Industrial conglomerate Illinois Tool Works (ITW) was a growth laggard in the first quarter, and slowing demand in markets like Europe, China, and the U.S. didn't help matters for this quarter. Margins held up well, though, and management's decision to simplify the business during this lull ought to have the company in good position to post good margins whenever the recovery may come. Illinois Tool Works just isn't cheap enough to be my favorite industrial name (a common complaint with me and this stock), but those who believe in the margin expansion story may find more to like here, even if the company is facing a stiffer headwind going into the second half.
Definitely A Mixed Bag For Q2
Although Illinois Tool Works definitely held up its "preserving earnings" end of the bargain with strong margins, growth has clearly slowed.
Reported revenue rose 1% and though underlying "base" revenue was stronger (up 2.3%), it still lagged other industrial conglomerates like Danaher (DHR), General Electric (GE), Honeywell (HON), and even Dover (DOV) and Ingersoll Rand (IR). On a more positive note, even the worst-performing segments (construction and polymers) didn't do badly, with organic revenue declines of less than 1%.
Margins were surprisingly powerful this quarter, as Illinois Tool Works saw a 120bp improvement in gross margin that basically carried through to the operating income line. Operating income grew 8% as a result, with 110bp margin expansion from last year. As the gross margin performance may suggest, the operating result had a lot to do with lower raw material/input costs. Still, every segment but construction saw a year-on-year margin improvement (and the erosion in construction wasn't bad).
Taking A Shot At The Read-Throughs
Illinois Tool Works operates so many businesses in so many markets, it's not always especially helpful to draw broad lines between this company and others. Still, it's worth having a go in some cases.
Power systems saw solid mid-single-digit growth on the back of nearly 9% global growth in welding - a good sign for Lincoln Electric (LECO). In the food business, though, ITW's growth of roughly 1% was substantial lower than the refrigeration and food equipment growth seen at Dover. The results in transportation actually seemed pretty decent all things considered, while the construction numbers seemed weaker than those from companies like Ingersoll Rand and Stanley Black & Decker (SWK)
Weak Guidance, But Consider The Long-Term
With growth as soft as it is, Illinois Tool Works management took down guidance for the remainder of the year. While the EPS number goes down about 4% relative to the company's prior range, revising the sales growth figure down by 4% (from a range of 5-7% to 1-3%) might be the scarier move.
Frankly, I think the company is being realistic, especially given the wobbles in markets like construction and autos/transport and the lack of major exposure to end-markets like aerospace or energy (which have helped companies like GE post stronger growth).
Longer term, though, I see little reason to worry about Illinois Tool Works. Yes, there are risks in the company's so-called simplification strategy (messing with any winning strategy is risky), but there's also the real possibility of moving peak margin potential from around 18% to maybe 20% or so. Likewise, it wouldn't hurt the company or the stock if management decided to divest operations like industrial packaging and/or decorative services and address some under-exposed markets with better growth outlooks.
The Bottom Line
In part because I do buy into the story that management's restructuring will lead to long-run improvement in margins and free cash conversion, I'm willing to estimate 8% free cash flow growth over the next decade - quite a lot for a company this large and mature. Even with that, though, and a reasonably favorable discount rate, I have a hard time seeing fair value much beyond the mid-$60s today.
To be fair, 25% undervaluation for a solid and dependable company (and one that pays a decent dividend) is not bad. That said, anybody buying a diversified/conglomerate industrial company today needs to understand that they may be buying into dead money (or further declines) ahead of that eventual rebound.