Illinois Tool Works prospects dampened by slow revenue outlook

By Meredith Wilson

Analysts are confident that Glenview-based Illinois Tool Works Inc. will continue to post profits in the coming years, but are concerned with the long-term feasibility of the company’s current growth plan, a reversal of its historic rapid-acquisition policy.

Forty-eight percent of analysts rate ITW stock as “buy,” and another 48 percent rate it as “hold.” On March 4, the stock was valued at $98.20. Its 52-week high was $101.82 and its low was $79.06. Analysts set the 12-month target price at just $101.82, the recent high.

The consensus earnings-per-share  estimate is for ITW to experience 11.86 percent growth in 2015 and 10.9 percent average annual growth over the next five years. The price-to-earnings ratio is projected to decrease to 18.81 in 2015 from 21.03 in 2014.

ITW’s growth potential is the result of its ability to successfully execute its five-year “enterprise strategy” begun in 2012. That strategy is centered around streamlining its holdings to focus on the highest-yielding products through portfolio management, business simplification and strategic sourcing.

“The extent of margin improvement culminating from ITW’s three major five-year initiatives is the primary valuation
driver,” Morningstar Inc. analyst James Krapful said in his Feb. 19 research note.

Since launching its enterprise strategy, ITW has sold its “most commodified” 25 percent of revenue and slashed the number of entities it holds from 800 to 90, resulting in healthier operating margins and a stronger revenue profile.

“We see Illinois Tool Works as a fine operator of the 80/20 business process, in which resources are dedicated to 20 percent of customers, products, and processes that drive 80 percent of revenue and profit,” Krapful said.

ITW is a diversified global manufacturer of industrial products and equipment. Diversification, its position as a brand leader in several markets, as well as the company’s “entrenched position with most of its customers,” insulate the company from being overtaken by competitors, according to Krapful.

It also helps insulate the company from economic upheaval.

“Overall, the diversified business mix helps to limit the impact of cycles in any single market, “ Matt Arnold, Edward D. Jones & Co. L.P. analyst, said.

Several analysts see the strength of ITW’s cash flow and an strategy of share buybacks and acquisitions as signals of good management.

“We believe the firm does a responsible job in allocating its strong free cash flows and incremental debt proceeds. Investments that are intended to drive organic growth and margins take precedence,” Krapful said.

Illinois Tool Works reported $1.9 billion of adjusted free cash flow for 2014. The amount of adjusted free cash declined by 8.4 percent from 2013, when the company reported $2.2 billion in adjusted free cash flow. Long-term debt increased from $2.8 billion in 2013 to nearly $6 billion in 2014.

While most analysts have faith in ITW’s enterprise strategy to improve margins and better position itself in a global market, they are concerned about the company long-term.

“We are a little worried about what the company will do to keep growth/improvement going post 2017,” BMO Capital Markets Corp. analyst Joel Tiss said in his most recent research note.

ITW posted “soft” revenue growth in 2014 of 3.5 percent, and the company projects its 2015 total revenue to shrink by 2 percent, primarily due to foreign currency fluctuations, according to an ITW press release.

Krapful notes that the company has averaged only 1.5 percent organic revenue growth over the past 12 years.

“The firm’s subpar organic revenue growth prospects temper our enthusiasm somewhat,” Krapful said. “It is too early to tell whether long-run returns will suffer as a result [of the enterprise strategy].”

Beyond dampening revenue projections, the enterprise strategy may blunt the company’s competitive edge.

“The company’s business structure simplification initiative could dilute some of the benefits of its decentralized model, such as its ability to rapidly respond to market changes and foster strong customer relationships,” Krapful said.

Alison Donnelly, director of communications for ITW, declared that while streamlining the company’s holdings will produce a drag on revenue in the short term, it will create a strong portfolio of businesses ready to grow in 2016 and beyond.

“If you take a look at our auto business, it’s further along in the process. In Q4, organic growth was 7 percent, compared to 1 percent in the market. It just shows that we are capable of growing these businesses,” Donnelly said.

Overall, Arnold, of Edward D. Jones, is not as concerned as other analysts about the potential negative effects of the company’s simplification strategy. He gives ITW a “buy” rating and s says it’s well-positioned for overall growth and investment returns.

“We believe ITW is a well-managed, diversified industrial company that should benefit from a gradual economic recovery,” Arnold wrote. “It also has a strong track record of dividend growth and new product innovations that should bode well for shareholders in the future.”

Tiss, of BMO, while giving the company an “outperform” rating, is anxious to see a concrete strategy for revenue growth. He believes that the company’s revenue strategy will “move back toward acquisitions more aggressively.”

Krapful believes the company needs to contend with the fact that its holdings are “mostly mature with subpar growth prospects.” The company has signaled that it plans to purchase fewer, higher-value companies every year rather than its historic strategy of buying 50 lower-cost companies every year.

He sees some “idiosyncratic risk” in the company’s signaled strategy, reasoning that It may be harder for ITW to spend 20 percent of its revenue for 80 percent of its profit when its acquisitions are more expensive; the company is at risk of overpaying for its acquisitions; management may not understand the unrelated companies, which may impact the quality of the company’s investments.

However, Krapful notes, “The many pros outweigh the cons associated with the move.”

Krapful advises investors to hold the stock.

Hear more from analyst Jim Krapful: