Illinois Tool Works (ITW) is one of the strongest, most diversified industrial conglomerates a dividend growth investor can find. While the stock only yields 2.4% today, the company raised its dividend by 13% last quarter and continued double-digit dividend growth isn’t out of the question.
ITW possesses many of the characteristics we look for when accumulating stocks in our Top 20 Dividend Stocks portfolio. Let’s take a closer look at the business.
ITW was founded over 100 years ago and has grown into an extremely diversified manufacturer of specialized industrial and consumer equipment and consumables with a presence in many different end markets – automotive, construction, manufacturing, food & beverage, and more. The company estimates that around 60% of revenue comes from consumer-facing businesses with the remaining 40% coming from industrial-facing businesses.
ITW consists of hundreds of businesses it has acquired over the years. It runs a unique decentralized operating structure that empowers acquired businesses to maintain most of their culture and operations while taking advantage of ITW’s resources to better serve their customers’ needs. The company’s business model also emphasizes the 80/20 rule, encouraging each business to focus on the 20% of its customers that generate 80% of its revenues and structure its operations around growing these key relationships.
By geography, ITW generates 50% of its sales in North America, 30% in Europe, the Middle East and Africa, and 20% in Asia. The company does business in over 50 countries, but its emerging market exposure is fairly limited.
Automotive OEM (19% of sales, 24.5% margin): produces plastic and metal components, fasteners, and assemblies primarily for automotive original equipment manufacturers.
Test & Measurement (14% of sales, 16% margin): sells equipment, consumables, and related software for testing and measurement of materials and structures, as well as equipment and consumables used in the production of electronic subassemblies and microelectronics.
Food Equipment (16% of sales, 24% margin): produces commercial food equipment and related services, including warewashing equipment, cooking equipment (e.g. ovens, broilers), refrigeration equipment, and more. Customers include restaurants and food retail markets.
Polymers & Fluids (13% of sales, 20% margin): sells adhesives, sealants, lubrication, fluids, and polymers for auto aftermarket maintenance and appearance.
Welding (12% of sales, 25.5% margin): sells welding equipment, consumables, and accessories for a wide array of industrial and commercial applications.
Construction Products (12% of sales, 20% margin): produces construction fastening systems and truss products used primarily in construction markets.
Specialty Products (14% of sales, 23% margin): the businesses in this segment produce beverage packaging equipment and consumables, product coding and marking equipment, and appliance components and fasteners.
Much of ITW’s historical growth was fueled by acquisitions into high-margin industrial and consumer niches. The company runs a decentralized organizational structure, which allows acquired companies to retain most of their unique culture and market knowledge to continue growing their business.
For many decades, this was a very successful strategy. However, ITW eventually grew to more than 800 regional business divisions, which became increasingly difficult to oversee and keep efficient. Over the last three years, ITW has embarked on a strategy to simplify its operations (transitioning from 800+ regional to 84 global divisions), take better advantage of its size and scale, and drive accelerated organic growth globally.
Like many conglomerates, ITW’s massive sales base contains good and bad businesses. As seen below, management has pointed out that about 45% of the company’s total revenue is healthy and expected to report organic sales growth of 6% in 2015. However, 40% of sales are not yet ready for sustainable, profitable organic growth and need some help.
ITW’s reported revenue has declined over the last three years as a result of the company’s portfolio management activities. From 2013-2014, ITW divested 32 businesses that generated $4.9 billion of revenue because they were operating in commoditized markets where profitable growth was harder to come by.
From 2014-2016, the company expects to exit an additional $350 million of revenue by exiting commoditized product lines to allow its divisions to focus on more profitable opportunities.
While sales have declined as a result of these moves, ITW’s profitability has soared. As seen below, the company’s operating margin and return on invested capital both increased over 500 basis points compared to 2012.
With profitability measures nearing their 2017 goals, more attention will turn to management’s objective to have a majority of revenues ready to grow by the end of 2016. The company hopes to achieve organic sales growth at least 2% higher than global GDP going forward while maintaining excellent profitability and delivering 12-14% annual shareholder returns (dividend yield plus earnings growth).
We confess that sluggish global growth trends, particularly within ITW’s industrial-facing businesses, could challenge the company’s abilities to hit its 2017 targets – lower sales growth would likely mean less operating leverage, and most of the low-hanging fruit from portfolio management activities has already been picked.
With that said, ITW’s operations would still be generating very strong 20%+ returns on capital, providing plenty of opportunity to compound earnings and the dividend.
The business earns high returns largely because management has (for the most part) successfully identified differentiated products in favorable markets with long-term growth opportunities. The company’s decentralized structure allows its business divisions to continue operating like small businesses, but with the full backing of ITW’s resources and financial benefits.
Over time, ITW has built up a portfolio of nearly 20,000 patents and applies for roughly 1,500 patents per year. The company’s intellectual property further strengthens its competitive lock on the customer relationships it has and the differentiated products it sells.
ITW’s diverse product lines, end markets, and geographies also add to the company’s quality. When one market is weak, another is usually strong, smoothing out earnings and providing consistent free cash flow for the company to reinvest in the highest-returning businesses. It’s hard to see a future in which ITW no longer becomes relevant – it’s hands are in too many pots, most products are protected by patents and sold in slow-changing markets, and its decentralized operating structure helps its numerous businesses run more efficiently.
Many industrial-related businesses are suffering in today’s business environment, which is marked by sluggish growth, commodity price weakness, and meaningful foreign currency exchange rate headwinds. No one knows when these headwinds will abate, but they seem unlikely to impact the long-term earnings power of ITW.
Two risks that seem like more reasonable threats to the company’s future are (1) the knock-on effects from major changes made to its organizational structure and (2) the challenge large conglomerates face grow organic sales faster than GDP.
Neither of these longer-term risks appears to be developing today, but we will continue monitoring them. Regarding the first risk, ITW has prided itself on letting its acquired businesses continue doing what they do best – understanding their customer needs on a deep level and maintaining their “small business” feel.
ITW became so large (over 800 regional business divisions) that it had to further consolidate its operational structure to less than 90 divisions. Will this take away some of the autonomy and success its acquired companies enjoyed? What impact will this have on the culture? Will bureaucracy increase?
It’s too early to say (most of these consolidation efforts began around 2013), but ITW’s renewed emphasis on organic growth and consolidated operational structure is a deviation from the company’s prior successful growth strategy.
Like many large cap businesses, ITW’s sales mix isn’t perfect. With so many companies, products, and markets, some will inevitably see margins slip and sales start to dip. ITW has been divesting underperforming businesses and product lines, which has significantly enhanced its profitability.
However, less than half of its total sales mix is growing organically. The company says it is “preparing for growth” in 40% of its business, with hopes to be ready for sustainable organic growth by 2017. We will give management the benefit of the doubt for now, but this is no small feat.
Otherwise, ITW’s diversification, strong cash flow generation, and reasonable balance sheet reduce its risk profile.
Let’s take a look at ITW’s dividend.
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. ITW’s long-term dividend and fundamental data charts can all be seen by clicking here and support the following analysis.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
ITW recorded an excellent dividend Safety Score of 96, suggesting its current dividend payment is extremely safe. The company’s low payout ratios, strong free cash flow generation, and diversified product mix support the favorable ranking.
Over the last 12 months, ITW’s dividend has consumed 39% of the company’s “as reported” earnings and 43% of its free cash flow. These relatively low payout ratios provide plenty of safety and should allow ITW to enjoy nice dividend growth going forward even if earnings growth temporarily slows down.
Looking at longer-term trends in payout ratios can also be helpful to see if growth in earnings per share has kept up with dividend growth. As seen below, ITW’s payout ratios have consistently fallen in the 20-50% range.
For dividend companies with enough operating history, it’s always a prudent exercise to observe how their businesses performed during the financial crisis. During 2009, ITW’s sales and earnings fell by 21% and 33%, respectively. The company is clearly sensitive to the broader economy, but it outperformed many other industrial businesses in part because of its consumer-facing businesses and consumable sales, which are somewhat more recession-resistant.
High quality companies are able to generate free cash flow year in and year out. Rising cash flow is important because it supports continued dividend growth without expanding the payout ratio. As seen below, ITW’s business is not very capital intensive, which has allowed the company to generate solid free cash flow in each of the last 10 years.
While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during recessionary conditions help give us a better sense of a dividend’s safety, the balance sheet is an extremely important indicator as well.
Companies with high amounts of debt, cyclical business operations, and inconsistent cash flow generation could find themselves in a cash crunch if demand unexpectedly weakens and they have overextended themselves. They will always cut the dividend before missing a debt payment, so monitoring cash and debt levels is important.
ITW’s balance sheet is in reasonably good shape. As seen below, the company has $7.8 billion in debt compared to $3 billion in cash on hand, but its net debt / EBIT ratio is a modest 1.7x. This means that ITW’s net debt could be covered with about 1.7 years of EBIT, which seems quite reasonable for a business with such consistent cash flow generation.
Overall, ITW appears to be an extremely secure source of income and is one of our favorite blue chip dividend stocks.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
ITW’s Growth Score is 70, meaning its dividend’s growth potential ranks much higher than most other dividend stocks. ITW’s relatively low payout ratios, consistent cash flow generation, and diversified growth opportunities support the rating. The company has also increased its dividend for 52 consecutive years, easily securing its spot on the dividend aristocrats list.
As seen below, ITW’s dividend has compounded by 13% per year over the last decade and by 5% per year over the last five years. ITW raised its dividend by 13% in the third quarter of 2015, and the company expects earnings per share to grow by 10-12% per year looking beyond 2016. If management hits the company’s objectives, the dividend seems likely to continue growing at a similar pace (8-12% per year).
Excluding the impact of foreign currency exchange rates, ITW trades at about 16.5x forward earnings guidance and has a dividend yield of 2.4%. The company’s earnings are expected to grow by 7% next year (10% excluding foreign currency headwinds) and 10-12% per year beyond 2016. The stock’s multiple seems reasonable here for a high quality industrial business, especially if the company executes on its organic sales growth goal (2% faster than global GDP).
If ITW can deliver high single-digit earnings growth, the stock could deliver annual total returns of 10-12%. You should never blindly accept management’s guidance, but ITW has established a goal of delivering 12-14% annual total returns, assuming global growth doesn’t slow. Regardless, double-digit annual return potential doesn’t sound too bad in today’s market.
ITW looks like a reasonable candidate for long-term dividend growth investors to consider. The company has some sensitivity to industrial markets, many of which are currently weak, but its consumer-facing businesses (around 60% of total sales) and consumables sales help provide cash flow stability. ITW’s decentralized management structure and sales diversification by end market and geography will also help the company remain a force for years to come.
The dividend is in excellent shape and appears to offer 8-12% annual growth going forward. While ITW’s 2.4% dividend yield isn’t enough for investors living off dividends in retirement, the stock’s double-digit annual total return potential is attractive in today’s market environment.