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Edited Transcript of ITW earnings conference call or presentation 26-Jul-19 2:00pm GMT

Q2 2019 Illinois Tool Works Inc Earnings Call

GLENVIEW Jul 31, 2019 (Thomson StreetEvents) -- Edited Transcript of Illinois Tool Works Inc earnings conference call or presentation Friday, July 26, 2019 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 & 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

* Jeffrey Todd Sprague

Vertical Research Partners, LLC - Founder and Managing Partner

* 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

* Mircea Dobre

Robert W. Baird & Co. Incorporated, Research Division - Associate Director of Research and Senior Research Analyst

* Nigel Edward Coe

Wolfe Research, LLC - MD & Senior Research Analyst

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Presentation

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Operator [1]

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Welcome, and thank you for joining ITW's 2019 Second Quarter Earnings Call. My name is Cheryl, and I will be your conference operator today. (Operator Instructions) As a reminder, this conference call is being recorded.

I will now turn the call over to Karen Fletcher, Vice President of Investor Relations. Karen, you may begin.

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

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Thanks, Cheryl. Good morning and welcome to ITW's Second Quarter 2019 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 second quarter financial results and provide an update on our 2019 full year outlook.

Slide 2 is a reminder that this presentation contains our financial forecast for the remainder of the year as well as other forward-looking statements identified on this slide. We refer you to the company's 2018 Form 10-K 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.

So with that, I'll turn the call over to our Chairman and CEO, Scott Santi.

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

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Thank you, Karen, and good morning. As you saw in our report this morning, during the second quarter, we experienced a deceleration in demand across our portfolio. At the total company level, second quarter revenues came in 2 percentage points or approximately $85 million below what they would have been had demand held at the level we were seeing exiting Q1. Q2 revenues were down across all 7 of our segments versus Q1 run rates with higher declines in CapEx-related products such as welding equipment.

EPS came in at $1.91, down from $1.97 last year. In addition to external market factors, known headwinds, primarily foreign currency translation and accelerated restructuring expense, reduced the EPS by 8% year-over-year in the quarter. Excluding the impact of these headwinds and a couple of small divestitures this quarter, EPS would have been $2 or an increase of 2%.

As usual, as the quarter progressed, the ITW team executed well on the elements within our control. Operating margin held solid at 24.1% supported by more than 100 basis points of benefits from Enterprise Initiatives. Despite negative volume leverage and excluding 30 basis points of restructuring impact, operating margin improved 10 basis points year-on-year. The team also managed working capital well as we delivered a 14% increase in free cash flow this quarter and after-tax return on invested capital was 28.6%.

Based on the data available to us and the fact that we've only seen these floating conditions for a couple of months, it is difficult to draw any conclusions as to whether this is a pause related to some near-term business tentativeness or something that may turn out to be more protracted. And in terms of visibility for us, keep in mind that as a result of the service levels that we provide to our customers, the majority of our divisions are "order today, ship tomorrow" businesses, and as a result, we carry very little backlog across the company.

That said, we have had contingency planning discussions with our segment leadership as to the adjustments that need to be made to our plans for the remainder of the year in light of the current operating environment. And as we always do, we are adjusting our full year guidance in line with conditions on the ground as they exist today. Current run rates exiting Q2 projected through the remainder of the year would result in an organic revenue decline of 1% to 3% for the full year, and as a result, we are reducing our full year EPS guidance by 4% at the midpoint. All other assumptions are essentially unchanged, and we continue to expect a stronger second half on a relative basis as first half headwinds from foreign currency translation and higher restructuring expenses dissipate.

While the combination of a declining global auto market, slowing manufacturing CapEx spending and significant business uncertainty has us operating in a challenging macro environment near term, our efforts over the last 7 years have been focused on leveraging the strength and resilience of the ITW Business Model to position the company for long-term through-the-cycle performance. To that end, I would point out that despite the external challenges at the moment, in Q2, we delivered the third-highest quarterly EPS in the 107-year history of the company.

Looking ahead to the remainder of the year, while we will be prudent in making appropriate adjustments based on the near-term demand environment and continue to drive quality execution on the elements within our control, we remain focused on managing and investing to maximize the company's growth and performance over the long term. Our teams are executing aggressively on our Finish the Job strategy agenda, and we continue to make solid and consistent progress in positioning the company to achieve our 2023 enterprise performance goals.

With that, I'll now turn the call back over -- or over to Michael to give you more detail in our quarter. Michael?

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

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All right. Thank you, Scott, and good morning. In the second quarter, organic revenue declined 2.8% year-over-year as demand slowed across our portfolio versus demand levels exiting Q1 to the tune of approximately 2 percentage points. Compared to Q1, Q2 year-over-year organic growth rates slowed in all segments with the most significant slowdown in welding.

By geography, North America was down 2% and international was down 4% in both Europe and Asia Pacific. Of note, China was down 5% with automotive as the main driver, and excluding automotive, China was up 1%. You'll recall that we previously talked about the first half of the year and Q2 being challenging due to a number of known headwinds, namely currency and restructuring. Those items played out as we expected.

GAAP EPS of $1.91 included $0.06 of unfavorable foreign currency translation impact, $0.02 of higher year-over-year restructuring expense and $0.01 loss related to 2 small divestitures in Specialty Products. We continue to expect that these first half headwinds moderate in the second half, and I'll provide more detail on the first half/second half dynamics on Slide 9.

Excluding these 3 items, EPS would have been $2, an increase of 2% versus Q2 last year, which you might recall is a record quarter with EPS of $1.97, which was up 17% versus the prior year. As usual, our execution on the elements within our control was strong. Operating margin of 24.1% improved 10 basis points, excluding 30 basis points of accelerated restructuring impact. As you may recall, in Q1, we made the decision to accelerate this year's planned restructuring projects into the first half of the year, a decision that sets us up well for the second half.

Price was well ahead of cost on a dollar basis and margin neutral for the first time since 2016 as pricing actions continue to more than offset moderating material costs. Enterprise Initiatives were the largest driver again in terms of margin expansion and contributed 110 basis points this quarter with more to come. Free cash flow increased 14% and conversion was 98%, seasonally strong for second quarter.

In terms of capital structure, we opportunistically refinanced our short-term debt and locked in annualized interest expense savings equivalent to $0.07 a share. And we repurchased $375 million of our shares as planned. Overall, in a softer macro environment than we expected entering into the quarter, the ITW team executed well to essentially hold operating margins despite a 6% decline in revenues, grow free cash flow double digits and deliver EPS of $1.91, the third highest in our company's history, the highest ever being Q2 last year.

Let's go to Slide 4 for some detail on the operating margin. Like I said, operating margin was a solid 24.1% as Enterprise Initiatives contributed 110 basis points. Setting aside the impact from higher restructuring year-over-year, operating margin was 24.4%, a 10 basis point improvement from last year despite negative volume leverage of 60 basis points. Price/cost margin impact was neutral this quarter, thanks to strong pricing and moderating costs. You can see the sequential price/cost trends on the bottom left side of the slide. And if things stay broadly as they are, price/cost is on track to turn margin positive in the second half.

The other category has a negative 40 basis points this quarter and includes 20 basis points of onetime items. Going forward, we expect the impact of the other category to normalize in the 10 to 30 basis points range, in line with historical.

So in summary, strong execution and margin performance with Enterprise Initiatives contributing 110 basis points again. And the Enterprise Initiatives impact is broad-based, ranging from 70 to 160 basis points across all 7 segments. In fact, in a few slides, you'll see some very strong margin performance in the segments, including Polymers & Fluids up 160 basis points, Test & Measurement/Electronics up 100 basis points and Construction up 50 basis points, just to name a few.

Turning to Slide 5 for details on segment performance. As we talked about on our last call, we expected Q2 to be pretty similar to Q1 based on the levels of demand we were seeing at the time we exited Q1. Based on historical data, we expected sales to be up approximately 3% from Q1 to Q2. In actuality, they were up only 1% as we experienced a broad-based deceleration in demand as the quarter progressed. The chart on the left illustrates that point. This is a summary of segment organic growth rates year-over-year in Q1 versus Q2. And to make it apples-to-apples, we equalized the number of shipping days in Q1, and you can clearly see the impact of slowing market conditions across the board with the largest decline in welding, which was up 5% in Q1 and down 2% in Q2.

At the enterprise level, while we were essentially flat year-over-year in Q1, Q2 ended up being down almost 3%. The decelerating demand occurred primarily in May and June, and after only 2 months, we don't have enough data points to tell whether this is a pause or potentially more of a sustained slowdown. That said, our standard approach is to recalibrate our full year expectations and guidance based on the demand levels that we are seeing exiting the second quarter, which essentially means that there's no second half re-acceleration built into our guidance. We'll get into that in more detail on Slide 10.

Now let's go into a little more detail for each segment, starting with Automotive OEM. And similar to Q1, organic revenue was down 7% compared to the most recent IHS builds down 9% for North America, Europe and China combined. Despite the fact that this quarter included 130 basis points of product line simplification, nearly half of which related to the ongoing integration of our European-based acquisition, this segment still outgrew the underlying markets by a comfortable margin.

North America was down 6% as builds at the Detroit 3, where we have our highest content per vehicle, were down 6% in the quarter. In Europe, organic revenue was down 8%, essentially in line with Q1 and beginning to show some signs of stabilizing. In China, organic revenue was down 12%.

On a positive note, we continue to take full advantage of the long-term growth opportunities in this segment. And our new product pipeline and new program wins remain strong, positioning us for 2% to 3% of above-market organic growth on a sustained basis. The segment is performing well in the current auto down cycle as evidenced by 22%-plus margins despite some pretty sizable declines in revenue over the last 4 quarters. Operating margin was 22.1% with a significant contribution from Enterprise Initiatives again this quarter.

We'll continue to manage our way through these near-term challenges and adjusting our cost structure as appropriate and focus on positioning the segment for the long term.

Looking forward to the second half. Even though IHS is forecasting that auto builds for North America, Europe and China combined will be flat versus down 8% in the first half, we are using current run rates, which equate to a decline in builds of approximately 5% in the second half.

Moving on to Slide 6. Food Equipment organic growth was solid, up 2%, with strong performance in our service business, which was up 4%, and equipment up 1%. In North America, results were similar to the first quarter with 2% organic growth with modest growth in the equipment side and service up 4%. Growth in independent restaurants and QSR was solid, up double digits, offset by a decline in institutional where we had a tough comp of 20%-plus growth in the prior year quarter. Food retail was a bright spot again this quarter, also up double digits, as the recovery here appears to be taking hold. International organic growth was up 2%, mostly on strength in Europe, which was up 4%, offset by weakness in China. Operating margin expanded to 25.6% with Enterprise Initiatives as the main driver.

Test & Measurement and Electronics organic revenue was down 1%. Excluding lower sales to semiconductor equipment manufacturers, which represent approximately $200 million, the segment organic growth would have been up 2%. As we have talked about before, we plan for semiconductor-related sales to be down double digits this year and so far, things are playing out as expected. Test & Measurement was down 3%, up 4% excluding semiconductor and Electronics was up 1%. Operating margin expanded 100 basis points to 24.5% with Enterprise Initiatives as the main driver.

Turning to Slide 7. In Welding, as we talked about earlier, we experienced significant deceleration in demand as the quarter progressed. Organic revenue declined by 2% against a challenging year-over-year comparison. Equipment sales globally were down 4% and the decline was broad-based by end market. Consumables were flat. North America was down 3% with equipment sales down 5% while filler metals were up 5%, suggesting that underlying welding activity in North America is still fairly solid, which is certainly a positive sign. International markets were flat and operating margin was the highest of our segments at 28.8%. Polymers & Fluids organic growth was flat with Polymers up 2%. Automotive Aftermarket was flat and Fluids were down 3%. Operating margin was up 160 basis points driven by Enterprise Initiatives.

Moving to Slide 8. Construction organic revenue was down 1% due to market softness in Australia, New Zealand, offset by pretty good results in North America, which was up 2% with commercial construction up 5% and residential remodel up 3%. Europe was stable, up 1%, and operating margin expanded 50 basis points due to Enterprise Initiatives.

In specialty, organic revenue was down 6% versus a tough comparison of 4%, driven in large part by PLS and the performance of potential divestitures in this segment. PLS was almost 1.5 points, of which 2/3 relates to a plant closure and the discontinuation of that product line. Organic growth in potential divestitures was lower in the quarter and reduced the overall organic growth rate for the segment by a little more than 2 percentage points. The remaining, call it, core specialty was down about 2.5% against an apples-to-apples comparison of plus 8% in the second quarter last year. By geography, international was down 8% and North America was down 5%. Operating margin declined due to negative volume leverage and higher restructuring.

So let's move to Slide 9 for a summary of first half financial performance and how that sets us up for a stronger second half. As we've talked about before, we fully expected the first half to be pretty challenging due to known headwinds and some tough comparisons versus prior year, including the fact that the first half last year was the most profitable first half ever in the history of the company as EPS increased 20%. As you can see, EPS for the first half was $3.72, which included approximately $0.20 of year-over-year headwinds from both foreign currency translation impact and higher restructuring expense, both factors that will moderate in the second half.

At this point, we have completed about 70% of our planned restructuring for the year. In the current FX rates, the headwinds from currency begin to dissipate in Q3 and are essentially gone in Q4. As a result, the $0.20 year-over-year headwind in the first half is approximately $0.05 in the second half, so a net positive of $0.15 from these 2 items alone.

In addition, we have a number of tailwinds to EPS in the second half, starting with restructuring savings of about $0.05 from the first half projects that were accelerated. These are projects with typically less than 1-year payback. And other than the acquisition integration we talked about on our last call, they relate to our typical 80/20 front-to-back activities and are pretty well distributed across the segments.

Furthermore, price/cost dynamics are favorable. Interest expense is lower as I mentioned earlier, and comparisons year-over-year get easier, and we have 1 extra shipping day in Q3. So overall, solid performance in the first half with a more challenging near-term environment, and importantly, a better setup for the second half, with organic growth at the enterprise level in line with the first half at current run rates, margin expansion year-over-year at the enterprise level and across the majority of our segments, strong cash flows and mid- to high single-digit EPS growth year-over-year.

In terms of the quarterly splits in the second half, we expect Q3 and Q4 to be fairly similar in terms of EPS. Q3 does have 1 more day but Q4 has favorability from lower restructuring expense and higher restructuring benefits as well as no year-over-year currency headwind at current rates.

Now let's talk about our updated 2019 guidance on Slide 10. As per our usual process, we're updating full year guidance to reflect current levels of demand. Run rates exiting Q2, adjusted for normal seasonality, project that full year organic revenue will be down 1% to 3%. This compares to our prior organic growth guidance of 0.5% to 2.5%. The reduction in organic growth rate from a midpoint of 1.5% to down 2% impact EPS by approximately $0.35.

As a result, we now expect EPS to be in a range of $7.55 to $7.85 with a midpoint of $7.70, up slightly 1% versus $7.60 last year. Lower organic growth also translates to lower volume leverage, and as a result, we now expect that operating margin will be flat to up 50 basis points.

As you saw, we're off to a strong start on cash flow in the first half, and the full year is expected to be strong with conversion well ahead of net income, and we expect to repurchase approximately $1.5 billion of our own shares for the full year.

Now a brief update on our portfolio management activities. Our divestiture activities are progressing well, and we remain on track to complete about half of our potential divestitures in 2019. Interest is strong and we expect to realize significant gains and cash proceeds upon divestiture, all of which is excluded from our guidance. As we have stated before, the positive impacts from the expected divestitures, when completed by the end of 2020, include approximately 50 basis points of structural improvement to our overall organic growth rate and 100 basis points to operating margin. Not counting the gains on sale, we're planning for divestitures to be EPS-neutral as any EPS dilution will be offset by incremental share repurchases above and beyond the approximately $1.5 billion that I just mentioned.

Before I hand it back over to Karen, let me just reiterate something that Scott said earlier. Given the strength of our core competitive advantages, the resilience of the ITW Business Model, our diversified high-quality portfolio of businesses and our team's ability to execute at a high level, we are well positioned to outperform across a wide range of economic scenarios.

In terms of the near-term macro, after only 2 months, it's too early to tell where near-term demand is headed and so we're assuming current run rates will extend through the second half. And as we go forward, we'll continue to make the appropriate adjustments, incorporating current market conditions and also remain focused on managing ITW and investing for the long term.

So with that, 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. Cheryl, please open up the lines for questions.

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Questions and Answers

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Operator [1]

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Our first question is from Jeff Sprague from Vertical Research.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder and Managing Partner [2]

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Just 2 questions from me and first for Scott, actually just picking up where we ended on the call like what is the complexion of this cycle? I clearly understand the point that it's very early. You and I have both been around the block a few times. Looking at what you're seeing in some of your leading indicator-type businesses or just customer behavior, could you share a little bit of context of how this looks or feels relative to other slowdowns that you've seen? What maybe looks like a point of worry or what looks like a reason to have some level of confidence that this might just be a pause in what otherwise is a very long extended cycle.

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

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Yes. I think as I look across what we saw in the second quarter, it looks a lot more to me overall like some short-term tentativeness. I think Michael talked about the welding business data is probably the most tangible data point where we saw a big deceleration in capital investment in the equipment side. But the filler metal business was up solidly mid-single digits in the quarter, which says that our customers are still welding, the activity level is very high.

And I think that's, if we look at the employment rate in the U.S., you look at a lot of -- it's an environment where overall it looks much more like a short-term pause, some tentativeness certainly impacting capital investment decisions. It's certainly difficult for me to say after couple of months that, that is -- that turns into something larger at this point. But we all know that it's a pretty uncertain environment right now, given all of the things going on from the standpoint of global trade issues and concerns and all of that.

So I think it's a couple of months in, it certainly was a meaningful delta between Q1 and Q2 in terms of overall demand rates. But it is only a couple of months and it certainly looks, in terms of the data point of Welding and some other things like it is some -- a bit of a pause. But I don't see anything that says this is the front end of -- the end of the expansion cycle, for sure.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder and Managing Partner [4]

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Okay. And then I'm just wondering, Michael, if you could clarify. The comments you gave us on headwinds and tailwinds as it relates to FX and restructuring, saves and the like, I believe those were sequential comments. Can you just clarify that and maybe put that in context of what the year-over-year would be?

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

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Yes. Yes. So the first half headwinds from restructuring and from foreign exchange are at $0.20 a share on a year-over-year basis. In the second half, those same items, the headwind from that is only $0.05. So incrementally, we get $0.15 year-over-year better in the second half versus the first half. And that is, as always, assuming that foreign exchange rates stay where they are today.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder and Managing Partner [6]

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And that's just relative to restructuring costs, correct, than we've got benefits to think about...

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

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Yes, that's a good catch. That's just the cost side. We are getting an incremental $0.05 of benefits from the restructuring activities, the projects that were implemented in the first half of the year as part of this acceleration that we've talked about before. So there's another $0.05 there.

Yes, if you want to go down to this price/cost, it's turning -- beginning to turn positive. If things stay where they are, we also have lower interest expense, I said $0.07 annualized, so we'll get about half of that in the second half of the year. We obviously had easier comps year-over-year even though the organic growth rate is the same at current run rates first half, second half. And then we have 1 extra day in Q3 that we've talked about a number of times. The straight math on that is that's worth about $0.03 to $0.04. So...

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Operator [8]

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Our next question comes from Andy Kaplowitz from Citi.

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Andrew Alec Kaplowitz, Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head [9]

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Michael, we know you usually use current run rates when forecasting organic sales going forward. But just to clarify, you do have easier comparisons you mentioned yesterday in Q3. So is it really just you're being conservative around auto builds? Because your forecast for declines in the second half is similar to your forecast in the first half. So being conservative for auto builds and then everything else kind of stays the same as June basically is how you do it?

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

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I wouldn't say we're being conservative. I think this is purely a mathematical calculation. We're taking existing run rates exiting Q2, projecting those into the back half of the year. And if you do that, we get to -- to do the math, our first half was down 2% organic. We're saying the full year will be down 2% and therefore, the second half will also be down 2%. But there's no subjective input to that calculation.

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E. Scott Santi, Illinois Tool Works Inc. - Chairman & CEO [11]

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Keep in mind, Q1 was flat. So we're basically projecting exit Q2 run rates, not first half run rates.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [12]

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That's right. These are Q2 run rates, yes.

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E. Scott Santi, Illinois Tool Works Inc. - Chairman & CEO [13]

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Which is why you get to even year-on-year with the extra day, right?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [14]

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Yes.

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Andrew Alec Kaplowitz, Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head [15]

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Yes, okay. That's fair. And then if we look at Specialty Products, you talked about the divestitures there. But maybe you can give us a little more color? Obviously, the decrementals there are a little bit weaker than the other segments. I think in the past, you talked about some tariff-related headwind on that business. So could you talk about sort of what you're seeing? Is it specific to your appliances there? What's going on in that business?

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

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Well, I think similar to the other businesses, we did see a slowdown in demand. But really, the bigger delta, which is down 6% is what I was trying to explain with the higher PLS, the divestitures and the core business being down 2.5%. On the margin side, I mean, the Enterprise Initiatives were good. The drag is really volume leverage and then higher restructuring, and that's -- those are the key drivers of the margin performance. There's really no real trends that we can point to inside of these businesses that we can tie back to some macro factor. It's really broad-based lower demand in those businesses with a lot of PLS. We're working on the divestitures. And so that's kind of the story on Specialty.

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Andrew Alec Kaplowitz, Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head [17]

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But to step back, Michael, you haven't seen -- with the 25% tariffs adding more impact on the margin side components or whatever, it's just there's obviously uncertainty out there on the sales side but no impact on the margin side in that segment?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [18]

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That's correct. I mean, this latest round of List 3 going from 10% to 25% has really had an immaterial impact on the company overall. We're talking pennies of EPS and well managed. And really, that goes back to we're largely a producer where (inaudible) sell many and that's also true for Specialty Products.

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Operator [19]

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Our next question comes from Ann Duignan from JPMorgan.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [20]

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I'm just curious if you'd comment on price/cost and by segment. What's your thoughts on your ability to hold pricing in an environment where demand is weakening and some of your input costs are probably declining, particularly into 2020? Is there any segment in particular where we might see pressure on the business to give up pricing? Is it lower volume environment?

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

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No. I mean, we do have a number of divisions with index pricing. Of course, those will have to adjust to contracts. But there's really -- when we look across the board here, price continues to improve in Q2 relative to Q1 on a dollar basis. And that is true across the board. As you know, automotive is a little bit more challenging, just given the way their contracts are structured. But across the board, we're really pleased with the price performance and we're entering into more of a normal pricing environment, I'll say. We've neutralized the cost impact, including the modest tariff impact we just talked about. And this issue for now, as things stay as they are, is essentially behind us. And to be very specific, there's no actions to give price back. Really, all we were trying to do was cover our material cost increases as those increases went through.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [22]

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Okay. And...

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

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We expect to hang on to most of it going forward.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [24]

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Okay, that's helpful. And then maybe you could comment on what you're seeing out in the marketplace. I know you talked about maybe a pullback in capital spending. But it was interesting to see that your Automotive Aftermarket business was flat. And I would have thought that, that was tied to consumer discretionary spending, which hasn't remained resilient versus maybe business CapEx. So maybe if you could just talk about what you're seeing in that business in particular.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [25]

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Yes. I mean, there's not much -- Automotive Aftermarket has been a grower in the low single digits here. And I think there were a couple of things. There's a small portion of their sales that is tied to overall automotive production. But beyond that, there's -- this business correlates more to miles driven than anything else. And we didn't really see much of a -- no big changes in this business in the quarter.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [26]

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Okay. So no sign of the consumer slowing down, I think, is what we can take from that...

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E. Scott Santi, Illinois Tool Works Inc. - Chairman & CEO [27]

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Yes. Yes. And the only thing I would add is that there is some, within quarters in that business, there are some impacts from the launch of new programs or new product launches. So I think overall, the demand there is, in our view, pretty positive overall in Q2. But we'll certainly go back and take a look at whether there's a specific issue related to a prior year launch. But it's -- I think as Mike said, the longer sort of full year trends there are up fairly solidly.

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Operator [28]

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Our next question comes from Joe Ritchie from Goldman Sachs.

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Joseph Alfred Ritchie, Goldman Sachs Group Inc., Research Division - VP & Lead Multi-Industry Analyst [29]

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So my first question maybe just high level in if we were to just go into a little bit more of a prolonged downturn, you guys historically have done a great job of taking cost out. I'm just wondering like how do you guys think about how much there's left within the organization to continue to take costs out? And then secondly, just from a strategy perspective, do you feel like you need to shift at all from really like the focus on growth to really cost at this point in the cycle?

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

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Well, I think overall, we have a couple of things going for us in -- when there -- when we're under -- we're seeing some pressure in the marketplace. The first is that we have a very flexible cost structure. We've talked about that before, given our 80/20 operating model. And the historic performance that you referenced is really built around the fact that we have the ability to move up or down, capacity up or down, I won't call it easily, but I would say we have the ability relatively quickly to adjust our cost to the current environment. I think we showed that to some degree in Q2, and certainly, we'll -- I would expect that we will going through the back half of the year.

So I would describe that as tactical. I would also describe our ability from a cash flow generation standpoint and the margin profile that we've now got as a company that will allow us in a downturn to stay invested in the things that we think are really critical to the long-term growth and performance of the company. And that's a very different dynamic perhaps than we -- from an overall position standpoint that we might have had in some of the prior downturns.

So I'm certainly very comfortable, and our view is that we will make prudent tactical adjustments in the near term and be able to both do that and stay invested in the things that we really think are the important things for us to be focused on and investing in from a long-term perspective.

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Joseph Alfred Ritchie, Goldman Sachs Group Inc., Research Division - VP & Lead Multi-Industry Analyst [31]

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And I guess -- and Scott, maybe just following on, on that question, really just from the cost levers. Like where do you think that there is still kind of opportunity within the organization? I know you guys have highlighted you've simplified the organization. You've highlighted sourcing as an opportunity before. So where do you see the opportunities today?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman & CEO [32]

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Well, I think we've talked about before, we're -- we've kind of certainly a ways to go from the standpoint of our Enterprise Initiatives. We are -- got 100 basis points this quarter. There's easily several more years of work there and opportunity there. It depends on -- we're talking about the next 2 or 3 years. That certainly is a lever that we will continue to access. And as I said before, the other is we will adjust our capacity very flexibly and the costs associated with supporting that capacity.

So I think we've got plenty of levers. And it also depends on sort of the magnitude of the sort of environment and the ups and downs that we're dealing with here. So our -- what we would do, I think, is would be -- our intent is to be very responsive to the environment as we see it in the short term while staying invested in the things that we think are really critical for the long-term performance of the company. And I don't know how to be more specific than that, yes.

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Joseph Alfred Ritchie, Goldman Sachs Group Inc., Research Division - VP & Lead Multi-Industry Analyst [33]

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No, no. That makes sense. If I could ask one question just quickly on growth. You guys -- I like the slide that you had showing Q1 versus Q2. The -- I'm just curious, it sounds like you certainly took a leg down. To the extent you guys can kind of quantify, and I may have missed this earlier, just the order of magnitude that June was down, that would be helpful.

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

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Yes. So June was -- we really started to see the decline in May. And in June, mid-single digit, I would say, in June year-over-year. And at the same time, going into July here, we are starting to see things certainly not getting worse and stabilizing maybe from what we saw exiting Q2, which again supports our view that run rates are a good way to look at this on a go-forward basis. So...

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E. Scott Santi, Illinois Tool Works Inc. - Chairman & CEO [35]

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Until we see something different.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [36]

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Until we see something different, yes. So June was the more significant leg down. July looks like things are stabilizing as we sit here today.

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Operator [37]

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Our next question comes from Steve Volkmann from Jefferies.

And we'll move along. Our next question comes from Joel Tiss from BMO.

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Joel Gifford Tiss, BMO Capital Markets Equity Research - MD & Senior Research Analyst [38]

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Two questions. Just one, I know you said that it's a little bit too early to tell, and I just wondered if the way you're characterizing sort of a little bit of amplification of slowdown in May and June and stabilizing in July, is there any way to tell? And I know you guys are hand to mouth, but is there any way to tell if your customer's demand was sort of impacted kind of like they amplified a little bit from inventory destocking or there's not really any way to tell, you know what I mean? So that the underlying demand in the markets is better than what the numbers show.

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

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Yes, I think we're a tough barometer for you on that. The fact that we deliver at the kind of level of responsiveness that we do means our customers have to carry relatively little amounts of inventory. So to the extent there was any inventory adjustment, it's probably not a particularly material number for us.

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Joel Gifford Tiss, BMO Capital Markets Equity Research - MD & Senior Research Analyst [40]

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But I meant for them. Like your comment was demand went down because their customers are reducing inventories, okay. Maybe it's too...

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

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We can't tell.

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Joel Gifford Tiss, BMO Capital Markets Equity Research - MD & Senior Research Analyst [42]

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Too much of a tangent. And can you give us a little bit of an update on your pivot to acquisitions and where we stand and what you're thinking and how your team is building and how you're seeing flow and prices and all that?

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

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Yes, sure. I don't want anyone to get carried away here, but we have -- certainly, as we talked going back to our last Investor Day, we have certainly begun the process of starting to explore. And we certainly are ready to, as we talked about, begin to supplement the portfolio with nice high-quality acquisitions.

I would say -- and I've made appropriate efforts in terms of communicating that update of our strategy to the appropriate people and have had a pretty interesting change in terms of flow of ideas and opportunities. So we are certainly looking at a number of things. The pipeline is sort of quickly rebuilt. I don't want that to, in any way, tip any -- or give anybody an indication that there's anything imminent there, but we're certainly starting to explore a range of potential opportunities and would expect that over the next 12 months or so that we will generate some activity there. But it's all a function of a quality fit and sort of, call it, affordability. Can we get good fit at what we think is the right value for our shareholders?

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Operator [44]

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Our next question comes from Andy Casey from Wells Fargo.

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Andrew Millard Casey, Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst [45]

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Top line question during the quarter and then come back to the Investor Day. You talked about the 6% of revenue and divestiture process last year, to date it, up to the Investor Day, seeing a 4.6% drop. With the latest weakening, did that pool of revenue associated with the divestitures, did that see a sharper decline than the overall?

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

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Yes. So Andy, these are rightfully characterized as long-term growth challenged, and we're certainly seeing a performance in those businesses that are below the kind of core ITW.

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E. Scott Santi, Illinois Tool Works Inc. - Chairman & CEO [47]

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You talked about specifically in Specialty.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [48]

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Specialty is a good example of that where we called it out.

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Andrew Millard Casey, Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst [49]

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Okay. And then the gross margin was flat in the quarter year-over-year despite the revenue drop. I'm just wondering, did any of the restructuring fall into gross profit?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [50]

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Yes. So I think there's both the 80/20 activities, and obviously, the sourcing activities. And so I think it goes back to what we talked about earlier, just the resilience of ITW with the 6% decline in revenues, half of which organic, the other half currency. We are holding margins above 24% and we're holding gross margins. We generate more cash in terms of the conversion rate. And so I wouldn't say we were -- that was not a big surprise to us that we were able to do that. That's kind of -- that's how we run...

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

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The railroad.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [52]

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The railroad here. So...

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Operator [53]

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Our next question comes from Mig Dobre from Baird.

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Mircea Dobre, Robert W. Baird & Co. Incorporated, Research Division - Associate Director of Research and Senior Research Analyst [54]

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I don't know if I missed this, but when you're talking about the back half of the year -- by the way, I'm looking at Slide 4 right now in your price/cost discussion there, what exactly is embedded in your guidance at this point for price/cost tailwind? And can you help us in Q3 versus Q4 as to kind of how your assumptions play out?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [55]

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Yes. I think if you look at the trend at the bottom left of the slide, we will probably expect that trend to continue into the back half of the year if things stay the way they are from a cost standpoint.

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Mircea Dobre, Robert W. Baird & Co. Incorporated, Research Division - Associate Director of Research and Senior Research Analyst [56]

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All right. But is this going to be like a 50 basis points tailwind? Is it 100 basis points? I mean, what's the right magnitude?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [57]

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Yes, I think a more realistic view is that it begins to turn slightly positive in the second half year. And beyond that, I can't really give you a number.

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Mircea Dobre, Robert W. Baird & Co. Incorporated, Research Division - Associate Director of Research and Senior Research Analyst [58]

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Okay. Well, I mean, I figured that you'd know since, obviously, this is one of the key elements in terms of the swing, the first half versus back half. And I get it, it's hard to forecast it perfectly. But...

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [59]

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Mig, I mean -- Mig, just because I don't answer your question specifically doesn't mean I don't know the answer, I just want to be clear. So it's just -- so we have never provided quarterly guidance on price/cost. And given the dynamic environment we're in, and it's -- I would put it this way. Overall, it's not going to be a material driver to our performance in the back half, but it certainly contributes. And relative to where we've been over the last 3 years, it's no longer a drag, which I think that's really the big story here, that price/cost has been neutralized. But in terms of price dollars, we are significantly ahead of the material cost side, including the tariffs we talked about. So hopefully that helps.

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Mircea Dobre, Robert W. Baird & Co. Incorporated, Research Division - Associate Director of Research and Senior Research Analyst [60]

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Okay. No, it does. Fair enough. I had to try. Then let me ask my follow-up on growth, right? I think everybody kind of understands what's going on with auto. But I was running some numbers here. Even if I take out auto, I think your organic growth was down something like 0.7% year-to-date. And we look -- I look at this and that almost feels like a recession-type environment. So I guess I'm wondering from your perspective, when you're looking at the remaining businesses excluding auto, how much of this decline is generated -- has been generated by businesses that you're actually looking to exit per Andy's question from earlier versus what's going to stay, what's going to remain in the portfolio? And do you sort of feel like you've got kind of the right portfolio mix and the right geographical exposure at this point or do you need to make maybe some more significant adjustments down the line?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [61]

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Well, I think in terms of the big -- if you look at it by segment, automotive accounts for the vast majority of the decline in revenues year-over-year. I think that's well understood. We're kind of being hit by a number of things here, including we've talked about semi and now down in Welding. So I think it's a little bit of an unusual time for us. Usually, we have things kind of moving in different directions. But like I said, auto is the majority. Then we have this unique situation in Specialty where the divestitures are underperforming. We're still doing a lot of product line simplification and then Welding took a step down here in Q2. So...

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E. Scott Santi, Illinois Tool Works Inc. - Chairman & CEO [62]

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Yes, and I'll answer the same question from a longer-term perspective, which is if you look at the margins we generate in every 1 of these 7 businesses, what that tells me is we deliver a lot of value for our customers in those -- in every one of those businesses. In every one of those businesses, we have significant share and penetration gain potential. And we expect, as we've said many times before, we're working on it like crazy, every one of those businesses to outgrow the underlying markets by 1 to 2 percentage points plus. Some have the potential to do more, some less. But every one of them should outgrow their underlying market growth. And we are working through sort of lots of all things we talked about before in our path to get there. But I have no doubt we will get there and supplement it with a couple of nice bolt-ons when we get there as well, a year maybe.

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Operator [63]

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Our next question comes from Jamie Cook from Crédit 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 2 follow-up questions. Just one on the Welding side, could you just provide some color which markets were -- end markets were hit hardest? And then I was impressed with the ability to hold the margins. I mean, they were down modestly year-over-year. But given the organic growth decline, I thought margins would have deteriorated even more. So was there anything unusual in that number and how to think about margins for the year?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [65]

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Yes. So I think in Welding, the decline was fairly broad-based. If you look at -- to the equipment side, down 4%. Consumables flat and the filler metals up 5%, like we talked about, so that's certainly a positive. The industrial side of Welding in North America was down kind of in the mid-single digits and was the biggest driver overall. The Commercial side, as we've talked about before, did relatively better than that. And then the last data point, Oil & Gas kind of was flat in the quarter. So...

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E. Scott Santi, Illinois Tool Works Inc. - Chairman & CEO [66]

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What I would add is in the equipment decline, Industrial was certainly the bigger decline relative to the Commercial line, so manufacturing.

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [67]

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Yes. I mean it's really the industrial economy here is where we're seeing the softening demand. And because we are shorter cycle and Welding is one of these receive the order today and ship tomorrow, we see it maybe faster than other companies that carry more of a backlog. You have to keep in mind that in Welding, since we're on that topic, we carry less than 2 weeks' backlog because of the best-in-class service levels that we provide in that business.

So -- and then I think on margins, I'm not -- were you talking about Welding specifically? I mean, I think certainly if you -- margins at 28.8%. If you take out the restructuring in Welding, they were actually positive in the quarter as well, up year-over-year. There was about 60 basis points of restructuring in the quarter. And I think it's back to the resilience of ITW. And given how we're organized, our teams on the ground when they see things slowing, they are able to react quickly and make appropriate adjustments and deliver. If you look at the decrementals for ITW in the quarter, we're in the mid-20s, which is given that we saw the slowdown late in the quarter, I think, is pretty strong performance. And as we talked about earlier, we expect that to continue as we go into the balance of the year.

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Operator [68]

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Our next question comes from Nigel Coe from Wolfe Research.

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Nigel Edward Coe, Wolfe Research, LLC - MD & Senior Research Analyst [69]

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Michael, your decrementals at 24.3%, just to be precise, so it's pretty good. So just in that regard, as we kind of went through the quarter, how satisfied are you that you're preserving the investment spending to kind of accelerate growth when the markets return to growth? Or are we sort of in the zone now where it's all about market preservation and some of this investment spending kind of gets deferred? I mean, how do you think about that?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman & CEO [70]

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Yes. We are -- we talked about our contingency planning discussions that we had with each one of our segments, and the first topic was the conversation around what are the things that we are going to absolutely stay fully invested in as we go through this little bit of a rough patch in terms of demand.

And again, I'd sort of go back, Nigel, to what I said earlier, is sitting here with mid-20s EBIT margins with a business that as we model it would have to shrink by 1/3 in some unprecedented economic depression for our margins to drop below 20%, suggests to us -- or not suggest, it puts us in a position where we are absolutely able to ride these cycles, power our way through these cycles and stay invested for the long haul. So I am -- there are certainly tactical adjustments that could be made in terms of managing capacity appropriately in the short run race around demand. Again, I talked about our flexible cost structure. That helps us move up or down from that standpoint as demand moves up and down. But from the standpoint of capacity to invest and desire to stay invest, we're not trying to be a hero based on decremental percentage. We're trying to build a company that over a 5- and 10-year period can outperform based on the core strengths that we have in terms of the business model, the end market positions we're in.

And the things -- I don't want to get too detailed on this but the things we've talked about in terms of sales capability building, in terms of new product innovation, all of those things are part and parcel of the conversations that we've had with each of our segments in terms of the things we are absolutely going to stay invested in as we ride this out.

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Nigel Edward Coe, Wolfe Research, LLC - MD & Senior Research Analyst [71]

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Great. And then just a quick follow-up on kind of taking a different approach to the price/cost question. Looking at gross price and -- have you seen any pushback or increasing sort of investment incentives in any of the businesses? And I'm thinking here about auto obviously going through a real rough patch and how is pricing looking in that end market. And then Welding is another one where we've seen some chatter about deceleration in pricing. Maybe just address those 2 and perhaps overall as well.

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E. Scott Santi, Illinois Tool Works Inc. - Chairman & CEO [72]

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Yes. I think overall, this is a general statement with millions of products, but I think all the work that we've done on the portfolio, we've talked about this before, we are in many -- the majority of our businesses, we are in spaces where we're doing something unique and value-added for our customers, which gives us some ability to price based on the value we deliver, not based on a commodity reference point.

It's not to say that those -- there aren't pressures in certain end markets as you talk about, but our response is to try to find a way to give the customer better value and not necessarily reduce the price that we're seeing -- we're serving. So we are doing things in an auto everyday to design products that help our customers be more efficient on how they manufacture, to give them better performance in terms of features and benefits. So we're not certainly immune to the pressures of the moment as much as I would say we have, from the standpoint of the differentiated nature of the product portfolio, we have multiple responses and ways that we can respond to that over time that again deliver value to our customers. We still get paid for the value that we deliver.

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

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And I'll just add, Nigel, one data point and then there was a question earlier, and if I didn't say it clearly, our year-over-year price, if you look at in dollar terms, was higher in the second quarter than in the first quarter. So if there's some nervousness around the ability to maintain price, hopefully, that data point is helpful.

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Operator [74]

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Our next question comes from John Inch from Gordon Haskett.

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John George Inch, Gordon Haskett Research Advisors - MD & Senior Analyst of Multi-Industrials [75]

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So the 55% of the ready-to-grow growing, presumably have some auto in there obviously. If you were to strip that out, how did that -- roughly speaking, how did that do in the second quarter? What's kind of the growth rate there for those businesses and sort of how are you thinking about them in the second half?

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Michael M. Larsen, Illinois Tool Works Inc. - Senior VP & CFO [76]

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Yes. I think it's a good question, John. I mean when we talked about this at Investor Day last year, I think we described it as a journey. And so what we were going to do is report on our progress on an annual basis. I can tell you we're certainly making progress in those businesses. We are having movement of businesses that were not ready to grow, not growing category that are moving up. Maybe the service business in Food Equipment is a good example of that where we're now putting solid 3% to 4% organic growth on the board at, by the way, really attractive margins as I'm sure you know.

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E. Scott Santi, Illinois Tool Works Inc. - Chairman & CEO [77]

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But I would also say that, that list was chockful of welding businesses. So to Michael's point, to try to calibrate this on a single quarter, given the macro influences, it's -- this is a data point that we are certainly comfortable being accountable for and reporting out but on an annual basis is a better way to reflect our progress in that regard.

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John George Inch, Gordon Haskett Research Advisors - MD & Senior Analyst of Multi-Industrials [78]

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Okay, that's fair. So it's fair to say, though, the choppiness, the CapEx deferrals, et cetera, that are going on, is that making it harder to do deals? Meaning is the sort of the end market demand choppiness and there's obviously project pushouts not applicable per se to your company but it's affecting CapEx, is that causing for a little bit of deal disruption in terms of the discussions you're having or looking to begin to have?

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E. Scott Santi, Illinois Tool Works Inc. - Chairman & CEO [79]

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Not yet. And there's no prediction, not yet. It hasn't really been a major focus. But yes, it's been a couple of months.

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John George Inch, Gordon Haskett Research Advisors - MD & Senior Analyst of Multi-Industrials [80]

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Okay. Just lastly, Michael, you said that the guide doesn't assume a re-acceleration. But what if there's a deceleration, obviously, which I realize you can't forecast, nobody really can. But it holds to reason things sometimes move in trends. And Scott, I take your comments. Obviously, I gather, right, this is probably ultimately just some kind of pausing. But if it's not, how should we think about sort of ITW's resilience? Or what kind of sensitivity is there if it, in fact, there's further deceleration?

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

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Yes. I mean, I think if things decelerate from here, we will give you an update in the third quarter. I think what you saw in terms of kind of the decrementals, a good way to think about how the company would -- that we saw in the quarter, a good way to think about how the performance might play out. There's one other data point in the materials today. You saw we adjusted our organic growth guidance down. Every point of organic growth is approximately $0.10 a share. So -- then you can -- and I think we're pretty transparent in terms of all the information that we provide, including at the segment level and then you can build your own models. And those decrementals, by the way, are fairly similar across all of our segments. So hopefully, that helps you model the sensitivities around the top line.

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John George Inch, Gordon Haskett Research Advisors - MD & Senior Analyst of Multi-Industrials [82]

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It does.

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Operator [83]

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I'll now turn the call back to Karen Fletcher for closing remarks.

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Karen A. Fletcher, Illinois Tool Works Inc. - VP of IR [84]

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Okay. Thanks, Cheryl, and thanks, everybody, for joining us this morning. And if you have any follow-up questions, I'm happy to take them off-line. Thank you.

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Operator [85]

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And thank you for participating in today's conference call, all lines may disconnect at this time.