Illinois Tool Works (ITW) is an S&P 500 Dividend Aristocrat (NOBL) that is poised to become a Dividend King – a stock which has consecutively raised its dividend for fifty years. Despite the underlying quality of this industrial manufacturer, no business – not even this one – should be bought when it is trading at a price far higher than it is worth, and that seems to be the case here.
At close of market on 08/14/2020, Illinois Tools Works traded at $196.13 per share. Chart generated by FinViz.
At close of market on 08/14/2020, Illinois Tools Works traded at a share price of $196.13 with a trailing price-to-earnings ratio of 29.02 based on earnings-per-share of $6.81, and a forward P/E of 27.92 based on projected earnings-per-share of $7.08. Both metrics are higher than the five-year average P/E of 22.66, and the current dividend yield of 2.17% is slightly lower than the five-year average dividend yield of 2.19%. By most metrics, in fact, Illinois Tools Works trades at a premium to both the machinery manufacturing sub-sector and to the S&P 500 (SPY).
|Metric||Illinois Tools Works||Sub-Sector||Index|
Figures collated from FinViz, Morningstar, and TheStreet.
All of the above suggests that Illinois Tools Works is trading at a premium to fair value – but what is fair value here?
To determine fair value, I will first divide the trailing P/E by the historical market average of 15 to get a valuation ratio of 1.94 (29.02 / 15 = 1.94) and divide the current share price by this valuation ratio to get a first estimate for fair value of $101.10 (196.13 / 1.94 = 101.10). Then I will divide the trailing P/E by the five-year average P/E to get a valuation ratio of 1.28 (29.02 / 22.66 = 1.28) and divide the current share price by this valuation ratio to get a second estimate for fair value of $153.23 (196.13 / 1.28 = 153.23).
Next, I will divide the forward P/E by the historical market average of 15 to get a valuation ratio of 1.86 (27.92 / 15 = 1.86) and divide the current share price by this valuation ratio to get a third estimate for fair value of $105.45 (196.13 / 1.86 = 105.45). Then I will divide the forward P/E by the five-year average P/E to get a valuation ratio of 1.23 (27.92 / 22.66 = 1.23) and divide the current share price by this valuation ratio to get a fourth estimate for fair value of $159.46 (196.13 / 1.23 = 159.46).
Next, I will divide the five-year average dividend yield by the current dividend yield to get a valuation ratio of 1.01 (2.19 / 2.17 = 1.01) and divide the current share price by this valuation ratio to get a fifth estimate for fair value of $194.19 (196.13 / 1.01 = 194.19). Finally, I will average out these five estimates for fair value to get a final estimate for fair value of $142.69 (101.10 + 153.23 + 105.45 + 159.46 + 194.19 / 5 = 142.69). On the basis of this estimate, the stock is overvalued by 27% at this time.
When examining the business, it is not hard to see why its share price has been bid up to the level that it currently sits at. Illinois Tools Works is a global manufacturer that divides its business operations into seven segments: Automotive, Construction Products, Food Equipment, Polymers & Fluids, Specialty Products, Test & Measurement, and Welding. A breakdown in revenue and organic growth shows how profitable each segment is for Illinois Tools Works.
|Segment||Revenue ($)||Organic Growth (%)|
|Automotive OEM||361 million||53|
|Construction Products||376 million||9|
|Food Equipment||336 million||39|
|Polymers & Fluids||354 million||14|
|Specialty Products||387 million||16|
|Test & Measurement||455 million||11|
Figures collated from Q2 2020 earnings presentation available on Illinois Tools Works’ investor relations page.
The diversity of its business lines shows one of the main strengths of Illinois Tools Works – its products, such as clothing zippers, automobile components, and resealable food packaging, can be found in almost every end market. An investment in Illinois Tools Works is thus an investment in the global economy. The profitability of such a firm can be gleaned from the revenue and net income figures it has reported over the past five years.
|Year||Revenue ($)||Net Income ($)|
|2015||13.41 billion||1.9 billion|
|2016||13.6 billion||2.04 billion|
|2017||14.31 billion||1.69 billion|
|2018||14.77 billion||2.56 billion|
|2019||14.11 billion||2.52 billion|
Figures collated from annual reports available on Illinois Tool Works’ investor relations page.
Illinois Tools Works maintains its profitability by divesting low-performing businesses and acquiring new ones. The best-known example of this was the $3.2 billion sale of its industrial packaging business to the Carlyle Group (CG) in 2014. However, being exposed to different facets of the global economy and managing its business portfolio prudently may not seem to be enough in the midst of a global pandemic and recession.
Illinois Tools Works benefits from having a decentralized business structure: each of its subsidiaries operates in an entrepreneurial fashion, which provides flexibility to its operations. That said, the impact of COVID-19 is clear from the drop Q2 reported from Q1 in the current financial year.
|2020 Quarter||Revenue ($)||Net Income ($)|
|Q1||3.23 billion||566 million|
|Q2||2.57 billion||319 million|
|Total||5.8 billion||885 million|
Figures collated from quarterly reports available on Illinois Tool Works’ investor relations page.
2020 will be a difficult year for Illinois Tools Works, and the firm withdrew its full-year guidance in early May. That being said, while profits have dipped, the firm nonetheless remains profitable, as is evident from its 22.78% operating margin and its reported free cash flow of $681 million.
In any event, Illinois Tools Works clearly believes it is profitable enough to maintain its progressive dividend: on 08/07/2020 the firm announced a 6.5% hike to its dividend, making a 45 year record of consecutively rising dividends. Should Illinois Tools Works be able to maintain this streak for four more years, it will achieve Dividend King status. In the near-term this seems likely given the firm’s profitability and its 61.60% payout ratio.
Illinois Tools Works looks set to be crowned a Dividend King in due course. Image provided by Barron’s.
The balance sheet is not spotless, however, as long-term debt of $7.77 billion is considerably higher than the firm’s net worth of $2.35 billion. Short-term finances are in better shape, with total current liabilities of $2.04 billion being offset by total current assets of $5.61 billion, cash-on-hand worth $1.81 billion, and total accounts receivable of $2.16 billion. Illinois Tools Works is profitable enough to cover its interest payments, and has a revolving credit facility in place that could provide $2.5 billion in additional liquidity.
In summary, there is little reason to doubt that Illinois Tools Works the business will outlast COVID-19, benefiting as it does from a diverse, decentralized business structure, decent profitability, and prudent portfolio management. But no stock should be bought at any price, and with a 27% premium to fair value, Illinois Tools Works can be considered a hold at this time, but not a buy. As an income investment, it looks attractive. As a growth investment, its projected earnings-per-share growth of 11.33% (3-5 years CAGR) seems decent, but neither of these warrants a 27% premium to fair value.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.