A Trio of Industrial Winners: Caterpillar, Honeywell and Illinois Tool Works

Includes: CAT, HON, ITW
by: Ray Merola

The books have closed on fourth quarter and year-end earnings for many corporations. As the dust settles, it's time to review performance and determine if the prior investment thesis is holding up.

For three large-cap, industrial equities, the road ahead looks straight and clear: Caterpillar (NYSE:CAT), Honeywell (NYSE:HON) and Illinois Tool Works (NYSE:ITW).

The macro thesis around these three companies is simple. Based upon the business cycle, as the economy moves from recession to early-phase recovery, one of the historically best-performing sectors are the Industrials.

Prospectively, this has certainly been the case. These three stocks have shown magnificent gains over the past year. Caterpillar has booked a 93% gain, Honeywell has enjoyed a 51% uplift, and the “laggard” Illinois Tool Works has registered a 27% share price improvement. The benchmark SPDR S&P500 ETF (NYSEARCA:SPY) has logged 24% over the same period.

Do these companies have any gas left in the tank?

Let's take a look for clues.


Here's what these three companies do:

Caterpillar Inc. is arguably the premier earth moving equipment manufacturer in the world. The company produces construction and mining equipment, diesel and natural gas engines, and industrial gas turbines. Management has recently announced a merger with Bucyrus (NASDAQ:BUCY).

Caterpillar (CAT) One-Year Price and Volume

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Honeywell International Inc. is a diversified technology and manufacturing conglomerate. The corporation serves a global customer base with aerospace products and services; automated control, sensing and security systems for buildings, homes and industry; turbochargers, automotive products (recently announced the sale of this unit); specialty chemicals, electronic and advanced materials, process technology for refining and petrochemicals; and energy efficient products and solutions for homes, business and transportation.

Honeywell (HON) One-Year Chart and Volume

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Illinois Tool Works Inc. is a unique manufacturer of a wide range of diversified industrial products and equipment. The company has approximately 840 operations in 57 countries. Business segments include transportation, industrial packaging, food equipment, power systems and electronics, construction products, polymers and fluids, and decorative surfaces. Management is known for providing local leadership with a high level of creative and business autonomy.

Illinois Tool Works (ITW) One-Year Price and Volume

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A Brief Fundamental Overview

Caterpillar has a highly leveraged balance sheet. The debt-to-equity ratio is 263%. CAT offsets this with a strong current ratio (1.5) by holding ample cash on the books ($2.87 per share), and high cash flows (2010: $7.87 a share). A 36% Return-on-Equity is roughly double its peers. Revenues and net income has been on an upwards tear. The company pays a modest dividend, but has shown a long-standing propensity to increase it.

Honeywell is less levered with a 61% D2E ratio. The company has an acceptable Return on Equity (14%; roughly the 60th percentile versus industry peers). HON differentiates itself through its cash flow machine. Free Cash Flow (Operating Cash less Capital Expenditures) as a function of net income is over 150%. Revenues and net income are recovering smartly from the 2009 generational lows. The company pays a dividend of over 2%.

Illinois Tools Works carries considerably less debt than its competitors. The Debt-to-Equity ratio is 30%. RoE (17%) is lower than peers. However, ITW operating cash flow has remained strong even through the recession. Revenues have ramped up over the past two years; quarter by quarter sequentially sans one flat quarter. Most of this growth has been organic. The company pays the highest dividend of the trio and has raised it for 43 consecutive years.

Please find a summary table below for some key metrics:



Illinois Tool Works

Recent Price








Price/Cash Flow




PEG ratio




Dividend Yield




Future Prospects

Wise investors don't care much for where a stock price has been. They focus upon where it's going.

I submit that each of these companies have demonstrated solid cash flows, safe/consistent dividends, and competent management teams. Recent earnings conference calls and forward guidance have indicated continued successes.

From a macro standpoint, I believe these three stocks will offer above-average investor returns. They are in the “right” sector. My rationale is that since 1960, Industrial stocks have outperformed the broad equity market by three to four percentage points per annum during the early and mid-phase economic cycle. This historical data is available via several sources. Indeed, Fidelity Investments published one such summary last year. Furthermore, I believe we are somewhere between these two phases of the cycle.

So now let us proceed by taking a more granular approach. What do I think these stocks may be worth in the next 12 to 18 months?

To forecast a future share target price, I will utilize a process whereas I estimate the future operating earnings for 2011 and 2012, and apply a reasonable PE multiple. We will then examine the upside.

The following table provides a summary:



Illinois Tool Works

2010 EPS (reported)




2011 Est. EPS




2012 Est. EPS




5-year avg. P/E (actual)




2011 Est. P/E




2011 Target per share




2012 Est. P/E




2012 Target per share




NOTE: I am less concerned with being “right” about 2012 EPS and PE forecasts as I am with determining that a clear earnings uptrend remains in place. My investment horizon is forward 12-to-18 months.

Please note that for Industrial stocks in general, history suggests that PE multiples will contract as the economic recovery expands and these stocks reach their cyclical top. I envision Caterpillar as a clear industrial cyclical. Honeywell is less cyclical than Caterpillar; this conglomerate has a broad range of business that tend to contribute well throughout the economic cycle (except during the recession phase). Given their huge range of businesses, Illinois Tool Works is a bit of a hybrid. While I forecast a company that has many early-phase business opportunities, the sheer number of businesses make it a play throughout the entire economic expansion. In addition, it is a stock with a smaller deviation from the average multiple throughout the entire economic cycle. The share prices tends to stay closer to the long-term P/E multiple.


The data and analysis leads me to believe that all three stocks are sound investments, despite their recent out-performance.

Caterpillar is beginning to get ahead of itself, as I project it has a 10% upside remaining in 2011 (excluding dividends). It's only February. However, the prospects are so explosive for 2012 and out, I would continue to own the stock and accumulate more on any weakness. This view is bolstered by the fact that the Bucyrus merger has not yet figured into the mix. I could hedge the position by writing some covered calls at a strike price of $100 or above, planning to keep the premium assuming the stock price consolidates.

Honeywell likewise has about 10% upside this year. However, I believe the price feels a bit more crowded. The PEG is looking high, and the Price/Cash Flow is above the market average. This is offset by expectations of outstanding future cash flows, the fact that the company has addressed its pension shortfall, its exceptional senior management, and my view that HON has several late-phase businesses that have yet to hit their peak; for instance, aerospace and turbochargers. I'd take a further cue from HON technical charts: the stock has been following a razor sharp trendline and snappy MACD since August. I will begin to scale out at around $60 a share.

Illinois Tool Works is the steady-Eddie of the lot. Institutions own about 80% of the shares. I see an upside just a little above 10% for the upcoming year. I envision ITW will continue to improve earnings consistently and the PE multiple will remain higher than some others. The expectation of another good increase in the already ample dividend will spur even more yield-hungry investors coupled with the best balance sheet of the lot. Indeed, a Beta of 1.1 is the lowest of this trio.

Disclosure: I am long CAT, HON, ITW.

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