Dividend Aristocrats Part 36: Illinois Tool Works Inc. (ITW) by Ben Reynolds, Sure Dividend
Illinois Tool Works (ITW) needs a name change.
What do you think of when you here the company name ‘Illinois Tool Works’? It brings up the idea of a small machine shop located in Illinois.
This may have been true in 1912 when the company was founded, but it is not true today. Illinois Tool Works now has a market cap over $30 billion and generates 57% of its sales outside the United States.
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Illinois Tool Works is one of only 17 Dividend Kings. The company has paid increasing dividends for an amazing 52 consecutive years.
Illinois Tool Works Business Overview
Illinois Tool Works operates in 7 separate business units. Each business unit is shown below along with the percentage of the company’s total operating income each business unit generated in the company’s most recent quarter:
- Automotive OEM generates 20% of total operating income
- Food Equipment generates 19% of total operating income
- Specialty Products generates 15% of total operating income
- Welding generates 13% of total operating income
- Construction Products generates 12% of total operating income
- Test & Measurement and Electronics generates 11% of total operating income
- Polymers & Fluids generates 10% of total operating income
Illinois Tool Works different business units give it wide diversification. 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 company has divested 32 low margin businesses which were responsible for $4.9 billion in revenue a year, and is currently exiting other slow growth commodity business lines which generate $350 million a year in revenue.
The downsizing process has been a success, as Illinois Tool Works has managed to consistently grow its operating margins since 2012.
Source: 2015 ITW Investor & Analyst Day Presentation, slide 21
Illinois Tool Works’ Competitive Advantage
Illinois Tool Works has managed to grow its dividend for 52 consecutive years by focusing on building lasting relationships with its customers.
The company’s long dividend growth streak is clear evidence of a strong and durable competitive advantage.
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 – and files 1,500 new patent applications a year.
Illinois Tool Works process of working with customers to find solutions combined with its large patent portfolio gives it an intellectual property based competitive advantage.
The core of the company’s competitive advantage is its efficiency focused management process.
Illinois Tool Works calls its customer-centric approach its “80/20 principle” because the company focuses on the top 20% of customers that generate 80% of profits.
You can see the benefits of the 80/20 approach in the company’s operating margin growth over the last several years.
In addition to its core competitive advantage of an ingrained efficiency-centered culture, 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, intellectual property portfolio, and ingrained ‘80/20’ focus on efficiency.
What Are Illinois Tool Works’ Growth Prospects?
Illinois Tool Works’ management is telling shareholders to expect excellent total returns of 12% to 14% a year over the long-run. The image below shows where these returns will come from:
Source: 2015 ITW Investor & Analyst Day Presentation, slide 70
Let’s take a look at these total return driers one by one to see if they are attainable.
Will Illinois Tool Works grow its revenue at 5% per year?
The underlying assumption is that global GDP growth will average 3% a year. That’s a reasonable assumption. Illinois Tool Works’ management believes it can grow 2 percentage points faster than global GDP on a continuous basis.
The company’s management has shed non-core brands to focus on growth. Organic revenue is expected to grow 3% in fiscal 2015, in a difficult operating environment. During better economic times, it is likely the company will grow revenues at around 5% a year. I estimate the company’s long-term revenue growth at 3% to 5% a year.
Will Illinois Tool Works be able to expand its operating margins at 4% to 5% a year?
This is (obviously) impossible over the long run. No company can grow margins indefinitely. 4% to 5% operating margin growth per year is very ambitious. The company can likely hit these numbers in the short run as management sheds non-core business line. Over a decade long period (or longer), operating margins cannot expand at 4% to 5% a per year. A fairer estimate is 1% to 5% per year margin growth. This gives management the benefit of the doubt, while tempering expectations at the low end.
Will Illinois Tool Works continue to repurchase 1% to 2% of shares outstanding and pay 2%+ in dividends?
The final two growth drivers for the company are share repurchases and dividends and share repurchases. I have no doubt Illinois Tool Works will repurchase 1% to 2% of its shares outstanding every year. The company currently has a 2.4% dividend and a long history of dividend increases, so there’s little reason to doubt this as well.
A more realistic estimate of the company’s total return potential is below:
- Revenue growth of 3% to 5% per year
- Margin improvements of 1% to 5% per year
- Share repurchases of 1% to 2% per year
- Dividend yield of 2.4%
This gives Illinois Tool Works investors an expected total return of 7.4% to 14.4%.
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 earnings-per-share throughout the Great Recession and subsequent recovery are shown below to illustrate how the company performed in that time period:
- 2007 earnings-per-share of $3.36 (high at the time)
- 2008 earnings-per-share of $3.05 (beginning of decline)
- 2009 earnings-per-share of $1.93 (recession low)
- 2010 earnings-per-share of $3.03 (partial recovery)
- 2011 earnings-per-share of $3.74 (new high)
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 on Illinois Tool Works
Illinois Tool Works is a high quality business that is experiencing strong earnings per share growth from efficiency gains.
The company’s long-term growth prospects are bright as evidenced by above-average expected total returns.
Illinois Tool Works is currently trading for a price-to-earnings ratio of 18.0. The company is likely somewhat undervalued at current prices given its shareholder friendly management, durable competitive advantage, and above-average expected total returns.
Illinois Tool Works ranks in the top 40% of businesses with 25+ years of dividend payments without a reduction using The 8 Rules of Dividend Investing.