ITW - Illinois Tool Works: Solid Growth Potential

• Approximately 85% of the Illinois Tool Works’ business portfolio is witnessing strong demand.
• The company should benefit from the pricing actions, stabilization in supply chain constraints and moderation in input costs.
• I have a buy rating on the stock.

Investment Thesis

Illinois Tool Works ( ITW ) experienced healthy demand for its products in Q2 FY22, which benefited its revenue growth and order book in the quarter. Looking forward, the company's revenue should benefit from strong demand across 85% of the total business portfolio, moderation in supply chain challenges, easier comps, and a healthy order book in 2H FY22. In terms of margin, the pricing actions taken by the company have started to benefit the company as the price/cost margin dilution in Q2 FY22 was negative 160 bps compared to 250 bps in Q1 FY22. The margin in 2H FY22 is expected to improve due to easier comps, pricing actions, and moderation in cost input.

ITW's Q2 FY22 Earnings

ITW recently reported its second quarter FY22 financial results that were better than expected. The net sales in the quarter increased 9.1% Y/Y to $4 bn (vs. the consensus estimate of $3.97 bn). The EPS declined 3.3% Y/Y to $2.37 (vs. the consensus estimate of $2.20). The sales benefitted from organic growth of 10.4% and the acquisition of MTS contributed 3%, partially offset by a 4% headwind from unfavorable foreign currency translation. The operating margin in the quarter declined 120 bps Y/Y to 23.1% due to the acquisition of MTS, restructuring expenses, and inflationary cost pressures. Poor operating margin performance as well as an increase in income tax rate led to a slight Y/Y decline in EPS despite good revenue growth.

Revenue Growth Potential

The strong demand across the business portfolio and the execution of the "Win the Recovery" strategy intended to gain market share (discussed in detail in our previous article ) helped the company deliver organic growth of 10.4% in Q2 FY22. The Automotive OEM segment delivered organic growth of 6% as the chip shortage situation improved modestly in the quarter. The Food Equipment segment's organic growth was 25%, with 27% growth in North America and double-digit growth across primary end markets. Both restaurants and institutions were up 40%, with the growth rate in retail being in the mid-teens. The order book remains strong for the segment.

The Test & Measurement and Electronics segment grew 15% Y/Y with organic growth of 1% due to tougher comps, resulting from the timing of some large equipment orders from an electronic customer in Q2 FY21. The Welding segment grew 22% organically, with equipment up 24% and consumables up 19%. The order rate in this segment was also strong in the quarter. The Polymers & Fluids segment grew 10% organically, with polymers being up 25% Y/Y due to continued strength in MRO and heavy industry applications. The automotive aftermarket and fluids business grew 4% and 3% Y/Y. The Construction segment delivered strong organic growth of 15%, with the U.S. residential growing 34% and commercial growing 20%. The North America business grew 29% Y/Y whereas, Europe and New Zealand grew 5% and 4% Y/Y. However, the order rates in the International construction business are slowing as the interest rate hike is impacting the growth in the housing industry. The US housing market is not that bad though as many US homebuilders have strong backlog which is likely to result in 2H FY22 growth. The Specialty was the only segment that didn't grow as the organic revenue declined 2% due to the delay on large equipment orders resulting from the supply chain constraint.

Looking forward, the company is experiencing headwinds across its auto aftermarket and international construction businesses. The auto aftermarket business is seeing some slowdown due to inflation and gas prices, which is leading to lower customer discretionary spending, while international construction is experiencing a pullback due to interest rate hikes as explained before. However, both the auto aftermarket and international construction contribute just ~15% to the total revenue. The rest (~85%) of the business is witnessing strong demand, which should drive the revenue growth in 2H FY22. Organic growth in July was up 18%, with five of the seven segments growing in double digits, more than offsetting the slowdown in other parts of the business.

Several auto companies are expected to ramp up their production in Q3 and Q4 of FY22 as the chip shortage issue is easing. So, Auto OEM business should accelerate in 2H FY22. The total revenue growth rate of the company should also benefit in 2H FY22 from easier comps as supply chain woes first started impacting its results in the second half of the last year. In addition, the company's healthy order book and further improvement in supply chain challenges should also help revenue growth. For FY22, the company is guiding for organic growth in the range of 7% to 10% for FY22 with additional 3% contribution from MTS acquisition, partially offset by a negative 4% headwind from unfavorable currency translation. For Q2 the company's organic revenue growth was above the upper end of this guidance range and July trends were much stronger. With comparisons easing in the back half of this year, I believe the company can easily meet or beat this guidance range.

Margins Outlook

The operating margin in Q2 FY22 benefited from operating leverage and the enterprise strategy undertaken by the company. However, these benefits were more than offset by headwinds from the MTS acquisition, higher restructuring expense related to the 80/20 strategy, and margin dilution impact from negative price/cost. The good news is the company witnessed stabilization in cost inflation and supply chain issues sequentially versus the prior quarter. The price/cost margin dilution headwind improved from negative 250 bps in Q1 to negative 160 bps in Q2 due to the pricing actions taken by the company and moderation in input costs.

Looking forward, the positive trend is expected to continue and the margin dilution should be neutral in 2H FY22 compared to 200 bps headwind in 1H FY22. Throughout the inflationary period, the company has more than covered cost increases on a dollar basis and absorbed as much as 250 bps of margin dilution impact. As cost inflation begins to moderate on a Y/Y basis, the margins of the company should improve. Further, comparisons are also easier in the back half of this year. The margins should also benefit from the operating leverage, with management expecting the incremental margins to be 35% or higher. The company's margin guidance for the full year is between 24% and 25% with 100 bps of improvement from the enterprise strategy, offset by the 100 bps of margin dilution impact from price/cost. However, the second half of this year is expected to be much better than the first half and the momentum should continue in FY23 as well.

Valuation & Conclusion

The stock is currently trading at 23.02x FY22 consensus EPS estimate of $9.06 and 21.68x FY23 consensus EPS estimate of $9.62 which is slightly below its five-year average forward P/E of 23.96x. While some investors are worried about the upcoming recession, I believe the stock offers a good return potential. The strong demand across 85% of the company's business and easing supply chain should drive the revenue growth in the near term, whereas the pricing actions taken by the company and moderation in input costs should reduce the impact of price/cost dilution, benefiting the margins. The long term prospects also looks good with the company implementing "Win the Recovery" strategy to gain market share and using M&A to further accelerate growth. The stock currently has a dividend yield of 2.34% and ranks highly in dividend safety, dividend growth and dividend consistency. I believe the stock offers attractive risk-reward at the current levels and hence have a buy rating on the stock.

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