids, and then Specialty. Other aspects of your portfolio over the last few years have grown more rapidly than these businesses. Pretty strong performance, relatively strong competitive positioning. And then as Europe has obviously softened, you've got elements of these portfolios, on I think the consumables side, weakening. So I'm curious, Scott, is this one of those things where they -- I'm sure they're all good businesses, but they're not necessarily performing as resiliently as some of your other segments. Does this suggest that maybe there's a lot more PLS work to do? Or perhaps even maybe make some select divestitures on, I don't know, some of these consumable elements of both of those segments?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [41]

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Well, I think what I can say for sure is, in both cases for slightly different reasons, they are -- the starting point was sort of further back in the pack in terms of just the complexity. Polymers & Fluids, was a complete acquisition-built segment. So we just had a lot more -- we've had a lot more stuff to deal with there in terms of getting that position to do what we think it is capable of. And that's sort of where I sit today. I think we've got another couple of years to get this whole company where we think it can be, and in those 2, I'd say parts of Specialty and a lot of Polymers & Fluids, it's just a matter of the starting point was further back, if you will, in terms of making the transformation that we're in the process of making. Both are highly differentiated, look at the margin rates. They're really solid position inside some really strong niches. So I think we like the competitive position, but they have to grow faster, there's no doubt. And if we determine that they can't at some point, then I think your logic is not unreasonable, but I think we've got some more room to go before we are ready to make a call on that.

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John George Inch, Gordon Haskett Research Advisors - MD & Senior Analyst of Multi-Industrials [42]

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Maybe just one last one on that point. Is there any kind -- I realize there's a lot of niche businessing here. Is any of this pertaining to scale? So in other words, maybe instead of looking at divestitures, maybe it might make sense to add to those portfolios in some manner to beef up scale to kind of push it further over the goal line, if you will? Again, I...

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [43]

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I think all of that across the whole portfolio is stuff -- those are sort of options that are certainly both valid and really interesting. I think the -- just given the level of performance, the profitability and what we think the core growth potential is, I think our focus is let's get what we have in full potential position and not try to fix our problems, let's address it with the businesses -- by operating the business we own to their full potential. And from that view, then we can look at what -- how we might supplement or perhaps organize ourselves differently.

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Operator [44]

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Your next question comes from the line of Steve Volkmann, Jefferies.

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Stephen Edward Volkmann, Jefferies LLC, Research Division - Equity Analyst [45]

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Just a couple of clarifications, if I might. I guess, we had a little bit of sequential improvement in sort of the price/cost headwind on margins, and I assume your goal is still to sort of fully offset that over time. Is the 10 basis point sequential improvement the right way to think about the kind of the path to get there? Or can you do it more quickly?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [46]

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Yes. I think what's encouraging is that, the margin impact, specifically year-over-year, it seems to have stabilized. And certainly, it's encouraging to see an improvement in Q3 relative to Q2. This is not going to be a quick fix. I mean, we do expect between raw materials and tariffs, there's -- we're going to have to continue to work the price lever, which we are. And the other piece of the equation is, we have a favorable -- price dollars were significantly higher than the cost dollars here in Q3 relative to the first half, we were neutral. So that's when we talk about things beginning to improve, that's really what we're talking about. But obviously, we're in a pretty dynamic environment here in terms of raw material costs and tariffs, and I just want to be a little bit cautious in terms of saying that all of this is behind us. We're going to have to continue to work this really hard, but certainly encouraged by what we've seen here in the near term.

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Stephen Edward Volkmann, Jefferies LLC, Research Division - Equity Analyst [47]

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And then just a quick follow up, and I apologize to keep beating on auto. But I think you had mentioned in your comments that there was a fair amount of restructuring and integration expense. And I think you said margins would have been up without that. And I'm just curious sort of where we are in that process? How long does that continue? As we get further down the road, when does that headwind sort of fade, if it does?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [48]

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Yes. We're making a really good progress there. We're in the year 3 of a basically 5-year process if we're talking specifically about EF&C that we added. And so the -- things are certainly progressing, I would say, at this point, ahead of plan. It's a great business. We've added some great team members and progress is really good. I think some of the quarterly timing in terms of restructuring is also -- I don't think it's a particularly big headwind for margin in auto on an annual basis, it is -- and might jump out on a quarter based on timing of when they're actually implementing certain things. I think that was probably more the case.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [49]

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Yes, the impact of Q3 here was 40 basis points. We laid out a plan, Steve, a 5-year plan to get margins to 20%, and really a steady 200 basis points improvement every year, and that's what we delivered so far. So -- but it's not a onetime -- it's really more of an ongoing program. No rush to do this, but we're definitely on the right track here.

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Stephen Edward Volkmann, Jefferies LLC, Research Division - Equity Analyst [50]

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Okay, great. And then just one final nit if I could. The destocking that you're seeing in European auto, I guess we had sort of heard through the channel that, that was somewhat short term in nature. And I guess, you're sort of saying that's going to continue. But at some point, I suppose that, that headwind goes away as well.

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [51]

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Well, we think -- from what we're hearing, the biggest factor is new emission standard. There's been a lot of, let's call them, bottlenecks in terms of our customers getting their vehicles through that process and to the extent that -- it's not something that we control nor is it something that we have direct input from our customers on or point of view in terms of where that bottleneck clears and things, let's say, normalize. So that was -- but that was a big factor in Europe in terms of the reduction, the decline in production in Q3. That's certainly going to continue to be there in Q4. We will hope to have, looking at '19 and by December in terms of -- at least give you our view of how that will play out. And the other parts of Europe was also with softer demand in China. A fair amount of auto production in Europe is exported to China, and ultimately have demand there. There being China on a go-forward basis will also have an impact. But right now, what we're calling is Q4 and we're not expecting any change.

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Operator [52]

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Your next question comes from the line of Andy Casey, Wells Fargo Securities.

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Andrew Millard Casey, Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst [53]

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I'm trying to understand some of the patterns that seem to be appearing in the results, on that seems a little sporadic by region, but industrial seems like it's reasonably strong, but some of the consumer-oriented stuff is -- seems to be softening. Is that consistent with how you're looking at the portfolio? And if so, outside of international auto, can you talk about whether you're seeing any of your channel partners destock?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [54]

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We talked a little bit about destocking on the Construction side, really into the big-box retailers here in Q3. That's really more of a near-term impact. You're correct, I mean, the industrial side continues to be very solid. And then on the consumer side, we are seeing some slightly lower growth rates on a year-over-year basis. I think on a geographic basis, like we talked about, I mean, North America continues to be very solid, up in the mid-single digits, year-to-date and for the year. And really what changed here in Q3 versus Q2 is what we talked about in terms of the international side of the business. Now when you look at it by geography, it's hard to say that there are any real trends.

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [55]

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It's pretty narrow in terms of the impacts that we saw, like auto in a couple of spots.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [56]

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It's couple of pockets, offset by strength in other pockets. So we're not making any regional calls here in terms of what's going on from the macro standpoint. We saw some challenges in a few end markets, but there was also strength in other markets in that same region. So we're not making a region call here.

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Andrew Millard Casey, Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst [57]

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And then separately on Food Equipment. What's -- within your prepared remarks, you mentioned retail was weak. Can you give a little bit more color on that?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [58]

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Yes. So I'd rather not go into too much detail here. Sorry, Andy. What I can tell you is it's been pretty challenged for a year now. The comps are going to get easier, but really last year, we saw the beginning of a slowdown in investment.

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [59]

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This is grocery stores.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [60]

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In grocery stores. As it relates to our products -- these are scales, weigh wrap equipment. We also had a major new rollout of product last year that didn't repeat this year. And we'll see when we do the plans here in a couple weeks with the Food Equipment team, what to expect for next year. But for Q4, in the near term here, we're expecting that things do not get better on the retail side and it's really strength outside of retail, what we call foodservice on the equipment side, particularly on the institutional side, where our business is up in the mid-teens with a lot of strength, as we talked about. And on the health care, education, lodging, those trends certainly look really good.

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Andrew Millard Casey, Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst [61]

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And if I could squeeze a clarification, in that 2019 $60 million headwind from tariff impact, does that include the anticipated 25% list 3 increase next year?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [62]

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Yes, it does.

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Operator [63]

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Your next question comes from the line of Scott Davis, Milius Research.

Your next question comes from the line of Mig Dobre, Robert W. Baird.

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

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Jamie Lyn Cook, Crédit Suisse AG, Research Division - MD, Sector Head of United States Capital Goods Research, and Analyst [64]

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Just a couple quick follow-up questions. One, in -- John sort of asked you about portfolio optimization, either divestitures or acquisitions, whether you need scale or to help the organic growth story. But how much is the macro sort of impacting your view of being more opportunistic on the M&A front and if multiples come down at all? And then my second question, just clarification. I think you said in response to one of the questions in the fourth quarter, sequentially expect Polymers -- P&F and the Specialty division to improve sequentially, just -- was there anything specific driving that?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [65]

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I'll take the first one and I'll let Michael take the second one. And again, I don't mean to be evasive, but I think in December, we'll give you a fulsome update on our thinking with regards to portfolio. And how we're thinking about it and how we will go forward.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [66]

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Yes. And specifically on Polymers & Fluids and Specialty, based on -- our guidance is based on the current level of demand, current run rates in those businesses. We factor in the comps on a year-over-year basis and based on that the year-over-year organic growth rate in Q4 is expected to be better than the equivalent in Q3. So it's -- there's nothing specific other than based on current run rates vectoring the comps.

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Jamie Lyn Cook, Crédit Suisse AG, Research Division - MD, Sector Head of United States Capital Goods Research, and Analyst [67]

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Okay. And just a follow-up question. Some other companies or investors have been concerned that -- with trade war talk, et cetera, and price increases, has there been any sort pull forward in demand, which is why some companies might be seeing good strength in the beginning of the year and then things sort of deteriorating in the back half. I mean, do you get a sense for any of that as you can you talk to your customer base?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [68]

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No. We're book and bill. I mean, you order today, we ship it tomorrow and we -- we've not seen any pull-forward that I can think of. I'm sort of running my head through the portfolio here. In fact, we sort of gain our delivery performance and send by the opposite.

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Operator [69]

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Your next question comes from the line of Joel Tiss, Bank of Montreal.

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Joel Gifford Tiss, BMO Capital Markets Equity Research - MD & Senior Research Analyst [70]

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I wonder, is there any -- you guys have been at this a long time. Are there any signals from your earlier cycle businesses that give you any sort of insight into what could be happening in the later-cycle businesses further down the road?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [71]

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I can't really -- we're looking at each other here and shaking our head. We can't really think of anything, Joel, in terms of short cycle being the leading indicator. Like we said, this was -- other than the auto and a few end markets internationally in the 2 segments we talked about, the performance is pretty good. And we're certainly not seeing anything that underlying demand trends are beginning to slow here.

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Joel Gifford Tiss, BMO Capital Markets Equity Research - MD & Senior Research Analyst [72]

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Okay, good. And then can we just spend a minute going through the different pieces inside the Construction business? We haven't talked about that very much. You mentioned about big-box retail was destocking a little bit, but can you just talk about some of the other trends you're seeing there, please?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [73]

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Yes. I think that was really the big one that we called out. I mean, I think overall, 1% organic growth in the quarter; Europe, really good, up 4%; Australia, maybe slowing just a little bit; in North America, the residential side is down -- and that's really more of a comp issue. We had -- there was the hurricane impact in Q3.

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [74]

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It was a factor this year versus last.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [75]

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So hurricane impact last year, businesses was up 7%. Sequentially, on a run-rate basis, the underlying demand is still very good. The business is up 4% on a year-to-date basis. Q4 looks to be in line with that and the full year should be up in that 4 to mid-single-digit range on the residential side. Commercial is the smaller part of our business. It can be a little lumpy. It's been flattish for a while here. We're up 5% in the quarter. I wouldn't get too excited about that, to be honest with you. I mean, I think this is a more of a low single-digit type growth rate on the commercial side. And even with this slowdown, some pressure on the cost side, the fact that the business improved operating margin 40 basis points is pretty good.

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Operator [76]

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Your next question comes from the line of the Steven Fisher, UBS.

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Steven Fisher, UBS Investment Bank, Research Division - Executive Director and Senior Analyst [77]

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I just -- talking about international Welding, some nice strength there. Can you just talk about where that strength internationally is coming from, which market? And what visibility you have to a kind of continuation of that?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [78]

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Really what we saw was a pickup. So most of our international business, as you remember, is oil-and-gas related. So we saw a pretty nice recovery. Europe, up 10%, a little more than that 11% in the quarter. On the Welding side, China up 15%. So the majority of that is really driven by oil and gas, which overall was up double digits. You saw the pickup also in consumables, I think up 12% in the quarter here. So those are kind of the big -- and just in terms of the sustainability, we haven't seen anything to suggest that things are slowing.

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Steven Fisher, UBS Investment Bank, Research Division - Executive Director and Senior Analyst [79]

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Okay, that's helpful. And then in terms of organic growth fourth quarter, number of positive segments versus the number of negative, obviously, we had a few, I guess 3, that turned to the negative side in Q3. And as you've talked about some of the comps get tougher in Q4, any way that -- and we can also get to that 1% to 2% organic growth for the fourth quarter in a variety of different ways, though. I'm just curious if you think the number of segments that are going to be negative in the fourth quarter are going to be more than what we've seen here in the third quarter?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [80]

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No.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [81]

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It will be -- we expect it to be less, and it's really -- the one that stands out is auto, even though auto was about flat this year in Q3. We're -- in our guidance, and based on what we're seeing we're planning for a little bit worse in that segment. The other segments should be positive. And for the full year, even auto is going to be very close to positive in all segments, even including auto.

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Operator [82]

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Your next question comes from the line of Nicole DeBlase, Deutsche Bank.

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Nicole Sheree DeBlase, Deutsche Bank AG, Research Division - Director & Lead Analyst [83]

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If I could just ask a little bit of a more detailed question around price/cost. So just compared to the headwind that you guys have had over the past several quarters, what's the expectation that's baked into the fourth quarter guidance?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [84]

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So we're assuming pretty similar Q4 to what we saw in Q3. It's like what we said earlier, I mean, on the cost side, this is pretty dynamic environment. That's -- even though certain of the raws may looking back have stabilized, there are others where that was not the case. So it's hard to call, but we're expecting Q4 is similar to Q3. And I think that's a pretty -- hopefully, a pretty conservative assumption, but it's hard to tell.

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Nicole Sheree DeBlase, Deutsche Bank AG, Research Division - Director & Lead Analyst [85]

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Okay, got it. That's helpful. And then on Specialty Products, that was kind of a big negative surprise for us this quarter. If you can just give us give us some color on what drove the pretty big swing to the organic decline? And if that continues into the fourth quarter?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [86]

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Yes, it was really -- it was the 3 divisions internationally that we talk about. So the marking and coating business, the graphics business, and then the appliance business, which we also sell components into appliance customers. And then a fair bit of PLS as well, particularly on the international side. So those were the key drivers. I think what's -- it masks a little bit of this really solid performance on the consumer packaging side, which, up 5%; the equipment side, up 7%.

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [87]

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Which is the biggest business in the segment.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [88]

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Right. And so it was really those, a couple of divisions on the international side that drove the negative organic growth rate here in Q3.

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Operator [89]

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Your next question comes from the line of Seth Weber, RBC Capital Markets.

Your next question comes from the line of Josh Pokrzywinski, Morgan Stanley.

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Joshua Charles Pokrzywinski, Morgan Stanley, Research Division - Equity Analyst [90]

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Just to follow quickly on the last question on price/cost, and how that layers in here from here? I get that 4Q doesn't be look a lot different. But tariffs ramp up again to start the year. Is there a potential for that 60 basis points to actually get a little bit worse before it gets better? I'm not trying to put too fine a point on it or get into 2019 guidance, it's just kind of on earmarked date on the calendar that I want to understand a little better.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [91]

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I can give you -- we gave you the -- what we think the impact of tariffs is going to be for 2019 at that $60 million compared to $30 million this year. That's a meaningful number, but nothing insurmountable here. And certainly manageable as we continue to work the price side of things. But beyond that, I can't really tell you until we've gone through the detailed plans here with everybody. Just to be clear, the $60 million includes, I think we said this earlier, the list 3 increase from 10% to 25%. And so that's an all-in number based on what we know today. But it's a pretty dynamic environment.

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E. Scott Santi, Illinois Tool Works Inc. - Chairman, President & CEO [92]

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And everybody's going through it. So the only thing I would add is that the pricing reaction of this in the marketplace is -- has been going all year, will continue to go on, not just by ITW, but you're hearing it from, I'm sure, all of your other industrial companies that you cover. So I think the environment is one that I think we've got a good view as to how costs are going to continue to escalate in terms of what's known. We've got contingency. We're certainly not anticipating them to go the other way anytime soon. So I think from the standpoint of attention and focus and our ability to continue to respond as necessary and as appropriate, I think we're pretty comfortable with where we sit.

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Joseph Alfred Ritchie, Goldman Sachs Group Inc., Research Division - VP & Lead Multi-Industry Analyst [93]

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Got it. That's helpful. And then just one quick one. I know we've talked a lot about destocking in European auto. But was there any restock that you guys saw in North America Welding? I've heard some of that comment in the channel, just curious did that impact you at all?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [94]

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No. No, we didn't see that, Josh.

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Karen A. Fletcher, Illinois Tool Works Inc. - VP of IR [95]

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Okay. Thanks, everybody, for joining us today. If you have any follow-up questions, just reach out, and we are happy to help you out after the call. Thank you.

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Operator [96]

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Thank you. This concludes today's conference call. You may now disconnect, have a good day.