Illinois Tool Works - 10-Q quarterly report FY

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

Commission File Number: 1-4797

ILLINOIS TOOL WORKS INC.

(Exact name of registrant as specified in its charter)

(Registrant’s telephone number, including area code) 847-724-7500

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

The number of shares of registrant’s common stock, $.01 par value, outstanding at September 30, 2005: 280,502,962.

Part I – Financial Information

Item 1 – Financial Statements

ILLINOIS TOOL WORKS INC. and SUBSIDIARIES

FINANCIAL STATEMENTS

The unaudited financial statements included herein have been prepared by Illinois Tool Works Inc. and Subsidiaries (the “Company”). In the opinion of management, the interim financial statements reflect all adjustments of a normal recurring nature necessary for a fair statement of the results for interim periods. It is suggested that these financial statements be read in conjunction with the financial statements and notes to financial statements included in the Company’s Annual Report on Form 10-K/A. Certain reclassifications of prior years’ data have been made to conform with current year reporting.

ILLINOIS TOOL WORKS INC. and SUBSIDIARIES

STATEMENT OF INCOME

(UNAUDITED)

(In thousands except for per share amounts)

ILLINOIS TOOL WORKS INC. and SUBSIDIARIES

STATEMENT OF FINANCIAL POSITION

(UNAUDITED)

(In thousands)

ILLINOIS TOOL WORKS INC. and SUBSIDIARIES

STATEMENT OF CASH FLOWS

(UNAUDITED)

(In thousands)

ILLINOIS TOOL WORKS INC. and SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)

Stock options and restricted stock have been issued to officers and other management employees under ITW’s 1996 Stock Incentive Plan. The stock options generally vest over a four-year period and have a maturity of ten years from the issuance date. Restricted stock generally vests over a three-year period. The restricted shares vest only if the employee is actively employed by the Company on the vesting date, and unvested shares are forfeited upon retirement, death or disability, unless the Compensation Committee of the Board of Directors determines otherwise. The restricted shares carry full voting and dividend rights unless the shares are forfeited. To cover the exercise of vested options, the Company generally issues new shares from its authorized but unissued share pool. At September 30, 2005, 18,048,432 shares of ITW common stock were reserved for issuance under this plan. Option exercise prices are equal to the common stock fair market value on the date of grant.

Effective January 1, 2005, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”), which requires the Company to measure the cost of employee services received in exchange for equity awards based on the grant date fair value. Starting in 2005, the Company records compensation cost related to the amortization of the unamortized grant date fair value of stock awards unvested as of December 31, 2004 over the remaining service periods of those awards. SFAS 123R superseded Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation and Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”).

Prior to 2005, the Company accounted for stock-based compensation in accordance with APB 25, using the intrinsic value method, which did not require that compensation cost be recognized for the Company’s stock options. The Company’s net income and net income per share for 2004 would have been reduced if compensation cost related to stock options had been expensed based on fair value at the grant dates. Pro forma net income as if the fair value method had been applied to all awards is as follows:

(In thousands, except for per share amounts)

The following table summarizes the components of the Company’s stock-based compensation programs recorded as expense:

(In thousands)

The following table summarizes the annual estimated pretax impact of compensation cost related to equity awards granted through September 30, 2005:

(In thousands)

The following table summarizes information on unvested restricted stock and stock options outstanding as of September 30, 2005:

The estimated fair value of the options granted during 2004 was calculated using a binomial option pricing model. Previous grants were valued using the Black-Scholes option pricing model. The following summarizes the assumptions used in the 2004 binomial model:

Lattice-based option valuation models, such as the binomial option pricing model, incorporate ranges of assumptions for inputs. The risk-free rate of interest for periods within the contractual life of the option is based on a zero-coupon U.S. government instrument over the contractual term of the equity instrument. Expected volatility is based on implied volatility from traded options on the Company’s stock and historical volatility of the Company’s stock. The Company uses historical data to estimate option exercise timing and employee termination rates within the valuation model. Separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The expected term of options granted is derived from the output of the option valuation model and represents the period of time that options granted are expected to be outstanding. The ranges given above result from separate groups of employees exhibiting different behavior.

The weighted-average grant-date fair value of options granted during 2004 was $21.99 per share. The aggregate intrinsic value of options exercised during the nine months ended September 30, 2005 and 2004 was $15,858,000 and $77,519,000, respectively. Aggregate intrinsic value of options outstanding and options exercisable at September 30, 2005 was $199,549,000 and $185,068,000, respectively. Exercise of options during the nine months ended September 30, 2005 and 2004, resulted in cash receipts of $18,318,000 and $69,029,000, respectively. For the quarter ended September 30, 2005, the weighted average remaining contractual term of options outstanding and options exercisable was 5.86 years and 4.75 years, respectively.

Inventories at September 30, 2005 and December 31, 2004 were as follows:

(In thousands)

The Company’s only component of other comprehensive income in the periods presented is foreign currency translation adjustments.

(In thousands)

Goodwill represents the excess cost over fair value of the net assets of purchased businesses. The Company does not amortize goodwill and intangible assets that have indefinite lives. In the first quarter of each year, the Company performs an annual impairment assessment of goodwill and intangible assets with indefinite lives based on the fair value of the related reporting unit or intangible asset.

As of December 31, 2004, the Company had assigned its recorded goodwill and intangible assets to approximately 340 of its 650 reporting units. When performing its annual impairment assessment, the Company compares the fair value of each reporting unit to its carrying value. Fair values are determined by discounting estimated future cash flows at the Company’s estimated cost of capital of 10%. Estimated future cash flows are based either on current operating cash flows or on a detailed cash flow forecast prepared by the relevant operating unit. If the fair value of an operating unit is less than its carrying value, an impairment loss is recorded for the difference between the implied fair value of the unit’s goodwill and the carrying value of the goodwill.

Amortization and impairment of goodwill and other intangible assets for the periods ended September 30, 2005 and 2004 were as follows:

(In thousands)

In the first quarter of 2005, the Company performed its annual impairment testing of its goodwill and intangible assets, which resulted in impairment charges of $11,255,000. The first quarter 2005 goodwill impairment charges of $6,206,000 were primarily related to a Canadian stretch packaging equipment business and a U.S. welding components business, and resulted from lower estimated future cash flows than previously expected. Also in the first quarter of 2005, intangible asset impairments of $5,049,000 were recorded to reduce to estimated fair value the carrying value of trademarks, patents and customer-related intangible assets related to a U.S. business that manufactures clean room mats in the Engineered Products – North America segment.

In the first quarter of 2004, the Company recorded goodwill impairment charges of $11,492,000, which were primarily related to a European automotive components business and a U.S. electrical components business and resulted from lower estimated future cash flows than previously expected. Also in the first quarter of 2004, intangible asset impairments of $10,220,000 were recorded to reduce to estimated fair value the carrying value of trademarks and brands related primarily to several U.S. welding components businesses and a U.S. industrial packaging business in the Specialty Systems – North America segment and a U.S. business that manufactures clean room mats in the Engineered Products – North America segment.

Pension and other postretirement benefit costs for the periods ended September 30, 2005 and 2004 were as follows:

(In thousands)

The Company expects to contribute $98,000,000 to its pension plans in 2005. As of September 30, 2005, contributions of $91,425,000 have been made.

In 2004, the Company entered into a $400,000,000 Line of Credit Agreement with a termination date of June 17, 2005. On March 7, 2005, the Company exercised a provision of the Line of Credit Agreement which provided for an increase in the aggregate commitment by $200,000,000 to a total of $600,000,000. This line of credit was replaced on June 17, 2005, by a $600,000,000 Line of Credit Agreement with a termination date of June 16, 2006.

The Company had outstanding commercial paper of $278,458,000 at September 30, 2005 and $134,982,000 at December 31, 2004.

On March 18, 2005, the Company issued $53,735,000 of 4.88% senior notes due December 31, 2020 at 100% of face value. The effective interest rate of the senior debt is 4.96%.

In June 2003, the Company entered into a $350,000,000 revolving credit facility (“RCF”). This RCF was replaced on June 17, 2005 by a $350,000,000 RCF with a termination date of June 17, 2010.

In October 2004, the American Jobs Creation Act of 2004 (“AJCA”) was enacted in the United States. One of the provisions of the AJCA was to allow a special one-time dividends-received deduction of 85% on the repatriation of certain foreign earnings to U.S. taxpayers, provided certain criteria regarding the sources and uses of the repatriated funds are met. The Company has not finalized its 2005 repatriation plans related to the AJCA. The range of possible total 2005 repatriated amounts and the related tax effects are as follows:

In 2004, the Company recorded a deferred tax liability of $25,000,000 to reflect the estimated tax cost of the minimum foreign dividends expected to be repatriated under the AJCA in 2005. As of September 30, 2005, the Company has repatriated $1,054,000,000 and recorded additional tax expense in the third quarter of 2005 of $4,500,000 to reflect the estimated tax cost of foreign dividends.

The Company is subject to various legal proceedings and claims that arise in the ordinary course of business, including those involving environmental, tax, product liability (including toxic tort) and general liability claims. The Company accrues for such liabilities when it is probable that future costs will be incurred and such costs can be reasonably estimated. Such accruals are based on developments to date, the Company’s estimates of the outcomes of these matters and its experience in contesting, litigating and settling other similar matters. The Company believes resolution of these matters, individually and in the aggregate, will not have a material adverse effect on the Company’s financial position, liquidity or future operations.

Among the toxic tort cases in which the Company is a defendant, the Company as well as its subsidiaries Hobart Brothers Company and Miller Electric Mfg. Co., have been named, along with numerous other defendants, in lawsuits alleging injury from exposure to welding rod fumes. The plaintiffs in these suits claim unspecified damages for injuries resulting from the plaintiffs’ alleged exposure to asbestos, manganese and/or toxic fumes in connection with the welding process. Based upon the Company’s experience in defending these claims, the Company believes that the resolution of these proceedings will not have a material adverse effect on the Company’s financial position, liquidity or future operations. The Company has not recorded any significant reserves related to these cases.

Wilsonart International, Inc. (“Wilsonart”), a wholly owned subsidiary of ITW, is a defendant in a consolidated class action lawsuit filed in 2000 in federal district court in White Plains, New York on behalf of purchasers of high-pressure laminate. The complaint alleges that Wilsonart participated in a conspiracy with competitors to fix, raise, maintain or stabilize prices for high-pressure laminate between 1994 and 2000 and seeks injunctive relief and treble damages. Indirect purchasers of high-pressure laminate filed similar purported class action cases under various state antitrust and consumer protection statutes in 13 states and the District of Columbia, all of which cases have been stayed pending the outcome of the consolidated class action. These lawsuits were brought following the commencement of a federal grand jury investigation into price-fixing in the high-pressure laminate industry, which investigation was subsequently closed by the Department of Justice with no further proceedings and with all documents being returned to the parties. Plaintiffs are seeking damages of $470,000,000 before trebling. Without admitting liability, Wilsonart’s co-defendants, International Paper Company and Panolam International, Inc. have settled the federal consolidated class action case for $31,000,000 and $9,500,000, respectively. The plaintiffs’ claims against Formica Corporation, the remaining co-defendant in the case, were dismissed with prejudice on September 27, 2004 as a result of its bankruptcy proceedings. As a result, Wilsonart is the sole remaining defendant in the consolidated class action lawsuit. While no assurances can be given regarding the ultimate outcome or the timing of the resolution of these claims, the Company believes that the plaintiffs’ claims are without merit and intends to continue to defend itself vigorously in this action and all related actions that are now pending or that may be brought in the future. The Company has not recorded any reserves related to this case.

See Management’s Discussion and Analysis for information regarding operating revenues and operating income for the Company’s segments.

Item 2 - Management’s Discussion and Analysis

CONSOLIDATED RESULTS OF OPERATIONS

The Company’s consolidated results of operations for the third quarter and year-to-date periods of 2005 and 2004 were as follows:

(Dollars in thousands)

In the third quarter and year-to-date periods of 2005, the changes in revenues, operating income and operating margins over the prior year were primarily due to the following factors:

North America base business revenues increased 5% in the third quarter of 2005 and 6% year-to-date. Internationally, base business revenues increased 2% in the third quarter and 3% year-to-date. The growth in North American revenues in both periods was primarily due to the continuing impact of price increases implemented to offset raw material cost increases, modest growth in industrial production and increased demand in certain capital equipment markets. Slowing economic growth in Europe continues to hamper international revenue growth.

Operating income for the third quarter of 2005 and year-to-date period improved due to leverage from the growth in base business revenue, income from acquired companies and favorable currency translation. These increases were partially offset in both periods by increased restructuring expenses. Variable margins improved modestly in the third quarter of 2005 due to price increases to recover higher raw material costs. However, year-to-date variable margins have remained below last year’s levels for the year-to-date period due to raw material cost increases. Lower overhead cost in the third quarter of 2005 also contributed to the increase in income. Leasing and Investments income increased in the third quarter due to gains on sales in the commercial mortgage portfolio but decreased year-to-date due to lower year-to-date gains on sales of mortgage properties and lower income from leases of equipment. In addition, operating income in the third quarter and year-to-date periods was negatively impacted by pretax charges to expense stock options of $6.5 million and $19.8 million, respectively. A 2005 first quarter charge of $8.7 million to resolve accounting issues at a European food equipment business negatively impacted income in the year-to-date period.

As a result of the Company’s annual impairment testing of its goodwill and intangible assets, impairment charges of $11.3 million were incurred in the first quarter of 2005. The impaired assets reflected diminished expectations of future cash flows and primarily related to a Canadian stretch packaging equipment business, a U.S. welding components business and a U.S. business that manufactures clean room mats.

ENGINEERED PRODUCTS - NORTH AMERICA

Businesses in this segment are located in North America and manufacture a variety of short lead-time plastic and metal components and fasteners, as well as specialty products for a diverse customer base. These commercially oriented, value-added products become part of the customers’ products and typically are manufactured and delivered in a time period of less than 30 days.

This segment primarily serves the construction, automotive and general industrial markets.

The results of operations for the Engineered Products – North America segment for the third quarter and year-to-date periods of 2005 and 2004 were as follows:

(Dollars in thousands)

In the third quarter of 2005 and year-to-date periods, the changes in revenues, operating income and operating margins over the prior year were primarily due to the following factors:

Revenues increased in the third quarter and year-to-date periods primarily due to revenues from acquisitions and higher base business revenues. Construction base revenues increased 2% for both the third quarter and year-to-date periods, primarily as a result of growth in the residential, remodeling/rehab and commercial construction markets. Automotive base revenues increased 3% and 1% for the third quarter and year-to-date periods, respectively, despite a 6% year-to-date decline in automotive production at the large domestic North American automotive manufacturers. This was due to increased product penetration which helped to offset lower production levels. Base revenues from the other industrial-based businesses in this segment grew 3% and 6% for the third quarter and year-to-date periods, respectively, as a result of increased demand in a broad array of end markets. The incremental acquisition revenue in the third quarter was primarily related to the acquisitions of a construction business in the second quarter of 2004, an automotive components business in the third quarter of 2004, one engineered polymers business in the fourth quarter of 2004, another engineered polymers business in the first quarter of 2005 and an automotive fasteners business in the third quarter of 2005. Year-to-date revenue also benefited from the acquisition of a construction business in the second quarter of 2004.

Operating income increased for the third quarter and year-to-date periods of 2005 primarily due to leverage from the growth in base business revenues described above, increased acquisition income and lower overhead costs stemming from 2004 restructuring projects. In addition, variable margins increased 0.4% in the third quarter of 2005 as raw material cost increases were fully recovered through price increases. Year-to-date variable margins declined 0.7% due to raw material cost increases as well as sales declines in high margin businesses. In addition, year-to-date income was higher due to lower goodwill and intangible asset impairment charges over the prior year. In the first quarter of 2005, an intangible asset impairment charge of $5.1 million was recorded related to the intangibles of a U.S. manufacturer of clean room mats. Additionally, year-to-date income increased due to a $10.0 million charge in the second quarter of 2004 associated with a warranty issue related to a discontinued product at the Wilsonart laminate business.

ENGINEERED PRODUCTS - INTERNATIONAL

Businesses in this segment are located outside North America and manufacture a variety of short lead-time plastic and metal components and fasteners, as well as specialty products for a diverse customer base. These commercially oriented, value-added products become part of the customers’ products and typically are manufactured and delivered in a time period of less than 30 days.

This segment primarily serves the construction, automotive and general industrial markets.

The results of operations for the Engineered Products – International segment for the third quarter and year-to-date periods of 2005 and 2004 were as follows:

(Dollars in thousands)

In the third quarter and year-to-date periods of 2005, the changes in revenues, operating income and operating margins over the prior year were primarily due to the following factors:

Revenues increased in the third quarter and year-to-date periods of 2005 due to higher revenues from acquisitions and the favorable effect of currency translation, primarily as a result of the Euro strengthening versus the U.S. dollar. The acquisition revenue increase was primarily due to the acquisition of a European polymers business at the end of the fourth quarter of 2004 and a European construction business in the second quarter of 2005. Year-to-date revenue was also favorably impacted by the second quarter 2004 acquisition of two European fluid products businesses and a first quarter 2004 acquisition of a European polymers business. Base business construction revenues increased 1% and 3% in the third quarter and year-to-date, respectively, as the European and Australasian markets remained weak in the third quarter of 2005. Increased demand at the Wilsonart high pressure laminate businesses offset declines in other sectors of the Asian construction businesses in the third quarter and year-to-date. In addition, automotive base revenues declined 3% and 4% in the third quarter and year-to-date period, respectively, primarily due to declines in automotive production at some European automotive manufacturers. The other businesses in this segment serve a broad array of industrial and commercial end markets. Base revenues from these businesses decreased 2% and 1% for the third quarter and year-to-date periods of 2005, respectively, due primarily to the sluggish European economy.

Operating income for the third quarter of 2005 increased primarily due to acquisitions, lower operating costs and the favorable effect of currency translation offset by lower base revenues and increased restructuring expenses. Year-to-date income increased primarily due to favorable currency translation, acquisitions, and lower impairment expenses offset by higher operating costs and restructuring expenses.

SPECIALTY SYSTEMS - NORTH AMERICA

Businesses in this segment are located in North America and design and manufacture longer lead-time machinery and related consumables, as well as specialty equipment for a diverse customer base. These commercially oriented, value-added products become part of the customers’ process and typically are manufactured and delivered in a time period of more than 30 days.

This segment primarily serves the food institutional and retail, general industrial, construction, and food and beverage markets.

The results of operations for the Specialty Systems – North America segment for the third quarter and year-to-date periods of 2005 and 2004 were as follows:

(Dollars in thousands)

In the third quarter and year-to-date periods of 2005, the changes in revenues, operating income and operating margins over the prior year were primarily due to the following factors: