Weak Growth And Robust Expectations Create Headwinds For Illinois Tool Works

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About: Illinois Tool Works Inc. (ITW), Includes: DOV, LECO, MMM, SWK
by: Stephen Simpson, CFA
Summary

The fourth quarter was yet another lackluster top-line result for ITW, as end-market pressures intensify, but margin performance was better than expected.

Management may well divest some lackluster units, but an end-market mix that leans more heavily toward autos, non-residential construction, and manufacturing could limit growth in 2019.

ITW is a top-quality industrial and a worthy hold, but the weaker-than-peer growth profile limits the near-term upside that I can see.

Quality is all well and good, and Illinois Tool Works (ITW) certainly has that, but growth and margin leverage tends to drive share price performance and ITW looks to be in shorter supply where those are concerned. Meaningful exposure to softer end-markets like auto, “general industrial”, non-residential construction, and electronics are headwinds to me, and I’m not sure there’s a lot that ITW management can do to repeat the meaningful past improvements in operating margins. On top of all that, the valuation is not all that cheap at this point.

Another Lackluster Quarter

It’s been a little while now since ITW posted a notably positive quarter, and the company’s sub-1% organic growth for the fourth quarter (and a 1% miss relative to sell-side expectations) doesn’t help. Gross margin was fine (flat in a quarter where peers like 3M (MMM) and Dover (DOV) have struggled to do much better), and segment-level profit squeaked out some growth and beat expectations by 1%, but little-to-no growth on the revenue and segment income lines won’t really get anybody excited.

The Auto OEM business saw revenue fall almost 4%, with the North American business up 2% and the EU business down 3%. 3M, Dover, and Stanley Black & Decker (SWK) all had better quarters in their auto businesses, which I believe is more to do with customer mix than deeper fundamental underperformance. Margin fell 150bp from the prior year (on a double-digit drop in segment-level profit), and this was definitely the biggest disappointment among ITW’s segments relative to expectations.

Test & Measurement was just barely up, missing expectations by about 5%, with actual test & measurement down 1% and electronics up 2%. Margins were notably better, and better than expected, improving 140bp yoy and driving the second-best segment-level profit outperformance.

Food Equipment saw better than 5% organic growth, with 7% growth in North America and 9% growth in North American equipment sales, driven by double-digit growth from institutional markets like education and lodging. Revenue was a little better than expected, and margins were a lot better than expected (up 70bp), making this a standout next to Dover and I’m curious to see what Wellbilt (WBT) and Middleby (MIDD) will report.

The Polymers and Fluids business saw better than 3% organic growth, helped by strong new product introductions that drove the auto aftermarket business up 7%. Polymers was solid (up 4%), and help offset Fluids (down 4%); this is a tough business to benchmark next to comps like 3M and Honeywell, but it looks like ITW outperformed here and the 170bp improvement in margin was good to see.

Welding was up close to 8%, on target with expectations, but certainly slowing (up 10% in the third quarter) ahead of increasingly challenging comps. Growth was balanced between equipment and consumables, but margin improved only 30bp and I’d say that’s disappointing relative to what should be volume leverage, and I’m interested to see what Lincoln Electric (LECO) and Colfax (CFX) say vis a vis margins in the quarter.

Construction was down 1%, 4% below the sell-side expectation, but more in line with my expectation of slowing performance. Sales in North America were down 2%, but margins were stronger than I expected, with a 160bp year-over-year improvement in segment-level operating margin.

Specialty revenue was down 2%, missing expectations, with a weaker-than-expected 70bp drop in operating margin.

Challenging End-Markets And Maybe Limited Near-Term Options

I can’t say that I was surprised when management lowered its revenue growth outlook to 1%-3% for 2019 (from 2%-4%), particularly after seeing 3M put a 1% in for the low end of guidance and Honeywell (HON) a 2% (Dover’s range was 2% to 4%). ITW has quite a bit of exposure to the auto sector and I’m concerned that the company’s particular OEM/geographic mix will see a down year for build rates in 2019.

I’m likewise concerned about the prospects for slowing growth in “general industrial” markets and follow-on effects for businesses like welding and polymers/fluids, and slower growth in non-residential construction, with companies like Ingersoll-Rand (IR) and Honeywell acknowledging some slowdowns in the market. On the flip side, Illinois Tool Works doesn’t have much leverage to areas like aerospace, agriculture, mining, healthcare, or process automation that are likely to be stronger in 2019.

I am also not so confident that Illinois Tool Works can do all that much on the margin side to offset the immediate revenue growth pressures. True, the company did outperform on margins this quarter, but the company is exiting a multiyear program that accomplished quite a lot and I just can’t see a lot of fruit left on the tree to pluck.

Portfolio optimization could be a source of upside. At the December investor day management mentioned seven business units with long-term growth issues and a willingness to consider sales. There isn’t enough information to really calculate the impact these sales would have on margins, but it seems reasonable to assume it would at least boost the top-line growth rate and give management some additional fuel for buybacks. In terms of growing the business through M&A, it doesn’t sound like management has any major plans here at this point, and it’s well worth noting that ITW has never been big on large-scale M&A.

The Outlook

Although I think ITW management has done a lot to optimize margins already, I do expect some incremental cost reduction opportunities over time (more automation, etc.). That should help push an underlying organic revenue growth rate of around 3% toward a 4% long-term FCF growth rate. Management does have the liquidity and flexibility to do more through M&A to enhance long-term growth, but I wouldn’t expect a lot – Illinois Tool Works has long been a “what you see is what you get” sort of company.

Valuation is a little muddled. The shares don’t look cheap at all on a discounted cash flow basis, but they do look noticeably undervalued (10%-plus) on a margin/ROIC/ROA-driven EV/EBITDA approach. I attribute the difference to the lower growth profile, both historically and prospectively, as ITW has never been known for its robust growth.

The Bottom Line

If you think that key end-markets like autos, manufacturing/general industrial, and non-residential construction will exceed expectations in 2019, ITW would be a name to consider as growth expectations seem to be quite low at this point (at management’s direction, I’d note). I don’t find the total risk-adjusted return to be all that exciting now, but similar to my feelings on 3M, I think it’s a decent enough hold for the time being, particularly given the well above-average quality element.

Disclosure: I am/we are long MMM. 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.