ITW - Illinois Tool Works Q1 Earnings: Resilient Investment In Uncertain Times

2023-05-03 06:58:59 ET

Summary

• ITW's unique business model, centered around the 80/20 principle and strategic sourcing, offers a competitive edge in uncertain markets.
• The company's strong financial performance and management's cautious approach to guidance indicate a focus on long-term growth.
• ITW's strategic investments in high-growth areas, such as electric vehicles, and successful navigation of cost inflation challenges make it an attractive long-term investment.

Illinois Tool Works ( ITW ) has consistently demonstrated its adaptability and resilience in the face of market uncertainties, making it an attractive investment option. With a powerful and easily understandable business model, ITW's focus on Front-to-Back 80/20, Decentralized Entrepreneurship, and Customer-Back Innovation positions the company for long-term growth. In this article, we will analyze the company's recent Q1 earnings and discuss ITW's strong financials, prudent management approach, and strategic investments that make it an ideal choice for investors seeking stability and growth. After careful consideration, we believe ITW is fairly valued and continues to be an attractive long-term investment.

Q1 Strong, Guide Disappointed Some

Illinois Tool Works delivered a remarkable Q1 2023 performance, exceeding expectations on multiple fronts. However, despite the strong results and management raising its 2023 EPS guidance, some investors might argue that the increase wasn't as substantial as they had hoped for. Nonetheless, we firmly believe that ITW's management is taking a prudent approach by tempering expectations and focusing on long-term growth.

The company's earnings per share ((EPS)) of $2.33 surpassed the consensus estimate of $2.23, showcasing ITW's robust financial health. Furthermore, the 5.2% year-over-year increase in organic revenue and impressive 24.2% operating margin demonstrate ITW's undeniable prowess in managing its diverse portfolio.

While it's true that the guidance raise wasn't as high as some investors had hoped, we must emphasize that ITW's management is adopting a cautious approach in light of potential risks from further slowdowns in certain end markets. The projected slower growth rate of 3% in the second half of the year is causing some jitters among investors; however, we believe this conservative stance reflects a prudent strategy that will pay off in the long run. There is no indication of any execution issues that would cause concern.

ITW's performance in China deserves special attention, as the company is bouncing back after a slower Q1 2023. With its automotive OEM business expected to grow by 40% to 50% year-over-year, and other segments like food equipment, Polymers & Fluids, and Welding also showing strong growth, ITW is making all the right moves to capitalize on the Chinese market. Their strategic investments in innovation and capacity expansion, particularly in the electric vehicle (EV) market, are a testament to the company's forward-thinking approach.

Moreover, ITW's management has effectively navigated cost inflation, a challenge that has plagued many other businesses. By focusing on addressing cost pressures from labor components within their supply chain, ITW is positioning itself to maintain its financial strength in the face of adverse market conditions.

In our opinion, ITW's Q1 2023 performance is a resounding success, indicating the company's resilience and adaptability. We firmly believe that ITW's management is being prudent in their guidance and long-term strategy. The impressive growth in China, strategic investments in high-growth areas like EVs, and effective management of cost inflation make ITW an attractive prospect for investors. With a solid start to the year and positive momentum heading into Q2, we are confident that ITW will continue to outperform in a variety of economic conditions throughout 2023.

Why ITW Wins

In an era of increasing uncertainty, we believe that investing in companies with durable competitive advantages and agility is the key to success. Illinois Tool Works perfectly fits this criterion, thanks to their powerful and easily understandable business model. At the heart of ITW's approach are the concepts of Front-to-Back 80/20 and Decentralized Entrepreneurship, which have recently been complemented by the addition of Customer-Back Innovation pillars. This 80/20 principle allows ITW to focus on their core customers and products, resulting in a highly resilient and adaptable company.

ITW's ability to translate customer needs into profitable products gives them a unique competitive edge. The company has proven to be highly resistant to crises and competition, owing to its focus on the most crucial aspects of its business. The company's impressive financials , including EBIT margins in the mid-20s and an after-tax return on capital of over 30%, demonstrate the strength of its diversified industrial portfolio.

We are confident that ITW has at least another five years of strong execution ahead, thanks to its ongoing commitment to its enterprise strategy. Over the past decade, ITW has consistently improved its margins by 100 basis points annually, resulting in a cost reduction of $1.5 billion. This success can be attributed to two main initiatives: the reimplementation of the 80/20 principle and strategic sourcing efforts.

ITW's updated 80/20 operating system has become more powerful and effective over time, as the company continues to refine its tools and techniques. ITW's teams have become experts at implementing this business model, which has been applied to more differentiated businesses after the company exited lower-growth, lower-margin sectors.

The strategic sourcing initiative involves leveraging the combined spending power of the enterprise to generate significant savings across the company. This approach is supported by strategic sourcing experts, a resource ITW did not have at its disposal when the strategy began ten years ago. The combination of these two capabilities, collectively referred to as the enterprise initiatives, has led to 100 basis points of margin improvement in 2023.

In our opinion, ITW's robust business model, which revolves around the 80/20 principle and strategic sourcing, makes it an ideal investment choice in times of uncertainty. With a proven track record of resilience and adaptability, we are confident in ITW's ability to continue delivering strong results and outperforming its peers in the coming years.

Financials & Valuation

Note: all data in this section comes from FactSet.

In 2022, Illinois Tool Works demonstrated impressive growth, with organic revenue increasing by 12.1% across all seven segments. Although product line simplification activities slightly reduced organic revenue by 40 basis points, the company's revenue reached $15.9 billion in 2022, up from $14.3 billion in 2017. This represents a compound annual growth rate ((CAGR)) of approximately 2.7%. In 2022, ITW's operating income increased by 9.0% to $3.8 billion, primarily driven by higher organic revenue, albeit partially offset by unfavorable foreign currency translation.

Despite a 30 basis point decrease in operating margin to 23.8% due to factors such as higher operating expenses, employee-related expenses, freight costs, unfavorable price/cost of 90 basis points, and the dilutive impact of 60 basis points from the MTS Test & Simulation acquisition, ITW managed to achieve a robust 15% growth in EPS in 2022, reaching $9.77, up from $6.59 in 2017. The CAGR for EPS during this period is around 8.2%.

Looking ahead, consensus estimates for 2023 through 2025 project sales growth of approximately 2.8% per year, while EPS is expected to remain flat in 2023 before growing by 7-8% per year in 2024 and 2025. ITW currently trades at a premium valuation due to its robust growth rate and competitive advantages, with a multiple of around 24x next-12-month consensus EPS. This figure falls within the 5-year range of 16x to 32x.

Compared to the S&P 500, ITW is trading at a 30% premium, which leans towards the higher end of its 5-year range. This reflects the market's positive outlook for industrial earnings relative to the benchmark index. In our opinion, ITW's current valuations are fair, and we continue to view the company as an attractive long-term holding at these levels, given its strong growth and competitive advantages in the market.

Conclusion

In our opinion, Illinois Tool Works stands out as a compelling long-term investment, thanks to its robust business model and proven resilience in the face of market challenges. The company's focus on the 80/20 principle, strategic sourcing, and innovation, combined with its impressive financial performance and growth prospects, make it an ideal choice for investors seeking a stable and reliable investment. As ITW continues to capitalize on opportunities in high-growth areas and navigate cost inflation challenges effectively, we remain confident in its ability to outperform peers and deliver strong returns for investors in the coming years.

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