Illinois Tool Works Slowing More Gently Than Most

By Stephen D. Simpson, CFA | October 25, 2012 AAA

If Illinois Tool Works (NYSE:ITW) gets too much criticism for not really delivering dynamic growth in the good times, it's also true that the company doesn't get enough credit for avoiding the worst of the slowdowns. While growth is very definitely slowing at Illinois Tool Works, as it is for almost all industrial companies, the company's margin leverage is impressive nonetheless. As is typically the case, Illinois Tool Works is not especially cheap but it still scores well as a good option for patient investors.

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Disappointing Revenue Offset Somewhat by Margins
I've observed in the past that Illinois Tool Works is among the most willing of industrial companies to guide down and be conservative on their revenue outlook. And yet, the company still came in a little shy of expectations.

Revenue declined almost 2% on a reported basis, while organic revenue rose almost 1%. That's not a huge decline from the 2% or so organic growth in the second quarter, and it definitely matches the overall trends seen at other industrial conglomerates such as General Electric (NYSE:GE), Dover (NYSE:DOV) and Ingersoll-Rand (NYSE:IR). On an organic basis, growth was led by the Power Systems and Polymers/Fluids business, while construction was, unsurprisingly, the weakest.

As said before, Illinois Tool Works did pretty well on margins. Gross margin improved over one point, while operating income rose 7% and core EBITDA rose about 6%. As every segment reported better margins, I have to think that some of this is due to the company-wide centralization/simplification process. Packaging, power systems and food equipment were all notably strong in terms of margin improvement.

SEE: How To Decode A Company's Earnings Reports

Not All Comparables Are Comparable
Whenever companies such as Honeywell (NYSE:HON), Dover, Danaher (NYSE:DHR) and Illinois Tool Works report, there's a lot of line drawing done (i.e. "if this company did this, it looks better/worse for these other companies..."). Maybe this quarter demonstrates that while such a process is natural and hard to resist, it's not always especially accurate.

In transportation, for instance, Illinois Tool Works seemed a lot stronger in Europe than Honeywell or Actuant (NYSE:ATU), and was likely due to specific differences in customer/product exposure. Elsewhere, ITW's 11% growth in electronics was helped by new customer rollouts, while the 12% growth in test and measurement was surprising, given the weakness at Danaher.

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Don't Mess with a Winning Formula
There's little in management's recent commentary to suggest that any major changes are on the way for Illinois Tool Works. The company recently sold a controlling stake in its decorative services segment to an investment fund, and I see little reason to think that the company will cease its perpetual acquisition/divestiture process. As an aside, however, I do wonder what the cost of all this turnover is to the company, as there are always costs involved in buying or selling a business (and they don't necessarily match the reported costs in SEC filings).

Nevertheless, it's worth asking if Illinois Tool Works does need to reorient the business. Most of the company's markets are short-cycle (in contrast to, say, General Electric) and that can increase volatility. It's also worth noting that ITW has less exposure to emerging markets than others, such as Danaher, Emerson (NYSE:EMR), Eaton (NYSE:ETN) and GE. That doesn't seem so bad now, when emerging market growth has contracted noticeably, but it could lead Illinois Tool Works to lag on the recovery. As much as I do subscribe to the "if it's not broken, don't break it" philosophy, I do believe ITW's emerging market exposure is a legitimate talking point.

SEE: An Evaluation Of Emerging Markets

The Bottom Line
A lot of ITW's performance is tied pretty simply to overall macroeconomic conditions. If the global economy (but most especially in North America and Europe) strengthens, markets like packaging, welding, automobiles/trucks and food equipment will also improve. What's more, there's that long-awaited construction recovery to keep in mind as well. On top of all that, there's the company's ongoing margin improvement initiative - a process that could add two or three points to peak margins.

I continue to expect high single-digit cash flow growth from Illinois Tool Works, even recognizing that growth gets more challenging as an enterprise gets larger. Unfortunately, even with a better-than-average discount rate, that growth isn't enough to push fair value much past the mid-$60s. If Illinois Tool Works can push its free cash flow conversion into the mid-teens (from a historical average in the very low teens), the fair value can go into the $70s, but I'd be careful about aggressively buying industrial conglomerates in today's market.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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