Illinois Tool Works is a Fortune 200 company that produces engineered fasteners and components, equipment and consumable systems, and specialty products. It was founded in 1912 by Byron L. Smith. In 2007, ITW had more than 20,000 unexpired patents and pending patent applications worldwide, including 2,900 U.S. patents and 1,116 pending U.S. applications. The company typically ranks in the top 100 of patent issuers in the U.S. The company earned $15,870 million in revenue and $1,527 million in net income.
- Transportation-related components, fasteners, fluids and polymers, as well as truck re-manufacturing and related parts and service
- Industrial packaging sSteel, plastic and paper products and equipment used for bundling, shipping and protecting goods in transit
- Power systems and electronics equipment and consumables associated with specialty power conversion, metallurgy and electronics
- Food equipment, commercial food equipment and related service
- Construction products tools, fasteners and other products for construction applications
- Polymers and fluids adhesives, sealants, lubrication and cutting fluids, and hygiene products
- Decorative surfaces, decorative surfacing materials for furniture, office and retail space, counter tops and other applications
- Foils, fasteners, clean room wipers, scientific equipments, etc.
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ITW has low capital intensity. Its capital expenditure has been in the range of 17-32% of total income in the last decade. This shows that ITW has consistently found good ways to grow organically and by acquiring new business. ITW acquired 24 companies representing $530 million of annualized revenues in 2010 — up from just under $300 million in annualized acquired revenues in 2009. We also note that with the capital expenditure ratio we see that ITW has never spent too much on acquisition in a particular year and has been steadily buying new companies and increasing sales.
2 Sales AnalysisThe first thing one needs to understand for a company is the sales. The company makes money and profit on the dollars it rakes in.
The company made $15.9 billion in sales in 2010. It makes sales to more than 15 different industries, none of which make up more than 17% of the revenue.
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Historically, North America and Europe had been the major customers. For example, in 2000, 66% of the revenue came from North America, 26% from Europe, Middle East and Africa, and 8% from Asia Pacific and others. Fast forward to 2010 and we see that North America now stands at 48%, Europe, Middle East and Africa at 32%, and Asia Pacific and others at 20%. The sales are now more geographically diversified which lowers the geographical risk. It also shows that ITW has a very good network which its sales rely on.
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I put ITW in a very low risk category in terms of where and who it sells its products to. It is not difficult to believe that ITW has been a slow and steady grower. The graph below is a testament of the fact that slow and boring industries when coupled with good management can be a boon to shareholders.
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ITW has performed fabulously maintaining its margins. We see that even when the sales dropped from $16.1 billion in 2007 to $13.8 billion in 2009, the gross margin did not suffer too much. It went from 35.3% to 34.1%.
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Let us look at the income statement during 2006-2011.
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We see that ITW’s operating profit has been in the $2.4 billion range. The minimum was in 2009 ($1.4 billion) and apart from that one blip in the graph it has always been in the range of $2.3-$2.7 billion.
ITW has consistently shown to be a good controller of cost. The gross margin has been 35% like clockwork since 2001, even during the downturn faced by the industry in 2009. The net margin has a median of 9% during the last decade and shows a potential competitive advantage on ITW’s side.
So, has ITW been able to maintain profitability and its costs quite well? My answer is a clear-cut yes. Anyone who sees the numbers above will not disagree.
3 Financial Strength
Let us look at the balance sheet of ITW since 2001. We see that ITW has a very strong balance sheet. The current ratio has never been less than 2 (in the current quarter the current ratio is 2.02). Furthermore, ITW can pay all its liabilities using its current assets+0.9B. Furthermore, this is not something new. ITW always had a very good balance sheet. The ratio of tangible liability and tangible assets has always been less than 0.5.
In 1999, the company issued $500,000,000 of 5.75% redeemable notes due March 1, 2009. The balance related to these notes was repaid at maturity. On March 23, 2009, the company issued $800,000,000 of 5.15% redeemable notes due April 1, 2014 at 99.92% of face value and $700,000,000 of 6.25% redeemable notes due April 1, 2019 at 99.98% of face value. The company had outstanding commercial paper of $1,038,044,000 at March 31, 2009 and $1,820,423,000 at Dec. 31, 2008. I see that as ITW is comfortable enough to repay the debts when they mature.
Not only that, ITW has also consistently been able to retain earnings, and this has also grown over the years. In 2010 alone it retained nearly $11 billion of earnings. As opposed to this, we see that the goodwill and intangibles come out to be $6.5 billion in 2010.
|Retained Earnings Growth||-||7.58%||11.85%||14.80%||14.43%||14.20%||-5.07%||-6.91%||3.54%||9.22%|
4 Dividends and Buybacks
ITW has been a very shareholder-friendly company. Illinois Tool Works is a dividend champion, has paid uninterrupted dividends on its common stock since 1933 and increased payments to common shareholders every year for 47 years. The most recent dividend increase was in August 2010, when the board of directors approved a 9.70% increase to 34 cents per share.
|Shares bought back||-||-0.7%||0.05%||1.11%||6.08%||0.75%||2.55%||6.77%||4.21%||-0.6%|
|Dividend Paid Per Share||0.41||0.44||0.46||0.50||0.58||0.70||0.90||1.15||1.24||1.26|
|Price at Year End||67.72||64.86||83.91||92.68||87.99||46.19||53.54||35.05||47.99||53.40|
Apart from the dividend, ITW has also bought back shares, year after year. There have been only two years, in 2002 and 2010, when the shares were diluted a bit. Overall the share count has gone from 613 million in 2001 to 503 million in 2010. This is a 15% decrease in shares outstanding.
To put it in perspective, if you had invested in ITW on Dec. 31, 2011, you would have, not counting dividends, gained 43% as opposed to the S&P500's return of 7.7%!
The management has done a wonderful job here. We see that the the cash return on invested capital has been above 10% with a mean of 16%. Furthermore, the return on equity has been above 10% too with a mean of 16%.
- In 2010, the annual cash retainer for non-employee directors was $135,000, and the annual fee for committee chairs was an additional $5,000, except for the Audit Committee chair, whose annual fee was $15,000, and the Compensation Committee chair, whose annual fee was $10,000. Non-employee directors are given the opportunity to elect annually to receive all or a portion of their annual retainer and chair fees in an equivalent value of ITW common stock pursuant to our Illinois Tool Works Inc. 2006 Stock Incentive Plan. The number of ITW shares to be issued to a director is determined by dividing the dollar amount of the fee subject to the election by the fair market value of ITW common stock on the date the fee otherwise would have been paid in cash.
- The directors and the executive officers hold 4.2% shares of the company with Robert C. McCormack holding 2.9% of the shares.
- ITW continues to believe, however, that stock options are an effective incentive for senior executives on a long-term basis because the option loses its value entirely if the price of ITW’s common stock falls below the grant price. Therefore, in 2010, two-thirds of the stock-based grants were in the form of stock options and the other one-third in the form of PRSUs. In 2010 executives as a group were paid $4 million in RSUs and $9 million in stock options with around $44 strike price.
When you take care of the downside, the upside takes care of itself. This section deals with the risk associated with an investment in ITW.
- Growth by acquisition: ITW has a history of achieving growth by acquisition. In 2010 alone it acquired 24 companies representing $530 million in revenue. In 2009, the acquired revenues were $300 million. As we well know, acquisitions fail more than they succeed because of the significant overpayment and sometimes failure to quickly and effectively integrate the new company in the old corporate structure. The Clare Ross Organization supports this assertion by claiming that less than 50% of corporate acquisitions are successful.
- Recession in home building: When spending on new home construction drops, so does spending on construction equipment and supplies, resulting in slowed revenue growth for Illinois Tool Works. More than one third of the revenue is effected by construction. A pickup in construction will lead to better sales and margins.
- Currency exchange rates: This is an obvious one. Because ITW generates a significant amount of sales in Europe and Asia, currency risks are always there and may effect ITW in a good or a bad way.
I do not see any liquidity risk (because of a very good balance sheet) or geographical risk (as the sales are not concentrated too much in a particular area).
It is imperative that one buys a company for the right price. Even buying a good company can lead to under-performance if the price paid does not provide a margin of safety.
|FCF (in $Bn)||1.09||1.02||1.11||1.25||1.55||1.77||2.13||1.87||1.9||1.27|
The five-year forecast growth rate is 11.8% for the company.
As we see the FCF has declined in the recent years mainly due to the hit in 2009. The TTM FCF has now recovered to $1.33 billion. Assuming a base FCF of $1.33 billion, a 10% discount to S&P, and a 2% terminal growth rate the current price of $45 implies that the market is assuming a FCF growth rate of 7% in the next five years as opposed to 11.8% forecast by analysts. Furthermore, we see that the 10-year average growth rate for ITW has been above 10%, except in 2009 and 2010. So, there is a strong indication that it can sustain a 10% growth rate going forward. This gives us a 30% margin of safety. For such a great company I would say that this is a good discount to get.
8 Investment thesis
Let me recapitulate the main points of the article here.
- ITW has a fantastic and a very liquid balance sheet. Its total liabilities are only 15% more than the current assets.
- ITW has returned 45% since Dec. 31, 2001, as opposed to the S&P which has returned only 7% (ignoring dividend).
- ITW is a dividend champion, has paid uninterrupted dividends on its common stock since 1933 and increased payments to common shareholders every year for 47 years.
- ITW runs a very good business with 34% gross margin, 17% operating margin and 10% net margin. The numbers here have not moved much in the last decade.
- ITW sells products to more than 20 industries and none of them account for more than 17% of net revenue. Furthermore, ITW is spreading its wings in Asia too. It generated 20% of its revenue there as opposed to 8% it generated in 200.
- ITW is currently undervalued by an order of 20-30% by the DCF calculation. I will consider buying ITW below $45 a stub.
- ITW does not have any major risks associated with it. Even another recession will not worry me too much if I am invested here.
Additional disclosure: I do not own any shares but am definitely interested if prices drop below $45.