Illinois Tool Works Inc (ITW) 2003 Q3 法說會逐字稿

Good afternoon and thank you for standing by.

Welcome to the ITW 2003 third quarter earnings conference call.

All participants will be able to listen only until the question-and-answer session of the conference.

This conference is being recorded.

If anyone has any objections, you may disconnect at this time.

I would like to introduce Mr. John Brooklier, Vice President of Investor Relations.

Sir, you may begin.

Thank you, Jen.

Good afternoon, everyone.

And welcome to our 2003 third quarter conference call.

As noted, I'm John Brooklier, VP of Investor Relations and with me today, as usual, is Jon Kinney, our CFO.

Thanks for joining us today.

By now you should have received our third quarter '03 earnings release.

To summarize, we are pleased with our third quarter performance, which breaks down as follows: Income from continuing operations increased 10%.

Revenues grew 5% and operating margins of 16.9% were 40 basis points higher than the year-ago period.

We were clearly helped in the third quarter by better revenue income performance in September, largely as a result of some improvement in North American end markets.

However, we remain cautious and hopeful about sustained end market recovery in the fourth quarter.

In just a few moments, Jon Kinney will give you a full rundown of our performance for the third quarter.

Here's the agenda for today's call.

Jon will give you a financial overview of our 2003 third quarter performance.

I will then review our performance for our four manufacturing segments and associated end-markets.

John will then come back and address our fourth quarter and full year 2003 forecast.

Finally, we will open the call to your questions.

One long-standing request I do have, please, I'm asking each person to ask questions only related to the third quarter earnings and such person to ask just one question and one follow-up question so we can accommodate everyone who has a question within a reasonable period of time.

Please note that I will strictly enforce this policy for this and future calls.

Another housekeeping item -- I would like to remind everyone that this conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including, without limitation, statements regarding end market conditions and base business expectations for full year 2003 and the company's related earning forecast.

These statements are subject to certain risks, uncertainties and other factors which could cause actual results to differ materially from those anticipated, including without limitation the following: One, a downturn in the construction, automotive, general, industrial foodservice and retail or real estate markets.

Two, deterioration of global and domestic business and economic conditions particularly in North America, the European community and Australia.

Three, the favorable or unfavorable impact of foreign currency fluctuations.

Four, an interruption in or reduction in introducing new products into the company's product lines.

And finally, five, an unfavorable environment for making acquisitions or dispositions domestic and international, including adverse accounting or regulatory requirements and market values of candidates.

One last piece of business, the telephone replay for the conference call is 402-998-1849.

No passcode necessary.

The replay is good through midnight, October 30.

Interested parties can also access our webcast PowerPoint presentation at our ITW.com website, it is in the Investor Information section of our website, via the earnings presentations tab.

Now I will turn the call over to Jon Kinney.

Thanks, John and good afternoon, everyone.

Highlights for the third quarter are as follows: Revenues increased 5% over last year compared to the 5% increase in the second quarter.

Operating margins were up 40 basis points, in spite of a 3% base revenue decline.

Income per share from continuing operations increased 10% over last year, that's the highest growth this year and it seems like we have a trend going.

We were up 3% in the first quarter. 7% in the second quarter.

And 10% in the third quarter.

And if we hit the mid-point of our forecast for the fourth quarter, we will be up 13%.

I like the slope of that line.

Free cash flow continued strong at 350 million for the quarter.

On a year to date basis, free cash from operations was 744 million, that's 100% of our net income.

Return on invested capital was 16.3% for the quarter or 70 basis points higher than last year.

In short, I believe the third quarter represents solid performance in a continuing soft industrial market.

Our 5% growth rate was primarily due to three factors.

First, base business revenue declined 2.9%.

This performance was 150 basis points stronger than last quarter.

Second, translation increased growth by 4.9%.

This increase was 130 basis points lower than last quarter.

And third, the acquisitions increased revenue growth 3.5% and this performance was 140 basis points higher than last quarter.

Overall, our 5% revenue growth was a result of positive currency translation and acquisitions.

Continuing declines in our base manufacturing revenues reduced these gains.

Our 2.9% year-over-year base revenue decline was made up of a 3.2% decline in North America and a 2.2% decline internationally.

In North America, the 3.2% decline was 260 basis points lower than last quarter's decline.

Internationally, the 2.2% decline was 120 basis points weaker than last quarter.

In short, North American experienced a modest improvement and international experienced a modest decline.

John Brooklier will provide more details when he discusses our operating segments.

Turning to operating margins, we experienced a 40-basis point increase in the third quarter compared to last year.

On the negative side, operating leverage reduced margins 70 basis points.

In addition, acquisitions diluted margins 20 basis points and higher restructuring costs reduced margins 60 basis points.

However, non-volume-related improvements such as cost reduction, pricing, product mix, increased margins by 170 basis points.

This improvement continues to be driven by our 80/20 efforts and related restructuring activities.

Excluding restructuring expense and acquisition dilution, margins would have been 18.9% for the quarter.

Before I leave margins, let me update you on Premark's progress.

If you recall, Premark's margins were 9% when we acquired them at the end of 1999.

We set our target to improve margins to 18% by the end of 2004.

We ended 2002 with margins of 13%.

Our plans for 2003 call for margins at 15.7%, although year-to- date revenues are below plan and well below 1999 levels, our year-to-date margins are 16%.

In short, Premark margins are 30 basis points above this year's plan and we're within 200 basis points of achieving our original target of 18%, in spite of lower revenues.

In our leasing and investment segment, income was $6 million higher than last year.

This was mainly the result of gains on sales of properties and increased income from our venture capital investment.

As a result of the adoption of Financial Accounting Standard Board's financial interpretation 46, in the third quarter, we have deconsolidated our commercial mortgage subsidiaries.

These mortgage investments will be presented on the balance sheet as a one-line investment, net of related non-recourse debt and deferred investment income.

This net investment will be accounted for on a prospective basis using the equity method.

There was no cumulative effect recorded for the change in accounting.

In the non-operating area, other income and expense was favorable to last year by 11 million.

This was primarily due to lower translation losses from last year, which were about 6 to 7 million.

Higher gains on the sale of operating affiliates, about 3 million.

And higher interest income of about 2 million.

Our effective tax rate for the quarter was held at 35%.

Turning to our invested capital, inventory months on hand was 1.9 months and our DSO was 59 days, both in line with our prior performance.

The decrease in receivables and inventory were due to translation and improved asset management that offset a close to a $70 million effect on newly-acquired companies, which would, of course, increase receivables and inventory.

In short, we continued our tight control of working capital in the third quarter.

Capital expenditures for the quarter were 61 million and depreciation expense was 70 million.

On the financing side, we reduced our debt 563 million from last quarter.

The debt reduction was mainly due to the deconsolidation of commercial mortgage subsidiaries in connection with the adoption of FASB's FIN 46.

Our debt to capital ratio declined from 19% to 12%.

This was also a result of the above deconsolidation.

Our cash position grew mainly because of our strong free cash from operations exceeded our acquisition and investment activity.

Free cash for the quarter was 350 million.

During the quarter, we spent $74 million on acquisitions, $71 million on dividends, 67 million on investments and $22 million on debt reduction.

Free cash exceeded these expenditures and our cash position increased $139 million in the quarter.

Our third quarter return on invested capital improved approximately 70 basis points to 16.3.

On a year-to-date basis, our returns are 15.8%, or 90 basis points higher than last year.

Considering our cost to capital is in the neighborhood of 9 to 10%, we continue to expand the economic profit that creates value for our shareholders.

Finally, on the acquisition front, we acquired nine companies in the third quarter with total revenues of 231 million at an aggregate purchase price of $74 million.

Our current acquisition backlog continues strong and coupled with the year-to-date activity we should achieve 400 to 600 million in acquired revenues by year-end.

Before I leave acquisitions, let me update you on the divestiture of our consumer segment.

Florida Tile is the last company to be sold and it's still, you've heard this for three quarters, it's still in the final stages.

We continue to hope that we will get this deal closed in 2003.

We are currently estimating no significant gain or loss in the sale of the consumer segment.

Now, John Brooklier will finish our review of the quarter with a discussion of our manufacturing segments.

Thank you, Jon.

Before I give you additional color on our manufacturing segments, here's an update on some key economic data that we focus on and report to you on a quarterly basis.

We believe these particular data points serve as a fairly reasonable proxy for our diversified end markets.

First of all, the Institute for Supply Management continued to be generally more positive indexed throughout the third quarter, while the ISM index of 53.7% in September was down slightly from 54.7% in August.

Both plus-50 numbers are encouraging.

Most of you know that the 50% level is the line of growth/no growth for the index.

Perhaps even more encouraging is that ISM's new order index reached 60.4% in September, up from 59.6% in August.

U.S. industrial production data, excluding technology, came in at minus 2.3% in August and that was slightly worse than the minus 2.2% in July.

Two things to note here.

The declining August numbers underlie our weaker base business performance in August.

Secondly, given the snap back in business that we saw in North America in September, we suspect the industrial production number for September will show some improvement.

Coincidentally, that number did come out this morning and it came in at minus 1.6%.

So, an uptick there.

Some improvement there.

Internationally, the key data points for Europe were mixed.

The euro's own purchasing manager's index improved to 50.1% in September, and that's up slightly from 49.1% in August.

Similarly, industrial production improved for the euro zone, it was at minus 0.4%.

In Germany, it was at 0.5%, or plus 0.5% in July.

On the other hand, industrial production for the U.K. declined to minus 0.5%.

France, which came in at minus 1.1%, was essentially flat with the prior month.

Now let's review our four manufacturing segments.

North America Engineered Products -- for the third quarter segment revenues increased 1.2% and operating income grew 2.2%.

Operating margins of 16.9% improved 20 basis points from a year ago as margin gains from Wilsonart and other ITW construction businesses were partially offset by weaker third quarter performance from our automotive units.

Looking more closely at revenues, the 1.2% increase in top line consisted of the following: We got a benefit of 3.7% from acquisitions, benefit of 0.3% from translation and that was offset by minus 2.6 from the base and minus 0.2 from other revenue.

So, again, those numbers very quickly -- plus 3.7% from acquisitions, plus 0.3% from translation, minus 2.6 from the base and minus 0.2 from other revenue.

Now, let's take a closer look at the business units.

Construction, as most of you know, is the largest part of this segment and its third-quarter performance was the best in the segment.

In total, our construction units grew base revenues 2% in the quarter.

That's the first increase in base revenues we've had all year in construction and it's attributable to the improvements in both our ITW construction businesses, which consist of Paslode, Buildex and Ramset/Redhead and our Wilsonart business.

The ITW construction businesses increased base revenues 6% in the quarter, thanks to top-line improvement in virtually all of the units.

The components of growth were as follows: Commercial construction and new housing revenues were slightly positive year-over-year and renovation rehab grew revenues low double digits -- I should say low single digits, in the high-pressure laminate business and the quarter was essentially flat year-over-year.

And that's after being down approximately 10% in the first half of the year.

Wilsonart generated its first positive base revenue number in September with low single-digit performance.

Given the fact that Wilsonart has large commercial construction revenues, it's apparent that the commercial side of their business got a little better, particularly in the flooring unit that has a commercial flavor to it.

Looking ahead, we still believe it's too early to call for continual improvement on the commercial side of construction.

We also believe that our units supplying the new housing segment will continue to benefit from a housing start rate which was 1.8 million units in August or 11% to 12% higher than a year ago.

Historic low interest rates continue to underpin growth in this segment of construction.

Finally, we have a higher degree of confidence that the renovation rehab businesses stand a better chance for ongoing growth given our product mix and penetration into the box stores, such as Home Depot and Lowes.

Moving to automotive in North America, the third quarter base revenues declined 8% thanks to a 9% decrease in auto production by the big three in the quarter.

It's clear that our penetration suffered a bit during the quarter, but we believe it was due to unusual events such as the blackout in the eastern part of the country and the hurricane that struck the East Coast in September.

Here are the details of the 9% decline in big three auto production.

GM was down 5%.

Ford declined 18% and Chrysler dropped 6%.

Looking ahead to the fourth quarter and full year, we're still forecasting auto production to be down 8 to 10% for the quarter and 8% for the year.

We have to admit that's a more conservative forecast than you're going to get from Ward's Auto Tracking Service, which is currently calling for a production drop of 4% for the quarter and down 6% for the year.

As we always say, we hope they're right and we hope we're wrong in this particular case.

Current inventory levels are at reasonably healthy days on hand level of 62 days.

The breakout among the big three is GM at 57 days, Ford at 69 days and Chrysler at 66 days.

In our industrial products category of businesses in the segment, base revenues were down 5%, and that's similar to the second quarter.

Our industrial plastics and metals businesses, which serve appliance manufacturers and other OEMs were down 8% in the quarter.

We also had low single-digit base revenue declines for our polymers and fluids businesses.

The sole growth business in the category was mini grip zip pack which saw base revenues increase high single digits in the quarter.

This project sell business to the food industry continues to invent new and exciting packaging applications for a growing number of customers.

Moving to our second segment, International Engineered Products.

For the third quarter, segment revenues grew 16.8% and operating income increased 7.3%.

Even with the improvement in revenues and operating income, third quarter operating margins of 13.8% were 120 basis points lower than a year ago, due to higher restructuring costs in the third quarter.

Now let's take a closer look at the top line.

The aforementioned 16.8% increase in revenues consisted of the following: 13.9% from translation, 2.2% from acquisitions and 0.7% from the base.

Again, those numbers are 13.9 from translation, 2.2 from acquisitions and 0.7% from the base.

Similar to North America, the principal business groupings in the segment are construction, auto and industrial-based.

In the third quarter, base revenue growth of approximately 1% was led by construction.

In construction, third quarter base revenues grew 2% on a year-over-year basis and were slightly better than the 1% base revenue growth we had at the second quarter.

By geography, the growth in the third quarter base revenues broke down as follows.

Europe was plus 1%.

Australasia was plus 1% and Wilsonart International was plus 6%.

Growth in Europe emanated from better top line in France, Germany and the U.K.

In Australia, the modest growth in the third quarter was attributable to increased sales of tools and fasteners, to the new housing sector.

Wilsonart International had another good quarter of growth as institutional construction activity in China and the U.K. helped improve their top line.

Our automotive businesses in Europe posted a 1% decline in base revenues versus 3% growth in the second quarter of '03.

Auto builds year to date were down 3% and we expect they could go down another full point by the end of the year.

Year to date bills were as follows: These were mostly negative as you would imagine.

BMW was down 3.5%.

Fiat down 13.3.

Ford down 2.9.

VW group down 5 and Daimler down 4.5%.

The only growth was registered at GM, they were up 6.2%.

The remaining part of the segment is the industrial-based business units, base revenue performance for these businesses was flat in the third quarter, which is slightly better than the minus 1% performance in the second quarter.

The units that improved the most included fluid products, moving from 2% in Q2 to plus 4% in Q3 and electronic component packaging moving from minus 6 in Q2 to flat in Q3.

Moving to the system side of the business, in North America specialty systems, for the third quarter, segment revenues decreased 0.9% and operating income grew 6.1%.

As important, operating margins of 18.2% were 120 basis points higher than a year ago, thanks to better operating leverage in a number of business units, particularly food equipment, decorating and welding.

Focusing on the top line, the 0.9% decline in revenues consisted of the following: Plus 2.2% from acquisitions.

Plus 0.5 from translation.

And minus 3.6% from base business.

Again, those numbers very quickly, plus 2.2 from our acquisitions.

Plus 0.5 from translation and minus 3.6% from base business.

The third quarter story for this segment centers on marginally better base revenue performance which translated into significantly enhanced income performance, thanks to ongoing 80/20 programs.

Case in point, while our food equipment base revenues were down 8% in the quarter, operating income grew significantly and operating margins improved more than 500 basis points in the quarter.

The food equipment business is still battling weak top line trends in the supermarket, or what we call food retail part of their business.

Trends in the restaurant and institutional part of their business, what we term foodservice, and our parts to service business, are better, but our corresponding revenues are anywhere from down modestly to flat.

Clearly, our 80/20 initiatives continue to mine gold here and we're excited about the future when revenues return and we get even better leverage from these food units.

In industrial packaging, our signal business saw its base revenues improve to minus 4 in the quarter, thanks to a pickup in the sale of consumables to a broad array of end market users, such as metals, general industrials, fiber, and corrugated box.

That minus 4% base revenue compares to a minus 7 base performance in the second quarter.

Whether this improvement is sustainable remains to be seen.

In welding, base revenues actually improved to plus 3 in the quarter.

That compares to a minus 2 in the second quarter.

We believe that the demand for welding products in the construction side of the business has helped to boost top line as have some price promotion programs designed to help get additional market share.

The other good news is that the welding business was able to move margins up 100 basis points in the quarter.

Finally, our finishing business, which is essentially a paint spray components operation, saw its base revenues decline 5% in the quarter.

The impact of fewer auto builds in Q3, coupled with weak demand for industrial paint applications continued to impact their top line.

Moving to our last segment, International Specialty Systems, for the third quarter, segment revenues increased 14% and operating income grew 16.6%.

Operating margins of 10.6% were 20 basis points higher than the year earlier period.

Margins would have been significantly higher had it not been for restructuring expenses of approximately $10 million in the quarter.

Taking a closer look at the top line, the 14% increase in revenues consisted of the following: Currency translation added 12.4%.

Acquisitions added 6.3% and base business was down 4.7.

So, 12.4% for translation. 6.3% for acquisitions.

And base declined 4.7%.

In our total packaging category, that's both our industrial packaging and consumer packaging, base revenues were down 9%.

This was mainly due to SIGnote Europe's performance which saw base revenues decline approximately 10% in the third quarter.

SIGnote Asia also saw its base revenues move to minus 2 in Q3.

The commonality with North America is that any demand we are getting for industrial packaging relates to plastic and steel consumables rather than any type of machinery.

There was better news in food equipment, international.

Base revenues were up 3% in the quarter versus minus 1 in Q2.

Demand for product internationally was tied to commercial dish washing and refrigeration, typically for large institutional purchasers such as hotels and airports.

As we said before, the story in this business continues to be improved profitability and better margins, case in point: Food equipment operating margins were more than 400 basis points higher than the year-ago period.

Finally, our finishing units had base revenues of minus 5 for the quarter, which is down from plus 1 in the second quarter.

The finishing businesses generally serve the automotive and general industrial sectors in Europe.

The decline in auto production in the third quarter clearly had an impact on their top line.

This concludes my formal remarks.

So I am going to reintroduce Jon who will walk you through our fourth quarter and full-year forecast.

Thanks, John.

The modest improvement we've had in the third quarter was an encouraging sign.

We have built in a continuation of these gains into our fourth quarter forecast.

We are forecasting fourth quarter income per share from continuing operations to be within the range of 79 to 89 cents per share.

The low end of this range assumes a minus 3% decline in base revenues and the high end assumes a minus 1 decline.

If we hit the mid point of this range, we will be up about 10 cents per share or 13% higher than the fourth quarter.

For the total year, we have raised the forecast range from $3.23 to $3.33 per share.

The base revenue growth supporting this forecast is expected to be in a range of minus 3 to minus 2%.

Overall, if we hit the mid point of this range full year income from continuing operations of $3.28 per share would be 9% higher than last year.

We certainly believe this would be solid performance in light of a continuing 2.5% decline in base revenues.

Other assumptions underlying this forecast are exchange rates holding at September 30 levels.

Acquired revenues in the $400 to $600 million range.

Restructuring costs of 65 to 70 million.

No further goodwill and intangible impairment costs for the balance of the year and a tax rate of 35%.

Okay, John, back to you.

Thank you, Jon.

Now we will open the call to your questions.

Thank you.

At this time we are ready to begin the question-and-answer session of the conference.

If you would like to ask a question, please press star 1 on your touch-tone telephone.

You will be announced by name and firm name prior to your question.

To withdraw your question, please press star 2.

Once again, to ask a question, please press star 1.

One moment.

Our first question comes from Deane Dray of Goldman Sachs.

You may ask your question.

Yes, hi, good afternoon.

Can you give us a sense of what kind of restructuring activities went on in the quarter and then summarize what went on year to date?

And what sort of payback should we be expecting?

What kind of timeframe, please?

Yes, our restructuring projects are -- number in the hundreds, in terms of open projects.

And they cross all segments.

I think if you looked at this last four quarters, we probably had a disproportionate amount of restructuring in our system's international side of the business and I think on that chart that we showed we have a significant cost improvement in that area, roughly 40% of our last four quarters restructuring, excluding this quarter, last four quarters of restructuring were within that segment.

What was the balance of that?

That was kind of a two-parter!

Yes, it was.

How much of that, Jon, can you quantify the total restructuring expense that's been flowed through?

And how much of that is cash?

And what's the payback?

Yeah, it's roughly, I want to say $20 million, yeah, in the $20 million range and the payback's a year or less.

And it's not -- the vast majority of these things tend to be severance-related costs.

We had some blank (ph) closing costs associated with that in there, but it's primarily a cash transaction that will happen over the next few months.

And payback?

About a year, or less.

Okay, good.

Thank you.

Our next question comes from Andrew Casey with National Equity Group.

You may ask your question.

That's a new one.

It's Prudential Equity.

Good afternoon.

I was going to ask you Andy if you changed firms.

Yeah.

It hasn't been that long, I guess.

Just a question on the acquisitions, what are you seeing out there and kind of what's the profile?

Is it still the same profile that you would prefer?

Or are some of the larger companies starting to look at reducing their debt by selling off pieces?

Thanks.

I think it's pretty much the same profile -- that $20 to $30 million company that's ideas bubbling up from our operating units.

That's primarily what we're seeing.

We see a little bit of the other, the disposal and we've looked at some disposals from venture capitalists, too.

But the mix is, I don't see much difference in mix at this point.

And the follow-up to that.

Thanks, Jon.

Is it starting to accelerate at all?

Or is it the same kind of rate that we've seen in the last.

We've, got probably enough of a backlog to accomplish what we're looking to this year and just from talking to folks, yeah, there's a little bit higher activity in terms of businesses we're talking with.

Thank you.

Our next question comes from David Raso with Smith Barney.

You may ask your question.

Hi, good afternoon.

Hi, David.

This question relates to the comment about September being better-than-expected.

Just trying to think through and I know my model, the Specialty Systems North America was part of the upside, the bigger driver to the upside.

Where were you seeing it?

And looking at what the core growth was for the full quarter, versus the two months that we already had, it looks like Specialty Systems North America and Engineered Products North America were the better-than-expected.

Can you help us understand where you're seeing it?

I'm trying to get a feel for the operating leverage.

I mean SSNA put up nice margins, but then you mentioned SIGnote was more consumable.

I was kind of hoping to hear it was more CAPEX driven to really drive the leverage.

Can you help us understand?

Yeah, we were hoping that too, but it's not the case.

If you look at a couple of things.

One, we said North America was better and you hit it on the head.

Systems was the better piece.

Systems businesses, the base in September, was up about 5%.

That's the strongest number we've had.

And EP North America was essentially flat and they've been running down sort of low single digits prior to that.

On the systems side of the world, most of the improvement came from businesses such as our welding unit, where base revenues were high single-digit improvement.

Finishing actually had some improvement that was up about 10% in the month.

And total packaging and I say the word total, David, I'm including both our consumer and our industrial packaging businesses, they were up sort of low single digits.

As important our food equipment business in the month actually was flat.

I mention that only because food equipment has been running down about 10%, on average over the last three to four months, so, to the extent they got back to zero certainly helped in the month and helped in the quarter and helped from a leverage standpoint.

Okay.

And welding was in that division, SSNA is a pretty high margin, I guess, so that helped, but I'm trying to square up September in the divisions that especially specialty systems speaks to, hopefully beginning CAPEX, the September comment is intriguing, but then you put out a still cautious guidance.

Part of the problem we're having is trying to figure out the improvement in September, particularly on the systems side of the world, is it more related to pickup and demand or is it more related to companies not doing anything in August because of all the peculiarities in August and they pushed it back and have rolled into September.

Some of it's obviously -- we always have the timing issues with these businesses, too.

Our sense is we think it's a combination of both, but I can't give you an order of magnitude.

Thank you very much.

John and I are used to, when we talk amongst ourselves, reminding each other that one month doesn't make a trend and August was one of our worst months in terms of year-over-year comparison in North America and clearly September was one of our best months.

So, how much was the types of things that we talked about?

The average of those two is minus 2.5%.

So, I wouldn't base a whole bunch on just our September numbers.

Although we are pleasantly surprised by them.

Our next question comes from Gary McManus from JP Morgan.

You may ask your question.

Good afternoon, guys.

Hi, Gary.

Just getting back to the acquisition side, I notice in the third quarter you only spent $74 million to get $230 million of annualized revenues.

So that's only like 30 cents on the dollar.

First of all, it must be a lower margin business, I assume.

But still -- this question seems to get asked every quarter, but you're sitting with so much of an underleveraged balance sheet, you've got now more cash than debt.

Are you going change anything to pick up the pace in terms of cash used for acquisitions because you got the nice problem of a really strong balance sheet?

There are a couple of things going on.

One, the difference in the revenues versus the cash flow.

The majority of that is due to the fact that we increased our ownership of a business that we now have over the 50% necessary to fully consolidate it.

So, what you saw in there is the price we paid for about 18% of this company, whereas the revenue side shows the full consolidated impact of that business.

And we also bought, one of the properties that we bought was Acme was a distress-type property, so we had a discount.

My second question is that, are you going to change how you look for acquisitions because you've got the problem of having such a strong balance sheet, I mean you're generating so much more cash flow than what you're able to use for acquisitions.

Are you still going to be patient and be disciplined in looking at acquisitions?

Or are you going change the process on how you're looking for acquisitions?

Not at this point.

Okay.

You're continuing to let cash pile up on the balance sheet?

Yes.

At the moment, yes.

Okay.

Thanks.

Thank you.

Our next question comes from David Bleustein with UBS.

You may ask your question.

Good afternoon.

It's really following right on to Gary McManus's question.

Are you planning on more subtle changes, like redoing the acquisition seminars that you'd done in the 1990s or anything to turbo-charge the process without changing your standards?

There's nothing in the planning at this point.

We've got all eight of our EVPs are very aware of acquisitions as a strategy for their business.

They're also very aware that reducing the returns on our business will have nothing but a deteriorating effect on our multiples and that over the long-term, I mean we can have increased earnings per share until we're blue in the face, in fact, until we're so far in debt that we would go bankrupt, it's not hard when your debt cost is 2%.

So, no, I don't see any change yet.

We're still actively working.

We've got lots of people looking at companies and --

I would add to that, David, I think what we think has changed is that -- our perception is the environment looks like it's more promising, certainly more promising now than it was three to six months ago.

If you notice the subtle change Jon made when he made the forecast assumptions that acquisitions $400 to $600 million for the year, which is a move up from where we were before.

Pipeline right now we have a number of deals in there that represent close to $400 million worth of acquisition possibilities.

So, I think that if we're looking for a change, we're really looking back for an environmental change in terms of the market.

In terms of our ability to close deals.

Which would allow to us use more of our cash, obviously, to get these deals done.

Certainly.

You mentioned it's picking up.

Is it picking up in part because the price expectations have come down into what is now an acceptable range?

Or, why do you think it's getting better now?

I think it's the whole perspective in terms of price.

I think people selling are much more realistic now than they were two or three years ago.

They remember the late '90s and everybody is realizing that those days don't look like they are going to come back any time soon.

And you couple that with a lot of the businesses that we participate in are anywhere from 15% to 20% below revenues in North America.

And that's not a wonderful time to be marketing your business and ITW is down in the 13%, 14%, 15% range from 2000 peak levels.

So, that is not a great environment for folks to go off and market their business or even want to talk about it.

That's another factor.

Got it, well, thanks.

And by the way, the slides were great and thank you for those, too.

Sure.

Thank you, our next question comes from Mr. John Inch with Merrill Lynch.

You may ask your question.

Thank you very much.

Good afternoon.

Hi, John.

Hi, John.

I know you don't always get a mid-month read, but in keeping sort of with the trend of September, do you have any sense of how business has thus far performed in the first half of October?

Even anecdotally?

No.

No, we really don't at this point.

I've had this conversation with you and other people, John, that you can ask three or four different people and you can hear good, bad and then you look at the numbers and they still don't foot (ph).

It depends on the people you're talking to.

And I don't think we have any clear read on what's happening on the North American side at this point in time.

No sense of what you saw in September [Inaudible].

Maybe you can talk a little bit about September, was it consistently strong throughout the month or was it sort of a surge in the middle or was there any color into the way the month delineated?

No, no.

We really don't track it on a sort of day-to-day or week-to-week basis.

That's fair.

Just as a follow-up question, I want to ask you, Jon Kinney, on Premark, you mentioned that basically you were ahead 30 bips [ph] ahead on margin targets.

But Premark sales, versus when you first bought it, are materially below where you would have expected at this point in 2003.

So, I'm just wondering, Jon, from a profit contribution basis, how far below are we in terms of where you had expected in kind of an absolute dollar number?

If you could do it that way?

Let's see.

We're probably in the year say $60,000.

Less than a doubling of earnings.

$60,000?

No, $60 million, excuse me.

Okay.

Right.

That's what I was looking for.

Okay, thanks, guys.

Thank you.

Your next question comes from Mark Kosnarnik with Midwest Research.

You may ask your question.

Hi, good afternoon.

Hi, Mark.

Kind of a general question first on the EP businesses because if you kind of match up sales versus operating income, it looks like the changes were basically one for one.

In other words, there is no leverage in those businesses in the quarter and you're getting all of your leverage, and I'm talking about base not all the adjustments below the line, all the leverage was in the systems parts of the business.

So, can you address sort of, I know there's a lot of moving parts, but in general why we're not getting leverage and what we might expect that you have in -- plans you have in place to generate more leverage out of the growth there?

This is in Engineered Products North America?

Yes, let's start with that.

I mean, looking at your slide, revenue is down 3%, income down 3%, on the base business.

On the base business, yeah, revenues were down 3%, income was down 6%.

Yeah, that's negative operating leverage.

We didn't offset it, but we certainly improved our cost structure 3% to reduce that.

There's not many businesses that hold margins on a 3% revenue decline.

And that's basically what we did.

We held margins.

So, I guess one of the businesses that did do it is Specialty Systems North America, where it was also down a little more than 3%, but your base was up 4%.

So, I mean maybe I'm expecting too much out of the EP businesses, but I'm just wondering why --

EP businesses have higher margin than our specialty systems businesses and we have been focusing pretty heavily on restructuring those areas and that's why you're seeing the larger cost improvements in both the systems North America and systems international.

So, basically more runway in those two for improvement.

Yes.

And then kind of a more specific on EP North America, is a really nice improvement here in the construction statistics, your commercial up 1% relative to down 9% or high single digit in the last quarter and residential making a nice improvement, too, and I'm not aware that general construction and spending improved that much, so, what was it specifically that ITW was doing to move the needle?

Well, I mean, if you look at the specific end markets, part of it is based on some general improvement and part of it is based on our ability to penetrate vis-a-vis product, whether it's a Paslode tool, whether it's a Ramset system or whether it's a new Buildex type of a product.

So, it's a combination of both product and what we think are better, I'm not going to say great, but better end market conditions.

We're not trying to say that commercial has improved dramatically, but it looks like it's gotten better from where it was six months ago.

And our ability to sell product and penetrate on the commercial side, whether it's Buildex or Ramset/Redhead, looks like it's helped us on the top line.

Well, John, that penetration thing, I'm just wondering is there a major new product rollout or is there a new big box you got into or any one or two major things?

Well, I mean the renovation side has been consistently a pretty strong number for us, Mark.

You know that.

Yeah.

We've talked about our ability to get into Lowe's and get better penetration there.

That helped us.

But I'd say generally, the end market economics there, buying patterns have been consistently pretty strong.

I think when you move into the commercial side of the world, it's a different story, not nearly as good but still looks like it's improved a little bit and our ability to continue to try to sell existing and some of the newer products, no big product launches, but newer innovations, looks like it certainly helped us from a penetration standpoint and I'd say the same would be true on the housing side, the ability to sell Paslode, cordless tools, pneumatic, the systems that go with them.

Nails, so on and so forth.

They all add up.

Okay.

Great.

Thank you.

Our next question comes from Robert McCarthy with RW Baird.

You may ask your question.

Good afternoon, guys.

Robert.

Wilsonart.

Jon, where are -- well, is Wilsonart, since the time you acquired Premark, is Wilsonart down more or less from the food equipment business and where are their operating margins relative to when they were acquired?

Their operating margins from the time they were acquired are up.

I'm not going to tell you exactly where they are, but they were --

Can you give us an idea, how much they've changed?

Yeah, 500 -- 400 basis points.

Okay.

And that's a combined number, right, Jon?

That's combined.

North America and international Wilsonart.

And the question about whether they -- are they down more from the time you bought them than food or less?

No, they're both about down the same.

Down the same.

Okay.

And then regarding outlook, you boosted your restructuring expense estimate for the year a little bit.

So, I'm wondering what's behind that and what you're assuming from L&I in the fourth quarter in your outlook?

L&I on a year-over-year comparison -- well, first L&I absolute numbers, probably in the $18 to $20 million range.

Okay.

For the fourth quarter and that will be about 2 cents a share down from where they were last year, if you recall last year we had a significant mark-to-market adjustment.

Yes.

And also the write-off of airplanes.

But that was still a net-big positive and so we're going to be 2 cents shy on that.

The restructuring expense, we had a very heavy quarter this quarter and we expect at least from what we're hearing to incur about $15 million in the fourth quarter and that should put us about even with the prior year.

It could be a little bit higher than that, I guess.

So, we should pick up 2 cents from the year-over-year comparison on restructuring in the fourth quarter.

And that's all bottom up driven?

I mean you just had more stuff come in than you assumed earlier?

Yes.

Okay.

Well, this is hard to predict, you know?

You got a lot of people out there that are thinking and working and on projects and we're not the first to hear about them.

So, like I mentioned, we have a couple of hundred projects open and they come in on a regular basis and there are quite a few bunched up in this quarter.

I understand.

Thank you.

Our next question comes from Joel Tiss with Lehman Brothers.

You may ask your question.

Hey, guys, how you doing?

Hi, Joel, how you been?

All right.

On the welding business you mentioned that you lowered the prices a little bit and the margins are up.

Can you give us any sense on if there's any margin deterioration in the pipeline?

Or how that's going to impact the business in the future?

No, we don't think so.

Remember that there were some price promotion programs that took place in the quarter, for one of the months, which helped, that didn't last, I don't think it lasted more than a month.

I think that if you look at the profile of the welding business with their components and the machinery side of what they do, those are pretty healthy margins and we don't foresee any margin deterioration.

In fact, knowing Frank Ptak, our Executive Vice President, I don't think he'd stand for any margin deterioration in welding.

I don't think that's the case at all.

Okay.

Because I just see Lincoln being pretty aggressive out there also.

Yeah.

Can you guys also talk about your tax rate?

Is there anything else you can do on the planning side to try to push it down closer to 30%?

Closer to 30?

Thank you very much, yeah, we can move our European production to somewhere very far off shore.

No, I don't see us getting to 30.

We've got a very active tax planning group and we're working on a number of projects that could yield some nice savings but it would be more in the area of a half to 1% type of improvement and those are being worked on.

But I don't see too many 30 percents out there.

Okay.

Thank you.

Sure.

Our next question comes from Walt Liptak with McDonald Investments.

Thank you.

Good afternoon, guys.

Hi, Walt.

In your North American automotive business, through the declines over the last quarter or two, have you been able to maintain margin or has there been margin deterioration?

I assume that's been the case?

There has been some, yes, clearly.

We got deleveraged in the business and when production goes down to that magnitude, it's very difficult to try to fend off margin deterioration.

So, there has been some deterioration.

I wouldn't describe it as a huge number, but they've certainly lost some margin.

Would you describe it as below the corporate average?

No, no.

Okay.

And the outlook that you have which is more pessimistic than Ward's automotive, why is that?

And I guess as a follow-on, what are the incremental margins, if you get say $50 or $70 million of higher-than-expected revenue?

The first part of the question is I think that they probably want to take a look at October builds to get a sense of what things look like in the fourth quarter.

We may be revising our production schedule.

Our forecast in terms of production.

Stay tuned for that.

In terms of the incrementals, I don't know, Jon, do you?

No, I don't have the automotive numbers in front of me.

So, I'm just sitting here with --

But presumably it would be something higher than the corporate average?

Oh, sure.

Oh, the incrementals?

Yeah.

You can figure in the 30% range.

Okay.

Okay.

Thank you.

Thank you.

Our next question comes from Bob Atchison with Adage Capital.

You may ask your question.

Yeah, thank you.

Guys, just on the restructuring, I just want to try to make sure that we got a good handle on it.

You say $60 to $65 million in '03, I know that it's a little hard to predict, but, Jon, can you give us any idea as you see the pipeline now, what an '04 level of restructuring spending might be?

Is it going to be again another $60 to $65 million, or is there much of a Delta around that number?

I think we could very easily be in the $50 to $60 million range next year.

We've got, that last part of the '90s and 2000, we had a boatload of acquisitions.

Yeah.

The business, right, was acquired in that period of time.

And there's still lots of businesses that need work.

So, I think there's still plenty of opportunity for margin gain vis-a-vis a restructuring and the last two points on Premark aren't going to come easily, either, there's still work to be done there, alone.

Okay.

Got it.

I got interrupted, forgive me if this is a repeat, but on the auto side, you were down 8% on about a 9% drop on production in North America.

Normally your penetration is much better than that in terms of just your content per car and can you help us with any changes that might have occurred as far as platforms you might have fallen off of or any nuances you can give us on that?

And what your expectation is assuming flat auto production.

What would your expectations be for your Delta over that?

As I tell people, it always, the number doesn't always equate to the month number or sometimes even in the quarter.

But you would expect in North America that penetration would be plus 3 to plus 4 points of growth.

We only got 1 in the last quarter but there were, as I noted, there were a lot of sort of peculiar events that took place.

A model changeover in the quarter, also, hampers penetration a bit.

You would expect penetration to get better in the fourth quarter and in the first quarter of next year in North America.

John, is there some sort of a catch-up off of that low penetration in the quarter?

Or is it just sort of back to a 3 percentish sort of plus?

I think it gets back to 3% to 4%.

Okay, thank you.

Our next question comes from Andrew Casey with Prudential.

You may ask your question.

Thanks.

Just a follow-up on Bob's question, Jon, I think I recall in the monologue that you were talking about a timing issue on North American automotive, kind of adding to the difficulty of penetrating against the underlying builds.

With that timing issue, is the 3% to 4% kind of a conservative estimate or is that just flat out what you expect?

I think that's what we expect.

I think 3% to 4% has been sort of the number that over the last couple of years, it's been a more realistic number in North America and we're doing a little bit better than that on the international side.

But 3% to 4% is, I think, a number you should build in to your expectations.

Okay.

Thanks.

Our next question comes from David Raso with Smith Barney.

Hi, quick question on the leasing that was the second area for some upside to my model.

I wanted to understand the $6 million higher income year-over-year basically from the venture capital and the properties held for sale.

Before I address that, was there any change at all in your rate of accrual for the guaranteed profits you have on the commercial mortgages?

The profits, the tax benefit, anything?

The whole accounting structure changed.

But since I guess maybe since the conversation we had before on this, since the FIN 46.

I mean because the year-over-year change you're saying wasn't so much that.

No, it wasn't.

Not at all.

We were, as we talked last quarter and then in the earlier months of this quarter, we were uncertain of what the impact was going to be.

We were looking at all kinds of alternatives for doing this.

And we settled out on an equity method of accounting that's used in partnerships similar to the partnership that we have with our third party finance company.

And so it's going to be a much, I will say the income recognition will be much smoother under this method in that it doesn't require any mark-to-market adjustments.

What will create volatility, of course, would be sales of properties, if all the sales of properties happen on the last day of the 10-year contract, it would be a smooth deal, but we are selling properties as we go along here and there will be step-ups in -- not step-ups, but there will be gains or losses on the sale.

So, I think we've got a much more stable accounting method that fits nicely within the generally accepted accounting requirements for partnerships of this nature.

Well, that said, the $6 million gains seems a bit large when I think the venture capital plus all the properties held for sale were only about $40 million going into the year and we just put up $6 million in gains, which is a pretty big gain.

Did you kind of clear the decks, then, are there any properties left held for sale?

Did you close the venture capital agreements?

What was it?

Well it was, as we've mentioned, we've had properties developments that gain was in the $2 million range.

Venture capital was in the $2 million range and then we had a couple of properties sold also in our commercial mortgage area.

So, I mean there was nothing, the venture capital thing was a mark-to-market situation but the majority of it was a public company within the venture capital activity that we have.

So, that's about as real as you get and mark-to-market accounting is the name of the game there.

So, I mean it's as complex or as simple as that.

So, going forward you're saying it's smoother, should we think then kind of baseline is $19 million per quarter?

Yeah, I think that's right.

I mean we've -- we'll be in -- next quarter we've made some new investments, we think we'll have $3 million of additional income there that would offset some of these sales that may or may not be there next quarter.

That's why that $18 to $20 million seems right.

Now, we do share responsibility on selling properties in our commercial mortgage area, but we're not completely in the driver's seat on the timing of those things, for sure, we're not.

And, so if some of that happens it could be a little bit more but we don't have anything built in for commercial mortgage property sales or gains on those sales at this point.

Okay.

Thank you very much.

Sure.

Our next question comes from John Inch with Merrill Lynch.

You may ask your question.

Thank you, just as a follow-up, John Brooklier, you mentioned $400 million of possible deals in the pipeline.

Presuming you'd pay somewhere around 1 times revenue, even if you were to close on all of those on a rolling basis, it still leaves you, presuming you generate cash next year, with a pretty underleveraged balance sheet.

And I guess the question I have is given the sort of increase in activity of acquisitions, would you expect the pipeline to build so that, I mean '04 prospectively shapes up to be a much larger year.

And if it doesn't, are you guys just going to keep [Inaudible] talking about potential uses of your cash?

Why not raise the dividend?

I just want to understand a little bit of the thought process.

Because people are wondering if this is just going to go on and on in terms of the underleveraged balance sheet situation?

Our balance sheet over the, I mean, it depends on your timeframe.

This has been going on all of a year and a half or so that our cash position has really been built.

Maybe two years.

We have had, over the past 10 or 15 years, a pretty high debt to cap for us, up to the 25%, 30% range, down to net of cash where you don't have any debt.

So, it ebbs and flows and we don't believe that acquisition activity in this country is dead.

We think a little healthier industrial environment and keep in mind that this industrial environment is about as negative as it's been in a long time for the longest period of time.

This is -- our base business has been negative since the fourth quarter of 2000 and if our base business has been negative, those companies that we would look at to be buying have been negative that long, also.

And it's been very deep and we're still in negative territory.

So, I think the opportunities will open up.

We've got a couple of new legs on our stool, vis-a-vis Wilsonart and food equipment opening opportunities, both domestically and internationally in those two arenas, which we haven't been actively pursuing as we focused on getting those businesses in better shape and so I think I continue to see opportunity there.

I have not heard any of our EVPs in any of the segments saying we're done, there is no acquisition opportunity.

We're still looking and periodically, as you know, we have bought larger companies of a diversifying nature.

I can assure you we continue to look at those types of businesses but we also refuse to make a 6% return on investment with not much opportunity to improve the business.

And so we might start at 6%, but we've got to be able to see our way clear to get to the 14% or 15% returns in a reasonable period of time, as we are doing on Premark.

That's a fair answer.

In other words, people should not be inferring the cash building and even just the kind of muted plans, that somehow preserving cash for a rainy day or maybe you're really seeing something that you're still cautious about or anything like that?

Nope.

No, I don't think they should view it that way.

It's a build up and it doesn't make much money and we're painfully aware of that, but on the other hand we think the environment has still got a ways to go before the types of companies we'd like to buy will be more available.

No, understood.

And just a follow-up, then, what were your sales, John, in Asia firstly and secondarily in China and what kind of growth rates are you seeing there?

China only represents about $50 million of sales for us, I think total company.

$50 million?

Yeah.

And I don't have a -- I'd have to go back.

Those are all -- they're contained in various segments.

I could tell you on -- I've already told you that the Wilsonart international numbers grew about 6% internationally and they were growing at a higher rate in China.

Obviously the revenue base is smaller, but growing double-digit there.

That's about the only data point I have, though, John.

That's fair.

Thanks, guys.

Our next question comes from Karen Oglehart with GIC.

You may ask your question.

My question was about would you periodically do big deals and that question was just answered, actually.

What are the chances of that?

Are there opportunities out there?

But you answered it, so, thank you.

Thanks, Karen.

Our next question comes from Robert McCarthy with RW Baird.

You may ask your question.

John, you made reference to incremental investments in L&I, can you put those in a bucket for us?

Are we talking about property development or leveraged leases or --

It's a leveragedlease for some air traffic control infrastructure in Australia.

Australia.

And it's about $50 million.

And it's got the same type of purchase undertaking agreement associated with it, protecting us on the principal and the lease payments, so, we're well secured and getting very healthy returns.

Okay.

Thank you.

Uh-huh.

Our next question comes from Andrew Casey with Prudential.

Hello again.

Hello again.

It's you again! [ Laughter ]

Yeah, like a bad penny, like that guy at the Cub's game.

Oh please!

I was hoping nobody would bring up the Cubs!

Yeah.

Can't avoid it, John.

The question is related to the food equipment area.

You mentioned that in North America, kind of surprisingly flat, I believe in September.

In September, yes.

Was there any one particular area within that business that showed improvement?

I think you mentioned food retail is still weak?

Yes, food retail is still weak.

And I've said that the parts and service business has been consistently strong, consistently positive, so, the swing in the month really came from the restaurant side.

The restaurant institutional side.

Their September was better than they'd seen over the last couple of months.

Now, in my conversations with them, the question of sustainability comes up and they're not sure exactly where that business goes over the next couple of months.

Clearly it's better than the supermarket side.

Is it going to continue to improve remains to be seen.

John, was it broad-based or was it just a few large orders?

I don't have specifics on that.

I can tell you that most of the growth is still continuing to emanate from the casual dining area.

The franchises, the Applebee's, Ruby Tuesday's of the world.

That's where their growth, that's their sweet spot within the foodservice side.

Thank you.

Sir, at this time, I have no further questions in queue.

Okay, we thank everybody for joining us and we look forward to talking to you again.

Everybody have a good day.

Thank you.