Published November 8th, 2016 by Bob Ciura
Illinois Tool Works (ITW) started out all the way back in 1902, when a financier named Byron Smith placed an ad in the Economist. Smith was looking for a “high class business (manufacturing preferred) in or near Chicago.”
A group of inventors approached Smith with an idea to improve gear grinding, and Illinois Tool Works was born.
Today, Illinois Tool Works operates in 57 countries around the world. It has more than 48,000 employees.
Illinois Tool Works is a 1 of only 50 businesses on the Dividend Aristocrats List. It has increased its dividend for 53 years in a row, including a hefty 18% dividend hike in 2016.
In fact, Illinois Tool Works qualifies to be a Dividend Aristocrat twice over (Dividend Aristocrats must have 25+ years of consecutive dividend increases). The company is also a member of the even more exclusive Dividend Kings List – which is comprised of just 18 businesses with 50+ years of consecutive dividend increases.
Illinois Tool Works’ long history of rising dividends and no-fee DRIP make it one of the best stocks for dividend reinvesting.
Keep reading this article to learn more about the investment prospects of industrial sector dividend growth stock Illinois Tool Works.
Illinois Tool Works is a diversified manufacturer of industrial products used in a variety of industries, including automotive, construction, paper products, and food and beverages. Its 2015 revenue breakdown is evenly distributed among its various industry groups:
- Automotive (18% of revenue)
- Food Equipment (16% of revenue)
- Test & Measurement, and Electronics (15% of revenue)
- Specialty Products (14% of revenue)
- Welding (13% of revenue)
- Polymers & Fluids (13% of revenue)
- Construction Products (11% of revenue)
Business conditions right now are challenged, but still supportive of growth. Illinois Tool Works is struggling with the strong U.S. dollar, which makes exports less competitive. Furthermore, it is also hurting from the decline in commodity prices, as the oil and gas industry is a significant customer of industrial manufacturers like Illinois Tool Works.
Fortunately, Illinois Tool Works has an effective management team that knows how to steer the company through troubled waters.
Last year, Illinois Tool Works grew earnings-per-share by 10%. The results are even more impressive when adjusting for currency fluctuations. Excluding foreign exchange, Illinois Tool Works’ earnings-per-share increased 19%.
It generated such impressive growth from multiple factors, including organic revenue growth and cost cuts. Because of this, Illinois Tool Works’ operating margin expanded by 150 basis points last year. Operating margin reached a company record of 21.4%.
In addition, return on invested capital hit a record 20.4% in 2015.
The company’s growth so far this year has been disappointing. Revenue over the first nine months of 2016 rose just 1% as compared with the same period last year. Illinois Tool Works is still feeling the effects of the strong U.S. dollar, and slowing economic growth in the emerging markets like China.
Fortunately, growth has picked up more recently. Total revenue grew 4% last quarter, and earnings-per-share increased 8% year over year.
Operating margin and return on invested capital both hit company records, of 23.1% and 23%, respectively.
Plus, the company still has attractive long-term growth prospects. Illinois Tool Works has set some ambitious growth targets for the next several years:
Source: 2015 Annual Report, page 3
While these targets may seem aggressive, they are also within reach. Illinois Tool has several levers it can pull to generate the growth it wants.
For example, revenue growth will be achieved through organic growth and bolt-on acquisitions. This will fuel high single-digit earnings growth. From there, margin expansion and share repurchases can propel double-digit earnings growth.
Competitive Advantages & Recession Performance
The first competitive advantage for Illinois Tool Works is its vast patent portfolio. The company has been extremely effective with research and development. Over time, it has amassed 10,600 patents granted, along with 6,000 additional patents pending.
Separately, Illinois Tool Works has a competitive advantage in the form of its proprietary business practices called the ITW Business Model.
The ITW Business Model calls for constant evaluation of the company’s focus and key strategies, to ensure it is operating efficiently and targeting the highest-growth opportunities. For example, one initiative that has come from the ITW Business model was to divest from low-growth commoditized businesses. Illinois Tool Works has made more than 30 divestitures over the past few years.
Instead, Illinois Tool Works reinvested in higher-growth opportunities.
Source: 2015 Annual Report, page 5
This resulted in the seven core segments that the company operates in today.
As an industrial manufacturer, Illinois Tool Works does not enjoy a recession-resistant business model. Its earnings-per-share fell 43% during the Great Recession of 2007-2009.
That being said, Illinois Tool Works remained profitable throughout the recession. This allowed it to continue raising its dividend, even during the economic downturn. Its earnings-per-share performance during the Great Recession is as follows:
- 2007 earnings-per-share of $3.36
- 2008 earnings-per-share of $3.05 (9% decline)
- 2009 earnings-per-share of $1.93 (37% decline, recession low)
- 2010 earnings-per-share of $3.03 (57% increase)
- 2011 earnings-per-share of $3.74 (23% increase, new high)
The downside of being exposed to the global economy is that earnings-per-share decline significantly during recessions. Illinois Tool Works has heavy exposure to the automotive and other cyclical industries. Its revenue is comprised mainly of other companies’ capital expenditures. During recessions, companies in cyclical industries typically reduce capital expenditures to tighten their belts.
Fortunately, Illinois Tool Works’ business model is strong enough that the company returned to earnings-per-share growth in 2010 and 2011.
Valuation & Expected Total Return
Illinois Tool Works stock trades for a price-to-earnings ratio of 21.4. This is slightly below the average price-to-earnings ratio of the S&P 500, of 24.
On the other hand, Illinois Tool Works stock traded for an average price-to-earnings ratio of 16 since 2000. From that perspective, the stock appears overvalued based on its own historical average.
As a result, investors should not count on further expansion of the price-to-earnings ratio to fuel future returns. Instead, shareholder returns will be comprised mostly of earnings-per-share growth and dividends.
A reasonable set of expectations for future earnings growth is as follows:
- 3%-5% organic revenue growth
- 2%-3% revenue growth through acquisitions
- 1%-2% operating margin expansion
- 1%-2% share repurchases
- ~2% dividend yield
Consequently, a realistic scenario would be for shareholders to earn 9% to 14% annualized returns going forward.
Illinois Tool Works is a tried-and-true dividend stock. It has survived recessions, wars, and several other periods of adversity through its 100-year history. And yet, it has continued to grow.
Illinois Tool Works is a Dividend Aristocrat. It has an above-average dividend yield and offers high dividend growth rates from year to year. As a result, it is an excellent long-term hold for dividend growth investors looking for exposure to the industrials sector. The company has an above average rank using The 8 Rules of Dividend Investing thanks to its reasonable payout ratio and strong growth prospects.