Simplicity Makes Illinois Tool Works Attractive

Illinois Tool Works (ITW) was established in 1912. The company is a global manufacturer of a broad range of industrial products and equipment with 85 divisions in over 50 countries. ITW employs approximately 50,000 people. The company reported USD 14.31 billion revenue and USD 3.5 billion operating income in 2017.

ITW has seven reportable segments: Automotive OEM; Food Equipment; Test & Measurement and Electronics; Welding; Polymers & Fluids; Construction Products; and Specialty Products.

Overview

The company’s seven segments incorporate: producing components and fasteners for automotive-related applications; manufacturing commercial food equipment; making test and measurement, and maintenance, repair, and operations solutions; producing welding equipment for industrial applications; manufacturing adhesives, lubrication, fluids and polymers for auto aftermarket maintenance; supplying fastening systems and solutions; producing beverage packaging equipment, coding and marking equipment and components. 

Illinois Tool Works generates diversified revenues starting from USD 1.5 billion to USD 3.3 billion in each of its segment. The company has completely renewed its enterprise strategy since late 2012 and focuses on improving the quality of the business portfolio and simplifying the operational structure. As part of its enterprise strategy, ITW using 80/20 front to back process. Each of ITW’s business concentrates 20% of customers that generate 80% of revenues and focuses on growth opportunities of these key customers. ITW has above-GDP growth rates and competitive margins which indicate the company is in the right strategic path. The company focuses on competitive advantage and seeking to explore organic growth opportunities, such as product development, marketing efforts, and operational simplification. As an operational simplification activity, ITW is divesting slow-growth businesses and concentrating on profitable, attractive and differentiated product lines.

ITW generates 53% of its operating revenue in North America and 28% in the EMEA region. According to Investopedia, industries involved in the production of durable goods, such as raw materials and heavy equipment, tend to be cyclical. The company’s quarterly income statement indicates that second and third quarter revenues lean to be high.

ITW’s more than 50% key executives working with the company for more than eight years. The company’s increasing gross profit and operating margins support the management’s success. ITW is also able to produce organic growth with sustainable competitiveness.

ITW’s CEO Mr. Santi started at the company’s construction division in 1983 and climbed the ranks as elected vice president in 2004, vice chairman in 2008 and finally took the CEO helm in 2012. Mr. Santi has more than 35 years of career with ITW, which assures a high level of understanding of the whole organization.

The in-house experience of its CEO provides an understanding of the company’s capabilities, competitive advantage elements, risk factors and growth potentials.

As an operational simplification activity, ITW is divesting slow-growth businesses and concentrating on profitable, attractive and differentiated product lines.

Investment Characteristics

When Mr. Santi started to work as a CEO; the company focuses more on core segments and its revenue declined by 21% in 2013; however, operating income only affected by 12%. The decline in revenue was related to ITW’s effort of divesting slow-growth businesses and less reduction of operating income ratio confirmed the effectiveness of the process at the beginning of the simplification strategy. Also, in 2014, the company’s sale of industrial packaging business net proceeds was USD 3.2 billion. Divesting slow-growth areas and simplifying its business structure by reorganizing product lines within each segment has helped efficient labor, purchasing, and transportations.

ITW has high working capital comparing prior periods due to high cash and equivalents. The amount of cash and equivalents increased by approximately 24% from 2016 to 2017, most of cash and equivalents are held by international subsidiaries. The company claims that cash in international operations used for daily operating needs, possible expansion needs of businesses, acquisition opportunities or debt repayments. However, with passed tax reform, the company recorded income tax expense of USD 658 million of repatriation tax and expects to repatriate an additional USD 2 billion of cash and equivalents held by international subsidiaries. The company’s tax rate is increased from 30% to 48% in 2017 due to repatriation; after considering of this one-time event, the increase in the tax rate looks acceptable.

ITW has the gross margin of 39%-42% range from 2013 to 2017. Its sales and administrative expenses-to-sales margin is consistently declining due to simplification and divestiture strategy. The company’s financial leverage ratio has to show an increasing trend, started from 2.06 to 3.66 during the 2013-2017 period. During the same period, return on equity increased from 16.57 to 38.17, which supports that the company is using its debt effectively and increase its profitability with additional financial obligation.

The company’s 5-year average revenue declined by 4.40%, however, its 5-year average operating income increased by 4.17%, which confirms ITW’s simplification strategy and its positive outcome in profitability ratios. The company’s operating income margin increased more than 3% on test & measurement, construction products, specialty products segments in 2015-2017, except the automotive OEM segment declined by 1.4% due to large industrial customers which have more pricing power.

During the 2013-2017 period, return on equity increased from 16.57 to 38.17, which supports that the company is using its debt effectively and increase its profitability with additional financial obligation.

Valuation

Our fair value estimate for Illinois Tool Works is USD 151.50 per share. The company has a trend of lowering the cost of sales and operating expenses. These expenses are reduced to 75% in 2017 and our calculation considered the company’s simplification strategy. Therefore, we estimate the future total cost of sales and operating expenses in the low 70% to high 65% range. The company’s organic revenue growth rate has averaged 1.5% to 2.0% range over the past decade. After post-election tax incentives, ITW’s growth rates are expected to be higher in 2018-2019. ITW segment growth rates are more correlated with each geographical industrial expansion rates. As consistent with our assumption, we model mid-term revenue growth more than 3% in early periods and gradually loosen to 2% range afterward. We expect the future cost of equity of more than 9% and cost of capital of more than 8%. The company’s 5-year price-to-earnings average is more than 19. In our firm multiple calculations, the company’s future enterprise value-to-EBITDA is on 14-15 range, and current enterprise value-to-EBITDA ratio is approximately 13. ITW’s expected enterprise value-to-revenue ratio is more than 4.7 and current enterprise value-to-revenue ratio is currently 3.6. These forecasts basically indicate that the company’s simplification strategy and focusing key areas help improving margins and to be consistent with targets. However, investors keep an eye on possible trade wars and tariffs with the EMEA region. Even though ITW has a broad range of segments and involves in diversified regions, global trade wars may deteriorate the company value.

Risks to consider

ITW’s growth rate is correlated with penetrated geographical locations’ industrial growth rates; therefore, slow industrial economies may adversely affect the growth strategies in near future. These conditions may cause increased credit needs and negative credit ratings.

The company acquired connectors unit of ZF TRW for USD 450 million in 2016. This indicates the company’s willingness to large corporate purchases, which may result in divergence from simplification strategy and possible management distractions.

ITW needs to develop consistently new products with research and development activities, which requires heavy investment and resources. The peer group company’s research and development expenses are higher than ITW. This may adversely affect the company’s organic growth strategy and competitive position.

ITW needs to develop consistently new products with research and development activities, which requires heavy investment and resources.

Other considerations

ITW’s stock price peaked in January 2018 and declined by more than 22% currently. Possible global trade war and tariffs are caused a burden on the stock price. The current trend is not only seen in ITW, but also in the industrial sector. The company fundamentals support that declining trend may not carry forward for the long-term. Improved organic revenue growth and core business approach help the company to raise operating efficiency. The diverse product line, various segments and geographies improve to strengthen current profitability and financial health ratios.

Conclusion

Illinois Tool Works 5 yr return as of 2017
*Assumes $100 invested on 12/31/12 in stock or index, including reinvestment of dividends. Fiscal years ended December 31. Copyright© 2018 S&P, a division of McGraw Hill Financial. All rights reserved. Source: 2017 ITW Annual Report

ITW’s stock price peaked in January 2018 and declined by more than 22% currently. Possible global trade war and tariffs are caused burden into stock price. The current trend is not only seen in ITW, but also in the industrial sector. The company fundamentals support that declining trend may not carry forward for the long-term. Improved organic revenue growth and core business approach help the company to raise operating efficiency. Diverse product line, various segments and geographies improve to strengthen current profitability and financial health ratios.

Disclosure: I do not have any of the securities mentioned above. This article expresses my own views, and I wrote the article by myself. I am not receiving compensation for it. I have no business relationship with any company whose security is mentioned in this article.

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Covers investment, financial analysis and related financial market issues for BrightHedge. He has extensive experience in portfolio management, business consulting, risk management, and accounting areas.

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The investment information, comments and recommendations contained herein are not subject to investment advice. The comments and recommendations contained herein are based on personal views. These views may not fit your financial situation and your risk and return preferences. For this reason, based only on the information contained herein, investment decisions may not have the appropriate outcome.