Contents
Summary
- ITW released Q4 and FY2018 results and FY2019 guidance on February 1, 2019 and held its Investor Day on December 7, 2018.
- Excluding a one-time $0.658B charge associated with the passage of the ‘Tax Cuts and Jobs Act’ in FY2017, ITW grew EPS by 15%, expanded operating margin by 60 bps to a record 24.3%, grew Free Cash Flow 10%, and returned $3B cash to shareholders in the form of dividends and share repurchases despite significant raw material cost headwinds and a decline in auto builds in North America, Europe and China.
- Organic growth has been lowered to 1 – 3% versus the 2 – 4% outlook provided at ITW’s December 7, 2018 Investor Day. Lower guidance is entirely related to taking a more conservative, risk-adjusted view with regards to auto builds and semiconductor-related demand in 2019.
- ITW shares were acquired April 30, 2018 and are held in one of the FFJ Portfolio’s ‘side accounts’.
Introduction
Illinois Tool Works Inc. (ITW), founded in 1912 and incorporated in 1915, is a global manufacturer of a diversified range of industrial products and equipment. It has 87 divisions and operates in 56 countries.
Operations are organized and managed based on similar product offerings and end markets, and are reported to senior management in the following 7 reporting segments:
- Automotive OEM;
- Food Equipment;
- Test & Measurement and Electronics;
- Welding;
- Polymers & Fluids;
- Construction
- Products;
- Specialty Products.
ITW is a diversified industrial company and is exposed to a macroeconomic downturn, potential operating deleverage, and slowing organic growth as it grows. Tariffs also present a risk but management has indicated this risk is manageable since the company is predominantly an ‘a produce-what-we-sell company’ and only ~2% of spend is sourced from China.
Prior to reading this article I encourage you to read my April 28th ITW article in which I provide a very high level Business Overview and touch upon its Business Model.
In my July 23rd follow-up article I suggested investors look upon price pullbacks in high quality companies from a positive perspective. At the time of that article, ITW had just reported its Q2 2018 results which reflected organic growth acceleration, strength/resilience of its business model, excellent operational execution and had just reported its most profitable first half of any fiscal year in its 100+ year history! ITW’s share price, however, was knocked back from ~$147 to ~$136.
Now that ITW has released its Q4 and FY2018 results on February 1, 2019 and it also held its 2018 Investor Day on December 7, 2018 I thought it would be an opportune time to revisit ITW.
December 7, 2018 Investor Day
The following are ITW’s 2023 Goals.
At ITW’s Investor Day, senior management provided an update on the company’s enterprise strategy and also provided preliminary guidance for 2019.
ITW’s competitive advantage is its business model. This enables ITW to generate superior operation margins in its 7 reporting segments. The following images compare ITW’s operating margins by business segments relative to its peers for FY2017 and FY2018; a listing of the companies in each segment’s peer group is provided just below.
Source: ITW – Investor Day Presentation – December 7, 2018
Source: ITW – Investor Day Presentation – December 1, 2017
In 2013, ITW launched its multi-year Enterprise Strategy consisting of:
- Portfolio Disciplined in which it would only in industries where it could generate significant differentiated competitive advantage from the ITW Business Model over the long-term;
- Quality of the 80/20 Front to Back Practice wherein ITW would operate with excellence in the practice of ITW’s 80/20 Front to Back business management process everywhere in the company every day;
- Provide Differentiated Performance with the goal of consistently delivering (1) solid growth with (2) full-potential margins and returns.
ITW’s progress as at the December Investor Day is reflected below.
Source: ITW – Investor Day Presentation – December 7, 2018
By the time ITW completes this transformation in 2022 it expects to have achieved 1 – 2% of additional improvement in enterprise organic growth rate and 3 – 4% of additional structural margin improvement.
ITW has grown over its 105+ year history through acquisition and the plan is to make further acquisitions only if they will reinforce or further enhance ITW’s organic growth potential.
This transformation does not only consist of acquisitions. ITW has identified the potential divestiture of 7 long-term growth-challenged divisions which currently generate ~$1B in revenue. This will naturally result in EPS dilution but the plan is to offset this dilution with incremental share repurchases.
ITW has also set a goal of generating Free Cash Flow that consistently meets or exceeds 100% of Net Income.
Source: ITW – Investor Day Presentation – December 7, 2018
Capital allocation as a percentage of cash flow is also expected to continue to be in the following ranges:
- Internal investments: 20 – 25%
- Dividend: 35 – 40%
- External Investments: 35 – 45%
Q4 and FY2018 Results
ITW’s Q4 and FY2018 results reported February 1, 2019 can be found here. The Q4 and FY2018 presentation that accompanies the February 1, 2019 earnings release can be accessed here.
2019 Guidance
ITW has reiterated its $7.90 - $8.20 full year EPS guidance provided at its December 7, 2018 Investor Day; the $8.05 mid-point represents ~6% YoY growth.
Organic growth is now expected to be 1 – 3% versus the previous 2 – 4% outlook. This lower guidance is entirely related to taking a more conservative, risk-adjusted view with regards to auto builds and semiconductor-related demand in 2019.
Source: ITW - Q4 and FY2018 Earnings Release - February 1, 2019
Projects and activities related to ITW’s Enterprise Initiatives are expected to deliver 100 bps points of operating margin expansion.
Included in ITW’s plan is a higher restructuring expense relative to FY2018 as it has a particularly heavy restructuring agenda in Q1 which is driven to a significant degree by actions being taken to right-size the Automotive OEM and Specialty businesses in Europe.
ITW anticipates that margin headwinds should continue to moderate as the majority of raw material costs appear to have stabilized. In addition, it has strong pricing momentum heading into the year and the vast majority of planned pricing actions have already been implemented.
ITW continues to view the overall tariff impact as manageable since ITW is predominantly an ‘a produce-what-we-sell company’ and only ~2% of spend is sourced from China.
ITW is confident the differentiated nature of its product offerings should enable it to offset the impact of any incremental raw material cost inflation and tariff impacts that might arise in 2019.
ITW also expects free cash flow conversion of 100%+, share repurchases of ~$1.5B, and a tax rate in the range of 24.5% - 25.5% versus 24.5% in 2018.
The first half of FY2019 is expected to be a little more challenging than what is typical in terms of YoY comparisons due to more difficult comps, more currency headwind in the first half versus the second half of the year, and higher Q1 restructuring costs.
On the Earnings call with analysts, ITW cautioned that guidance does not accommodate for any potential M&A activity and in particular the potential divestiture of 7 long-term growth-challenged divisions which currently generate ~$1B in revenue; this matter was mentioned in the December 7th Investor Day presentation. In essence, guidance is presented on the basis of the portfolio remaining as current. ITW, however, is making good progress on its potential divestitures and if there is any EPS dilution from divestitures it will be completely offset by incremental share repurchases so as to make these divestitures EPS neutral.
Credit Ratings
Moody’s rates ITW’s Senior Unsecured Long-Term Debt as A2 (mid-point of the upper medium grade) while S&P Global rates it A+ (top-end of the upper medium grade). Neither rating is under review and both ratings are strong!
Valuation
At ITW’s December 1, 2017 Investor Day, 2018 guidance called for GAAP EPS of $7.05 - $7.25 which included the settlement of a confidential legal matter. On that day, ITW closed at $164.87 thus giving us a forward PE range of ~22.74 - ~23.39.
When Q4 2017 results were presented January 24th, ITW raised its GAAP EPS guidance to $7.45 - $7.65. ITW closed at $173.76 that day. Using these metrics, ITW’s forward PE range was ~22.71 - ~23.72.
When ITW released its Q1 2018 results on April 26th, GAAP EPS projections were revised upward $7.60 - $7.80 and ITW’s share price closed at $141.41. On this basis, ITW’s forward PE range was ~18.13 - ~18.61 and compared favorably ITW’s 5 year average PE level of ~19.7.
When ITW released its Q2 results on July 23rd the 2018 GAAP EPS range was revised downward to $7.50 - $7.70. On July 20th, ITW’s stock price closed at $146.86 so using the new GAAP EPS guidance we arrived at a forward PE range of ~19 - ~19.6. Investors did not react kindly to this downward revision in 2018 EPS and ITW’s stock price dropped ~$136 on July 23rd thus giving us a forward PE range of ~17.5 - ~18.
With FY2018 results and FY2019 guidance having recently provided let’s compare ITW’s current valuation with historical levels.
ITW generated FY2018 GAAP EPS of $7.60 and FY2019 guidance calls for $7.90 - $8.20 in EPS. With ITW trading at $134.43 we get a diluted PE level of ~17.69 and a forward diluted PE range of ~16.39 - ~17.02.
When compared to ITW’s ~22.5 historical PE over the past 5 years it appears ITW is attractively valued.
ITW’s dividend history can be found here and high level institutional ownership details can be found here.
Source: ITW – Investor Day Presentation – December 7, 2018
ITW has historically announced an increase in its dividend in August which takes effect with its October dividend.
In my July 23rd article I indicated that I expected ITW to announce a 15% increase in its dividend within the next 3 weeks. I was somewhat off the mark as ITW increased its dividend by just over 28% ($0.78 increased to $1.00/quarter).
The current $4/year dividend provides investors with a ~2.98% dividend yield on the basis of the current $134.43 share price.
The current $4 annual dividend is a ~52.6% payout ratio of ITW’s FY2018 EPS of $7.60. This leaves ITW with ample flexibility.
I also take comfort that ITW’s dividend payout ratio will very likely continue to be maintained at a ~50% of free cash flow payout level.
Using the recently provided FY2019 EPS guidance of $7.90 - $8.20, the $4 annual dividend represents a ~48.7% - ~50.1% payout range. This is slightly better than the current dividend payout level.
ITW repurchased $0.5B of its shares in Q4 and $2B in FY2018 and as noted earlier the plan is to repurchase $1.5B in FY2019.
ITW’s average number of diluted common shares in FY2018 amounted to 337.1 million. This compares favorably with 346.8 million in FY201, 357.1 million in FY2016, and 370.1 million in FY2015.
Final Thoughts
ITW is a well-run collection of businesses in which activities are centered on resolving its customers’ most important pain points. Its products and services are essentially designed to reduce customers’ costs through ease of use thus reducing training costs or through the elimination of steps in a manufacturing process or parts in an assembly.
I like that ITW is becoming increasingly focused on its most important customers and is simplifying its product line.
This is a cyclical business which means that investors can expect more performance volatility than companies in more stable industries (eg. utilities). If you are prepared to accept this slightly higher volatility then I think the currently depressed valuation presents an opportunity to acquire shares.
The next dividend increase is likely to be announced in mid-February for payment the 2nd week of April. I think that interest announcement will result in Mr. Market sparking an uptick in ITW’s share price. I, therefore, intend to acquire more shares for the ‘Side Accounts’ within the FFJ Portfolio within the next 72 hours.
I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long ITW.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
