Dividend Aristocrats In Focus Part 16 of 54: Illinois Tool Works

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Oct 12, 2014

In part 16 of the 54 part series on Dividend Aristocrats, I take a look at the competitive advantage and future growth prospects of diversified manufacturer Illinois Tool Works (ITW, Financial). Don’t let the Illinois in Illinois Tool Works fool you; the company is truly global. Illinois Tool Works generates about 50% of its revenue in the US, and 50% internationally. It has 51,000 employees in 26 countries and boasts a market cap of $32 billion. Illinois Tool Works has a large history of rewarding shareholders through increasing dividends. The company has increased its dividend payments for 51 consecutive years.

Business Overview

Illinois Tool Works operates in 7 separate business units. The company’s business units are broken down below along with the percentage of revenue and operating profit they contribute to the overall company:

  • Automotive OEM: 18% total revenue, 20% total operating income
  • T&M Electronics: 15% total revenue, 11% total operating income
  • Food Equipment: 14% total revenue, 13% total operating income
  • Polymers & Fluids: 14% total revenue, 13% total operating income
  • Welding: 13% total revenue, 16% total operating income
  • Construction Products: 12% total revenue, 10% total operating income
  • Specialty Products: 14% total revenue, 17% total operating income

The company is extremely well diversified across different manufacturing industries and fields. The company generates no more than 20% of total operating income from any one business segment. Illinois Tool Works has been going through a business line consolidation. The company went from over 800 smaller business units to 90 larger business units in an attempt to simplify the structure and operating procedures of the company. The process has been a success, as Illinois Tool Works has managed to consistently grow its operating margin and return on invested capital over the last 5 years.

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Source: ITW 2013 Annual Report

Competitive Advantage

Illinois Tool Works has managed to grow its dividend for over 50 years by focusing on building lasting relationships with its customers. The company often works with its largest customers to find solutions to problems they have. As a result, Illinois Tool Works has over 10,000 patents under its name.

An example of the company’s strategy is the development of the Advansys CLeR warewasher. This product was developed for the food industry as customers have demanded greater sustainability and higher energy efficiency. The Advansys CLeR warewasher combines several Illinois Tool Works developed technologies to save customers over $11,000 in energy and water costs.

Illinois Tool Works calls its customer-centric approach its “80/20 principle” because they focus on the top 20% of customers that generate 80% of profits. This approach is the underlying reason Illinois Tool Works has managed to grow over a five decade period.

In addition, the company has a global reach with offices and manufacturing facilities around the world. New entrants into the manufacturing industry would have a considerably difficult time matching Illinois Tool Works global scale and strong supply chain which has been built over a multi-decade period.

Growth Prospects

Illinois Tool Works laid out robust 5 year growth goals in 2012. The company has 3 goals to reach by 2017:

1. 2 percentage points of organic growth above the market per year

2. 20%+ operating margins

3. 20%+ return on invested capital (ROIC)

For the first half of 2014, the company has achieved operating margins of 20.5%, accomplishing goal 2. Illinois Tool Works has also raised its return on invested capital to 19.5%, nearly achieving its 2017 goal 2.5 years early. The company is only expecting 2% to 3% organic growth for 2014. I have little doubt Illinois Tool Works will achieve its second and third goals, but its growth goal appears unattainable. The company has only managed 2% per year revenue per share growth over the last decade, including acquisitions (which would not be counted as organic growth).

Going forward, I believe Illinois Tool Works will grow revenue at a 2% to 3% a year pace, and revenue per share at around 5% a year. The company has made significant efficiency gains, but top line growth will likely not pick up for Illinois Tool Works as there is no specific catalyst which would drive higher than average growth for the company.

Valuation

Illinois Tool Works trades for a PE multiple of 20. The median PE multiple for large cap diversified machinery companies as 18.4. The overall market is currently trading at a PE ratio of about 19. Historically, Illinois Tool Works has traded around an average P/E ratio of about 17. The company appears slightly overvalued at this time as it is trading over the PE multiple of the market, its competitors, and its own historical average.

I believe a fair PE ratio for Illinois Tool Works is somewhere in the range of 15 to 18, in line with its historical average and at a slight premium to the market’s historical average PE ratio of 15. The company should trade at a slight premium to the market average because of its long history of rewarding shareholders through rising dividends and earnings per share.

Dividend Analysis

Illinois Tool Works currently has a dividend yield of 2.4%, higher than the S&P500’s dividend yield of about 2%. The company has a payout ratio of 48%. Illinois Tool Works has been increasing its dividend payments somewhat faster than earnings per share growth. I see no reason for this trend to stop as the company still has a relatively conservative payout ratio. Based on the company’s long term revenue per share growth rate of about 5% and its payout ratio, I expect dividends to grow at 5% to 10% a year for the next several years.

Recession Performance

Illinois Tool Works remained profitable throughout the Great Recession of 2007 to 2009. With that said, the company saw a steep decline in earnings per share in 2009 during the worst of the recession. The company’s revenue per share and earnings per share throughout the recession are shown below to illustrate how the company performed in that time period:

  • 2007: earnings per share of $3.36, revenue per share of $30.51
  • 2008: earnings per share of $3.05, revenue per share of $31.80
  • 2009: earnings per share of $1.93, revenue per share of $27.63
  • 2010: earnings per share of $3.03, revenue per share of $31.88

The company’s reliance on the automotive industry and capital expenditures from other industries hurts the company during recessions. Businesses, governments, and consumers tend to put off large purchases and capital expenditures when the future is uncertain. As a result, Illinois Tool Works sees steep declines in earnings during recessions. The company did rebound quickly, and achieved new highs in earnings per share by 2011.

Final Thoughts

Illinois Tool Works is a high quality business that is experiencing strong earnings per share growth from efficiency gains. The company’s long-term prospects are somewhat more mundane. I expect long term intrinsic value per share growth for the company of around 5%. Overall, Illinois Tool Works appears to be slightly overvalued at this time as well. Despite this, the company has very little risk of business obsolescence and will likely reward shareholders with continually rising dividend payments. On the whole, I believe there are better investment opportunities available for enterprising dividend growth investors.