Between the company's December analyst day and the general market melt-up, shares of Illinois Tool Works (NYSE:ITW) made a fresh 52-week high on Jan. 28. Management used that analyst day to highlight some logical steps toward better growth, margins and returns for the long term, but these fourth quarter results serve as a reminder that self-improvement programs don't usually follow smooth lines. Illinois Tool Works has long been a solid generator of free cash flow and returns on capital, but investors may want to pause before chasing this stock further.
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Not so Impressive in the Fourth Quarter
Illinois Tool Works didn't have a terrible fourth quarter, but it was a reminder that the company's restructuring program is going to have some ups and downs. Moreover, several of Illinois Tool Works' units offer up reminders that for all of the post-election optimism, conditions are still challenging.
Excluding divestitures, revenue rose 2% as reported, good for a slight beat versus Wall Street, but organic revenue growth was only 0.6%. Only two segments had positive organic growth - Transportation (up about 4%) and Construction (up about 1%). Power Systems (which is now where welding and electronics reside), Industrial Packaging and Food Equipment were all down about 1%, while Polymers/Fluids saw organic revenue decline 7%.
I don't expect investors to be all that bothered by the revenue numbers (though the rare decline in welding was a surprise, and should make the Lincoln Electric (Nasdaq:LECO) numbers more interesting), but the margin numbers were disappointing. Gross margin rose a bit from last year, but fell more than a point sequentially.
Operating income was down 6%, and the company not only showed a 60 basis points (BPS) decline in operating margin from last year, but a 250 BPS drop from the prior quarter. There wasn't all that much correlation between revenue and margin performance by segment - Industrial Packaging and Polymers both reported double-digit operating income growth, while Construction was down by 14%.
SEE: How To Decode A Company's Earnings Reports
Finding Growth Could Be More Challenging in 2013
Admittedly, none of the major industrial conglomerates like General Electric (NYSE:GE), Danaher (NYSE:DHR), 3M (NYSE:MMM) or Dover (NYSE:DOV) have pointed to stellar growth expectations for 2013. Even so, Illinois Tool Works falls on the weaker end of guidance with an expected organic growth of 1 to 3%.
The company did well in its auto business (up 11%) this quarter, certainly better than others like Johnson Controls (NYSE:JCI) or Honeywell (NYSE:HON), but that will be tough to maintain absent a recovery in vehicle production activity. Likewise, while the company saw good growth in North American construction, there still hasn't been a real turn in residential or commercial activity.
Against that backdrop, I wouldn't be surprised to see more quarter-to-quarter turbulence in the operating figures. Restructuring programs are lumpy by nature, and moves like streamlining and centralizing purchasing could create a little extra variability.
The Long-Term Plan Is Legit
Partly in response to pressure from investors, Illinois Tool Works has laid out a five-year plan for the first time. In addition to the previously announced moves to re-centralize and consolidate purchasing, management has re-categorized its operating businesses into above-average, average and below-average growth buckets. About 25% of the company's current revenue fits in the below-average profile, and could be put up for sale in the coming years. At the same time, management is looking to do fewer deals, but is making them larger and more impactful.
SEE: Evaluating A Company's Management
Focusing in on better growth prospects is good news for investors, particularly as the company has only shown about a 1% organic growth over the past 10 years. It will be interesting, though, to see how the divestment process impacts margins and cash flow - just because a business isn't growing well doesn't mean it's not a lucrative margin or cash-flow generator.
The Bottom Line
I've often complained about Illinois Tool Works' valuation, and today is no exception. Simply put, for the growth and economic returns on capital available here, I think Wall Street is paying too much. Companies like Danaher and 3M aren't particularly cheap, either, but you're arguably getting better businesses there, particularly from an organic growth perspective. To the extent that owning any of these stocks is a requirement, I'd go with GE, 3M or Danaher before Illinois Tool Works at today's respective prices.
At the time of writing, Stephen D. Simpson owned shares of 3M for over five years.
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