Illinois Tool Works Comes Up Short On Growth

By Stephen D. Simpson, CFA | July 23, 2013 AAA

Margins typically drive industrial stocks over the long term, but growth can certainly impact share prices on a more short-term basis. That's working to the detriment of Illinois Tool Works (NYSE:ITW), as this high-quality industrial has broken from the peer group this quarter in reporting pretty weak growth numbers. As is typically the case with this company, the shares are not particularly cheap today and even the company's quality edge isn't quite enough to argue strongly for buying today.

Q2 Disappoints On Revenue, But Outperforms On Margins
Illinois Tool Works had a decidedly mixed second quarter report. Illinois Tool Works definitely came in below other industrial conglomerates like General Electric (NYSE: GE), Danaher (NYSE:DHR), Honeywell (NYSE:HON), and Dover (NYSE:DOV) in terms of growth, even though management continues to execute ahead of plan on the restructuring efforts.

SEE: Conglomerates: Risky Proposition?

Revenue rose 1% this quarter, or basically flat on an organic basis. Revenues declined 1% in both North America and the EU, and the company continues to see a relatively weak environment for capital spending, as equipment sales were down 4% while consumables were up 1%.

Between the divestiture of the decorative surfaces business and the company's ongoing restructuring efforts, margins continue to come in better than expected. Gross margin rose about a point from the year-ago period, and ticked up about 30bp sequentially. Operating income rose nearly 4% from the year ago period, with about 40bp of operating margin leverage. The company's food equipment and polymers/fluids businesses were notable outperformers on margins, while test/measurement & electronics and industrial packaging were notable laggards.

Strong Autos, But Construction And Electronics Remain Weak
Like Honeywell, Illinois Tool Works saw a solid performance in autos, as the company's 12% organic revenue growth was well ahead of production growth in North America, Europe, and China. Unfortunately, that is pretty much all of the good news for the quarter from a revenue growth perspective.

SEE: A Look At Corporate Profit Margins

Welding remains stubbornly weak due to sluggish construction, energy, and industrial conditions, and I'll be very curious to see the sort of performance that Lincoln Electric (Nasdaq:LECO) and Colfax (NYSE:CFX) report, as these three leading welding businesses have not exactly moved in lock-step recently. Polymers and fluids revenue was down about 4%, and ITW's more explicit construction business was also soft (up 0.3%), as slight growth in the U.S. residential market was largely overshadowed by weakness overseas and in commercial activity.

ITW also continues to see the effect of weak electronics markets, as the test & measurement and electronics segment was down 9% on exceptional weakness in electronics (down 16%, with electronics assembly down 38%) and sluggishness in test & measurement (down 2%) worse than that seen at Danaher.

It's All About Exposure
It's not too hard to see why Illinois Tool Works came up short versus some of its peers this quarter. Unlike GE and Honeywell, Illinois Tool Works doesn't have much leverage to the aviation end market, and likewise the company's exposure to energy is low relative to GE and Dover. Even so, that doesn't completely absolve this quarter's performance – although ITW did better in autos than Honeywell, the performances in test & measurement, polymers/fluids, food equipment, and construction seemed weaker than I would have expected given other companies' reports. Coupled with the strong margin improvement, I wonder if Illinois Tool Works has (knowingly or not) given up a little growth in the cause of better margins.

The Bottom Line
Barring a sharp turnaround in consumer electronics and/or construction, I think Illinois Tool Works will likely continue to lag its peers in terms of organic revenue growth for the remainder of this year. Given the improvements in margins, though, as well as the long-term full-cycle philosophy of management, I wouldn't sell the stock on that basis.

The reason I might consider selling the stock is that the shares look pretty richly valued. A 7% long-term free cash flow growth (above the long-term trailing growth rate of about 5%) doesn't generate an appealing price target even if you give the company a very low discount rate (which seems inappropriate given the cyclicality). What's more, metrics like EV/EBITDA don't suggest any particular undervaluation in these shares, though the company's P/BV ratio does appear low relative to its ROE.

I don't expect many individual shareholders of ITW shares to be momentum or fast-money traders, so selling out today may not make all that much sense in the context of viewing ITW as a strong long-term holding. Even so, if I needed to raise funds to acquire a cheaper industrial conglomerate, Illinois Tool Works would look like a candidate to sell right now.

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