Published by Bob Ciura on November 1st, 2017
At Sure Dividend, we often talk about the merits of the Dividend Aristocrats. The Dividend Aristocrats have strong brands, are consistently profitable even during recessions, and possess durable competitive advantages. There are just 51 Dividend Aristocrats.
Each year, we review all 51 Dividend Aristocrats. The next in the series is Illinois Tool Works (ITW).
Illinois Tool Works is not just a Dividend Aristocrat, it is a Dividend King as well.
The Dividend Kings are a group of just 23 companies with 50+ consecutive years of dividend increases. You can see all 23 Dividend Kings here.
If the Dividend Aristocrats are among the best dividend growth stocks in the market, then the Dividend Kings are the “cream of the crop”.
This article will discuss why Illinois Tool Works is a member of dividend royalty.
Business Overview
Illinois Tool Works has been in business for more than 100 years. It started out all the way back in 1902, when a financier named Byron Smith placed an ad in the Economist. At the time, Smith was looking to invest in a “high class business (manufacturing preferred) in or near Chicago.”
A group of inventors approached Smith with an idea to improve gear grinding, and Illinois Tool Works was born.
Today, Illinois Tool Works has a market capitalization of $54 billion, and generates annual revenue of more than $13 billion.
Source: Investor Day Presentation, page 42
Illinois Tool Works’ portfolio is concentrated in product segments that each hold growth potential of 2%+ above the average in their respective markets.
The overarching strategic growth plan for Illinois Tool Works is to continuously reshape its business model, when necessary. The company frequently utilizes bolt-on acquisitions to expand its reach.
At the same time, it has conducted more than 30 divestments in commoditized, low-growth product lines. Illinois Tool Works routinely trims businesses and adds new ones, to maintain a growth trajectory over time.
Growth Prospects
Judging from Illinois Tool Works’ financial results, it is clear its strategic growth plan is working just fine. 2016 was the most profitable year in the company’s history. Earnings-per-share rose 11% last year, to $5.70.
2017 is shaping up to be another very good year. Revenue and earnings-per-share increased 4.7% and 19%, respectively, through the first three quarters. Organic revenue has increased in all seven of the company’s operating segments.
Cost controls are a major driver of earnings growth. In 2012, the company launched a strategic program called the Enterprise Strategy. The goal of the Enterprise Strategy is to maintain best-in-class margins, by focusing on cutting costs and being more selective with investments.
From 2012-2016, Illinois Tool Works’ operating margin expanded from 15.9%-22.5%. Last quarter, operating margin expanded by 130 basis points.
Source: Q3 Earnings Presentation, page 5
Over the past four years, strategic sourcing has delivered more than $345 million in company-wide cost savings.
For 2017, Illinois Tool Works forecasts 2% to 3% organic revenue growth. The combination of cost controls and share repurchases are expected to drive earnings growth several percentage points above the revenue growth rate.
Illinois Tool Works expects earnings-per-share of $6.62 to $6.72 this year. This would represent 16% to 18% earnings growth for 2017.
Competitive Advantages & Recession Performance
Illinois Tool Works has a significant competitive advantage. It possesses a wide economic “moat”, which refers to its ability to keep competition at bay. It does this with a massive intellectual property portfolio.
Illinois Tool Works holds over 17,000 granted and pending patents, including more than 1,000 new patent applications filed last year.
Separately, another competitive advantage is Illinois Tool Works’ differentiated management strategy.
The company has employed a management process called “80/20”. This is an operating system that is applied to every business line at Illinois Tool Works.
The company focuses on its largest and best opportunities (the “80”), and seeks to eliminate costs or divest its less profitable operations (the “20”).
At the same time, Illinois Tool Works has a decentralized, entrepreneurial corporate culture. This also sets the company apart from the competition. Illinois Tool Works empowers its various businesses with significant flexibility, to customize their own approaches to serving customers in the best way possible.
One potential downside of Illinois Tool Works’ business model, is that it is vulnerable to recessions. As an industrial manufacturer, Illinois Tool Works is reliant on a healthy global economy for growth.
Earnings-per-share performance during the Great Recession is below:
- 2007 earnings-per-share of $3.36
- 2008 earnings-per-share of $3.05 (9% decline)
- 2009 earnings-per-share of $1.93 (37% decline)
- 2010 earnings-per-share of $3.03 (57% increase)
That said, the company remained highly profitable during the Great Recession. This allowed it to continue increasing its dividend each year.
And, thanks to its strong brand portfolio, the company recovered quickly. Earnings-per-share soared 57% in 2010. By 2011, earnings-per-share surpassed 2007 levels.
Valuation & Expected Returns
Illinois Tool Works trades for a price-to-earnings ratio of 24. This is significantly above its historical price-to-earnings ratio going back to 2001. Over this time, the stock held an average price-to-earnings ratio of 16.9.
As a result, Illinois Tool Works is currently valued at a 42% premium to its average valuation since 2001.
Source: Value Line
If the stock experiences a valuation “reversion to the mean”, it would negatively impact future returns.
Aside from changes in the price-to-earnings multiple, future returns will be driven by earnings growth and dividends. Illinois Tool Works increased earnings-per-share by 5.4% compounded annually in the past 10 years, according to ValueLine.
Earnings growth has accelerated in recent years, and could reach the high-single digits moving forward. A potential breakdown of future returns is below:
- 2%-3% organic revenue growth
- 1%-2% revenue growth from acquisitions
- 2%-3% share repurchases
- 2% dividend yield
In this scenario, total returns would reach 7%-10% per year, through revenue growth, share repurchases, and dividends.
Final Thoughts
Illinois Tool Works is a high-quality company, and an even better dividend growth stock. It has a strategic growth plan that is working well, and shareholders have been rewarded with rising dividends for over 50 years.
The stock appears to be overvalued at this times, which means investors should consider waiting for a better price before initiating a position.
