Illinois Tool Works - Cost Cutting To Prop Up Earnings

| About: Illinois Tool (ITW)

Summary

Illinois Tool Works posted better-than-expected earnings on January 27.

Investors seeking exposure in this stock should take a long-term view amid increasing uncertainty about global growth, which could prompt a downgrade in the company's own near-term guidance.

As the global economy gradually recovers over the long run, we expect ITW's revenues to rise accordingly. However, that would be accompanied by greater competition, resulting in compression in operating profit margins.

Illinois Tool Works Inc. (NYSE:ITW), incorporated on June 19, 1961, is a manufacturer of a range of industrial products and equipment. The company operates in seven segments: Automotive OEM, Test & Measurement and Electronics, Food Equipment, Polymers & Fluids, Welding, Construction Products and Specialty Products. The company has approximately 90 divisions in 57 countries.

In 2015, ITW grew earnings per share 10%, expanded operating margins by 150 basis points to a record of 21.4%, and improved after-tax return on invested capital by 140 basis points to a record 20.4%. Free cash flow was strong in 2015 at 106% of net income, and the company invested roughly $560 million in its businesses for growth and productivity. In addition, ITW returned more than $2.7 billion to shareholders in the form of dividends and share repurchases.

For 4Q15, EPS of $1.23 increased 4% versus prior year, 11% excluding currency effects. Quarterly results were driven by strong execution across the board, as operating margin improved 110 basis points to 20.7% and ITW's self-help Enterprise Initiatives contributed 110 basis points of improvement. Price/cost was favorable 30 basis points. Going forward, management expects an additional incremental 100 basis points of margin expansion from its Business Structure Simplification, sourcing, and 80/20 excellence initiatives in each of 2016 and 2017.

Organic revenue was modestly better than expected, with some fairly challenging comparisons in a few segments. While demand for capital equipment remains sluggish, underlying demand trends were stable across ITW's business portfolio. Adjusted for seasonality, demand in the company's industrial businesses improved 4% sequentially in Q4 versus Q3. Free cash flow was very strong at 140% of net income, and the company continues to progress on its return on invested capital metric. In summary, stable demand across its business portfolio and solid execution drove strong Q4 performance.

Management continues to execute the various elements of its Enterprise Strategy in a well-planned and logical sequence as it positions ITW to deliver solid growth, with best-in-class margins and returns, and the company remains firmly on track to deliver on its end-of-2017 enterprise performance goals. ITW also began its pivot to focus on an organic growth agenda and the company has made meaningful progress, with 60% of the company's revenues achieving ready-to-grow status and 45% growing at 6% in 2015.

By geography, in 4Q15, North America was down 1.6%, with its consumer-facing businesses up 2% and the industrial businesses down 5.6%. International was positive, up 0.6%, with Europe, the Middle East, and Africa up 1.9%. ITW's consumer businesses grew 4.6% with strength in Automotive OEM, up 10% in Europe, and Food Equipment. Asia-Pacific and China were essentially flat. However, it's worth pointing out that China Automotive was up 14% in the fourth quarter.

Heading into 2016, management guidance calls for 1-3% organic revenue growth EPS to be $5.35-5.55 per share, up 16% Y/Y. 1Q16 EPS is expected to be $1.20-1.30.

Financial Valuation:

Here is an excerpt of the company's past performance. Every metric is presented in millions of dollars, except for percentages and ratios.

ITW (USD Mil.)

CY11

CY12

CY13

CY14

CY15

Sales

14,515

14,791

14,135

14,484

13,405

Sales Growth

-5.8%

1.9%

-4.4%

2.5%

-7.4%

Operating Profit

2,361

2,475

2,544

2,888

2,867

Operating Profit Growth

4.7%

5%

3%

14%

-1%

Operating Margin

16.27%

16.73%

18.00%

19.94%

21.39%

Net Margin

14.27%

19.40%

11.88%

20.34%

14.17%

PAT Growth

141.9%

38.6%

-41.5%

75.5%

-35.5%

ROE

18.1%

21.7%

16.1%

22.9%

31.5%

Total Assets/Total Equity

1.80

1.83

2.06

2.59

3.01

CFO/Net Income

0.94

0.72

1.51

0.55

1.21

Click to enlarge

Source: Reuters, Company Website

ITW's sales growth has been anemic and highly volatile over the past 5 years (CY11-15), with 2015 being the weakest year where it posted a topline decrease of 7.4% Y/Y. In order to counter the volatility in revenue growth, the company has historically implemented cost-cutting initiatives which have allowed it to preserve its operating profit margins to a great extent. Note that even as revenue growth has posted a 4-year CAGR of -2.0% per annum, ITW's operating profits have grown at a 4-year CAGR of 4.0% per annum, while margins have grown from 16.27% to 21.39% over the period. As a result of cost saving drives, the company's PAT growth has averaged 35.8% during CY11-15, albeit with high volatility. The high growth in PAT combined with 31% average dividend payout rate, plus share buybacks have pushed up the company's ROE from 18.1% in CY11 to 31.5% in CY15.

The table below summarizes the projections until CY21.

ITW - Forecasts (USD Mil.)

CY16

CY17

CY18

CY19

CY20

CY21

Sales

13,271

13,271

13,337

13,471

13,673

13,946

Sales Growth

-1.0%

0.0%

0.5%

1.0%

1.5%

2.0%

Operating Profit

2,986

2,986

2,801

2,627

2,598

2,574

Operating Profit Growth

4.1%

0.0%

-6.2%

-6.2%

-1.1%

-0.9%

Operating Margin

22.50%

22.50%

21.00%

19.50%

19.00%

18.46%

Net Margin

16.62%

15.08%

15.75%

15.60%

16.72%

16.24%

PAT Growth

16.1%

-9.3%

5.0%

0.0%

8.8%

-0.9%

ROE

36.4%

26.8%

23.7%

20.5%

19.1%

15.9%

CFO/Net Income

1.21

1.11

1.00

0.99

0.99

0.99

Click to enlarge

In line with management guidance, we have incorporated a 1% Y/Y decline in topline for the fiscal year ahead as weak economic conditions are likely to prevail in the US and around the world. Additionally, for EPS, we have penciled in adjusted earnings per share to be $5.45, which matches the mid-range of management guidance for this year; this EPS translates into an annual PAT of $2.21 billion, up 16.1% compared to CY15, as the company will implement its cost saving plans and other profit margin preserving initiatives. As growth gradually recovers over the long term, we expect ITW's revenues to rise accordingly. However, the recovery, we anticipate, would be accompanied by greater competition, resulting in compression in operating profit margins.

We have valued this stock based on Free Cash Flow to Firm (FCFF) basis, with valuation parameters presented below:

Long-term debt (USD Mil)

6,896

Short-term debt (USD Mil)

526

Total debt (USD Mil)

7,422

Total assets (USD Mil)

15,729

Cost of debt

3.05%

Tax rate

30.10%

After-tax cost of debt

2.13%

Terminal Growth

1.25%

Risk Free Rate

2.24%

MRP

4.40%

Beta

1.09

Cost of equity

7.04%

Debt Weight

47.19%

Equity Weight

52.81%

WACC

4.72%

Click to enlarge

By assuming terminal FCFF growth of 1.25% and applying the discounted cash flow (DCF) valuation method, the equity value comes out to be $39.38 billion, resulting in a target price of $97.34 per share, offering a modest upside of 6.4% from the last closing price of $91.46 per share. The stock is currently trading at 16.2x CY16 earnings which is very near its target multiple of 17.9x. The stock also offers ~1.5% forward dividend yield which would be topped-up by share repurchases in the year ahead.

Conclusion:

ITW has outperformed the market over the past 12 months, falling by 1.8% (as of 4th February closing) as compared to the S&P 500 Index which fell by 4.0% over the same period. Going forward growth in earnings will most likely be driven by cost cutting programs combined with acquisitions of other businesses/companies. Investors seeking exposure in this stock should take a long-term view amid increasing uncertainty about global growth, which could prompt a downgrade in the company's own near-term guidance.

Disclosure: I/we 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.