Illinois Tool Works (ITW) was founded in 1912 and has a long history of being a conglomerate in the industrial segment. It has over the years acquired company after company, making it a powerhouse within its various operating segments. With operations in automotive equipment, test and measurement and electronics, food equipment, polymers and fluids, welding, the construction industry, and specialty categories, the company is economically sensitive in more ways than one. The company has, however, been a steady compounding growth machine and continues to work toward a brighter future. The company has been experiencing weakness for a few quarters, which should lead the shares closer to low, not highs. At the very least, shares should not be trading at a premium valuation until the fundamental story has changed.
ITW recently reported first quarter earnings that missed on the top and bottom line.
Source: Seeking Alpha
This marked the 3rd quarter in a row with revenue declines. The third quarter of 2019 was the first time since the first quarter of 2016 that the company reported an actual decline in revenue. The company attributed the $0.16 decline in earnings per share to foreign currency headwinds, higher restructuring costs and a higher effective tax rate.
The company was able to affirm guidance as is believes the second half of the year will be much stronger. It saw improving business sentiment after January which led it to believe it will continue to see its expectations for growth met. The company is expects EPS of $7.90 to $8.20, which represents 4-8% percent growth year over year. It will be interesting to see if the company can maintain this now with the recently reignited trade war.
Below we can see a better picture of the first quarter performance.
Source: Earnings Presentation
On a positive note the company was able to produce strong free cash flow growth of 21%. This is attractive and helps the company continue to reward shareholders through share repurchases and increased dividends.
The company saw the weakest results in its automotive division.
Source: Earnings Presentation
This is where they highlight they believe stable or growing demand in the back half will improve operating performance. However, as we can see, almost every division experienced a decline in organic growth. Some of this was attributable to the amount of days in the quarter. But, even after adjusting they see anemic or no growth.
The company continued repurchasing shares in the quarter as well with almost 13 million shares outstanding reduced from the year prior.
This is about 4% of shares outstanding taken out of the market. A rather large amount for given year. The company has reduced shares outstanding from 500 million shares in 2010 to the current 327 million.
With more than 33% of shares outstanding repurchased in the last 8 years, investors would be larger shareholders of the company. It also has been a well-allocated plan; as we can see above the share price has increase three fold since it started.
Lastly, taking a look at the balance sheet, we see the company is financially sound.
Though debt is a bit high versus cash on hand, the company generates plenty of free cash flow each quarter to cover its obligations. With $1.755 billion in cash on hand versus $7.9 billion in debt, the company is well-positioned to continue to return capital to shareholders and acquire companies when an opportunity arises.
The company has outlined its debt/EBITDA ratio by using the below calculation, making it easy for investors to keep an eye on financial soundness.
The rise in the Debt/EBITDA was due to both the decline in net income and rise in short term debt. Investors should continue to expect debt to be reduced, as short-term debt included $700 million of short term 6.25% paper due April 1, 2019 and $700 million.
When I last wrote about ITW, I said I thought the company could perform well in the current environment. However, it has been another 2 quarters of disappointing performance. While the company expects to perform better in the coming quarters, there is little room for error at the current share price. The company is a prudent manager of capital and produces strong free cash flow but is reliant upon strong industrial demand. Should the current trade dispute remain unsolved, the company may have to end up revising guidance downward. With that we must see if the shares are a good value at this time.
Illinois Tool Works shares have rallied off the lows to new highs.
Competitor 3M (MMM) recently reported weaker than expected results for the 3rd quarter in a row, which led to a sell of in the shares. Because of that, 3M can be had at a more reasonable valuation while investors wait for the turnaround. ITW shares trade at the highest forward P/E, offer the lowest yield, and have the highest forward PEG ratio. This would all be understandable if the company was significantly outperforming peers, but that is not the case.
Looking at valuation historically for the company we see the following results.
The shares currently offer a lower forward P/E and P/E in than in the past 5 years, however, it is marginal. They also offer a higher P/B and P/S ratio than they have for the last 5 years. With many of the metrics are sending mix signals. The company certainly isn't over or undervalued by much based on its own history.
Next, we look at the company's historical yield to see if shares are offering a higher than normal yield.
Sure enough, the company is currently yielding 2.69% thanks to a recent 28% increase in the dividend. With a new quarterly payout of $1 per share, the company, which has raised its dividend for 43 years, now offers an above average yield versus its own history. The high spike in the middle of the chart was during the 2008 recession and the company was then yielding over 4%. A situation being unlikely to unfold like that again leaves the 2.69% looking quite nice. In fact only about 15% of the time in the past 24 years of trading has the company offered a yield in this range. The average yield is around 1.8% so investors would do well purchasing shares at a time when it is 50% higher than normal.
Illinois Tool Works shares have rallied to a level that offers little upside. With the recent performance coming in below expectations, I would need to see a turnaround to believe in the rally. With the company steadily reducing shares outstanding, being a dividend aristocrat, and performing reliably, investors can be assured that their investment will do well over time when acquired at the right price. Investors should keep an eye on areas of weakness that may cause further pressure on results. Such categories as automotive are cyclical and could cause a downturn in earnings, but as any cycle goes, it usually returns to normal at some point. A trade deal in the coming quarters would be a positive as well as the price increases implemented to deal with tariffs would remain and further increase margins. But in the meantime the company continues to face margin pressures and currency headwinds that will put pressure on earnings. When many other competitors are facing the same weakness and trading at lower valuations, it is a testament of the strength in the ITW shareholder base. This sentiment can turn at any time though. The dip we saw earlier in the year and recommended buying has come and gone. The shares need to fall back or fundamentals need to improve for me to become a buyer.
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.