ITW - Illinois Tool Works: A Dividend King To Buy At The Right Price

Summary

• Illinois Tool Works has a strong, diversified and flexible business model.
• It has a long track record of market-beating returns and is executing very well.
• I also highlight the dividend, share buybacks, and valuation, and make a recommendation.

Sleep well at night stocks come in all shapes, sizes, and forms. One such name is Illinois Tool Works ( ITW ), which is a dividend aristocrat that's raised its dividend annually for over 50 years. Needless to say, ITW is a stock that may check off a lot of boxes for investors.

As shown below, ITW has produced outsized returns for investors over the past decade, with a 358% total return, far surpassing the 225% return of the S&P 500 ( SPY ). In this article, I highlight whether the stock is currently a buy or hold, so let's get started.

Why ITW?

Illinois Tool Works may be a relative unknown for some investors, but it's indeed a Fortune 200 global industrial giant with 45,000 employees, serving multiple economic sectors. This includes automotive, food equipment, electronics, welding, polymers and fluids, construction, and specialty products.

While ITW is a cyclical company, its management has done a good job of leveraging technology to drive scale and process efficiencies. This is reflected by the significant ramp-up in operating leverage at the company, with margin improving substantially over the past 10 years, from 16.8% to 23.3%, as shown below.

This helps ITW to drive more value to the bottom line for shareholders and is reflected by its A grade for Profitability. ITW produces a sector-leading EBITDA and Net Income margins of 26% and 17.5%, respectively, far surpassing that of the sector medians, as shown below.

Meanwhile, ITW has demonstrated impressive growth that's outpaced inflation, with revenue growing by 13% YoY (16% on an organic basis) to $4.0 billion in the third quarter. This was partly driven by the acquisition of MTS, which contributed 3% to revenue, and by double-digit organic growth in five out of ITW's seven segments. Moreover, had it not been for unfavorable currency (due to a stronger dollar), revenue would have been 6% higher.

Notably, it also generated record operating income of $983 million, representing a 16% increase over the prior-year period, and importantly, ITW continues to demonstrate efficient scale, as operating margin improved by 70 basis points to 24.5%.

Looking ahead to fourth quarter results, ITW expects to see a strong finish to the year. However, there is potential for an economic slowdown this year, which may pressure operating fundamentals. This question was brought up during the last conference call, with management highlighting its flexible cost structure and 80/20 (20% of customers generate 80% of revenues) that makes it more resilient to downturns, noting as follows during the Q&A section :

Q: It seems like we're walking into a construction recession. How do you get ahead of that so that you can limit the impact of it?

A: Well, we've talked about this before, but one of the fundamental elements of 80/20 is that we have a very flexible cost structure. So we do a lot of outsourcing upstream. We want to assemble. We want to control the manufacturing elements that really matter from the standpoint of control of quality-controlled delivery. But we don't necessarily have to bend all the metal. We don't have to necessarily do all the upstream work.

And so what that gets us fundamentally, is a relatively flexible cost structure. So we are a read and react company. Our businesses are going to respond to whatever the demand is that sits right in front of them. We've talked about that before. We don't do a lot of forward forecasting. We are producing today what our customers bought yesterday. And as demand rates start to decline in places like construction, then those adjustments will take place real time.

Meanwhile, ITW carries a very strong A+ rated balance sheet. Its 2.3% dividend yield is also well-covered by a 57% payout ratio and comes with a 5-year CAGR of 12.1%. As shown below, ITW scores A and B grades for dividend safety, growth yield, and consistency.

While the dividend yield isn't high, it's worth noting that management tries to balance payouts with share buybacks, which are a more tax-efficient form of capital return. As shown below, ITW has meaningfully reduced its outstanding float by 9.5% over the past five years alone.

My only complaint with ITW is its valuation, which at $228.67 seems pricey with a forward PE of 24.4. As shown below, this sits above ITW's long-term normal PE of 21.5. Moreover, at the current high PE, ITW is only getting a 4% earnings yield, which isn't enough to move the needle much. Plus, given the cyclical nature of ITW's business, it may be closer to the top of the cycle than the bottom. As such, I believe investors should wait for at least a 10% to 15% drop in price before initiating a position.

Investor Takeaway

ITW has a strong track record of market-beating returns, driven by a diversified and moat-worthy business model with a flexible operating structure. However, while ITW has demonstrated strong execution, it appears that's been fully baked into the share price, without consideration to the cyclical nature of the business and potential for economic softness in the near term. As such, investors may want to wait for a pullback before initiating a position on this dividend aristocrat.

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