How New Money Thinks About Illinois Tool Works

| About: Illinois Tool (ITW)


Let's examine ITW through the eyes of new money.

Illinois Tool Works posts a Valuentum Buying Index score of 7, reflecting our "fairly valued" DCF assessment of the firm, its attractive relative valuation versus peers, and very bullish technicals.

Though we prefer companies that register a 9 or 10 on the Valuentum process, this is actually a very good score.

As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. Let's examine what we think Illinois Tool Works (NYSE:ITW) is worth in this article and whether shares are timely for new money.

But first, a little background about us. At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We focus on value and timeliness of the idea. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies (good value, good momentum, etc.), thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). For an in-person seminar on the Valuentum process, please visit our YouTube page here.

At the core, if a company is undervalued both on a discounted cash-flow basis and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. For relative valuation purposes, we compare Illinois Tool Works to peers Dover (NYSE:DOV), Flowserve (NYSE:FLS), and Graco (NYSE:GGG). We understand the pitfalls of relative valuation analysis, which is why we combine the process with a rigorous discounted cash-flow exercise.

Illinois Tool Works posts a Valuentum Buying Index score of 7, reflecting our 'fairly valued' DCF assessment of the firm, its attractive relative valuation versus peers, and very bullish technicals. Though we prefer companies that register a 9 or 10 on the Valuentum process, this is actually a very good score. In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score with respect to companies in the Best Ideas portfolio:

Our Report on Illinois Tool Works

Investment Considerations

Investment Highlights

• Illinois Tool Works earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 20.3% during the past three years.

• Famous for its 80/20 business process that focuses on what is most important (the 20% of the items which account for 80% of the value), Illinois Tool Works is a multinational manufacturer of a diversified range of industrial products and equipment. Still, the firm faces fierce competition.

• Illinois Tool Works has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 15.2% in coming years. Total
debt-to-EBITDA was 1.5 last year, while debt-to-book capitalization stood at 32.3%.

• The firm's share price performance has been roughly in line with that of the market during the past quarter. We'd expect the firm's stock price to converge to our fair value estimate within the next three years, if our forecasts prove accurate.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Illinois Tool Works' 3-year historical return on invested capital (without goodwill) is 20.3%, which is above the estimate of its cost of capital of 10.2%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Illinois Tool Works's free cash flow margin has averaged about 8% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at At Illinois Tool Works, cash flow from operations increased about 9% from levels registered two years ago, while capital expenditures expanded about 33% over the same time period.

Valuation Analysis

The estimated fair value of $70 per share represents a price-to-earnings (P/E) ratio of about 13.3 times last year's earnings and an implied EV/EBITDA multiple of about 10.3 times last year's EBITDA. We understand that this is below the company's $80+ per share trading price at present. Though our fair value range (which we show below) still captures the upside of the current price, we note that the firm's valuation is not that attractive. This is one of the reasons why ITW receives a 7 on our scale instead of a higher rankings such as a 9 or a 10. The high end of the company's fair value range is $88 per share.

Our model reflects a compound annual revenue growth rate of -0.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 8.9%. Our model reflects a 5-year projected average operating margin of 22.2%, which is above Illinois Tool Works' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.3% for the next 15 years and 3% in perpetuity. For Illinois Tool Works, we use a 10.2% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $70 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Illinois Tool Works. We think the firm is attractive below $53 per share (the green line), but quite expensive above $88 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Illinois Tool Works' fair value at this point in time to be about $70 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Illinois Tool Works' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $90 per share in Year 3 represents our existing fair value per share of $70 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.