Seeking Alpha

Illinois Tool Works: An Overvalued Total Return, Growing Income And Dividend King Investment

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About: Illinois Tool Works Inc. (ITW), Includes: DHR, EOS, HD, JNJ, OHI
by: William Stamm
William Stamm
Long only, dividend growth investing, growth at reasonable price, Total Return
Summary

Illinois Tool Works' total return over-performed the Dow average for my 58-month test period by 51.82%, which is fantastic for this industrial company.

Illinois Tool Works has increased its dividend for 55 years in a row (a dividend king) and presently has a yield of 2.5%, which is above average.

Illinois Tool Works is extremely well-diversified in the industrial equipment field, with new products leading the way.

Illinois Tool Works (ITW) is a strong hold for the total return and dividend growth investor. Illinois Tool Works is one of the largest manufacturers and distributors of industrial products and equipment for commercial customers worldwide.

Illinois Tool Works is being reviewed using the Good Business Portfolio guidelines. The company has steady growth and has plenty of cash it uses to buy bolt-on companies, develop new products and systems, and increase the dividend each year.

I use a set of guidelines that I codified over the last few years to review the companies in The Good Business Portfolio (my portfolio) and other companies that I am reviewing. For a complete set of guidelines, please see my article "The Good Business Portfolio: Update to Guidelines, August 2018". These guidelines provide me with a balanced portfolio of income, defensive, total return, and growing companies that hopefully keeps me ahead of the Dow average.

When I scanned the five-year chart, Illinois Tool Works has a great chart going up and to the right for 2016 and 2017 in a strong solid pattern. It is a cyclic company and was down in 2018 and has recovered well in 2019.

ChartData by YCharts

Illinois Tool Works is reviewed in the following topics below.

  • Investment Fundamentals
  • Company Business
  • Conclusions
  • Portfolio Management Highlights

Investment Fundamentals

I use total return as my starting point in looking at a company’s business. The total return must be greater than the Dow's total return over my test period. Illinois Tool Works beat against the Dow baseline in my 58-month test compared to the Dow average. I chose the 58 month test period (starting January 1, 2015, and ending to date) because it includes the great year of 2017, and other years that had a fair and bad performance. The great Illinois Tool Works total return of 104.20% compared to the Dow base of 52.38% makes Illinois Tool Works a good investment for the total return investor. Looking back five years, $10,000 invested five years ago would now be worth over $21,300 today. This gain makes Illinois Tool Works a good investment for the total return investor looking back, which has future growth as the United States and foreign economies continue to grow.

Dow's 58 Month total return baseline is 52.38%

Company name

58 Month total return

The difference from Dow baseline

Yearly dividend percentage

Illinois Tool Works

104.20%

51.82%

2.5%

Illinois Tool Works does meet my dividend guideline of having dividends increase for 8 of the last ten years and having a minimum of 1% yield. Illinois Tool Works has an above-average dividend yield of 2.5% and has had increases for 55 years, making Illinois Tool Works a good choice for the dividend growth investor. The dividend was last increased in August 2019 for an increase from 1.00/Qtr to 1.07/Qtr or a 7% increase. The next dividend increase is estimated to be in August 2020 to $1.13/Qtr. or a 6% increase. The five-year average payout ratio is low, at 41%. After paying the dividend, this leaves cash remaining for increasing the business of the company by buying bolt-on companies and new product development.

I only like large-capitalization companies and want the capitalization to be at least greater than $10 billion. Illinois Tool Works easily passes my rule. Illinois Tool Works is a large-cap company with a capitalization of $56 billion. Illinois Tool Works 2019 projected operating cash flow at $2.9 billion is good, allowing the company to have the means for company growth and increasing dividends each year. Large-cap companies like Illinois Tool Works have the cash and ability to buy other smaller companies and overcome any storms that might come along.

Illinois Tool Works S&P CFRA rating is two stars or sell with a target price to $146. Illinois Tool Works price is above the target by 20% and has a high forward PE of 22, making Illinois Tool Works a wait for a better price investment at this entry point.

I look for the earnings of my positions too consistently beat their quarterly estimates. For the last quarter on October 25, 2019, Illinois Tool Works reported earnings that beat expected by $0.09 at $2.04, compared to last year at $1.90. Total revenue was lower at $3.48 billion less than a year ago by 3.6% year over year and missed expected revenue by $70 million. This was a fair report with bottom-line beating expected and top-line decreasing compared to last year. The next earnings report will be out January 2020 and is expected to be $1.85 compared to last year at $1.83 a small increase. The fair third-quarter earnings report shows the slow growth for the company and makes Illinois Tool Works a hold. The graphic below gives a summary of the third quarter’s earnings data.

Source: Earnings call slides

I also require the CAGR going forward to be able to cover my yearly expenses and my RMD with a CAGR of 7%. My dividends provide 3.3% of the portfolio as income, and I need 1.9% more for a yearly distribution of 5.2% plus an inflation cushion of 1.8%. The three-year forward S&P CFRA CAGR of 6% misses my guideline requirement. This slow future growth for Illinois Tool Works can continue its uptrend benefiting from the continued strong growth of the worldwide and United States economies. The China sector of the company is growing strong, as shown in the graphic below, while the others show small changes.

Source: Earnings call slides

The above-average growing dividend makes Illinois Tool Works a good business to own for income, but the future estimated slow growth misses my requirement of 7%. My Portfolio likes to embrace all kinds of investment styles but concentrates on buying businesses that can be understood, makes a fair profit, invests profits back into the business, and also generates a good income stream. Most of all, what makes Illinois Tool Works interesting is the long-term dividend history of 55 years of growing dividends and the possibility of better growth over time with a good world economy.

Company Business

Illinois Tool Works is one of the largest developers and distributors of industrial products and equipment in the United States and foreign countries.

As per paraphrase from Reuters:

The Company operates through seven segments.

The Automotive OEM segment produces components and fasteners for automotive-related applications.

The Food Equipment segment offers commercial food equipment.

The Test & Measurement and Electronics segment produce test and measurement and electronics manufacturing and maintenance, repair, and operations (MRO) solutions.

The Welding segment produces welding equipment, consumables, and accessories for industrial and commercial applications.

The Polymers & Fluids segment produces adhesives, sealants, lubrication and cutting fluids, and fluids and polymers for auto aftermarket maintenance and appearance.

The Construction Products segment supplies engineered fastening systems and solutions.

The Specialty Products segment produces beverage packaging equipment and consumables, product coding and marking equipment and consumables, and appliance components and fasteners.

Overall, Illinois Tool Works is a good business with a fair CAGR of 6% projected growth as the world economy grows going forward. The fair earnings, revenue growth, and positive cash flow give ITW the capability to continue its growth and have enough cash to increase the dividend each year and expand the business. The talking heads that preach recession should be ignored, and even with a slowdown in the world economy, Illinois Tool Works products are still needed to satisfy the world’s industrial requirements.

The paraphrase below from the 3rd quarter earnings call indicates steady growth for the company's industrial products.

While slowing CapEx investment and declines in auto production in North America and China impacted the demand environment across a broad cross-section of our portfolio, we delivered another solid quarter with excellent operational execution.

Despite the macro challenges, we delivered earnings per share growth, operating margin of 25%, and a 12% increase in free cash flow. Despite lower volumes, we improved operating margin 40 basis points year-over-year with enterprise initiatives contributing 120 basis points and increased after-tax return on invested capital by 120 basis points to more than 29%.

Looking ahead at the balance of the year, based on demand rates and our margin performance exiting Q3, we are maintaining our full-year 2019 EPS guidance range of $7.55 to $7.85, while acknowledging that the combination of near-term macro uncertainties and the lingering strike at General Motors likely skews the probabilities of potential outcomes toward the lower end of the range.

Moving forward, we continue to focus on executing at a high level on the things that are within our control in the context of the near term macro uncertainties, while remaining fully invested in driving progress on a Finish-the-Job enterprise-ready strategy agenda, and on positioning the company to deliver on our 2023 enterprise performance goals.

Our demonstrated ability to deliver strong results across a range of economic scenarios while continuing to make consistent progress towards our long-term full potential performance is a direct result of the combination of the performance power and resilience of the ITW business model and a dedicated team of ITW professionals around the world who leverage it to serve our customers and execute our strategy with excellence day-in and day-out.

This shows the feelings of top management for the continued growth of the Illinois Tool Works business with an increase in future growth. Illinois Tool Works has constant fair growth and will continue as the United States and foreign industrial needs grow. The cash flow is good to allow company growth, an increase of the yearly dividend, and to buy back shares.

Conclusion

Illinois Tool Works is a good investment choice for the dividend growth investor with its growing dividend for 55 years and a fair investment for the total return investor with projected growth of 6%. Illinois Tool Works will not be considered for The Good Business Portfolio because of the volatile nature of the company’s business and present over-valuation. The entry price right now is high, but the yearly gain potential of 6% or better makes ITW a fair investment for the long term investor.

Portfolio Management Highlights

The five companies comprising the largest percentage of the portfolio are: Johnson & Johnson (JNJ) at 7.8% of the portfolio, the Eaton Vance Enhanced Equity Income Fund II (EOS) at 7.9% of the portfolio, Home Depot (HD) at 10.4% of the portfolio, Omega Health Investors (OHI) at 8.9% of the portfolio, and Boeing at 13.0% of the portfolio. Therefore, BA, EOS, JNJ, OHI, and HD are now in trim or close to trim position, but I am letting them run a bit since they are great companies.

On August 19, I wrote covered calls against my Danaher (DHR) position to collect another premium ($1.72/share Sept $145). I like DHR, but it’s getting a bit pricey, and the covered calls give me some extra income and downside protection. On September 12 th, I bought back the calls for $0.07/share making $1.65/share in one month. I intend to continue writing covered calls on the DHR position when the next upswing occurs.

On August 30, I trimmed HD to 10% of the portfolio. HD is a great business but needs more foreign expansion to grow even stronger.

On August 30, I trimmed OHI to 9% of the portfolio. OHI is a great income business, but it has risks, so 9% is my limit on this company until the operator problems are totally under control.

Boeing is going to be pressed to 15% of the portfolio because of it being cash positive on 787 deferred plane costs at $938 million in the first quarter of 2019, an increase from the fourth quarter. Boeing has dropped in the last five months because of the second 737 Max crash, and I look at this as an opportunity to buy BA at a reasonable price. On July 19 th BA said that they expect to have the 737 Max flying by the early fourth quarter. From the latest earnings call, Boeing now expects the 737 Max to fly by the end of the year. The software data and training materials have been submitted to the FAA.

JNJ will be pressed to 9% of the portfolio because of its defensive nature in this post-BREXIT world. Earnings in the last quarter beat on the top and bottom line, and Mr. Market did nothing. JNJ in April 2019 increased the dividend to $0.95/Qtr., which is 57 years in a row of increases. JNJ is not a trading stock but a hold forever; it is now a strong buy as the healthcare sector remains under pressure.

The total return for the Good Business Portfolio is ahead of the Dow average YTD by 6.46%, which is a nice gain above the market for the portfolio with BA a strong drag. Each quarter after the earnings season, I write an article giving a complete portfolio list and performance, the latest article is titled “The Good Business Portfolio: 2019 2nd Quarter Earnings and Performance Review”. Become a real-time follower, and you will get each quarter's performance after this earnings season is over.

Disclosure: I am/we are long BA, JNJ, HD, DLR, EOS, SLP, DHR. 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.

Additional disclosure: Of course, this is not a recommendation to buy or sell, and you should always do your own research and talk to your financial advisor before any purchase or sale. This is how I manage my IRA retirement account, and the opinions of the companies are my own.