What drove ITW's strong 2004 earnings growth?

Growth came mainly from an 8.1% increase in base business revenue, reflecting a North American industrial recovery (base revenue up 9%) and a 6% rise internationally. Operating leverage amplified this, since overhead does not scale with revenue. Acquisitions contributed about 5 points of revenue growth and currency translation about 4.4 points, while lower restructuring costs and the 80/20 process also supported margins.

How is ITW using its cash, and what does it mean for shareholders?

In 2004 ITW returned capital aggressively: it bought back $1.73 billion of stock under an authorization of up to 31 million shares, paid $305 million in dividends (with a payout objective of 25–30% of the three-year average net income), and spent $588 million on acquisitions. Buybacks reduced cash by about $1 billion and modestly increased leverage, but the company still had $750 million of unused U.S. debt capacity and strong free cash flow to fund future payouts.

What are the main risks in the Leasing and Investments segment?

The segment's largest exposure is to 1995–1997 mortgage investments structured with a third-party swap counterparty. ITW's expected future income from these investments is about $113 million, recognized through 2008, and it depends on the counterparty's ability to sell the underlying assets and pay ITW its $26 million annual cash flow. Management notes that the counterparty is AAA-rated and has guaranteed certain property values, which limits ITW's exposure to market declines. Other exposures include telecommunications and aircraft leases, with the 2002 United Airlines aircraft impairment as a reminder of credit risk.

How material is the Wilsonart laminate lawsuit?

Plaintiffs in the consolidated class action seek damages of $439–475 million before trebling, which could be very large if successful. Co-defendants have settled for $31 million and $9.5 million, and Formica's claims were dismissed after its bankruptcy, leaving Wilsonart as the sole defendant. ITW believes the claims are without merit, and it has recorded no reserve, so the outcome remains an open risk for investors to monitor.

What is the outlook for 2005 and what could change it?

ITW forecasts 2005 diluted EPS from continuing operations of $4.91–$5.11, assuming base revenue growth of 4.4–6.4%, $600–800 million in annualized acquisition revenue, restructuring costs of $30–50 million, Leasing and Investments income of $60–70 million, and a 33% tax rate. The company expects modest slowing in end markets. Risks include a downturn in construction, automotive, or industrial markets, weaker European or North American economies, currency and raw material cost swings, and changes in tax law.

ITW 10-K FY2004 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 4, 2005. Cited figures are marked; the original filing is the authoritative source.

Illinois Tool Works (ITW) closed 2004 with record results: operating revenues rose 16.9% to $11.73 billion^a, operating income grew 25.9% to $2.06 billion, and operating margin expanded 120 basis points to 17.5%.

Income from continuing operations reached $1.34 billion^b, or $4.39 per diluted share, up 30% from $3.37 in 2003. Growth was driven mainly by a 8.1% increase in base business revenue (9% in North America, 6% internationally), with acquisitions adding about 5% and currency translation about 4.4%. Operating leverage from base growth was the largest contributor to margin expansion.

Return on average invested capital improved to 18.5% from 16.1%. The balance sheet shows a deliberate shift in capital allocation. ITW repurchased about 18.9 million shares for $1.73 billion^c under an April 2004 authorization, which drove cash down by $1.02 billion to $667 million.

Acquisitions consumed $588 million across 24 deals, and total debt rose to $1.12 billion^d (12.8% of total capitalization) from $976 million, largely from commercial paper used for acquisitions. Free operating cash flow was $1.33 billion, comfortably covering the $305 million in dividends paid. Management guided 2005 diluted EPS to $4.91–$5.11 before SFAS 123R, assuming modest end-market slowing, base revenue growth of 4.4–6.4%, and a 33% tax rate.

Investors should weigh several items beyond the headline growth. The Leasing and Investments segment (about $132 million operating income) relies on a legacy 1995–1997 mortgage investment structure that is expected to unwind by 2008, with roughly $113 million of future income still to be recognized. Wilsonart faces a consolidated high-pressure laminate price-fixing class action seeking $439–475 million before trebling, which management calls without merit, and no reserve has been recorded.

International operations account for about 44% of revenue, exposing results to currency and foreign-market risk. Overall, the filing portrays a highly decentralized, 80/20-driven industrial company with strong cash generation and an aggressive buyback program.

02—Key points

Key Highlights

Record 2004 operating revenues of $11.73 billion, up 16.9% year over year, with base business growth of 8.1%.
Operating margin expanded to 17.5% from 16.3%, with operating income up 25.9% to $2.06 billion, driven by operating leverage and the 80/20 business process.
Diluted EPS from continuing operations rose 30% to $4.39; net income reached $1.34 billion.
ROIC improved to 18.5% from 16.1%, reflecting higher after-tax operating income and a lower 33% effective tax rate.
Repurchased $1.73 billion of common stock (18.9 million shares at an average $91.45) and completed 24 acquisitions for $588 million.
Free operating cash flow of $1.33 billion; cash fell to $667 million and total debt rose to $1.12 billion (12.8% of capitalization).
2005 guidance of $4.91–$5.11 diluted EPS before SFAS 123R, which management expects to reduce EPS by about $0.12 once adopted.

03—Questions

Frequently Asked Questions

What drove ITW's strong 2004 earnings growth?
Growth came mainly from an 8.1% increase in base business revenue, reflecting a North American industrial recovery (base revenue up 9%) and a 6% rise internationally. Operating leverage amplified this, since overhead does not scale with revenue. Acquisitions contributed about 5 points of revenue growth and currency translation about 4.4 points, while lower restructuring costs and the 80/20 process also supported margins.
How is ITW using its cash, and what does it mean for shareholders?
In 2004 ITW returned capital aggressively: it bought back $1.73 billion of stock under an authorization of up to 31 million shares, paid $305 million in dividends (with a payout objective of 25–30% of the three-year average net income), and spent $588 million on acquisitions. Buybacks reduced cash by about $1 billion and modestly increased leverage, but the company still had $750 million of unused U.S. debt capacity and strong free cash flow to fund future payouts.
What are the main risks in the Leasing and Investments segment?
The segment's largest exposure is to 1995–1997 mortgage investments structured with a third-party swap counterparty. ITW's expected future income from these investments is about $113 million, recognized through 2008, and it depends on the counterparty's ability to sell the underlying assets and pay ITW its $26 million annual cash flow. Management notes that the counterparty is AAA-rated and has guaranteed certain property values, which limits ITW's exposure to market declines. Other exposures include telecommunications and aircraft leases, with the 2002 United Airlines aircraft impairment as a reminder of credit risk.
How material is the Wilsonart laminate lawsuit?
Plaintiffs in the consolidated class action seek damages of $439–475 million before trebling, which could be very large if successful. Co-defendants have settled for $31 million and $9.5 million, and Formica's claims were dismissed after its bankruptcy, leaving Wilsonart as the sole defendant. ITW believes the claims are without merit, and it has recorded no reserve, so the outcome remains an open risk for investors to monitor.
What is the outlook for 2005 and what could change it?
ITW forecasts 2005 diluted EPS from continuing operations of $4.91–$5.11, assuming base revenue growth of 4.4–6.4%, $600–800 million in annualized acquisition revenue, restructuring costs of $30–50 million, Leasing and Investments income of $60–70 million, and a 33% tax rate. The company expects modest slowing in end markets. Risks include a downturn in construction, automotive, or industrial markets, weaker European or North American economies, currency and raw material cost swings, and changes in tax law.

04—Continue

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