- Illinois Tool Works just reported its first-quarter earnings, which came in above expectations.
- The company saw weak organic sales growth, withdrew its guidance but maintained strong Q1 margins.
- While I expect another wave of selling, ITW is one of the best stocks to buy lower due its margin expansion and solid balance sheet.
My previous article covering Illinois Tool Works (NYSE:ITW) could not have started any better. I wrote about a pending breakout after bottoming economic growth would further support the company's sales. Unfortunately, while the stock price indeed started to break out, the COVID-19 crisis has hit this stock like a wrecking ball. The just-released Q1 results were better than expected as margins remained stable in a challenging environment. For Q2, the company expects a sales implosion as its cyclical business was impacted like never before. Fortunately, the company is well-positioned to face these challenges, and, as a result, I have put the stock on my watchlist. While I do not expect a V-shaped recovery, I think the company is currently shaping up to be a great long-term buy at lower prices.
Source: Illinois Tool Works
Q1 Was Bad, Q2 Will Be Worse
As usual, I will start this article by taking a look at earnings per share. The just-released results showed a decline of 2% to $1.77 per share. That's $0.06 above expectations, but ends the three-quarter growth streak the company started in the second quarter of 2019.
While the largest COVID-19 impact will be visible in Q2 earnings - as the shutdown started at the end of March, the company saw weakness across the board. For example, sales declined by 9% in the first quarter as organic sales were down 6.6%. Foreign currency translation deduced 150 basis points. Divestitures accounted for a 100 basis points decline. Fortunately, and this is why the company managed to do so well after the global growth peak of Q1/2018, the operating margin was flat at 23.6%. Enterprise initiatives (+120 bps), price/cost (+20 bps), and others (+20 bps) were able to offset volume leverage (-150 bps).
As the overview below shows, the operating margin improved in 5 out of 7 segments. The worst decline occurred in the food equipment segment, which saw operating margin drop by 60 basis points. Unfortunately, the overview also shows the damage economic contraction has done. Organic sales in the automotive OEM segment were down 12%, followed by a 9% decline in both welding and specialty products. As one might expect, the early impact of COVID-19 in China has resulted in underperformance in that country. Organic sales growth in China was down 21% in the first quarter. In North America, it was slightly less bad at -13%.
As nobody is surprised that Q1 was bad, one also shouldn't be surprised that Q2 is going to be worse - much worse. ITW expects a revenue decline between 30% and 40% in the second quarter. Automotive OEM sales are expected to decline between 60% and 70%. Based on these numbers, the company still expects to generate operating income of $200 to $400 million and more than $500 million in free cash flow. These numbers include tighter cost control, but no measures that will prohibit the company from benefiting from a recovery.
If full-year sales contraction can be limited to 20%, the company will likely see an operating margin decline to 18% to 20%. Note that the FY2019 operating margin was 24.1% (including restructuring). While these numbers are still bad, I am still mentioning them because the company is in a pretty good position despite doing business in some of the most cyclical industries in the world. The company will more than likely continue to generate positive operating income while maintaining a solid balance sheet. Right now, the company has $1.4 billion in cash and almost no short-term debt/no commercial paper. The company's current ratio is almost 3.0, meaning that current assets cover almost 300% of current liabilities.
Additionally, the company has access to $2.5 billion in an undrawn credit facility if needed and has a net debt/EBITDA ratio of 1.7x. While I could tell you again how good these numbers are, I think the company's A+/A2 credit rating confirms it even better.
Like many other companies, ITW has withdrawn its guidance as the duration of COVID-19 and its impact are impossible to forecast. That's why leading economic indicators are less valid. While they have helped me predict economic cycles in the past, now, it's largely up to government policies and the development of a vaccine. Even if the economy reopens, spending will be subdued. Not only because of millions in job losses but also because people will continue to avoid crowds.
As the graph below shows, regional economic sentiment is down to 2008 levels, implying that general economic growth could drop to these levels as well.
Source: Author's Spreadsheets (Raw Data: ISM, regional Federal Reserve banks)
I am mentioning these indicators because the longer the economic shutdown takes, the more likely stocks will adjust again. Right now, ITW is down roughly 11% year to date and up almost 3% over the past 12 months. While I have tremendous respect for everything management has achieved, these results do not reflect a pending global economic implosion.
I get that stocks are up as investors are pricing in lockdown easing, but I think we will not see an easy V-shaped recovery due to the aforementioned reasons. I think stocks will attempt at least one move lower. I don't know if we will retest the lows, but it won't be this easy for bulls. The economy is simply different compared to 2011 or 2016.
My plan is to buy ITW at lower prices if I get the chance. The company is one of the best automotive suppliers and producers of cyclical machinery and equipment. Its balance sheet is rock solid, and I have no doubt the next recovery will further fuel the company's margins and earnings expansion. The only problem I have is finding an entry. I do not trust the most recent recovery and hope to buy the stock below $130 if I get the chance.
Thank you very much for reading my article. Feel free to click on the "Like" button and don't forget to share your opinion in the comment section down below! My long-term investments are stated in my Seeking Alpha biography.
This article was written by
Leo Nelissen is an analyst focusing on major economic developments related to supply chains, infrastructure, and commodities. He is a contributing author for iREIT on Alpha.
As a member of the iREIT on Alpha team, Leo aims to provide insightful analysis and actionable investment ideas, with a particular emphasis on dividend growth opportunities. Learn More.
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