Why is ITW changing how it reports its Leasing and Investments business?

Management plans to run off the Leasing and Investments portfolio and wants to use free cash flow for core manufacturing investments and acquisitions rather than new financial investments. Starting in 2006, its income will be reported as non-operating investment income instead of as an operating segment, which will make operating segment results more representative of the core manufacturing businesses.

How much of ITW's 2006 earnings outlook depends on the wind-down of investments?

Management expects nonoperating investment income of $45–$55 million in 2006, which is $75–$85 million lower than in 2005. Against 2005 diluted EPS of $5.20, the $5.60–$5.78 guidance implies growth driven mainly by the core business, which management projects to grow operating income by 9.4% to 13.0% excluding Leasing and Investments.

What are the main risks to ITW's business and results?

The filing cites a downturn in construction, automotive, general industrial, food service, or real estate markets; weaker global economic conditions, especially in North America, Europe, Asia, and Australia; foreign currency swings and raw material costs (metals, plastics, paper); difficulty introducing new products; a weaker acquisition environment; and unfavorable tax changes. Raw material costs and currency were both highlighted as headwinds in 2005.

What is the status of ITW's legal exposure, and does it matter materially?

The main case is a consolidated class action against subsidiary Wilsonart over alleged laminate price-fixing from 1994 to 2000, with plaintiffs seeking $470 million before trebling. Co-defendants settled for $31 million and $9.5 million, and Formica's claims were dismissed after its bankruptcy, leaving Wilsonart as the sole defendant. ITW says the claims lack merit, has recorded no reserve, and intends to defend the case vigorously. Other matters, including welding-fume toxic tort suits, are not expected to be material.

How is ITW returning capital to shareholders, and how sustainable is it?

In 2005 ITW repurchased about 12.1 million shares for $1.04 billion and completed a 31 million-share program that began in 2004. It paid $335 million in cash dividends and raised its declared dividend to $1.22 per share. With $1.55 billion of free operating cash flow and a total debt-to-capitalization ratio of 13.8%, management says internally generated cash is adequate to service debt, pay dividends, and fund acquisitions, though future buybacks are not committed in this filing.

ITW 10-K FY2005 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed February 24, 2006. Cited figures are marked; the original filing is the authoritative source.

Illinois Tool Works (ITW) closed 2005 with record results: operating revenues rose 10.1% to $12.92 billion^a, operating income grew 9.9% to $2.26 billion, and diluted EPS from continuing operations reached $5.20, up 18.5% from $4.39 in 2004 (income from continuing operations up 11.6%).

Operating margin held at 17.5%, and return on average invested capital improved to 18.7% from 18.1%. Growth was driven mainly by base business volume leverage, roughly 5% revenue contribution from acquisitions (22 deals for $627 million^b in cash), and favorable currency translation. Free operating cash flow rose to $1.55 billion from $1.25 billion, and the company returned capital through $1.04 billion of share repurchases (completing a 31 million-share program) and $335 million of dividends.

The dividend declared rose to $1.22^c per share from $1.04. The most important investor-facing change is the planned wind-down of the Leasing and Investments portfolio. That segment's operating income fell to $116 million from $132 million, and management said it will stop reporting it as a segment in 2006 and will reclassify its income as non-operating investment income.

The 2006 guidance reflects this: diluted EPS of $5.60 to $5.78^d, with nonoperating investment income expected at only $45 to $55 million, down $75 to $85 million from 2005. Remaining mortgage-entity exposure is about $292 million in net equity, with future income of roughly $36 million expected through 2008. Investors should treat the core manufacturing business as the primary earnings driver going forward.

Risks flagged in the filing include the Wilsonart high-pressure laminate antitrust class action, which seeks $470 million before trebling and where ITW has recorded no reserve, along with raw material cost inflation (steel, plastics, resin) and exposure to construction and automotive end markets. The company also reports effective internal control over financial reporting as of December 31, 2005, audited by Deloitte & Touche.

02—Key points

Key Highlights

Record 2005 results: operating revenues of $12.92B (+10.1%), operating income of $2.26B (+9.9%), and diluted EPS of $5.20 (vs. $4.39).
Operating margin stable at 17.5%; base business revenue grew about 4.4% in 2005, with North American base revenue up 5.8%.
Free operating cash flow of $1.55B (up 24%) funded $627M in acquisitions across 22 deals, $1.04B in buybacks, and $335M in dividends.
ROIC improved to 18.7% from 18.1%, supported by higher after-tax operating income and a lower effective tax rate (31.5% vs. 33.0%).
Leasing and Investments is being wound down and will no longer be reported as a segment in 2006; 2006 EPS guidance is $5.60–$5.78, reflecting a $75–$85M drop in nonoperating investment income.
Dividend declared rose to $1.22/share from $1.04; the stated payout objective is 25–30% of the three-year average net income.
Wilsonart antitrust class action seeks $470M before trebling; ITW believes the claims lack merit and has recorded no reserve.

03—Questions

Frequently Asked Questions

Why is ITW changing how it reports its Leasing and Investments business?
Management plans to run off the Leasing and Investments portfolio and wants to use free cash flow for core manufacturing investments and acquisitions rather than new financial investments. Starting in 2006, its income will be reported as non-operating investment income instead of as an operating segment, which will make operating segment results more representative of the core manufacturing businesses.
How much of ITW's 2006 earnings outlook depends on the wind-down of investments?
Management expects nonoperating investment income of $45–$55 million in 2006, which is $75–$85 million lower than in 2005. Against 2005 diluted EPS of $5.20, the $5.60–$5.78 guidance implies growth driven mainly by the core business, which management projects to grow operating income by 9.4% to 13.0% excluding Leasing and Investments.
What are the main risks to ITW's business and results?
The filing cites a downturn in construction, automotive, general industrial, food service, or real estate markets; weaker global economic conditions, especially in North America, Europe, Asia, and Australia; foreign currency swings and raw material costs (metals, plastics, paper); difficulty introducing new products; a weaker acquisition environment; and unfavorable tax changes. Raw material costs and currency were both highlighted as headwinds in 2005.
What is the status of ITW's legal exposure, and does it matter materially?
The main case is a consolidated class action against subsidiary Wilsonart over alleged laminate price-fixing from 1994 to 2000, with plaintiffs seeking $470 million before trebling. Co-defendants settled for $31 million and $9.5 million, and Formica's claims were dismissed after its bankruptcy, leaving Wilsonart as the sole defendant. ITW says the claims lack merit, has recorded no reserve, and intends to defend the case vigorously. Other matters, including welding-fume toxic tort suits, are not expected to be material.
How is ITW returning capital to shareholders, and how sustainable is it?
In 2005 ITW repurchased about 12.1 million shares for $1.04 billion and completed a 31 million-share program that began in 2004. It paid $335 million in cash dividends and raised its declared dividend to $1.22 per share. With $1.55 billion of free operating cash flow and a total debt-to-capitalization ratio of 13.8%, management says internally generated cash is adequate to service debt, pay dividends, and fund acquisitions, though future buybacks are not committed in this filing.

04—Continue

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