Why I'm Removing Illinois Tool Works From My Core Holdings, And What I'm Replacing It With

Dec. 12, 2019 5:52 AM ETIllinois Tool Works Inc. (ITW)BMY, MMM, ILPT, SPG, FRT38 Comments22 Likes

Summary

  • Illinois Tool Works is an innovative, efficient industrial company and dividend growth stock.
  • But the company has struggled (or been uninterested) in growing revenue over the past decade, which is problematic.
  • I discuss some possible replacements for Illinois Tool Works in my top ten list and settle on one: Federal Realty Trust.
  • Federal exhibits all the traits I look for in a core holding: safety, financial strength, and steady growth.
  • Importantly, Federal's profit growth stems not from financial engineering but rather smart capital allocation.

Introduction

As much as I or anyone else would like to be a long-term buy-and-hold investor, there are always curveballs being thrown that make one review and rethink one's previous decisions.

This happened recently as I was reviewing the ten stocks that make up my core holdings. Most of the time, I manage to remember my original thinking, agree with it, and talk myself out of making any changes. But sometimes, as in this most recent instance, I realize that my disposition toward a certain company needs to change, even if slightly.

That is what happened with my recent review of one of my favorite dividend growth stocks, Illinois Tool Works (NYSE:ITW).

The Fault In ITW's Stars

The idiom "the fault in our stars" was not invented by the young adult book of the same name. It actually comes from Shakespeare's Julius Caesar play. Traditionally, the positioning of the stars has represented fate - the cryptic outworking of forces that are out of human control. The famous line is spoken by a Roman conspirator against Julius Caesar, whom the aristocracy sees as a menace to be stopped at all costs.

The fault, dear Brutus, is not in our stars / But in ourselves, that we are underlings.

It is not fate that determines the outcome of man, but rather men themselves. They would no longer be treated as underlings in Caesar's kingdom. Julius Caesar, after all, is no less a man than anyone else. As we all know from the iconic line delivered later, Brutus is present when Julius Caesar is being betrayed and executed by Roman senators.

"Et tu, Brute?" Caesar asks to his friend and confidant. ("And you, Brutus?")

Image Source

Demonstrating that fate is indeed in his own hands, Brutus takes part in the assassination of Caesar.

Now, this may seem a bit dramatic, but there is an application to ITW. You see, ITW has taken fate into its own hands as well, in its own way. One would never know this simply by looking at any individual quarterly earnings statement or report. But by looking at a long-term chart, the problem becomes apparent.

In my "manifesto" article from several months back, I outlined nine criteria that any company would need to meet as a prerequisite for my investment dollars. One of those points (a very important one, in my opinion) is "a long-term history and trajectory of revenue growth." The key word here is "long-term." Here's what I wrote in that previous article:

Would a single year of negative revenue growth negate a stock from consideration? No. But looked at over any five- or ten-year period, revenue growth should be positive. This is the sign of a company that is actually growing, not merely financially engineering EPS growth.

The fundamental issue with ITW is that there has been practically zero revenue growth over the last ten years.

ChartData by YCharts

In response to this sputtering, lackluster sales performance since the Great Recession has been, basically, financial engineering. ITW has relentlessly focused on the 20% of its business that produces 80% of the profits and cut everything else out. It has cut its costs to the bone and refined its business model into the most efficient one it can be. And, of course, it has plowed billions of dollars into buybacks, reducing its total share count by 36% in ten years.

As a result of these measures, the company has enjoyed a near-doubling of its operating margin and return on invested capital over the last decade.

Source: ITW Q3 Earnings Report

ITW has taken matters into their own hands, not letting fate have its way with them. The upshot, since enacting the new business plan in 2012, has been a radical divergence of earnings per share from revenue.

ChartData by YCharts

The fault lay not in the stars of ITW's flattish revenue growth, but rather in the notion that it needed to succumb to this fate. As it turns out, it did not. So ITW did something about it - namely, the sort of financial engineering described above.

Now, all of this (including my use of the term "financial engineering") may give the impression that I've turned sour on old ITW. I haven't. I first decided that I liked ITW in late 2017/early 2018, when revenue growth was still solid. I thought that trend would continue.

ChartData by YCharts

As you can see, it unfortunately did not. With about half of revenue derived from outside of North America (19% from Asian markets), the trade war and global economic weakness has reversed that revenue trend.

Of course, ITW still meets every one of my other investment criteria for a great company. It has a recession-resistant track record, having grown its payout right through the Great Recession. It has continuously grown its net income and free cash flow over a very long period of time (and can boast a 100% FCF conversion rate). It has a very reasonable payout ratio of 56% and aims to keep it at 50% by 2023. It has a low debt level of 2x EBITDA and 3.9x free cash flow.

With a weighted average interest rate on debt of 2.59% and an average dividend yield over the last four years of 2.2%, ITW enjoys an enviably low cost of capital. Annual dividend growth has been well above the rate of inflation, clocking in double-digit raises in the last ten years. The earnings and FCF yields are acceptable, though not as high as I'd like. (When I was buying shares in late 2018, they were much closer to my comfort zone.)

ChartData by YCharts

And, finally, based on my current yield-on-cost of 3.24% on shares purchased last year, I am projecting that my yield-on-cost after ten years will come to at least 8.4%. That means that ITW, as of last Winter, meets my 10-year YoC target.

ITW is an innovative, well-oiled machine of a company and I am by no means turning bearish or negative on it. I am not selling shares. But I am starting to rethink the company's position in my core holdings. Do I want outsized exposure to a company that can't - or doesn't seem interested in - sustainably growing its top line? The margin expansion ITW has achieved since 2012 is impressive, and the company's diversity of cutting edge products for automobiles, electronics, machinery, welding, packaging, etc. is first-rate.

But only so much efficiency is even possible or achievable. Margins can't expand indefinitely. Only so much fat can be cut away before the knife starts to take meat and bone with it. One cannot get blood from a stone. Especially concerning is the company's reliance on share buybacks for its stellar EPS growth. What happens when (not if) those buybacks go away or are reduced in the next recession? Without revenue growth, or buybacks to wring greater EPS out of the available revenue, from whence will growth come?

In the long run, there needs to be revenue growth for the business to thrive. Flat revenue is certainly better than declining revenue, but for a long-term dividend growth investor such as myself, flat revenue is not enough.

Another disconcerting finding is that ITW insiders have been offloading shares heavily over the past few years. Typically, as soon as they are able to purchase discounted shares as part of their compensation packages, they execute those stock options and turn around to sell at the much higher market price. In the last twelve months, insiders have been net sellers to the tune of 761,215 shares, or $114,562,858 in aggregate based on the midpoint of the stock price this year.

Now, the members of the executive team still have a substantial portion of their respective net worth in ITW stock (e.g. over $20 million for the CEO), but their holdings have been declining this year, for the most part.

This leads me to the conclusion that ITW should really be more of a secondary holding in my portfolio, rather than a core holding. Since I've made the determination (somewhat arbitrarily, but with my limited time and focus in mind) that I'll always have ten core holdings -- no more, no less -- that leaves a slot to be filled.

The New Core Holding Candidates

What kind of company should be the tenth stock in my core holdings list? I already have three utility names (Brookfield Infrastructure Partners (BIP), Duke Energy Corporation (DUK), and WEC Energy Group (WEC)), three net lease real estate names (Realty Income (O), National Retail Properties (NNN), and W. P. Carey (WPC)), an apartment REIT (Mid-America Apartment Communities (MAA)), a consumer staples company (PepsiCo (PEP)), and a midstream energy company (Enterprise Products Partners (EPD)).

One would think that, for diversification's sake, I should replace ITW with another industrial name. So how about 3M (MMM)? I gave my pitch for MMM back in a May article here on Seeking Alpha. The industrial giant is another dividend growth legend, having paid out a rising dividend for 60+ years straight. With tens of thousands of individual products sold to both consumers and businesses in both domestic and international markets, MMM is almost like an industrial mutual fund in itself.

But seeing that the payout ratio has crept up to around 60% over the years does not give me the kind of comfort I would want as a core holding. That's not to say the dividend is unsafe. But it's not a sleep-well-at-night quality level.

How about adding exposure to healthcare with Bristol-Myers Squibb (BMY)? I wrote about this biopharma company's recession-resistant revenue stream back in April (see here) and the stock has returned over 30% since. But the political risk is too great for me to ever consider BMY as a core holding.

How about Monmouth REIT (MNR)? I wrote about this little gem just last week (see here). While small in size, MNR prioritizes quality over quantity, and its slow-and-steady growth has helped it outperform most of its industrial REIT peers over long periods. Plus, I very much like that the company is a family business, with the current CEO being the son of the founder. Even the CEO's kids (founder's grandkids) own shares in the company, thanks to their father's indirect purchases in accounts dedicated for them. Will the company stay a family business into the third generation? Who knows. But the family certainly makes it seem as though that is the plan.

Then again, the primary downside of MNR is that it isn't quite a pure-play warehouse REIT. It has a securities portfolio made up of lower-quality, higher-yield REITs that significantly increases the company's risk profile and holds back the stock's valuation.

How about high-end mall landlord Simon Property Group (SPG)? I also wrote an article on this one last week, in which I argued that SPG should buy its smaller high-end mall REIT peer, Macerich (MAC). There's a lot to like about SPG, and I don't mind having a contrarian play in my core holdings as long as I believe wholeheartedly in the investment thesis.

SPG's investment thesis is quite compelling and goes like this: The company's large portfolio of Class A malls afford SPG ample profitable redevelopment opportunities, and it has access to plenty of low-cost capital to pay for it because of its strong balance sheet. I'm happily a shareholder of SPG. But, on the other hand, the creative destruction being wreaked by the "retail apocalypse" is very much a real thing. Exposure to Sears, J.C. Penny (JCP), and other struggling department stores as tenants is enough of a headwind to keep SPG out of my core holdings list.

Instead of any of the above admittedly phenomenal companies, the blue-chip, sleep-like-a-baby-at-night stock I am promoting to my core holdings is Federal Realty Investment Trust (FRT).

The Crown Jewels Of Open-Air Retail Real Estate

There's a reason that FRT has earned itself an entry into the ultra-exclusive "Dividend Kings" list, meaning that it has raised its dividend for over 50 years in a row (52 to be exact). FRT has the longest dividend growth streak of any REIT.

Source: FRT Q3 Earnings Presentation

Like Simon, FRT is one of only a handful of REITs that commands an A credit rating - and from all three major ratings agencies. This gives it the enviable ability to issue 10-year bonds at interest rates of 2.74%, as it did this past August. In other words, FRT's cost of capital is extremely low, giving it the ability to acquire the finest, lowest cap rate properties accretively. Also like Simon, FRT owns some of the highest quality, best located retail real estate in the country. But unlike Simon, FRT's properties are mixed-use urban town centers and open-air shopping centers.

In terms of location, FRT boasts the best demographics and population density of all its shopping center REIT peers, with an average household income of $127,000 and population of 162,000 within three miles of its properties. This attracts the best, most productive tenants to FRT's centers. The majority (85%) of the REIT's properties are located in top 20 metro areas such as Washington D.C., Los Angeles, the Bay Area of California, New York City, Philadelphia, Boston, Miami, Baltimore, and Chicago - basically, the biggest cities in the United States.

These are markets where the barriers to entry are very high, adding depth to FRT's competitive "moat." What's more, if and when less productive retail real estate shuts down or is converted to other uses, FRT's better located and more productive properties should benefit by picking up some of that foot traffic.

Both revenue and cash flow from operations have increased at a solid, steady clip over the past ten years:

ChartData by YCharts

FRT's top tenants include retail bargain treasure hunt stores, grocers (Ahold USA: Food Lion, Giant, Stop & Shop), a leading data analysis company office, pharmacies, fitness centers, movie theaters, and outdoors stores. A strong 94% of its leasable space is occupied.

Source: FRT Investor Factsheet

Moreover, FRT enjoys stunningly strong (double-digit) leasing spreads along with 10% average rent growth on comparable leases. Perhaps even more importantly, rent growth even remained strong during the Great Recession, coming in at 10% in 2009, 8% in 2010, and 9% in 2011.

FRT is the master of the tricky mixed-use space in the REIT world, deriving 33% of property operating income from these types of properties. Logistically speaking, it isn't always easy to meld residential, retail, lodging, and office spaces, but FRT has been doing it successfully for decades. Apartment rents actually make up the largest percentage of annual base rent by category.

Source: FRT Q3 Earnings Presentation

Like Simon, one of the primary (if not the primary) avenues of growth from invested capital right now is redevelopment projects, offering stabilized yields of 6-8%, versus a weighted average cash cost of capital of 3.26% (by my calculation). With cap rates for Class A shopping centers between 4-6%, redevelopments often are the most profitable use of investable capital.

With net debt to EBITDA at 5.3x, the weighted average maturity of bonds sitting at 11 years, and a ultra-low (for a REIT) payout ratio of 66%, FRT is incredibly financially strong and capable of continued steady growth.

At the current starting yield of 3.24%, a 5% average annual dividend growth rate would result in only a 5.3% yield-on-cost after ten years. If it could return to a 7% average annual dividend growth rate, buying at the current share price would render a 6.4% 10-year YoC. To get above a 7% 10-year YoC would require buying in at around a 3.6% starting yield, or $116.50 per share.

Unfortunately, FRT's stock price has not hit that price since the Christmas Eve selloff and for a brief period at the beginning of the year. I may, however, nibble at shares on pullbacks even above that price in order to build a full position. After all, I view FRT as a very conservative ultra-long-term investment, not just one for the next decade.

What do you think? Is FRT better as a core holding than ITW? Or the other way around? Let me know in the comments.

This article was written by

Austin Rogers profile picture
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Become a “Passive Landlord” with our 8% Yielding Real Estate Portfolio.

My adult life can be broken out into three distinct phases. In my early 20s, I earned a bachelor's degree in Cinema & Media Arts (emphasis in screenwriting), but I hated working in Hollywood. Too much schmoozing and far too much traffic. So, after leaving California, I earned a Master of Fine Arts in Creative Writing from Western State Colorado University. I loved writing fiction, but it didn't pay the bills.

In my mid-20s, I became a real estate agent and gained some very valuable experience in residential and commercial real estate. But my passion for writing never went away.

Now, in my early 30s, I write for Jussi Askola's excellent marketplace service, High Yield Landlord, as well as its sister service, High Yield Investor. I also perform freelance research for a family office that owns and manages over 40 net lease commercial properties in Texas and Arkansas. Writing about finance and investing scratches that creative itch while paying the bills - the best of both worlds.

I'm a Millennial with a long-term horizon and am fascinated with the magic of compound interest and dividend growth investing. I also have an interest in macroeconomic trends, though I am but an amateur in that field.

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Disclosure: I am/we are long FRT, ITW, EPD, BIP, DUK, PEP, O, NNN, WPC, MMM, MNR, MAA, WEC, BMY, SPG. 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.

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