Breaking Up Is Profitable To Do

Dec. 21, 2004
A paragon of decentralization, Illinois Tool Works turns a raft of small business units into big dollars at the bottom line.

Why would a company choose to divide itself into more than 400 business units? Better still, how can such a seemingly splintered organization not only succeed, but thrive in this fashion? These questions are more than adequately answered by Illinois Tool Works Inc. (ITW), the Glenview, Ill.-based, $5.6 billion diversified manufacturer of self-described dull products (nails, spray guns, molded parts) that parlays smallness into big and brilliant numbers. Like microorganisms undergoing cell division, ITW businesses grow to a critical mass, then split apart. Acquired businesses likewise are divided into parts that make their elements most homogeneous. In each case the objective of a unit is to focus on its customer set as a niche market, with laser-like intensity. "It costs us money upfront to split the businesses, but each grows so fast afterward that it eclipses the small amount of premium you are paying to separate them," says Chairman and CEO Jim Farrell. Although the decentralization strategy has driven a healthy 12% compounded annual revenue growth for years, the yardstick of performance at ITW is earnings. The company has delivered on that measure consistently -- in April announcing its 21st consecutive quarter of double-digit earnings growth. In fact, during the last 10 years ITW has averaged 17% compounded annual earnings growth, powering a shareholder-delighting 700% run on Wall Street during the same period. "We love competing against a big company, because their management teams don't have the same feel that our people have," says Vice Chairman Frank Ptak. "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." Corporate mitosis Though Executive Vice President Russell Flaum jokes that ITW will divide a business unit when its parking lot overflows or the cafeteria lines are too long, splits typically are wedged by market and product factors and by opportunities. By the numbers, $50 million is a good guide as a threshold for action. "When a business hits $50 million we have the view that it is going to lose its growth focus," says Ptak. "You are spreading yourself around too much. It's starting to get too complicated. So we will take the $50 million business, split it into three $15 million to $18 million businesses, narrowly niched and refocused on whatever their specific opportunity is. We'll give them their own engineering, their own manufacturing. Over time we will make them totally autonomous. Maybe we will share an accounting department -- that's about it." For example, the Deltar division, a business focused on plastic fasteners for the automotive market, took about seven years to reach $2 million as part of the Fastex industrial fastener group. Split out, given its own manufacturing facility and a focused business force, the unit grew sevenfold in four years. Deltar since has been split four times into smaller units including fasteners, insert-molded parts, and specialties. The insert-molded parts business itself has split into seven niche markets and added five other businesses to grow from $40 million in 1995 to $135 million in 1999. The original Deltar business now is broken into 26 units with $300 million combined revenues. "First we choose not to compete in niches where we can't differentiate ourselves," says Ptak. "Then when we do assign a business team and challenge it to grow in its niche, they get really resourceful. It becomes their sole focus. The basic advantage is you have people down in the trenches who really understand the business because they are specifically dedicated to it." In addition to the business benefits, extreme decentralization presents enhanced personal career opportunities for a wide range of employees. "The soft side of this, the human side, is that young people get to run businesses," says Ptak. "We develop managers so rapidly that a person can start running a business when he is in his 20s. Some segments start out very small, perhaps $5 million to $8 million. That's a great place to try a young person. If they fail, we just pick up the pieces and move on. If they worked for another company, they would be trapped in some function. Here they get a chance to do everything. That gives a lot of people the chance to train and see what they can do." 80/20 creates action Although closeness to markets helps drive the top line, efficient operations drive the basic earnings objectives of the company. "We believe if a company is able to get itself into strong profitable shape, then it is able to grow the top line," says Farrell. "But until you have really organized yourself and figured out how to make money at what you do, we don't want you to go out and get sales just for sales' sake. We want our businesses to be physically in great shape. Then they can go out and compete." Getting in shape at ITW means applying 80/20 principles to streamline and remove complexity from every function in the business or new acquisition, from sales to manufacturing to accounts payable. The focus is finding the very best way to serve the key 20% that accounts for 80% of the business and some other way to serve the 80% that causes all the complexity. Although many companies preach 80/20, "the difference at ITW is that when we 80/20 a business, it leads to specific actions," says Farrell. For example, in one of its construction businesses, ITW analyzed the nails typically used by the variety of trades in the construction of a wood-framed house. In fact, four types of nails represented roughly 80% of the volume with the remainder comprised of 20-plus other types of nails. To focus on the bread-and-butter part of the business, ITW initially produced the four key nails in different manufacturing cells from the others. Today they are produced in totally separate plants. "If you keep them together, you end up compromising on both," says Dave Speer, executive vice president. "If you separate them, you optimize both," which pretty much sums up the ITW 80/20 operational philosophy. In other 80/20 manifestations, ITW will do product development only with the 20% of customers that give them 80% of the business. Whereas the 20% customers are handled in person by field sales, the other 80% are serviced by distributors. Supplier relationships are focused on the 20% who supply 80% of raw materials. Clerks match up invoices against receiving reports only for the 20% of bills representing 80% of accounts payable. "For us, 80/20 is a business-planning process," says Farrell, "a way to analyze a business, isolate it, figure out where its core competencies are, and determine if those competencies have growth potential. Then we line up the support functions behind them without the encumbrance of 80% of the transactions or part numbers or customers that confuse the issue. It means analyzing a lot of data, then having the courage to tear the business apart. It's a hard thing to do, and it can be demoralizing. But I hasten to say, if you mess up the key 20%, you are going to demoralize a lot more folks. You have to win here." Join the crowd While the ITW businesses are splitting, the company also adds many businesses via acquisition, contributing significantly to growth in revenues and earnings once they are streamlined. Thirty-six companies were acquired in 1998 (average value $23 million), and 28 in 1997 (average value $15 million). Acquisition typically is driven bottom-up by unit general managers, who use them to increase product penetration with existing customers or open new markets for an existing business. In addition, ITW selects companies ripe for improvement with application of ITW principles and a management that is flexible enough to adopt them. "We look for complementary, bolt-on acquisitions that allow us to build a core business," says Flaum. The acquisitions often bring in related product expertise, access to a particular marketing channel, or even an untapped group of customers; for instance, a company with an especially strong relationship with a Fiat or BMW. Smaller acquisitions are favored by ITW because much of the effort required to integrate them is driven down to the unit level. "Also it's less risky," says Jon Kinney, CFO. "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. We made an $800 million acquisition in 1998 -- it was just split up into 30 to 40 pieces." The company's strong cash-rich balance sheet helps fund the acquisitions. In fact, 80% of cash generated is reinvested into the business, with nearly half of that applied to acquisitions. ITW has been very successful with cash management, with return on equity averaging 20% during the last 10 years and 22% for the last five. CEO Farrell foresees the day when ITW will be making "50 to 60 acquisitions per year in the $20-million-to-$30-million range and integrating them like that," he says, as he snaps his fingers. As with individual ITW businesses, the first scrutiny of a newly acquired company is segmentation, then the application of 80/20 principles, simplification, and deployment of manufacturing-efficiency techniques such as in-lining, just-in-time, kanban, and supply to market-rate-of-demand. Signode packaging systems -- a whopping $800 million acquisition made in 1986 that at the time doubled the size of ITW -- was split into about 50 separate businesses. Moving forward, Signode sales have doubled while earnings tripled. Orgapack GmbH, a $50 million Swiss packaging company acquired in 1996, was split into four units, and while sales have remained roughly the same, margins have doubled as a result of application of the ITW operations principles. Two concrete-fastener businesses have doubled revenues since 1990. Managing the mlange To manage the mix of businesses that has increased by an average of 38 per year during the last four years, ITW has built a lean, flattened headquarters structure, with seven executive vice presidents reporting to CEO Farrell. Each executive vice president has about 50 business units under his wing run by some 35 general managers, some of whom double up on business units. There are no corporate financial hurdles passed down from on-high to the business units, just a mantra of simplification, continuous improvement, and increasing earnings. Though approved by management, business-unit performance targets percolate from the bottom up. "We expect all of our businesses to move up their margins each year, whether they are a 5%- or a 35%-margin business," says Farrell. Incentive compensation strongly reinforces the earnings emphasis, with 50% of bonus opportunity directly tied to them. Farrell's friendly, common-sense approach drives his personal management style, which he describes as relaxed, informal, and loose. For instance, he never has demanded a monthly report from anyone and never has written one himself during his climb to the top spot after a 34-year ITW career. But don't mistake informal for undisciplined or loose for careless. "One of the strengths of the company is focusing enough on the details that we know where to lead people," says Farrell. For instance, while extreme decentralization optimizes focus, it seemingly minimizes synergies and the supposed leverage of shared services. At headquarters are tax, audit, and associated financial functions, investor relations, a skeleton HR staff, and an R&D group that supports the individual businesses with application development. Otherwise, the businesses are self-supporting. "The potential downside, although I'm not sure I believe it, [would be] if, for instance, we had a common system for taking orders across 50 businesses," says Farrell. "We could have a lot cheaper computing cost but then I would be taking control away from the businesses and putting it someplace else. Businesses would talk about charge-backs and how they don't have control over that. We want the businesses to feel the pain of that cost so they have to do something about it. We may miss some efficiencies, but I think we more than make it up by paying closer attention to the details." One of the premier challenges for the company is communication. And yet, while e-mail seems like an obvious candidate for spreading the word, CEO Farrell advises a minimum of electronic communications in favor of face-to-face, see-the-troops interaction. He himself has no computer at his desk. Farrell eschews job descriptions, instead matching the talent to the job at hand at the time. Nor are operating principles, such as 80/20 methodologies, written down and codified. "It reduces the importance of it by putting it in a book," says Farrell. "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."

Sponsored Recommendations

Voice your opinion!

To join the conversation, and become an exclusive member of IndustryWeek, create an account today!