Company overview
Illinois Tool Works (ITW, Financial) was founded over 100 years ago and has grown into one of the largest and most profitable industrial companies in the world.
The company manufactures a broad range of products, including robotic components and subcomponents, fastening devices and other core production components and heavy machinery equipment for manufacturers and builders.
The company’s key clientele include producers and distributors in the automotive, construction, electronics, food and beverage and chemicals industries. It currently operates 85 divisions in 56 developed and developing countries and has almost 50,000 employees. Some of the company’s most recognizable products include Wolf and Hobart kitchen equipment and Paslode air power tools. Most of its products, however, are highly unrecognizable to the typical consumer and would only be known by those working within its core industries.
The company is highly globally diversified, with overseas sales accounting for almost two-thirds of total revenue.
In 2014, the company signed an agreement to divest itself of its industrial packaging business and sold the division to the Carlyle Group for $3.2 billion. This transaction led to an immediate drop in sales as the division was responsible for about 15% of total revenue. Management believed this divesture was critical as it felt it was losing its competitive advantage in the space and wanted to leverage proceeds from the sale to support new organic growth opportunities. This included differentiating its core business activities, developing new products and advancing new marketing programs, which, overall, were expected to boost returns on investment.
The company operates along seven key segments. The automotive segment is the largest business, accounting for about 23% of total revenue. The segment manufactures fasteners, polymer, and truck parts. Its top brand includes Drawform door handles. The electronics segment accounts for 15% of revenue and produces components for microelectronic devices. Top brands include Buehler and Magnaflux. The company’s polymers and fluids segment accounts for 12% of revenue and manufactures adhesives, sealants and lubricants for a variety of industries. The food equipment segment is the second-largest division and accounts for 15% of sales. Main products include food manufacturing equipment such as ovens, refrigerators, mixers and ventilation systems. Top brands include Hobart and Traulsen. The construction segment acounts for 12% of revenue and produces tools and construction equipment.
Illinois Tool Works also operates a welding segment that accounts for 11% of revenue and specializes in power generation and mining equipment. The company also has a specialty products segment that produces plastic packaging.
Purchase considerations
There are several things we really like about this company:
- Illinois Tool Works is a well-run company and provides investors exposure to a broad array of industries. This operational diversification helps to smooth out any unwanted volatility in sales. That is, a drop in sales in one division is frequently offset by growth in sales in another. This offset is what has helped stabilize the company’s sales while transitioning out of the industrial packaging business over the last several years.
- We like the degree to which the company is internationally diversified. Cyclical swings in one geographic region tend to be offset by more stable production in its other regions.
- The company is developing a solid track record in acquiring and divesting businesses. Success in this area will help to grow shareholder value over time.
- Management is committed to only investing in product lines in which it can retain a strong competitive advantage and believes its current portfolio of products will continue to offer solid growth potential.
- The company continues to generate solid operating and free cash flows.
- Illinois Tool Works has been able to maintain a strong balance sheet, with net profit margins forecasted to rise.
- We like that the company is a relatively simple business and that management is straightforward and transparent with investors. The company also sets clear performance targets and approaches those targets at an acceptable pace.
- The backlog of orders remains strong and has been on an upward trend.
- Key raw materials relied on by the company, including steel, resins and chemicals, remain in strong supply.
- The company continues to invest heavily in research and development, spending over $225 million in 2017. R&D efforts are aimed at broadening the application of existing products and developing new products to reduce customers' costs and improve their manufacturing efficiencies.
All considered, it is still important to recognize the intensity of competition within most of Illinois Tool Works' industries is quite high and, understandably, its stock might not be the best pick for investors that fear a little competition.
We will admit that we were quite worried about this when first seeing a list of its top competitors, which included the likes of 3M (MMM, Financial), Caterpillar (CAT, Financial), Cummins (CMI, Financial), Deer & Co. (DE, Financial), Dover (DOV, Financial), Emerson Electric (EMR, Financial) and Honeywell (HON, Financial). These are all very good, very strong and very well capitalized companies. Competing against these industry leaders will prove challenging and will always place an upper limit on margins and the company’s growth potential.
Estimating sales growth
When assessing the competitive strength and investment merit of a company, we like to first assess what’s going on with sales. Ideally, we are looking to invest in companies whose sales are strong, consistent and are generally growing faster than nominal gross domestic product growth (that is, real GDP growth and inflation combined).
Based on Illinois Tool Works' historical sales data, you can see its revenues have grown by about -0.4% over the last 10 years. This compares to average nominal GDP growth of 3.2% per year over the same period. The company's sales have grown by -0.7% per year over the last five years and -0.4% per year over the last three years.
It is worth noting that Illinois Tool Works' three-year revenue growth rate is ranked higher than 59% of the 1,737 companies in the Diversified Industrials Industry. This company's growth trajectory has not been terribly impressive, but we do think it is operationally on solid ground. We also believe it retains sufficient pricing power. We feel comfortable recommending investing in this company for modest growth, however, and expect impressive things from the stock in the future, particularly following this year's 17% drop in price.
The second thing we like to do when assessing sales is to look at consensus market estimates. As reported by Morningstar Inc., the market is projecting 3.6% annual growth for this year, 1.8% annual growth for next year and 1.2% for the year after that. These growth estimates translate into $14.8 billion in sales for this year and $15.1 billion in sales for next year. The projected increase in sales is expected to be driven by an increase in product demand, rising prices and improved production capacity.
A third thing we like to do when assessing sales is to compute the company's sustainable growth rate. The sustainable growth rate reflects the rate of growth in sales that a company can support given its existing earnings power, capital resources and dividend payout policy. In any given year, a company's sustainable growth rate is calculated by multiplying its return on equity by its retention rate. Rather than rely on data from only one year, however, we calculate sustainable growth by using the company's three-year average ROE and three-year average retention rate. Illinois Tool Works's ROE averaged 37.6% over the last three years while its retention rate averaged 53%, giving the company a sustainable growth rate of 19.9% per year.
Let's recap briefly what the sales data is showing us. From what we can tell, it is not unreasonable to estimate that sales over the next five years could grow at a rate of somewhere between -0.7% and 19.9%.
We're going to select a rate of 1.2%. This represents a blended rate forecast, reflecting consensus three-year rate projections scaled by a 10-year average incremental change for the last two years of the five-year forecast horizon. With $14 billion in sales generated last year, this means we believe sales will reach about $15 billion in five years. This estimate reflects our understanding of the company's historical results, market demand, pricing trends, levels of competition and changing regulatory requirements.
Estimating earnings per share
Now that we have generated our sales estimate, we’re going to estimate growth in earnings per share. The method applied below takes the sales growth projection — in this case, 1.2% per year — and subtracts the expenses and taxes. What we're left with are the earnings. Then we divide by the projected number of diluted shares outstanding to determine the earnings per share (see table below).
A projected growth rate of 1.2% will result in about $15 billion in sales five years out. Now we need to take a look at the company's pretax profit margin (what’s left over after expenses but before taxes are subtracted). In the figure below, we can see that Illinois Tool Works produces some pretty stable margins — 22.8% in 2017, 21.4% in 2016, 20.3% in 2015 and 18.6% in 2014. The average for the last five years has been 20% and the average for the last 10 years has been 17.3%. We believe that Illinois Tool Works' margins will hold at 17.3%. At this rate, projected pretax profits on $15.2 billion in sales would be about $2.6 billion. This means expenses would amount to $12.5 billion.
The next step in our estimation process is to establish what tax rate will be paid on the company's profits. The most recent year’s rate was 48.4%. Normally we wouldn't play with that number too significantly because, in general, it shouldn't change very much from year to year. The only time we would make major changes to this number would be in instances where maybe the current rate differed significantly from that of the past or if we had some knowledge about what rate was likely going to persist in the future, perhaps because the company is going to get some preferential tax treatment on operations abroad or because of a broad change in state or federal tax policy.
For Illinois Tool Works over the last 10 years, the company's tax rate has been as low as 20.1% and as high as 48.4%. Tax rates for most U.S. companies are around 16.1%. We're going to select a rate of 20%. This would result in a tax expense of $0.5 billion from pretax profits of $2.6 billion in five years. This would leave us with $2.1 billion in projected earnings five years from now.
Our next main consideration is a matter of determining the number of diluted shares that will be outstanding in five years. Illinois Tool Works has decreased the number of shares outstanding over the last decade. There were 556 million shares outstanding in 2007, then the number of shares went to 473 million in 2012 and then fell to 370 million in 2015. Currently, there are 347 million shares outstanding. This data suggests the company has been redeeming about 20.9 million shares per year. We're going to rely on the company's historical share repurchase activities to guide our estimation process. As such, we project share repurchases of 19.3 million per year over the next five years.
With shares estimated at 250 million in five years, earnings per share are expected to rise at an annual compound rate of 11.5% over the period. This is higher than our projected five-year revenue growth rate. Based on this earnings per share growth forecast, we are expecting earnings of $8.37 per share five years out. Results of our forecasting procedure are summarized in the table below.
Forecasting a target price-earnings multiple
Illinois Tool Works’ stock has traded with a relatively stable price-earnings multiple over the last decade, averaging 18.6 over the last 10 years, 21.9 over the last five years and 24.6 over the last three years. Currently, the company is trading at 24 times trailing 12-month earnings per share and 16.4 times expected future earnings.
For determining an estimated target price-earnings multiple, the first thing we like to do is eliminate any outliers from the historical data series. This includes abnormal price-earnings ratios that are not reflective of the normal operations of the company, and this could be the result of abnormal growth or significant one-time non-recurring charges or gains. The next thing we like to do is to run an optimization procedure that tells us what price-earnings multiple yielded the best forecasting accuracy over the evaluation period. If in our judgement this multiple continues to accurately portray the earnings and cash generating power of the company as well as the growth and risk characteristics of the company, then we will use this multiple as our target multiple. If not, we will adjust the multiple upwards or downwards accordingly.
The figure below presents the historical price-earnings profile for Illinois Tool Works. We will utilize a target multiple of 17.8 times, which we believe reasonably characterizes the risk-return attributes of the company's stock. This multiple represents a contraction of 48.1% relative to the current multiple. It also represents a contraction of 20.5% relative to the five-year average price-earnings multiple.
Setting a target price and valuation range
Now we need to take a look at the price history of the company's stock. From the figure below, we can see the spread between the high and low stock prices has increased over the last 10 years. We have a current price of $133.26, with a high in the past 10 years of $168.55 and a low of about $26.19. We want to keep this variability in mind when establishing our upper and lower valuation range. Specifically, given the company's historical stock price behavior, we should expect the stock to fluctuate by at least $25.77 over the course of a year.
Given our selected target price-earnings multiple of 17.8, to determine a price target five years out, we then multiply this by our earnings per share estimate. Earnings are estimated to reach $8.37 per share in five years, giving us a target price of $149.32. This price is higher than the current price. To properly judge to what extent the stock may be under- or overvalued, we need to determine a fair value range within which we expect the stock to trade. To do this, we rely on the trend-adjusted average annual trading range for the stock, which, from the analysis above, we know is $25.77. This means that, given our target price estimate, we expect the stock to trade naturally, and fairly, between $136.43 and $162.20. The result of this is that when the stock is trading below $136.43, it is in the buy zone. When the stock trades above $162.20, it is in the sell zone. Currently, the stock is in the buy zone.
Return potential
So what return can we expect for holding Illinois Tool Works' stock? Well, we now know we can expect stock price appreciation of 12%. We can also expect to earn dividend income of about $16.70 over the evaluation period. Added to our price estimate, this means we could earn a compound annual rate of return of 4.5%, provided our estimates prove accurate. All in all, we are reasonably happy with this company and believe it offers sufficient return potential to qualify for investment. We recommend buying the stock at current valuation levels.
Disclosure: We currently do not hold any positions in this company.
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