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Summary

  • This fairly recently acquired member of the FFJ Portfolio just reported Q2 2018 results  wherein Total Revenue increased 7% of which 4% was organic growth.
  • All 7 of the company’s business segments delivered positive YoY organic revenue growth but 5 of the business segments missed quarterly revenue expectations and only 2 units beat expectations.
  • First half of FY2018 Free Cash Flow of $0.977B just about services the entire amount spent on YTD $1B in share repurchases. Management expects to repurchase another $0.5B of outstanding shares in the 2nd half of the current fiscal year.
  • Projected FY2018 EPS range revised downward by $0.10/share to $7.50 - $7.70.
  • Company faces currency headwinds and in the2nd half of the current fiscal year higher costs are expected to be a headwind. This has led to management lowering its full-year operating margin to 24% - 25%, down from 25% - 25.5% range.
  • Despite downward revision in projected EPS, FCF is expected to be strong which management has indicated will, subject to Board approval in August, lead to a significant dividend increase.

Introduction

The nice thing about having invested in North American equities for a few decades is that I have able to learn from the teachings of several highly successful investors who are willing to share their knowledge. When I talk about successful investors I mean the likes of Buffett, Munger, Greenblatt, Lynch, Pabrai, Templeton, Fisher, and Bogle.

Every once a while I am bound to invest in a wonderful company only to see the stock get the stuffing knocked out of it even though the company has just reported strong results. It certainly gives me some comfort knowing every investor listed above has had a similar experience.

In the case of Illinois Tool Works (NYSE: ITW), I see a company which reported organic growth acceleration, strength/resilience of its business model, and excellent operational execution. In fact, this company just reported its most profitable first half of any fiscal year in its 100+ year history!

This is when I take a step back and remind myself of Warren Buffett’s pearl of wisdom:

“In the short term, the market is a popularity contest. In the long term, the market is a weighing machine.”

When I initiated a position in ITW in late April 2018 I also had in mind a couple of his other famous quotes:

“If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

“Successful Investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can’t produce a baby in one month by getting nine women pregnant.”

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

This is why I have absolutely no concern how the market has reacted to ITW’s recent Q2 earnings release. In fact, if investors would approach the acquisition of shares in wonderful companies much the same way as they approach the purchase of large tickets items (eg. house, vehicle), price pullbacks should be looked upon favorably. Now, if an investor is employing the use of margin to invest in equities….that’s a whole different story and I wish them luck.

Q2 2018 Results

ITW reported Q2 2018 results and provided a revised forecast for FY2018 on July 23, 2018.

ITW - Q2 2018 Financial Performance July 23 2018

ITW - Q2 2018 Operating Margin July 23 2018

ITW - Q2 2018 Segment Performance July 23 2018

ITW - 1H 2018 Financial Performance July 23 2018

Source: ITW Q2 2018 Presentation - July 23 2018

2018 Outlook

Second half EPS are projected to have a $0.12 negative currency impact versus prior guidance based on current foreign exchange rates. This has resulted in ITW reducing its 2018 full-year EPS guidance to $7.50 - $7.70 (from $7.60 - $7.80). Operating margin projections have also been revised down to 24 – 25%.

ITW continues to expect to recover the impact of raw material cost increases through price actions on a dollar for dollar basis for the full year. As a result, the full year price/cost impact on EPS is expected to be neutral.

Organic growth of 3 – 4% and free cash flow equal to or greater than 100% of net income are expected.

ITW now expects to repurchase $1.5 billion of its own shares in 2018 and it has already repurchased $1B in the first half of FY2018.

ITW - 2018 Guidance July 23 2018

Source: ITW Q2 2018 Presentation – July 23 2018

ITW provided Q3 guidance on its July 23 rd analyst conference call wherein EPS in the $1.80 - $1.90/share range is expected; in Q3 2017 ITW reported $1.71/share but that figure included a $0.14/share benefit from a legal settlement.

Long-Term Debt (LTD)

I recognize some readers may have a concern about the level of long-term debt ITW has taken on in recent years. In FY2013, LTD was $2.771B. In FY2017….$7.478B. GULP!

I’ll be perfectly honest with you…I don’t like debt. My entire career was in the Canadian Banking industry (Commercial Banking and Commercial and Corporate Cash Management). I’ve seen what can happen when people/companies get in over their head with debt.

In the case of ITW, however, I am of the opinion the current level of debt is not totally unreasonable. During the FY2012 - FY2017 timeframe it generated $1.69B, $2.16B, $1.255B, $2.015B, $2.029B, and $2.105B in FCF. It has also generated $0.977B in FCF in the first 6 months of the current fiscal year which was used to purchase $1B in shares.

Even if ITW’s annual FCF were cut in half it could make quick work of its debt. That may, however, not be the most optimal use of FCF. Have a look at page 59 of 102 in ITW's 2017 Annual Report where you will find a schedule of LTD. Look at some of those interest rates. Heck, lend me money at some of those fixed rates and I’ll suddenly start to like debt (just a little bit).

Rest assured you are not the only person looking at ITW’s debt level. Read the next section of this article.

Credit Ratings

Well….the hit to ITW’s stock price was not related to any deterioration in its credit rating. The credit ratings are the same as when I wrote my April 28th article!

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

On December 1, 2017, ITW’s 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 24 th, 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 26 th, GAAP EPS projections were revised upward $7.60 - $7.80. On April 26, 2018 when Q1 2018 results were released, ITW 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.

Q2 results released July 23 rd now call for 2018 GAAP EPS in the range of $7.50 - $7.70. On July 20 th, ITW’s stock price closed at $146.86 so using the new GAAP EPS guidance we get 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 has dropped ~$11.80 to ~$136 on July 23 rd. Now the forward PE range is of ~17.5 - ~18. In my opinion, this valuation certainly makes ITW an attractive long-term investment opportunity.

Dividend, Dividend Yield, Dividend Payout Ratio, and Share Repurchases

My review of ITW’s dividend can be found in my April 28th article.

In recent years ITW has announced an increase in its dividend in early August (2017, 2016, 2015, and 2014).

I am of the opinion that investors can reasonably expect a 15% increase in ITW’s dividend to be announced within the next 3 weeks. This increase does not appear to be entirely unreasonable when compared with the dividend increases in recent years.

ITW - Dividend CAGR 2008 - 2018

I draw to your attention the following comment made by ITW’s SVP & CFO on the July 23 rd conference call with analysts.

“ As a reminder, subject to board approval in August, we plan to significantly raise our dividend as we increase ITW's dividend payout ratio to 50% of free cash flow.

If my assumption is correct, investors can expect the $3.12 annual dividend to rise to ~$3.58 (a ~15% increase). This would give investors a ~2.6% dividend yield on the basis of the current ~$136 share price.

As a reminder to Canadian investors, you would incur a 15% withholding tax on the dividends you receive if your shares are held in a non-registered account. I mention this because that is my predicament. Personally, I am not concerned as I did not invest in ITW for its dividend yield.

If you look at the following images you will see that the potential for attractive long-term capital gains is far more enticing than the growth in the dividend.

ITW vs SP500 10 year return comparison

ITW vs SP500 20 year return comparison

Source: Tickertech

Based on the recent projected GAAP EPS range of $7.50 - $7.70, the current $3.12 annual dividend represents a ~40.5% - ~41.6% dividend payout ratio. If ITW’s Board of Directors announces a dividend increase to ~$3.58 in early August, the dividend payout ratio would be ~46.5% - ~47.7%. High but not excessively high.

In my April 28 th article I indicated that $0.5B of common shares had been repurchased in Q1. In Q2 another $0.5B of common shares were repurchased. The intent is to repurchase $1.5B of common shares in FY2018 so between now and the end of the current fiscal year we can expect a further $0.5B reduction in share count. Here’s hoping ITW’s share price plunges before this next tranche of shares are repurchased!

In Q1, ITW generated $444 million in Free Cash Flow but it repurchased $500 million of outstanding shares. At least in Q2, ITW generated $533 million in Free Cash Flow which aided in the repurchase of $500 million of outstanding shares. While the value of shares repurchased YTD2018 exceed Free Cash Flow by $0.023B, this variance is insignificant in the grand scheme of things.

Final Thoughts

I think Mr. Market may have overreacted when ITW released its Q2 results on July 23. Quite frankly, I am not concerned.

This is a strong company that continues to generate strong free cash flow and is highly profitable. I really don’t care if the stock price has dropped over 7% on the day Q2 and 6 month results were released. I have invested in this company for the long-term and view the price drop as an opportunity for you to acquire shares in this great company at a superior valuation than when I purchased shares in late April.

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.