Changing a successful model is a risk that most corporate executives simply don't have the guts to take. Make no mistake, while Illinois Tools Works' (ITW) heavy reliance on serial acquisitions and its decentralized structure break a lot of how-to rules they teach in business school, the results have been good. Companies like Dover (DOV) and Ingersoll Rand (IR) have closed some of the market outperformance gap in recent years, but ITW has still done well by investors over almost any long-term time horizon.
Then again, maybe that shrinking margin of outperformance is a good reason for the company to think about altering the plan a bit.
Respectable Results In Place Of Rumor
Although the whisper numbers on Illinois Tool Works were not especially strong going into the quarter, the company's results were just fine. Reported revenue growth came in over 10%, while organic growth was nearly 6%. Although ITW's exposure to short-cycle European end-markets was (and remains) a concern, organic growth over there was better than 2% (while growing nearly 9% in North America and better than 9% in China).
Profitability was also okay, though the company did need a lower than expected tax rate to beat the numbers. Gross margin improved almost two points, while operating income rose 34%. Margins were better in every operating unit except polymers, and the food equipment segment showed a surprisingly large improvement this quarter.
Teasing Out The Numbers
On one hand, the dozens of operating segments makes Illinois Tool Works a royal headache to model and monitor. On the other, it also provides a pretty good snapshot for a wide range of industries and markets.
Strength in auto OEM customers helped transportation post nearly 9% organic growth. With a recovering auto market (and a strong truck market) being a key part of the story on steel companies like Steel Dynamics (STLD) and U.S. Steel (X), as well as parts companies like Eaton (ETN) and Johnson Controls (JCI), this is encouraging.
Also encouraging was the uptick in residential construction seen within the nearly 3% organic growth in the construction segment. Residential construction has been all but dead of late in the U.S. and the much-awaited recovery would be a good offset to expected overall industrial weakness in Europe this year.
Power systems saw better than 10% organic growth, helped in large part by the nearly 23% growth in welding. Illinois Tool Works is seeing much of the same as Lincoln Electric (LECO) and Colfax (CFX) - demand in the energy market is extremely strong, as is the demand in heavy machinery.
Considering A New Battle Plan
Although Illinois Tool Works has been almost proudly defiant in the past with regard to its sprawling decentralized operating structure, it looks as though management is pondering some significant restructurings. Management has acknowledged not only the possibility of divestitures, but a broader focus on consolidation.
At this point, this does not sound so much like a repudiation of the model, but a recognition that companies like Danaher (DHR) may be on to something with a more top-down, cost-centered model. Whether or not this really delivers better long-term margins and capital returns will remain to be seen, but it likely will mean more restructuring efforts (and charges) in the future.
At the same time, don't expect the company to stop looking to add businesses that fit its criteria. Test and measurement in particular seems like an area of interest to ITW management, though it will mean competing more against well-run rivals like Danaher and Agilent (A).
The Bottom Line
Although analysts are pretty lukewarm on Illinois Tool Works ("good company … good management … too much Europe risk and uncertainty about the restructuring"), their free cash flow estimates still look a bit high - even after downward revisions that have dropped the average target price by some 20% since midyear 2011. With management sounding a somewhat cautious note on 2012 guidance, momentum may be hard to find absent some impressive economic growth numbers here in North America and/or Europe.
At today's price, Illinois Tool Works looks like a weak hold. Companies like Danaher and Agilent look like somewhat cheaper conglomerates right now, while companies like Lincoln Electric, Tenneco (TEN), and Stanley Black & Decker (SWK) look like more attractive ways to play those markets where Illinois Tool Works is seeing interesting growth opportunities.