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ITW > SEC Filings for ITW > Form 10-K on 14-Feb-2014All Recent SEC Filings

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Form 10-K for ILLINOIS TOOL WORKS INC


14-Feb-2014

Annual Report


ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

INTRODUCTION
Illinois Tool Works Inc. (the "Company" or "ITW") is a global manufacturer of a diversified range of industrial products and equipment with operations in 56 countries.
The Company periodically makes changes to its management reporting structure to better align its businesses with Company objectives and operating strategies. Effective January 1, 2013, the Company made certain changes in how its operations are reported to senior management in order to better align its portfolio of businesses with its enterprise-wide portfolio management initiative. As a result of this reorganization, the Company's continuing operations are internally reported as 28 operating segments to senior management as of December 31, 2013, which have been aggregated into the following seven external reportable segments: Automotive OEM; Test & Measurement and Electronics; Food Equipment; Polymers & Fluids; Welding; Construction Products; and Specialty Products.
The significant changes that resulted from this reorganization included the following:
Certain businesses within the former Transportation segment, primarily related to the automotive aftermarket business, are reported in the Polymers & Fluids segment and the Transportation segment has been renamed Automotive OEM.

The Welding business, which was formerly reported in the Power Systems & Electronics segment, is reported separately as the Welding segment.

The Electronics business, which was formerly reported in the Power Systems & Electronics segment, has been combined with the Test & Measurement business, which was formerly reported in the All Other segment, to form a new Test & Measurement and Electronics segment.

The All Other segment has been renamed Specialty Products.

The changes in the reportable segments and underlying reporting units did not result in any goodwill impairment charges in the first quarter of 2013. Commensurate with the change in reportable segments described above, the segment operating income was also revised for a change in how the operating expenses maintained at the corporate level are allocated to the Company's segments. Prior to January 1, 2013, the Company allocated all operating expenses maintained at the corporate level to its segments. Beginning January 1, 2013, segments are allocated a fixed overhead charge based on the segment's revenues. Expenses not charged to the segments are now reported separately as Unallocated. Because the Unallocated category includes a variety of items, it is subject to fluctuation on a quarterly and annual basis.
The prior year segment results and related disclosures have been restated to conform to the current year presentation under the new segment structure and expense allocation methodology.
Due to the large number of diverse businesses and the Company's decentralized operating structure, the Company does not require its businesses to provide detailed information on operating results. Instead, the Company's corporate management collects data on several key measurements: operating revenues, operating income, operating margins, overhead costs, number of months on hand in inventory, days sales outstanding in accounts receivable, past due receivables and return on invested capital. These key measures are monitored by management and significant changes in operating results versus current trends in end markets and variances from forecasts are discussed with operating unit management.
Management analyzes the Company's consolidated results of operations and the results of each segment by identifying the effects of changes in the results of the base businesses, newly acquired and recently divested companies, restructuring costs, goodwill and intangible asset impairment charges, and currency translation on the operating revenues and operating income of each segment. Base businesses are those businesses that have been included in the Company's results of operations for more than 12 months. The changes to base business operating income include the estimated effects of both operating leverage and changes in variable margins and overhead costs. Operating leverage is the estimated effect of the base business revenue volume changes on operating income, assuming variable margins remain the same as the prior period. As manufacturing and administrative overhead costs usually do not significantly change as a result of revenues increasing or decreasing, the percentage change in operating income due to operating leverage is usually more than the percentage change in the base business revenues. Changes in variable margins and overhead costs represent the estimated effect of non-volume related changes in base business operating income and may be driven by a number of factors, including changes in product mix, the cost of raw materials, labor and overhead, and pricing to customers. Selling price versus material cost comparisons represent the estimated net impact of increases or decreases in the cost of materials used in the Company's products versus changes in the selling price to the Company's customers. Management reviews these price versus cost comparisons by analyzing the net impact of changes to each segment's operating margin.


80/20 BUSINESS PROCESS
A key element of the Company's business strategy is its continuous 80/20 business process. The basic concept of this 80/20 business process is to focus on what is most important (the 20% of the items which account for 80% of the value) and to spend less time and resources on the less important (the 80% of the items which account for 20% of the value). The Company uses this 80/20 business process to simplify and focus on the key drivers of business profitability, and as a result, reduces complexity that often creates unnecessary expense and disguises what is truly important. The Company utilizes the 80/20 process in various aspects of its business. Common applications of the 80/20 business process include:
Simplifying product lines by reducing the number of products offered by combining the features of similar products, outsourcing products or, as a last resort, eliminating low-value products.

Segmenting the customer base by focusing on the 80/20 customers separately and finding alternative ways to serve the 20/80 customers.

Simplifying the supplier base by partnering with 80/20 suppliers and reducing the number of 20/80 suppliers.

Designing business processes, systems and measurements around the 80/20 activities.

The result of the application of this 80/20 business process is that the Company has over time improved its long-term operating and financial performance. These 80/20 efforts can result in restructuring projects that reduce costs, and improve profitability and returns. Corporate management works closely with those businesses that have operating results below expectations to apply this 80/20 business process and improve results.

ENTERPRISE STRATEGY
During 2012, the Company embarked on an Enterprise Strategy that includes three key initiatives - portfolio management, business structure simplification, and strategic sourcing. These initiatives are expected to enhance the business through 2017 and are targeted at expanding organic revenue growth and improving profitability and returns.
Portfolio Management - The Company's portfolio management initiative aims to construct a business portfolio that leverages the Company's differentiated business model and growth potential. As part of this initiative, the Company reviews its operations for businesses that may no longer be aligned with its long-term objectives. As a result, the Company's divestiture activity increased over historical periods in 2012 and 2013 and is expected to increase further in 2014 with the planned divestiture of the Industrial Packaging segment. The Company has historically acquired businesses with complementary products and services, as well as larger acquisitions that represent potential new platforms. Going forward, the focus will be on businesses with sustainable differentiation and growth potential. Refer to the Discontinued Operations note in Item 8. Financial Statements and Supplementary Data for discussion of the Company's discontinued operations.
Business Structure Simplification - The business structure simplification initiative simplifies the Company's organizational model and adds scale to the Company's operating divisions in order to increase organic revenue growth, enhance global competitiveness and drive operational efficiencies. This initiative focuses on reducing the number of the Company's operating divisions and increasing the average revenue size of each division, while retaining the positive attributes of a decentralized operating model. The Company expects to enhance its profitability and returns through a combination of applying its 80/20 business process to the new divisions, more focused growth investments and reduced infrastructure.
Strategic Sourcing - The Company's strategic sourcing initiative focuses on building sourcing capability in order to leverage purchasing scale to enhance profitability and global competitiveness. It incorporates both enterprise-level and segment-level purchasing that cross the Company's many businesses. This initiative is expected to transform sourcing into a core strategic function in the Company.

DIVESTITURE OF MAJORITY INTEREST IN FORMER DECORATIVE SURFACES SEGMENT On October 31, 2012, the Company divested a 51% majority interest in the Decorative Surfaces segment. Accordingly, the Company ceased consolidating the results of the Decorative Surfaces segment as of October 31, 2012 and now reports its 49% ownership interest using the equity method of accounting. Due to the Company's continuing involvement through its 49% interest, the historical operating results of Decorative Surfaces are presented in continuing operations. Effective November 1, 2012, Decorative Surfaces was no longer a reportable segment of the Company. See the Divestiture of Majority Interest in Former Decorative Surfaces Segment note in Item 8. Financial Statements and Supplementary Data for further discussion of this transaction.


DISCONTINUED OPERATIONS
The Company periodically reviews its operations for businesses which may no longer be aligned with its enterprise initiatives and long-term objectives. As such, the Company may commit to a plan to exit or dispose of certain businesses and present them as discontinued operations.
In February 2013, the Company announced that it was initiating a review process to explore strategic alternatives for the Industrial Packaging segment. In September 2013, the Company's Board of Directors authorized a plan to commence a sale process for the Industrial Packaging segment. The Company classified the Industrial Packaging segment as held for sale beginning in the third quarter of 2013 and is no longer presenting this segment as part of its continuing operations.
On February 6, 2014, the Company announced that it had signed a definitive agreement to sell the Industrial Packaging segment to The Carlyle Group for $3.2 billion. The transaction is subject to regulatory approval and customary closing conditions, and is expected to close by mid-2014.
In the third quarter of 2013, the Company also committed to plans for the divestiture of a construction distribution business previously included in the Construction Products segment and a specialty coatings business previously included in the Polymers & Fluids segment. The construction distribution and specialty coatings businesses were classified as held for sale beginning in the third quarter of 2013.
In the first quarter of 2013, the Company committed to plans for the divestiture of two transportation related businesses and a machine components business previously included in the Specialty Products segment, two construction distribution businesses previously included in the Construction Products segment, and a chemical manufacturing business previously included in the Polymers & Fluids segment. These businesses were classified as held for sale beginning in the first quarter of 2013.
These held for sale businesses discussed above, as well as certain previously divested businesses, are reported as discontinued operations in the statement of income. All related prior period income statement information has been restated to conform to the current year reporting of these businesses. Refer to the Discontinued Operations note in Item 8. Financial Statements and Supplementary Data for discussion of the Company's discontinued operations.

CONSOLIDATED RESULTS OF OPERATIONS
The Company's consolidated results of operations for 2013, 2012 and 2011 are summarized as follows:

Dollars in millions    2013         2012         2011
Operating revenues  $ 14,135     $ 14,791     $ 14,515
Operating income       2,514        2,475        2,361
Margin %                17.8 %       16.7 %       16.3 %

In 2013 and 2012, the changes in revenues, operating income and operating margins over the prior year were primarily due to the following factors:

                                               2013 Compared to 2012                                2012 Compared to 2011
                                                                 % Point  Increase                                    % Point  Increase
                                    % Increase (Decrease)           (Decrease)           % Increase (Decrease)           (Decrease)
                                  Operating       Operating          Operating         Operating       Operating          Operating
                                   Revenues         Income            Margins           Revenues         Income            Margins
Base business:
Revenue change/Operating
leverage                              0.2  %          0.6  %             0.1  %            2.2  %          2.7  %             0.1  %
Changes in variable margins and
overhead costs                          -             6.4                1.1                 -             6.5                1.1
                                      0.2             7.0                1.2               2.2             9.2                1.2
Acquisitions                          1.7             0.4               (0.2 )             3.5             0.8               (0.6 )
Divestitures                         (6.3 )          (5.1 )              0.3              (1.3 )          (0.7 )              0.1
Restructuring costs                     -            (1.0 )             (0.2 )               -            (2.0 )             (0.3 )
Impairment of goodwill and
intangibles                             -               -                  -                 -            (0.1 )                -
Translation                             -             0.3                  -              (2.5 )          (2.4 )                -
 Total                               (4.4 )%          1.6  %             1.1  %            1.9  %          4.8  %             0.4  %


Operating Revenues
Revenues decreased 4.4% in 2013 versus 2012 primarily due to divestitures which reduced revenues by 6.3% over the prior year. On October 31, 2012, the Company divested a 51% majority interest in the former Decorative Surfaces segment. Accordingly, the Company ceased consolidating the results of the Decorative Surfaces segment as of October 31, 2012 and now reports its 49% ownership interest using the equity method of accounting. Due to the Company's continuing involvement through its 49% ownership interest in Wilsonart, the historical operating results of Decorative Surfaces are presented in continuing operations. Excluding the 2012 revenues of the former Decorative Surfaces segment of $921 million, 2013 revenues increased by $265 million, or 1.9%, over the prior year, primarily driven by higher revenues from acquisitions and higher base revenues (see "Results of Operations by Segment" table below). Worldwide base revenues increased 0.2% in 2013 versus 2012 primarily due to growth in the Automotive OEM segment, partially offset by lower revenues in the electronic assembly equipment businesses within the Test & Measurement and Electronics segment. International base revenues increased 1.2% due to growth in Asia Pacific of 3.6%, primarily due to the result of strong growth in China in 2013 versus 2012. European base revenues declined 0.8% due to weakness in the European economic environment in the first half of 2013 which moderately improved in the second half of the year. North American base revenues were lower by 0.5% primarily due to the electronic assembly business within the Test & Measurement and Electronics segment. This was partially offset by growth in the North American Automotive OEM, Food Equipment, and Construction Products businesses. Acquisitions contributed 1.7% to revenues in 2013 versus 2012 primarily due to the purchase of a European consumer packaging equipment business and a Chinese food equipment business. Revenues increased 1.9% in 2012 versus 2011 primarily due to higher base revenues and revenues from acquisitions, partially offset by the unfavorable effect of currency translation and the reduction of revenues due to divestitures. Divestitures reduced revenues by 1.3% primarily due to only ten months of operating results for the Decorative Surfaces segment in 2012 versus twelve months of operating results in 2011 as the Company divested a 51% interest in the Decorative Surfaces segment on October 31, 2012, at which time the segment was deconsolidated. Base revenues increased 2.2% in 2012 versus 2011 as North American economic conditions were stronger than the European and Asia Pacific economic environments. North American base revenues increased 4.3% in 2012 versus 2011. International base revenues decreased 0.2% as Europe declined 0.9% in 2012 versus 2011 primarily driven by weakness in Southern Europe. Asia Pacific base revenues increased 0.7% in 2012 versus 2011 primarily due to growth in the Automotive OEM segment across the region. Acquisitions contributed 3.5% to revenues primarily due to the purchase of a manufacturer of specialty devices used to measure the flow of gases and fluids in the first quarter of 2012 and a thermal processing and environmental equipment manufacturer in the third quarter of 2011. Currency translation resulted in a 2.5% decline in revenues primarily due to a weaker Euro versus the year ago period. Operating Income
Operating income increased 1.6% in 2013 versus 2012 primarily due to lower overhead expenses and an increase in base revenues, partially offset by the divestiture of the former Decorative Surfaces segment and higher restructuring expenses. Total base operating margins increased 120 basis points in 2013 versus 2012 primarily due to lower overhead costs. The changes in variable margins and overhead costs increased base margins by 110 basis points in 2013 versus 2012, driven by reductions in overhead expenses from the Company's enterprise initiatives of 80 basis points, resulting primarily from the benefits of business structure simplification activities, and the favorable effect of selling price versus material cost comparisons of 40 basis points. Operating income increased 4.8% in 2012 versus 2011 primarily due to improved variable margins and the positive operating leverage effect of the increase in base revenues. Currency translation resulted in a 2.4% decline in operating income primarily due to a weaker Euro versus the year ago period. Higher restructuring expenses due to increased cost reduction activities also negatively impacted operating income by 2.0%. Base margins increased 120 basis points primarily due to improved variable margins. Changes in variable margins and overhead costs improved base margins 110 basis points primarily due to the favorable effect of selling price versus material cost comparisons of 60 basis points and benefits of restructuring projects. The increase in base margins was partially offset by a 60 basis point decline related to acquisitions, primarily due to amortization expense related to intangible assets. Restructuring expenses diluted total operating margins by 30 basis points primarily due to restructuring activities related to continued improvements in operating structure and efficiencies.


RESULTS OF OPERATIONS BY SEGMENT
The reconciliation of segment operating revenues and operating income to total
operating revenues and operating income is as follows:
                                            Operating Revenues
In millions                           2013         2012         2011
Automotive OEM                     $  2,396     $  2,171     $  2,092
Test & Measurement and Electronics    2,176        2,299        2,011
Food Equipment                        2,047        1,939        1,985
Polymers & Fluids                     1,993        2,063        2,059
Welding                               1,837        1,847        1,724
Construction Products                 1,717        1,724        1,752
Specialty Products                    2,007        1,871        1,856
Intersegment revenues                   (38 )        (44 )        (48 )
 Total Segments                      14,135       13,870       13,431
Decorative Surfaces                       -          921        1,084
 Total                             $ 14,135     $ 14,791     $ 14,515


                                           Operating Income
In millions                          2013        2012        2011
Automotive OEM                     $   490     $   421     $   386
Test & Measurement and Electronics     321         342         300
Food Equipment                         385         332         311
Polymers & Fluids                      335         327         328
Welding                                464         470         440
Construction Products                  238         201         218
Specialty Products                     408         365         383
 Total Segments                      2,641       2,458       2,366
Decorative Surfaces                      -         143         154
Unallocated                           (127 )      (126 )      (159 )
 Total                             $ 2,514     $ 2,475     $ 2,361

AUTOMOTIVE OEM
Businesses in this segment produce components and fasteners for automotive-related applications.
In the Automotive OEM segment, products and services include:
plastic and metal components, fasteners and assemblies for automobiles, light trucks, and other industrial uses.

In 2013, this segment primarily served the automotive original equipment manufacturers and tiers (84%) and automotive aftermarket (8%) markets. The results of operations for the Automotive OEM segment for 2013, 2012 and 2011 were as follows:

Dollars in millions     2013        2012        2011
Operating revenues    $ 2,396     $ 2,171     $ 2,092
Operating income          490         421         386
Margin %                 20.5 %      19.4 %      18.4 %


In 2013 and 2012, the changes in revenues, operating income and operating margins over the prior year were primarily due to the following factors:

                                               2013 Compared to 2012                                2012 Compared to 2011
                                                                 % Point  Increase                                    % Point  Increase
                                    % Increase (Decrease)           (Decrease)           % Increase (Decrease)           (Decrease)
                                  Operating       Operating          Operating         Operating       Operating          Operating
                                   Revenues         Income            Margins           Revenues         Income            Margins
Base business:
Revenue change/Operating
leverage                              9.5 %          17.8  %             1.5  %            7.5  %         14.5  %             1.2  %
Changes in variable margins and
overhead costs                          -             0.2                  -                 -            (0.2 )                -
                                      9.5            18.0                1.5               7.5            14.3                1.2
Acquisitions                            -               -                  -                 -               -                  -
Divestitures                            -               -                  -                 -               -                  -
Restructuring costs                     -            (3.2 )             (0.6 )               -            (1.6 )             (0.2 )
Impairment of goodwill and
intangibles                             -               -                  -                 -               -                  -
Translation                           0.9             1.7                0.2              (3.8 )          (3.9 )                -
 Total                               10.4 %          16.5  %             1.1  %            3.7  %          8.8  %             1.0  %

Operating Revenues
Revenues increased 10.4% in 2013 versus 2012 primarily due to an increase in base business and the favorable effect of currency translation. Worldwide automotive base revenue growth of 9.5% in 2013 versus 2012 exceeded auto builds of approximately 4% primarily due to worldwide product penetration gains. International automotive base revenues increased 10.9% over the prior year. Base revenues for Asia Pacific increased 20.8% over the prior year primarily due to revenue growth in China of 37.7%, which exceeded Chinese auto build growth of 14%. European base revenue growth was 6.8% while auto build growth was flat in 2013 versus 2012. North American automotive base revenue growth of 8.0% exceeded auto build growth of 5% over the prior year.
Revenues increased 3.7% in 2012 versus 2011 due to the increase in base business, partially offset by the unfavorable effect of currency translation. Worldwide automotive base revenue growth of 7.5% in 2012 versus 2011 was primarily due to an increase in worldwide auto builds of 6%, favorable customer mix and product penetration gains in Europe, and growing product penetration with automotive original equipment manufacturers in China. International automotive base revenues increased 7.2% in 2012 versus 2011. European base revenue growth of 3.0% exceeded auto build declines of 5% in 2012 versus 2011. Base revenues for Asia Pacific increased 22.1% in 2012 versus 2011 while base revenue growth in China of 31.3% exceeded Chinese auto build growth of 6% in 2012 versus 2011. North American automotive base revenues grew 8.1% as North American auto builds increased 17% in 2012 versus 2011. Operating Income
Operating income increased 16.5% in 2013 versus 2012 primarily due to higher base revenues and the favorable effect of currency translation, partially offset by higher restructuring expenses. Total base operating margins increased 150 basis points due to the positive operating leverage effect of the increase in base revenues described above. The changes in variable margins and overhead costs had no significant effect on base margins as the benefits of business structure simplification activities were offset by higher overhead costs primarily related to business expansion in China. Higher restructuring expenses diluted total operating margins by 60 basis points in 2013 versus 2012. Operating income increased 8.8% in 2012 versus 2011 primarily due to the positive operating leverage effect of the base revenue increase, partially offset by the unfavorable effect of currency translation and higher restructuring expenses. Base margins increased 120 basis points due to the . . .

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