In its first 100 years, what type of diversification strategy did ITW use, and how has it changed since 2012? Do you think managers were encouraged to over diversify? Explain your an

Case 7: Illinois Tool Works: Retooling for Continued Growth and Profitability C-95

CASE 7

Illinois Tool Works: Retooling for Continued Growth and Profitability1

In June 2016, Illinois Tool Works (ITW) was at a crit- ical juncture in its evolution. The company had iden- tified a number of lofty goals in its 2015 annual report to be achieved by the end of 2017. ITW expected to reach above 200 basis points in organic growth above the market (assumed at 3 per cent), a 23 per cent oper- ating margin, a 20 per cent after-tax return on invested capital, 100 per cent free cash flow as a percentage of net income, and 12 to 14 per cent shareholder returns.2 At the beginning of the year, riding on a successful 2015, these targets had seemed eminently achievable, based on ITW’s performance up to 2012 (see Exhibit 1) and more recent performance (see Exhibit 2). However, in 2016, the U.S. and world economies seemed to face a variety of challenges, including political uncertainty in the United States and Europe because of a presidential election and

the United Kingdom’s vote to exit from the European Union, as well as continued weaknesses in emerging markets and volatile currencies, among other factors.

Since taking over as chief executive officer (CEO) in 2012 after the untimely death of his predecessor David Speer, E. Scott Santi had implemented a number of divestments and consolidated the 800 small divisions he had inherited into 84 larger divisions, reducing the com- plexity of the company and improving its prospects for organic (rather than acquisitions-driven) growth, albeit with an accompanying reduction in revenues.3 Results had been encouraging. However, Santi’s strategy was dependent on achieving continued organic growth and undertaking bigger acquisitions, each posing its own set of challenges. Continued organic growth would depend on environmental developments, and ITW had already

Professor Nitin Pangarkar wrote this case solely to provide material for class discussion. The author does not intend to illustrate either effective or ineffective handling of a managerial situation. The author may have disguised certain names and other identifying information to protect confidentiality. This publication may not be transmitted, photocopied, digitized, or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) “mailto:[email protected]” [email protected]; “http://www.iveycases.com” www.iveycases.com. Copyright © 2017, National University of Singapore and Richard Ivey School of Business Foundation Version: 2017-01-30

2012 2011 2010 2009 2008 2007 2006 2005 2004 2003

Operating revenues ($ million)

17,924 17,787 15,416 13,573 16,544 15,550 13,254 12,029 10,836 9,201

Operating income ($ million)

2,847 2,731 2,254 1,383 2,410 2,535 2,286 2,021 1,808 1,407

Operating income margin (%)

15.9 15.4 14.6 10.2 14.6 16.3 17.2 16.8 16.7 15.3

Net income ($ million)

2,870 2,071 1,503 973 1,519 1,870 1,718 1,495 1,339 1,024

Return on average invested capital (%)

15 16.8 14.6 10.6 15.4 17.4 17.5 16.9 15.9 12.9

Number of acquisitions

23 28 24 20 50 52 53 22 24 28

Cash paid for acqui- sitions ($ million)

723 1,308 497 281 1,547 813 1,379 627 588 204

Total debt ($ million)

5,048 3,990 2,868 3,075 3,682 2,299 1,418 1,211 1,125 976

Total-debt-to-total- capitalization ratio

32.3 28.5 23.1 26.1 32.4 19.7 13.6 13.8 12.8 11

Exhibit 1 Illinois Tool Works’ Ten-Year Summary of Key Performance

Note: All currency amounts are in US$.

Source: ITW, “Differentiated Business Model Differentiated Performance: 2015 Annual Report,” Illinois Tool Works, March 23, 2016, accessed November 29, 2016, http://investor.itw.com/~/media/Files/I/ITW-IR/documents/online-proxy-voting/2015-itw-annualreport.pdf.

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Part 4: Case StudiesC-96

been adversely affected by the struggles of its customers in the oil and gas sectors. Large acquisitions, such as the US$470 million4 purchase of Engineered Fasteners and Components in early 2016, also posed higher implemen- tation risks, which would likely result in significant per- formance issues if the strategy failed to meet its goals.5 Santi’s strategy had yielded excellent results over the past few years, but there was considerable uncertainty about achieving future goals.

History In 1912, Frank W. England, Paul B. Goddard, Oscar T. Hogg, and Carl G. Olson formed ITW, a company that manufactured and sold metal-cutting tools. Supported by Chicago financier Byron L. Smith, the company quickly expanded to include products such as truck transmis- sions and pumps, which were in demand because of America’s involvement in World War I. Before the end of the decade, three other companies were formed—the DeVilbiss Company, the Hobart Brothers Company, and Signode—which would later become parts of ITW.

The company continued to develop new engineered products, as well as grow its portfolio of products through acquisitions. Its engineering excellence earned the company representation on the War Production Board in World War II. In 1940, Harold B. Smith, the company’s CEO at the time, implemented the strategy of decentralization, which was still a key ITW organiza- tional strategy in 2016.

Soon after its 50th anniversary, the company was listed on the New York Stock Exchange. During the 1960s, ITW further strengthened its position in the construction, industrial, and packaging markets, as well as expanding into international markets, which continued through the 1980s. Signode had by this time become a large multinational manufacturer of metal and plastic strapping, stretch film, industrial tape, application equipment, and related products. Its merger with ITW doubled the company’s size. In 1996, Jim Farrell became chairman of ITW and refined the company’s strategy towards numerous smaller acquisitions.6

The ITW Business Model By its own accounts, the ITW business model was composed of three elements: the 80/20 management process, customer-back innovation, and a decentralized entrepreneurial culture.7

The 80/20 management process implied focusing on the most rewarding areas such as the most profitable customers. The simplicity of this principle enabled ITW to concentrate its efforts, resources, and investments on key customers and products that were best positioned for profitable organic growth.

One concrete example of implementation of the 80/20 principle was provided in the manufacturing of nails for wood-framed houses. ITW’s analysis revealed that four types of nails accounted for 80 per cent of the

2015 2014 2013

Revenues Operating Profits Revenues

Operating Profits Revenues

Operating Profits

Automotive 2,529 613 2,590 600 2,396 490

Test and measurement and electronics

1,969 322 2,204 340 2,176 321

Food equipment 2,096 498 2,177 453 2,047 385

Polymers and fluids 1,712 335 1,927 357 1,993 335

Welding 1,650 415 1,850 479 1,837 464

Construction products 1,587 316 1,707 289 1,717 238

Specialty products 1,885 439 2,055 440 2,007 408

Intersegment revenue 223 271 226 270 238 2127

Total 13,405 2,867 14,484 2,888 14,135 2,514

Exhibit 2 Illinois Tool Works’ Recent Results (in US$ Millions)

Source: ITW, “Differentiated Business Model Differentiated Performance: 2015 Annual Report,” Illinois Tool Works, March 23, 2016, accessed November 29, 2016, http://investor.itw.com/~/media/Files/I/ITW-IR/documents/online-proxy-voting/2015-itw-annualreport.pdf.

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Case 7: Illinois Tool Works: Retooling for Continued Growth and Profitability C-97

volume and more than 20 other types of nails accounted for 20 per cent of the volume. To distinguish the prod- ucts based on their salience, ITW started making the high-volume nails in different manufacturing cells from the other nails. Over time, ITW moved the high-volume nails to separate plants from the low-volume nails. Speer, the executive vice-president at the time, summarized the benefits of this approach as follows: “If you keep them together, you end up compromising on both. If you sep- arate them, you optimize both.”8

ITW’s customer-back innovation placed an empha- sis on solving customer problems. ITW had a strong intellectual property portfolio. Of its 16,000 granted and pending patents, 1,900 had been applied for in 2015 alone. ITW also took pride in applying technology expertise to solve customers’ problems. For example, after realizing that smaller, fuel-efficient automobile engines generated higher levels of noise and vibration, ITW developed the WaveShear Isolation Springs to dampen noise and vibration.9

Another example of customer-back innovation, the “click and collect food equipment” initiative, offered customers who ordered perishable groceries online

temperature-controlled lockers placed at strategic loca- tions (proximate to customers) with the convenience of a flexible pick-up service, rather than having to wait for delivery.10

ITW promoted a decentralized-entrepreneurial cul- ture. The company believed that its employees under- stood its business model, strategy, and core values, which allowed ITW to empower its business teams to make decisions and customize their approach to specific cus- tomers and end markets. In other words, ITW employ- ees thought and acted like entrepreneurs and delivered results.

Products ITW competed in seven broad product areas: automotive original equipment manufacturer,11 food equipment, test measurement and electronics, welding equipment, power and fluids, construction products, and specialty products (see Exhibit 3). In 2015, each of the seven product groups accounted for revenue ranging from US$1.6 billion to US$2.5 billion across various geograph- ical areas (see Exhibit 4).

Automotive OEM Under this vertical, ITW designed and manufactured fasteners, interior and exterior components, and powertrain and braking systems for OEMs and their top-tier suppliers.

Food equipment Under this vertical, ITW offered products in ware wash, cooking, refrigeration, and integrated services to institu- tional, industrial, restaurant, and retail customers around the world.

Test measurement and electronics

ITW’s test and measurement business provided specialized test and measurement products to a diverse set of customers operating in highly regulated, demanding environments. ITW’s electronics business provided manufac- turing and maintenance, repair, and operations solutions that served the semiconductor, industrial, life sciences, and automotive industries, among others.

Welding equipment

This ITW division offered value-added equipment and specialty consumables for a variety of industrial and infra- structure applications.

Power and fluids Under this vertical, ITW offered specialized adhesives, lubricants, and additives for global wind energy, automotive aftermarket, aerospace, construction, industrial, and automotive customers.

Construction products

ITW’s construction products group was a supplier of engineered fastening systems and related consumables and software. These products were uniquely specified for a variety of materials, including wood, concrete, steel, and engineered lumber for the residential, commercial, and renovation markets.

Specialty products ITW’s specialty products segment was composed of diverse businesses who met the needs of large customers with specific solution requirements. Specialty products businesses included consumer packaging products such as zippers on re-sealable bags and multi-packaging carriers (six-pack rings); software and equipment for warehouse automation; single-use products for the medical industry; aircraft ground support equipment; and, coating and metalizing businesses for the branding and security markets.

Exhibit 3 Illinois Tool Works’ Product Portfolio

Note: OEM 5 original equipment manufacturer.

Source: ITW, “Differentiated Business Model Differentiated Performance: 2015 Annual Report,” Illinois Tool Works, March 23, 2016, accessed November 29, 2016, http://investor.itw.com/~/media/Files/I/ITW-IR/documents/online-proxy-voting/2015-itw-annualreport.pdf.

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Part 4: Case StudiesC-98

Decentralization12

Decentralization had been a key pillar of ITW’s strategy since 1940. Until 2012, when Santi took over as CEO, the company practiced an extreme form of decentralization by acquiring small companies in most cases, and at other times, creating hundreds of small units from bigger companies that had either grown internally or had been acquired (e.g., Signode). Jim Farrell, an ITW CEO who had accelerated the implementation of the decentraliza- tion strategy, explained its advantage: “We’re competitive in the marketplace. So run your consolidated model.

It seems to me my costs are lower than yours with my decentralized model.”13 ITW’s acquisitions followed by the implementation of a decentralization strategy were referred to by Forbes magazine as a form of “conquer and divide.”14 The extreme practice of decentralization was also pursued with vigour under Farrell’s successor Speer, who once aimed to have 1,000 small divisions under the ITW umbrella.

Under the extreme decentralization strategy, ITW would typically consider splitting a business unit when the revenues reached the $50 million range. The resulting small size of the divisions would reduce the possibility

2015 Total Revenues by Geography

2015 Operating Margin (%)

Patent Portfolio (Granted and Pending) Key Brands Remarks

Automotive US$2.5 billion North America: 47% EMEA: 34% APAC: 19%

24.2 2,755 Deltar, ITW Shakeproof ITW Drawform

Organic revenue CAGR of 8% since 2012

Test measure- ment and electronics

US$2.0 billion North America: 42% EMEA: 28% APAC: 30%

16.3 1,753 Test and measurement: Buehler, Instron, Brooks Instrument, Avery Weigh-Tronix, Wilson Electronics: Kester, Vitronics Soltec, Speedline, SIMCO-ION, Despatch Industries, Texwipe, Stockvis Tapes, Loma Systems, Magnaflux

Revenue CAGR of 14% since 2005

Food equipment US$2.1 billion North America: 55% EMEA: 36% APAC: 9%

23.7 1,178 Baxter, Foster, Hobart, Stero, Traulsen, Vesta, Vulcan, Bonnet, MBM, Elro

Operating margin improvement of 660 basis points since 2012

Polymers and fluids

US$1.7 billion North America: 55% EMEA: 23% APAC: 22%

19.6 602 Black Magic, DensitD, Devcon, ITW Wind Group, Permatex, Plexus rainx, Wynn’s

Operating margin improvement of 380 basis points since 2012

Welding US$1.6 billion North America: 76% EMEA: 11% APAC: 13%

25.2 3,012 Miller, Hobart, Tregaskiss, Bernard

Revenue CAGR of 8% since 1993

Construction products

US$1.6 billion North America: 41% EMEA: 30% APAC: 29%

19.9 3,325 Alpine, ITW Buildex, Paslode, Ramset, Red Head, Spit, Reid

Operating margin improvement of 830 basis points since 2012

Specialty products

US$1.9 billion North America: 58% EMEA: 27% APAC: 15%

23.3 3,927 Filtertek, Hartness, Hi-Cone, Meurer, Zip-Pak

Operating margin improvement of 380 basis points since 2012

Exhibit 4 Illinois Tool Works’ Portfolio and Performance

Note: EMEA 5 Europe, the Middle East, and Africa; APAC 5 Asia Pacific; CAGR 5 compound annual growth rate

Source: “Business Segments,” Illinois Tool Works, accessed on June 22, 2016, www.itw.com/business-segments/; ITW, “Differentiated Business Model Differentiated Performance: 2015 Annual Report,” Illinois Tool Works, March 23, 2016, accessed November 29, 2016, http://investor.itw.com/~/media/Files/I/ITW-IR/documents/ online-proxy-voting/2015-itw-annualreport.pdf.

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Case 7: Illinois Tool Works: Retooling for Continued Growth and Profitability C-99

of achieving economies of scale, but ITW found that it would enable the small divisions to be more focused and competitive. ITW’s former vice-chairman Frank Ptak explained the concept as follows:

We love competing against a big company, because their management teams don’t have the same feel that our peo- ple have. It’s not that we’re smarter. It’s that our people are only concentrating on one small part of the market. They are like entrepreneurs—it’s not an exaggeration. The basic advantage is you have people down in the trenches who really understand the business because they are specifically dedicated to it.15

Extreme decentralization had another important ramification. It enhanced career opportunities for ITW’s employees, and high-performing employees could have the opportunity to be in charge of a business at a young age. In fact, ITW pitched these entrepreneurial opportu- nities to attract high-quality employees.

Believing in the benefits from the decentralized strat- egy, ITW consciously deemphasized synergies. Its head- quarters hosted only tax, audit, and associated financial functions; investor relations; a skeleton human resource department staff; and a research and development group that supported the individual businesses with applica- tion development.16 This strategy allowed each senior

executive at the headquarters to handle multiple busi- nesses. For example, in 2007, 50 executives at the head- quarters level were in charge of 750 units in the United States and in 48 foreign countries.17

The corporate management didn’t specify financial targets for divisions, preferring to have targets percolate from the bottom up. The top management, however, required each division to continuously show improve- ment, especially in terms of margins. As Farrell once stated, “We expect all of our businesses to move up their margins each year, whether they are a 5 per cent- or a 35 per cent-margin business. Incentive compensation strongly reinforces the earnings emphasis, with 50 per cent of bonus opportunity directly tied to them.”18

The dramatic performance enhancement from the extreme decentralization strategy was evident, especially in terms of growth. Between 1965 and 1972, as a part of ITW’s Fastex division, ITW’s Deltar business grew to achieve sales of $2 million (see Exhibit 5). After sepa- ration from Fastex in 1972, Deltar grew rapidly and was divided many times. Whenever opportunities arose, it also added new divisions, especially between 1995 and 1999, when its insert-moulded business grew revenues from $40 million to $135 million by adding five divisions. By 1999, the original Deltar business had been divided into 26 different units and had revenues of $300 million.19

Fastex Distribution

1997

HiCone 1962

Deltar 1972

Nine Operatng Units

1972–99

Lynx 1982

Nexus 1984

Fastex 1955

Seven Operating Units

1955–99

Shakeproof

Fastex OEM 1997

Exhibit 5 An illustration of Illinois Tool Works’ Decentralization Strategy

Source: Company files. PowerPoint presentation by Jane L. Warner at the Great Lakes Manufacturing Forum in June 2008.

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Acquisitions ITW had always undertaken acquisitions. However, under CEOs Farrell and Speer, ITW implemented a strategy of undertaking up to 30–50 acquisitions per year, in some years. ITW typically focused on targets valued under $100 million that were available at less than 1.1 times the book value (see Exhibits 1 and 6).20 Speaking about ITW’s preference for small acquisitions over large acquisitions, former CFO Jon Kinney once said, “When you acquire just one large business, all the assumptions you made about it and what ITW can do with it had better be correct. You’re putting all your eggs in one basket.”21 In rare cases, ITW made large acquisitions and divided the large acquired company into many small pieces, as in the case of Signode, which was acquired for $800 million in 1986 and then divided into 50 companies.22

ITW’s acquisitions strategy was based on a number of rules of thumb. It sought targets that filled gaps in its capabilities, such as complementary product expertise or relationships with important customers. The acqui- sitions were also typically initiated by middle managers, rather than flowing down from the top, which ensured that implementation issues would be taken into account before the acquisition, instead of afterwards. Recognizing that a typical middle manager would likely lack the nec- essary skills to find or undertake acquisitions, former CEO Speer implemented two-day acquisition workshops for business unit managers.23 ITW also tried to minimize

the negative impact on the morale of target employees post-acquisition by retaining the identity of the target company. It would only stipulate that target companies attempt to integrate at a broad level (e.g., by using a company-wide accounting package), and seek simplicity and operational excellence through deploying the 80/20 principle. Finally, ITW was careful not to use acquisi- tions for novel situations, such as entering new countries. It developed its own knowledge-base about a country by establishing owned-operations before embarking on acquisitions. In 2005, out of ITW’s 21 businesses in China, only one had been through an acquisition, and that one was converted from a joint venture. At the same time, only two of its 11 businesses in India had started out as joint ventures and were subsequently converted into wholly-owned subsidiaries.24

In general, the acquired companies’ employees and management seemed to appreciate the benefits of ITW’s approach. For example, in 2005, ITW acquired Permatex; the next year, Permatex’s marketing director Tony Battaglia commented on the acquisition:

They are very decentralized though, so we operate inde- pendently. However, ITW does train all of its companies to operate efficiently by using 80/20 simplification pro- cesses. That has helped us to focus better on customers and products. Financially, it has allowed us to step up our market research, category management, and website investments. . . . Permatex is an ideal platform to bring on additional aftermarket acquisitions in the future.25

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Number of Deals 28 36 32 45 29 21 28 24 22 53 52

Average Acquisition Size in US$ Millions

15 23 119 22 19 9 12 26 27 32 19

1000

100

10

1

Average Acquisition Size in US$ MillionsNumber of Deals

Exhibit 6 Illinois Tool Works’ acquisition strategy before 2013

Source: Company files. PowerPoint presentation by Jane L. Warner at the Great Lakes Manufacturing Forum in June 2008.

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incoming CEO that the counsel of previous CEOs was always available.

ITW’s culture was informal and relationship-driven, as described by Santi: “It’s a lot of conversations. It’s not a lot of memos. It’s not a lot of PowerPoints, but it’s a lot of belly-to-belly conversations and creating that alignment, engagement, and enthusiasm that turns this culture loose.”28 Echoing similar thoughts, former CEO Farrell had once said:

I want to see your eyes; I want to see if you’re getting it. If you’re not, I haven’t communicated very well. And I clearly can’t do that via e-mail. In our organization, we rely so much on trusting our people to do the right things that trying to talk to them electronically would diminish that personal communication and compromise our business success.29

Many other executives described ITW’s culture as highly egalitarian and down-to-earth. ITW’s headquar- ters were described by an article in the Crain’s Chicago Business as “a cluster of nondescript low-rise buildings, [where] there is no executive cafeteria and the only reserved parking spaces are for the food and mail trucks.” Former ITW vice-chairman Ptak once remarked: “You realized that there was a part of business and a part of making money that wasn’t so draconian. That you could be nice.”30

Retooling ITW’s Strategy In January 2012, ITW reached an agreement with activ- ist investor Relational Investors (Relational), which had acquired a small stake in ITW. According to the agreement, Relational’s principal and co-founder David Batchelder would join the ITW board of directors.31 Relational had suggested a strategy makeover for ITW consisting of centralizing its operations and divestment of a number of its small divisions. Many analysts agreed with Relational’s suggestions primarily because ITW’s strategy of small acquisitions and extreme decentraliza- tion had resulted in lagging returns versus peers since the onset of the global recession in 2007.32 After assuming the role of CEO in November 2012, Santi moved quickly to implement a new strategy based on divestment of small divisions that sold commoditized products, or that were likely to grow slowly.

Taking Stock in 2016 By the end of 2015, ITW had made considerable prog- ress in implementing its new strategy (see Exhibit 7).

ITW’s Acquisition of Precor: An Illustration of Its Acquisition Strategy and Approach to Operational Excellence ITW’s acquisition of Precor served as an excellent exam- ple of the transformation it brought about in acquired companies. Since its inception in 1983, Precor had gained a reputation as an innovative and leading manufacturer of exercise equipment in the United States and interna- tionally. Despite its innovation and market-leading reve- nues, Precor exhibited poor performance with regard to a variety of metrics at the time of its acquisition by ITW. Its on-time shipments stood at a dismal 42 per cent. It had a rather unwieldy supply chain, consisting of as many as 3,000 suppliers, with most suppliers accounting for small volumes, and its employee turnover was high.

ITW implemented a number of its usual policies at Precor: the 80/20 rule, product line simplification, ratio- nalization of manufacturing plants and suppliers, and workflow simplification. Within three years, the new strategy had produced spectacular results. The percent- age of on-time deliveries improved from 42 to 91, head- count was reduced from 952 to 456, and the number of plants was reduced from seven to five without negatively affecting production. Inventory levels went down by 40 per cent and warranty claims by 57 per cent, resulting in savings of millions of dollars. After bringing about a dramatic improvement in Precor’s financial results, ITW sold Precor in 2002 for €180 million26 to Amer Sports, based in Helsinki, Finland.27

Organization and Human Resources Policies ITW implemented a number of organizational and human resources policies that were aligned with its broader enterprise-level strategy, as well as other functional-level policies.

Throughout its history, ITW had emphasized continuity and stability in terms of its leadership. When Santi assumed the role of CEO, he was only the sixth CEO in the company’s 100-year history, imply- ing an average tenure of more than a decade. Many of the CEOs had also previously worked in ITW for a long time, and thus were steeped in the ITW cul- ture and tradition. For example, Santi had spent his entire working career at ITW. Since 1995, ITW had also adopted a tradition that each incoming CEO be presented with a crystal frog wearing a golden crown and bearing the name of prior CEOs, signalling to the

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Part 4: Case S