Illinois Tool Works Inc. (NYSE: ITW) Q1 2022 earnings call dated May. 03, 2022
Corporate Participants:
Karen Fletcher — Vice President of Investor Relations
E. Scott Santi — Chairman and Chief Executive Officer
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Analysts:
Scott Davis — Melius Research — Analyst
Tami Zakaria — JPMorgan — Analyst
Joe Ritchie — Goldman Sachs — Analyst
Jeff Sprague — Vertical Research — Analyst
Andy Kaplowitz — Citigroup — Analyst
Nigel Coe — Wolfe Research — Analyst
Mig Dobre — Baird — Analyst
Julian Mitchell — Barclays — Analyst
Presentation:
Operator
Good morning. My name is David, and I’ll be your conference operator today. At this time, I would like to welcome everyone to the ITW Q1 2022 Earnings Conference Call. [Operator Instructions] [Operator Instructions]
Karen Fletcher, Vice President of Investor Relations, you may begin your conference.
Karen Fletcher — Vice President of Investor Relations
Thank you, David. Good morning, everyone, and welcome to ITW’s First Quarter 2022 Conference Call. I’m joined by our Chairman and CEO, Scott Santi; and Senior Vice President and CFO, Michael Larsen. During today’s call, we’ll discuss ITW’s first quarter financial results and update our guidance for full year 2022. Slide two is a reminder that this presentation contains forward-looking statements.
We refer you to the company’s 2021 Form 10-K for more detail about important risks that could cause actual results to differ materially from our expectations. This presentation uses certain non-GAAP measures, and a reconciliation of those measures to the most directly comparable GAAP measures is contained in the press release.
So please turn to slide three, and it’s now my pleasure to turn the call over to our Chairman and CEO, Scott Santi.
E. Scott Santi — Chairman and Chief Executive Officer
Thanks, Karen, and good morning, everyone. We have talked often about the fact that the core focus of our enterprise strategy is to leverage the performance power of the ITW business model to consistently deliver top-tier performance in any environment. And our teams around the world continue to do an exceptional job of doing just that as evidenced by the 11% organic growth and 23% operating margins that they delivered in Q1.
In the quarter, we saw continued strong demand almost across the board, while input cost inflation and supply chain issues remain challenging to say the least, and our business has responded. Across the company, we continue to leverage the advantaged supply capabilities inherent in our 80/20 front-to-back operating system to support our customers and execute our Win the Recovery strategy to accelerate profitable market penetration and organic growth across our portfolio.
Many of our businesses continued to receive strong feedback from their customers that their current delivery performance is truly differentiated and that they are being awarded additional share as a result. And despite another step-up in input cost inflation in Q1, we more than offset cost increases on a dollar-for-dollar basis in the quarter.
Looking ahead at the remainder of 2022 based on our first quarter results and projecting current demand, supply rates and all-known cost increases through the balance of the year, we are raising our guidance for full year 2022 organic growth to 8.5% at the midpoint and GAAP EPS of $9.20 at the midpoint, which is 14% earnings growth year-over-year and would be an all-time record for the company. While the near-term environment certainly has its challenges, we remain focused on delivering differentiated service to our customers, differentiated financial performance for our shareholders and continued progress on our path to ITW’s full potential.
Now I’ll turn the call over to Michael, who’ll provide more detail on the quarter and our full year outlook. Michael?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Thank you, Scott, and good morning, everyone. In Q1, demand was strong across the board and supported by our advantaged supply position, ITW grew revenue by 11.2% to more than $3.9 billion. Organic growth was 10.6%, and the MTS acquisition contributed about $100 million or 2.8% to revenue. Foreign currency translation reduced revenue by 2.2%. GAAP EPS of $2.11 tied last year’s Q1 record. Foreign currency translation reduced GAAP EPS by $0.05.
By geography, North America grew 13%, international grew 7%, with organic growth of 7% in Europe and China grew 1%. six of seven segments delivered positive combined organic growth of 14%, while Automotive OEM was down less than 1%. Orders remained strong across the board. And while we’re doing significantly better than many of our competitors in terms of lead times and delivery performance, we grew backlogs again in the first quarter. Sequentially, from Q4 to Q1, organic revenue grew 6% on a sales per day basis, as compared to our historical sequential of minus 1%.
And while we’re on the topic of sequential improvement, GAAP EPS of $2.11 grew 9% relative to Q4 ’21. Operating margin was 22.7%, 23.4%, excluding 70 basis points of margin dilution from the recent MTS acquisition. Enterprise Initiatives contributed 90 basis points. And as we always do, our business teams reacted appropriately to higher cost inflation by adjusting selling prices. And as a result, we remain positive on a dollar-for-dollar basis. Price/cost was still dilutive to operating margin by 250 basis points.
After-tax ROIC was 27.6%, 29.8% excluding the impact of the MTS acquisition. Free cash flow was $249 million with a conversion rate of 38%, which is below our typical 80% to 85% in the first quarter. As we’ve talked about before, the lower conversion rate is due to intentional working capital investments that support our strong growth momentum, mitigate supply chain risk and sustained service levels to our key customers. And down the road, once supply conditions begin to normalize, so will our working capital needs resulting in our typical strong cash flow performance.
As planned, we repurchased $375 million of our shares in the first quarter and the effective tax rate was 23.1%, 70 basis points higher than Q1 last year. So overall for Q1, an excellent start to the year, characterized by strong broad-based demand, supported by our differentiated supply position, as we delivered organic growth of 11%, operating margin of 23% and GAAP EPS of $2.11. Moving to slide four. We’re including an analysis of our current operating margin performance.
Reported Q1 operating margin was 22.7%, but there are three factors pressuring our margins in the near term, starting with 250 basis points of margin dilution impact from price cost. At some point in the future, when raw material costs begin to normalize, we expect the margin impact from price/cost to turn positive and that we will fully recover the margin differential. Second, Q1 was also the first full quarter of the recent MTS acquisition, which, as expected, diluted margins by 70 basis points.
As we’ve talked about before, it will take us a few years to fully implement the ITW business model on MTS and get the business growing organically at ITW caliber margins and returns. Finally, we had slightly higher restructuring associated with 80/20 front-to-back projects, which impacted margins by 20 basis points. And the point here is that our core operating margins are currently running around 26%-plus, which is closer to what we would expect from ITW in a normal environment and not far from our prepandemic target of 28%-plus and also further evidence of our continued progress on enterprise strategy driven structural margin improvement through the pandemic.
If you recall, 2019 prepandemic margins were right around 24% versus 26% on a core run rate basis here in Q1. And as we’ve said before, we have full confidence in our ability to deliver sustained above-market organic growth at 30% to 40% incremental margins. And as a result, we will continue to expand operating margins as we grow. Moving on. Automotive OEM was the only segment that didn’t grow this quarter with organic revenue down a little less than 1%, much improved compared to being down 16% in Q4 ’21.
By geography, North America grew 3%, Europe was down 11% and China grew 12%. You’ll remember that the segment is up against a pretty tough comp of plus 8% organic growth in Q1 last year, as the impact on auto production from chip shortages didn’t fully materialize until Q2. At this point and for guidance purposes, we do not expect an improvement in the chip shortage situation until 2023. As a result, our guidance assumes that automotive production and our associated automotive OEM revenues are essentially capped at current Q1 levels through the balance of the year.
Turning to slide five for Food Equipment, which led the way with the highest organic growth rate this quarter at 28%. North America was up 23% with Equipment up 24% and Service up 21%. Restaurants were up over 40% with strength across the board and institutional growth was almost 10% led by education and lodging. International growth was strong at 36%, with Europe up 45% and Asia Pacific up 4%. Both Equipment and Service revenues increased around 36%.
In Test & Measurement and Electronics, organic growth was 8%, with Test & Measurement up 10% and Electronics up 6%. Strong demand for semiconductor-related equipment continued to drive organic growth in the mid-teens, while demand for capital equipment also remained strong with Instron, for example, up 6%. Finally, as expected, the MTS acquisition diluted operating margin by about 400 basis points. Excluding the MTS impact, margins were 26% versus 26.4% in Q4 ’21.
Moving to slide six. Welding organic revenue grew 13%, with Equipment up 10% and Consumables up 17%. Industrial grew 14% and the Commercial business grew almost 10%. North America was up 12% and International growth was 17%, including 18% growth in oil and gas. Europe was up 20%, and Asia Pacific was up 15%. Due to strong operating leverage and a solid contribution from enterprise initiatives, Welding operating margin was a record 30.8%, an all-time quarterly record for an ITW segment and another proof point that as we deliver organic growth, with best-in-class margins, there’s plenty of room for further margin expansion in all seven segments.
In Polymers & Fluids, organic growth was 13%, as Automotive aftermarket grew 17%. Polymers was up 11% with continued strength in MRO and heavy industry applications. Fluids grew 6%. On a geographic basis, North America grew 15%, and International was up 9%. On to slide seven. Construction delivered strong organic revenue growth of 21%, as North America grew 32%, with Residential up 36% and Commercial up 15%. Europe grew 16%, and Australia and New Zealand was up 10%.
While construction margins were impacted by rising steel costs, operating margin was still a solid 24.7%, with strong volume leverage and a meaningful contribution from enterprise initiatives. Specialty organic growth was 1% with North America up 7%, while International was down 9%. With that, let’s turn to slide eight for an updated view of our full year 2022 guidance. And based on our Q1 results and projecting current levels of demand through the balance of the year as per our standard approach to guidance, we are now projecting organic growth of 7% to 10% and total revenue growth of 8.5% to 11.5%.
Due to the higher revenue growth projections, we’re raising GAAP EPS by $0.10 to a range of $9 to $9.40, and the midpoint of $9.20 represents 14% earnings growth and puts the company on track for another year of record financial performance. Operating margin guidance is unchanged with strong volume leverage and 100 basis points of contribution from enterprise initiatives. When it comes to price cost, our operating teams will continue to more than cover inflation on a dollar-for-dollar basis.
And as usual, our guidance includes all known costs and price increases as we sit here today. We expect strong free cash flow growth of 10% to 20% year-over-year with a conversion rate of 85% to 95% of net income. As we’ve talked about before, this is below our target of 100%-plus. Because of our decision to invest in the working capital necessary to support the company’s strong growth, mitigate supply chain risk and sustained service levels to our key customers.
Finally, we are on pace to repurchase 1.5 billion of our shares, and we continue to expect an effective tax rate of 23% to 24%. So in summary, Q1 was another quarter of high-quality execution in a very challenging environment. And as a result, we’re off to a solid start on raising both our organic growth and EPS guidance for the full year.
So with that, Karen, I’ll turn it back to you.
Karen Fletcher — Vice President of Investor Relations
Okay. Thanks, Michael. David, let’s open up the lines for questions, please.
Questions and Answers:
Operator
[Operator Instructions] We’ll take our first question from Scott Davis with Melius Research. Your line is open.
Scott Davis — Melius Research — Analyst
Good morning, guys.
E. Scott Santi — Chairman and Chief Executive Officer
Good morning.
Scott Davis — Melius Research — Analyst
Thanks for making an uneventful quarter versus what we’ve seen in some other places.
E. Scott Santi — Chairman and Chief Executive Officer
You’re welcome.
Scott Davis — Melius Research — Analyst
A couple of little things here. I mean first, your guidance implies kind of — or perhaps doesn’t imply, but you’re not forecasting additional inflation. Does that mean that you’ve seen kind of some plateauing in the supply chain price increases and materials, etc?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Well — so let me just — it’s a good question. So let me just explain kind of how we are modeling price cost because I think there’s an opportunity to maybe clarify a few things. So what we are doing, consistent with our past approach around price/cost is we’re including in our guidance today. all known cost increases and all of the associate price increases. Those are the two things that we know today. And based on that, you saw the actuals of 250 basis points of margin headwind in the first quarter, but actually positive on a dollar-for-dollar basis.
As we project into the future based on what we know today, that 250 basis points is going to become less of a drag on a go-forward basis and maybe even turn slightly positive in the back half of the year, okay? So that’s kind of — that’s what we know. What we don’t know, and that’s to your question, what are the additional cost increases going to be? We don’t know, as we sit here today, we have not seen anything to really suggest that inflation is slowing down. But we do know that our operating teams will offset any cost increases with price on a dollar-for-dollar basis.
And so therefore, EPS-neutral, which is a really important point here. But obviously, that will create additional top line growth, but it will also put pressure on margins as this additional top line growth comes through at essentially no incremental margin, if that makes sense. So hopefully, that answers your question. So that’s what’s embedded here. Everything we know as we sit here today is included in our guidance. Additional inflation will be offset on a dollar-for-dollar basis. And to the extent that happens, that will put some further pressure on margins. And so hopefully, that answers your question.
Scott Davis — Melius Research — Analyst
That’s totally fair. Is there any way to disaggregate the content growth in auto versus kind of potential inventory builds versus sell-through, etc? Just any color there will be helpful…
E. Scott Santi — Chairman and Chief Executive Officer
I’d say, at this point, that would be really tough just given all that’s going on.
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Yes, I agree with that. I would just add. I mean I think it’s a tough number, and it doesn’t make a lot of sense on a quarterly basis. I think in terms of long term, we’re highly confident that we’re outgrowing the underlying market by two to three percentage points. What exactly that was in one quarter versus the other is a little bit more difficult to ascertain, especially in the current environment. But on a full year basis, certainly, the way these plans are set up is for two to three percentage points of outgrowth on an annual basis.
Scott Davis — Melius Research — Analyst
Okay. Sounds good. Thank you, guys. Appreciate the color.
E. Scott Santi — Chairman and Chief Executive Officer
Sure. Thank you.
Operator
Next, we’ll go to Tami Zakaria with JPMorgan. Your line is open.
Tami Zakaria — JPMorgan — Analyst
Hi. Good morning. Thanks for taking my questions. So I wanted to get some clarity on the improved organic growth guidance, you’re raising it by one point. And is that a reflection of better-than-expected first quarter performance versus your internal expectations or does it embed improved organic growth you’re seeing quarter-to-date? And if the latter, which segments are driving that? And is it solely coming from incremental pricing or are you expecting volume improvement as well?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Yes. So Tami, our growth projection is based on the Q1 actual results that we are reporting today. And then we are projecting based on historical run rates into — through the balance of the year. So there’s really no assumption here, no economic forecasts or an underlying assumptions, things are going to get better in the back half or worse than the back half of the year. It’s based on, again, revenue per day in Q1 and projected into — through the balance of the year.
Tami Zakaria — JPMorgan — Analyst
Got it. And so you’re not embedding any pricing benefit into the updated guidance?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
No. I think the only pricing that is included in our guidance is what we know as of today. So we know what price increases we have actioned and announced and so that is known. But any further increases beyond that would not be included in our guidance as we sit here today.
Tami Zakaria — JPMorgan — Analyst
Got it. Super helpful. If I can ask one more follow-up?
E. Scott Santi — Chairman and Chief Executive Officer
Sure.
Tami Zakaria — JPMorgan — Analyst
Have you seen any slowdown or impact in your business in the European markets since the war in Ukraine broke? Ask another way, have you — do you feel the demand environment has changed since then?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Well, so I think in Q1, I think Europe was up 7%. I think we’re seeing — we saw some pressure. In — if you look at the automotive numbers, the sales numbers — we saw a lot of strength on the food equipment side to offset that. I think — and if you kind of look at the projection for the balance of the year, I think it adds up to somewhere in the low single-digit type growth rate in Europe. Just to maybe comment or put it down, I think so far through April, everything appears to be on track, including Europe.
Tami Zakaria — JPMorgan — Analyst
Great. Thank you so much.
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Sure. Next, we’ll go to Joe Ritchie with Goldman Sachs. Your line is open.
Joe Ritchie — Goldman Sachs — Analyst
Thanks. Good morning everybody.
E. Scott Santi — Chairman and Chief Executive Officer
Good morning Joe.
Joe Ritchie — Goldman Sachs — Analyst
I guess my first question, I want to just touch on China. I know it’s a relatively small part of your business. I saw that it grew double digits in the auto business. But maybe just provide some color on what you’re seeing on the ground there with the COVID shutdowns and how that’s impacting your business, if at all?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Yes. I mean I think just to kind of dimensionalize it. China is about 8% of our revenues. And I think we — at this point, we’ve not seen — we’re obviously not immune to what’s going on in China. But like I said, so far through April, everything appears to be on track, including in China.
Joe Ritchie — Goldman Sachs — Analyst
Okay. Good to know. And then I guess, just a follow-on question. You guys — price/cost negative 250, but only down 100 basis points for the year. I mean, it’s fair to say, I think, like where you’re seeing the most acute pressure in the auto OEM segment. So I guess just maybe confirm that that’s correct or if you’re seeing other pressure across other parts of your business as well? And then just within that improvement that you’re seeing, how much of it is already like baked into the pricing of those auto contracts that come through as the year progresses?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
So everything that we know is baked in, Joe. So — and I think the — it’s fair to say that the inflationary pressures are real across all seven segments. They are a little more pronounced as you can see it in the margins in auto, maybe construction this quarter, I mentioned that as well as Polymers & Fluids. I think there is a little bit of a — we’re still catching up to some extent. So the 250 basis points of headwind will be better starting in Q2 based on what we know today, somewhere closer to 200 and then from there, in the back half, if things stay the way they are, like I said earlier, we’re starting to turn positive.
And we’re beginning — I think the important point is we’re beginning to recover the margin impact that we’ve had over the last four or five quarters now. So I think once we get through this cycle, like I said in the prepared remarks and when things do begin to normalize down the road from a supply chain and from a cost standpoint, that is when the margin recovery begins. And so we’re taking, to some extent, this is a — we described it as a near-term pressure here in Q1 and over time, we’ll begin to recover those margins again.
Joe Ritchie — Goldman Sachs — Analyst
That’s helpful. Thank you.
Operator
Next, we’ll go to Jeff Sprague with Vertical Research. Your line is open.
Jeff Sprague — Vertical Research — Analyst
Thank you. Good day, everyone. Just first on auto, Scott or Michael. Is the idea that you’re capped here, what you’re hearing directly from your customers, what you can see on kind of forward build schedules? Or is this just, for lack of a better term, a dose of caution given the uncertainty?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
It’s a combination of things. I think, Jeff, if you go back to our last call, the — what was baked into our guidance at the time was half of the IHS growth build forecast of 9%. So we were basically at somewhere around 4% to 5% builds. And that’s where IHS is today. So I think there’s actually not a big change relative to where we were three months ago.
And what we’re basically, based on various data inputs, including from our customers, we thought the best way to update kind of forecast the auto business is to say that revenues stay where they are, which is somewhere around $760 million in Q1, and that’s what we’ve assumed for Q2, Q3 and Q4. So — and then ultimately, I mean, we still believe that down the road, when these supply chain issues get resolved and automotive production recovers, this segment is going to be very well set up as a strong contributor to the overall organic growth rate of the enterprise, but we just think it’s going to take a little bit longer based on everything that we are seeing and hearing from our customers.
Jeff Sprague — Vertical Research — Analyst
Understood. And then just back on price. Understanding that what you know is embedded in the guide, but if we think about the point addition to the organic growth guide, I suspect all of that, maybe even more than 100% of it is price. Could you just give us a little color on that?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
So I think you tried this on the last call to get me to tell you a little bit more about price versus volume. So — and just to reiterate, these are our best estimates. So I can’t give you a lot of detail other than I can tell you that the — there is volume leverage on the 1% revenue growth increase and that’s really the 10% — $0.10 a share that we’re adding to our guidance, okay? So it is not — from that, you can infer, it’s not all price. It’s a combination of things.
Jeff Sprague — Vertical Research — Analyst
Great. Understood. Thank you for the color.
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Sure.
Operator
Thank you. Next, we’ll go to Andy Kaplowitz with Citigroup. Your line is open.
Andy Kaplowitz — Citigroup — Analyst
Good morning, everyone.
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Andy.
Andy Kaplowitz — Citigroup — Analyst
Scott or Michael, so I know you probably don’t want to update us on your segment revenue growth expectations. But outside of auto, where you already gave a specific guide, it looks like Food Equipment & Construction accelerated versus your run rate, specialty products, maybe weakened a bit. Is that a fair characterization of where revenue growth is moving versus your original forecast? And can you give a little more color regarding what you’re seeing in specialty products that’s maybe holding down that business a bit, segment.
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Yes. I think the — I heard your first part. What the second part was, what did you say slowdown?
Andy Kaplowitz — Citigroup — Analyst
Specialty.
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Specialty. Yes, I think specialty is really more of a timing issue related to some specific equipment projects in Europe and a few projects in China. So I think that’s really more of a timing issue than anything else. I think if you just kind of take a step back, I think you pointed out the right ones in terms of a lot of strength in certainly Food Equipment, but also Welding. Test & Measurement, there’s some up against some difficult comps. Construction, there’s certainly a lot of positive momentum really across the board.
And what does not come across, and we’ve talked about this before, we’re not a backlog-driven company. But in the segments that are more exposed to the capital equipment space, so that would include Test & Measurement, Welding, Food & Equipment, we are building significant backlog and really despite the fact that we are performing, like I said, at a high level relative to our competitors, we’re building substantial backlog. That’s not showing up, obviously, yet in our revenues.
Andy Kaplowitz — Citigroup — Analyst
And Michael, you obviously had — you had a large number in construction, specifically, you mentioned North American renovation, I think, up in the low 30% range. It’s been going on for a while here, but this is a big number and you’re getting stronger despite sort of concerns about rising rates. So are you taking share there? Is it just a lot of activity and sort of visibility going forward here in ’22?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
I think as you know, I mean, there’s still a lot of strength in the U.S. housing market, and that’s where you saw these residential remodel numbers up 36%. And included in that is also some meaningful share gains based on what we’re seeing in portions of that business where it’s difficult to supply the market, we are taking advantage of our supply position to take share.
The commercial side, 15%, that’s a smaller part of the business. And then really on a geographic basis, it’s not just North America, but it’s also Europe up 16%. For example, the U.K. up 20%; and then Australia and New Zealand still delivering a solid 10%. So it’s pretty broad-based, and again, we’re modeling based on run rates. And so we have not seen anything to suggest that the market is slowing down at this point.
Andy Kaplowitz — Citigroup — Analyst
Appreciate the color.
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Sure.
Operator
Next, we’ll go to Nigel Coe with Wolfe Research. Your line is open.
Nigel Coe — Wolfe Research — Analyst
Thanks. Good morning.
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Good morning.
Nigel Coe — Wolfe Research — Analyst
And thanks for leaving a lot of time for — yes, good morning. It’s actually great that you give so much time to Q&A. So thanks, I wish all other company to do this. So I know you don’t like to talk about price. And I know Jeff took a crack at the question. But if I just put through the margin dilution from price/costs and it seem as neutral, then I get to a 9%, 10% type price impact. Is that the kind of scale of pricing we’re seeing here? And is the message that pricing gets better from here through the year?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Well, what does get better from here, if things stay the way they are is price/cost as we talked about. And so we’re going from significant margin dilution here in Q1 of 250 basis points to maybe even slightly positive in the second half of the year. So that’s — and that’s based on everything that we know today. And Nigel, it’s not that we don’t want to — so the issue around price is that it is an estimate at best.
And it is not — especially with — in such a dynamic environment, it would be very difficult to sit here and give you a number with a high degree of confidence, and we have not done that historically. And like I think — I think we talked about on the last call, we’re not going to go down the path of breaking out price versus volume any further. So that’s the best I can do here for you.
Nigel Coe — Wolfe Research — Analyst
Okay. No, that’s fine. And then just turn to page four, as my follow-up, the margin bridge. Enterprise was, I think, 90 bps of tailwinds. So if we put that in as sort of a tailwind to that bridge, there would have been 90 bps elsewhere so — as an offset. So I’m assuming that productivity in the plans, etc, is that fair, Michael? And how do you see sort of productivity, labor productivity, etc, improving through the year?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Well, I think that’s productivity. I’m not sure exactly how you get there. I mean I think there’s 90 basis points of enterprise initiatives that’s not on here.
E. Scott Santi — Chairman and Chief Executive Officer
That’s embedded in the 26.1%.
Michael M. Larsen — Senior Vice President and Chief Financial Officer
In the 26,1%. And so is the — any other productivity gains. There’s a couple of things that are nodding here is there’s some margin dilution from increased sales commissions. When you grow your revenues double digit, your commissions are going to go up. But broadly speaking, what we try to do is give you a fairly accurate representation of these near-term pressures and therefore, what our core operating margins are running at which is somewhere around 26%-plus in the current environment. And as we just talked about, these price/cost pressures normalize, that’s where we would expect margins to head as we continue on our path to our target of 28%-plus.
Nigel Coe — Wolfe Research — Analyst
No, that’s very clear. Thank you very much.
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Sure.
Operator
Thank you. Next, we’ll go to Mig Dobre with Baird. Your line is open.
Mig Dobre — Baird — Analyst
Good morning, everyone. So Michael, a question for you. I think I heard you mention that in the second quarter, the price/cost headwind moderates to the tune of about 50 basis points. So when we’re thinking about year-over-year margin, is it fair to still embed roughly 200 basis points of year-over-year compression in Q2 and then things get better in the back half, basically?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Yes. I think that’s what I said. Yes, I think that’s — based, again, with the caveat that we are in a very dynamic uncertain environment. But to the extent that — based on what we know today, that is — that would be correct.
Mig Dobre — Baird — Analyst
Okay. And then sorry to keep beating up this topic on price, it’s just that this environment it’s not something I’ve encountered in my career, well, frankly, before. But when we’re looking at PPI data, I mean, we’re seeing some pretty material increases in Food Equipment, in Welding. And I’m sort of wondering if your business is sort of kind of keeping up with this industry data as well or if there are some divergence that we need to be aware of? Because it would seem that most of the growth is really coming from pricing, not volume, if volume grows at all in 2022.
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Yes. I mean, I…
E. Scott Santi — Chairman and Chief Executive Officer
We wouldn’t share that view.
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Yes. We don’t agree with that one; two, I’m not quite sure what you’re — what data you’re looking at. So it’s a little bit difficult for me to comment. All I can do is report the actual results for our Food Equipment business, for example. And I think we give you a fair bit of detail, including by end market. And beyond that, I can’t really — like I said before, we don’t report price versus volume, and so I’m not sure I can help you.
Mig Dobre — Baird — Analyst
Understood. Maybe one last follow-up. I’m curious as to how you’re thinking about this pricing dynamic longer term? Because to your point, eventually, we’re going to start to see material costs coming down, do you expect to be able to keep the pricing gains that you have had in this environment? Or is it fair to assume some pressure is weakened about ’23 and beyond?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Well, so I think let me just start by saying that our customer relationships are strategic long-term relationships. We’re not trying to maximize price. We’re trying to serve our customers and make sure that we get paid for offering a really differentiated product, service or solution. So we’ve always had pricing power in these businesses. I think ultimately, these are going to be discussions with customers when costs start to normalize, and there might be a few exceptions, but by and large, we expect to hold on to these price increases to recover the margins, like I said earlier. So that’s typically what happens. If you go back and look in time, we’re going to end up with a period where we recover that margin percentage, and we don’t expect the current cycle to be any different.
Mig Dobre — Baird — Analyst
Okay. Thank you.
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Sure.
Operator
Next, we’ll go to Julian Mitchell with Barclays. Your line is now open.
Julian Mitchell — Barclays — Analyst
Hi. Good morning. Maybe just wanted to try and understand the sort of earnings framework for the year a little bit. So it looks as if sort of operating margins are set to go up by about 300 basis points between kind of Q1 and Q4 with a flattish dollar revenue. Is that all simply the price cost removal of the headwind? Is there any other kind of major moving parts? And also, to that point, are you sticking to that kind of 47-53 first half, second half EPS split?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Yes. So let me address that. I mean I think we’re still in that 46% to 47% in the first half and the balance in the second half. And the big driver really is what we’ve talked about, it feels like for a while here, is price/cost beginning to turn positive based again on the assumptions that we’re making in our guidance. So that’s the drive. Now historically, we do 49%, 51%. So it’s a couple of percentage points.
So — but it is a little bit more back-end loaded. We expect that as we go through the year, sequentially, starting in Q2, margins will improve and so will revenues. And that’s just based again on kind of historical run rates. And so we expect a steady kind of improvement in Q2, Q3 and in Q4, including on the margin side. Whether it’s exactly the number you laid out, I can’t really comment. But directionally, that’s — that is the right way to look at it.
Julian Mitchell — Barclays — Analyst
And then switching to the balance sheet, which I don’t think has been touched on yet and maybe some customer element as well. But your inventories are up, I think, almost sort of 50% year-on-year and up 10%-plus sequentially in Q1. Just kind of trying to understand when do you think that starts to level out? And this major sort of inventory build that you’re seeing, how assure you that you’re not seeing the same phenomenon across your customers and channel partners as well with obviously some risk to that if we do see final demand slowdown?
Michael M. Larsen — Senior Vice President and Chief Financial Officer
Well, so I think if you look at our inventory levels, we were running at about three months on hand. Our historical is two months. And so we have an extra month of inventory on hand. And I think we’ve been very clear about why that is. It’s to mitigate supply chain risk, it’s to take care of our customers and ultimately, to win this recovery and take share at a point where our competitors are maybe not able to service our customers.
So that’s the vast majority of these inventory increases, just kind of maybe a little housekeeping. If you look at our conversion rate here in Q1, the difference between the 38% and the 80 to 85 is about $300 million of working capital, very intentional investments. We believe, a really smart use of our balance sheet. And you saw the top line growth, right, at 11% organic this quarter. That, I would argue, would not have happened if we’ve not taken this approach starting really last year to make a conscious decision to invest in inventory.
And then obviously, receivables will go up as you grow double digit. Ultimately, we don’t see any reason why structurally when supply chain begins to normalize, both from an availability standpoint and also from a cost standpoint, that we will go back to two months on hand. And at that point, if that happens, you’ll see these free cash flow numbers will deliver above-average performance until we’re back to kind of normal levels.
So we view this really as a temporary increase in working capital. How quickly that will come down, depends on a lot of things, including what you’re talking about and — which is inventory in the channel where we really don’t have a lot of visibility, other than, I can tell you, for the most part, the channel does not carry a lot of inventory because they’re used to the fact that we will take care of them when they need products. So there’s no incentive for them to carry a lot of extra inventory. So that’s probably the best I can give you, Julian.
Operator
[Operator Closing Remarks]