Our rating on Illinois Tool Works Inc. (NYSE: ITW) is BUY. Management is clearly focused on generating shareholder value.
The beta on ITW is 1.16.
On October 23, ITW reported that organic revenue declined 4.6% to $3.3 billion. The pro forma operating margin narrowed by 120 basis points to 23.8%. Third-quarter GAAP EPS came to $1.83. In the nine-month period, the company earned $4.61 per share.
Given the challenging economic outlook due to the pandemic, management suspended its guidance in May. The company had expected organic revenue to be flat to up 2% and projected EPS of $7.65-$8.05. Management commented on the 3Q call that revenues continued to improve as the quarter progressed, and that 3Q revenue was up 29% sequentially from 2Q.
Management believes that the company has ‘significant margin cushion’ that will allow it to support a rebound in customer demand and take share from competitors.
EARNINGS & GROWTH ANALYSIS
Illinois Tool Works has seven primary segments: Automotive OEM (22% of revenue), which designs and manufactures powertrain and braking systems; Test & Measurement and Electronics (15%); Food Equipment (14%), which designs and manufactures dishwashing, cooking, refrigeration and food processing equipment; Polymers & Fluids (13%), which includes brands such as Permatex, RainX and Wynn’s; Welding (11%); Construction Products (14%), which focuses on fasteners; and Specialty Products (13%), which range from zippers on resealable bags to six-pack rings to coatings for branded products.
All segments reported lower revenue in 3Q except Construction Products and Polymers & Fluids. Food Equipment suffered the most, down 19%. Welding declined 14% and Specialty Products dropped 5%. By geographical market, North American revenue was down 5%, EMEA was down 8%, APAC was up 3%, and China was up 10%. We expect a return to more normal demand in 2021 as the impact of the pandemic recedes.
Management continues to focus on controlling costs through its ‘Finish the Job’ Enterprise Initiatives program, which is designed to reduce the complexity and lower the overhead associated with smaller product lines and customers. In 3Q, the pro forma operating margin narrowed by 120 basis points to 23.8%, as lower volume and higher restructuring costs were partially offset by benefits from the Enterprise Initiatives program.
EPS continued to benefit from stock buybacks.
FINANCIAL STRENGTH & DIVIDEND
The after-tax ROIC in 3Q was a healthy 29.6%. Free cash flow in 3Q was $631 million, and free cash accounted for 108% of net income.
The company pays a dividend, which it has raised annually without interruption for more than 50 years. In August 2020, the board raised the quarterly payout by 7% to $1.07 per share, or $4.56 annually, for a yield of about 2.3%. We think the dividend is secure and likely to grow. Our dividend estimates are $4.42 (reduced from $4.46) for 2020 and $4.78 (reduced from $4.90) for 2021.
Illinois Tool Works also buys back stock.
MANAGEMENT & RISKS
The company is focused on generating solid growth, with best-in-class margins and returns on capital.
Performance goals by 2023 include:
— Organic growth of 3%-5%.
— An operating margin of 28%.
— An after-tax ROIC of 40%.
— 7%-10% annual EPS growth.
— A 50% payout ratio.
The company has long relied on innovative cost-control strategies, including the 80/20 rule and, more recently, its ‘Finish the Job’ Enterprise Initiatives program and strategic sourcing initiative.
On a macro basis, the company’s results are impacted by global economic conditions. Downturns in the markets served by the company could adversely affect its businesses, results of operations, or financial condition. The global nature of the company’s operations also subjects it to political and economic risks. On a more micro basis, the benefits from the company’s Enterprise Initiatives program may not be as expected and the company’s financial results could be adversely impacted. ITW may also fail to meet its long-term financial targets.
The share price is susceptible to pullbacks if earnings disappoint, as has happened in recent quarters despite double-digit growth.
Illinois Tool Works is a global manufacturer of engineered industrial products and equipment. The company’s operations are divided into seven segments: Test & Measurement and Electronics, Automotive OEM, Polymers & Fluids, Food Equipment, Welding, Construction Products, and Specialty Products. The company has 45,000 employees.
Following the March 2020 pandemic lows, that bullish pattern has resumed.
ITW’s multiples are generally in line with or slightly above industry averages, but we think that this well-managed company should trade at a premium.