Company Background (sourced from Yahoo! Finance):
Illinois Tool Works Inc. manufactures and sells a range of industrial products and equipment worldwide. Its Transportation segment offers plastic and metal components, fasteners, and assemblies; fluids and polymers; fillers and putties; polyester coatings, and patch and repair products; and truck remanufacturing, and related parts and services. The companys Power Systems & Electronics segment provides arc welding equipment; metal arc welding consumables and related accessories; metal solder materials; equipment and services for microelectronics assembly; electronic components and component packaging; static and contamination control equipment; airport ground support equipment; pressure sensitive adhesives and components; and metal jacketing and other insulation products. Its Industrial Packaging segment offers steel and plastic strapping and related tools and equipment; plastic stretch film and related equipment; and paper and plastic products that protect goods in transit. The companys Food Equipment segment provides warewashing, cooking, refrigeration, and food processing equipment; and kitchen exhaust, ventilation, and pollution control systems; and food equipment maintenance and repair services. Its Construction Products segment offers anchors, fasteners, and related tools; metal plate truss components, and related equipment and software; and packaged hardware and other products for retail. The companys Polymers & Fluids segment provides adhesives; chemical fluids; epoxy and resin-based coating products; and hand wipes and cleaners. The company also offers equipment and related software for testing and measuring materials, structures, gases, and fluids; plastic reclosable packaging and consumables; foil and film products; product coding and marking equipment; and conveyor systems.
Analysts expect Illinois Tool Works to grow earnings 8.77% per year for the next five years and I've assumed they can continue to grow at 3.50% per year thereafter. Running these numbers through a two stage DCF analysis with a 10% discount rate yields a fair value price of $82.96. This means the shares are trading at a 24.7% discount to the DCF.
With a current book value per share of $23.21 and TTM EPS of $6.06, the Graham Number is calculated to be $56.26. Currently ITW is trading for a 11.1% premium to the Graham Number.
Average High Dividend Yield:
Illinois Tool Work's average high dividend yield for the past 5 years is 3.61% and for the past 10 years is 2.61%. This gives target prices of $42.13 and $58.14 respectively based on the current annual dividend of $1.52. I think the 10 year average yield might be a little low but although the 5 year is also skewed higher due to the great recession plummeting the share price. It yielded as high as 4.63% during 2009. I think you'll start to see the average yield to be closer to the 2.60-2.80% range going forward, but we'll use the 5 year average high yield to determine the fair value to be conservative. Illinois Tool Works is currently trading at a 48.3% premium to the average high dividend yield valuation.
ITW's average low PE ratio for the past 5 years is 11.19 and for the past 10 years is 13.35. This corresponds to a price per share of $47.90 and $57.12 respectively based off the analyst estimate of $4.28 per share for fiscal year 2013. The 5 year and 10 year low PE price targets are overvalued by 30.5% and 9.4%, respectively. To be conservative I'll use the 5 year average. Illinois Tool Works should see the average low PE ratio trend higher since during 2011 and 2012 they traded down to a 10 and 8 PE which is much lower than their historical ranges. I expect in more normal years to see the low PE ratio around the 13 mark.
Average Low P/S Ratio:
Illinois Tool Work's average low PS ratio for the past 5 years is 1.11 and for the past 10 years is 1.41. This corresponds to a price per share of $42.95 and $54.52 respectively based off the analyst estimate for revenue growth from FY 2012 to FY 2013. Their current PS ratio is 1.57 over the last 12 months. I'll be using the 5 year average in my calculations. ITW is currently trading at a 45.5% premium.
Dividend Discount Model:
For the DDM, I assumed that ITW will be able to grow dividends for the next 5 years at the minimum of 15% or the lowest of the 1, 3, 5 or 10 year growth rates. In this case that would be 5.71%. After that I assumed they can continue to raise dividends for 3 years at 75% of 5.71% or 4.29% and in perpetuity at 3.50%. The dividend growth rates are based off fiscal year payouts and don't necessarily correspond to quarter over quarter increases. To calculate the value I used a discount rate of 10%. Based on this, ITW is worth $25.72 meaning it's overvalued by 143.0%.
Illinois Tool Work's trailing PE is 10.31 and it's forward PE is 13.10. The PE3 based on the average earnings for the last 3 years is 14.12. I like to see the PE3 be less than 15 which ITW is currently under. Compared to it's industry, ITW seems to be undervalued versus GE (18.28) and MTW (26.13). Against the industry as a whole, Illinois Tool Works is undervalued with the industry carrying a PE of 15.54. All industry comparisons are on a TTM EPS basis. ITW's PEG for the next 5 years is currently at 1.66 while GE is at 1.33, MTW is at 1.00, and the industry is at 1.19. Based on the PEG ratio, ITW is overvalued.
Illinois Tool Work's gross margins for FY 2011 and FY 2012 were 37.1% and 37.9% respectively. They have averaged a 37.6% gross profit margin since 2001 with a low of 36.4% in FY 2001. Their net income margin for the same years were 11.6% and 16.0%. Since 2001 their net income margin has averaged 10.8% with a low of 6.8% in FY 2009. I typically like to see gross margins greater than 60% and at least higher than 40% with net income margins being 10% and at least 7%. ITW is well over on the gross margin and their average net income margin is sitting nicely above the 10% mark. Of course each industry is different and allows for different margins, so let's see how ITW has done when compared to their industry. For FY 2012, Illinois Tool Works captured 91.8% of the gross margin for the industry and 205.1% of the net income margin. I'd like to see the gross margin comparison come up, but as long as the net income margin is well above the industry there's no issue.
ITW's shares outstanding have been in an overall downtrend with an average decrease of 2.63% per year since 2001. Over that time they've bought back 25.4% of their shares outstanding. By repurchasing shares, ITW is able to increase EPS and management can return cash to shareholders this way by increasing the ownership stake of the company for all the outstanding shares. Seeing how lumpy the share buybacks have been, on the surface it seems that management has been selectively repurchasing shares based on their belief of it being undervalued. More research would be needed to check on this.
A negative number for the % change value means shares were bought back by the company and a positive value means the shares outstanding increased.
Illinois Tool Works is a dividend champion with 49 consecutive years of increases with their next increase marking 50 years. Their current annual dividend sits at $1.52 for a yield of 2.43%. ITW's annual increases for the last 1, 3, 5 and 10 years has been 5.71%, 6.08%, 10.22% and 12.64%. These numbers are different from the actual quarterly increases since they are based off the dividends paid out during each fiscal year. Their payout ratio has averaged 32.6% since 2001, peaking in 2009 with a 65.6% ratio. Having a low payout ratio leaves more room for management to increase the dividend without overly burdening the underlying business.
Illinois Tool Work's free cash flow per share has been great since FY 2008 with dividends only taking up an average of 41.6% of the available FCF. I am a little concerned that the total shareholder return, share buybacks plus dividends, has averaged 98.2% since FY 2008. They've still managed to increase their cash per share though.
Return on Equity and Return on Capital Invested:
ITW's ROE has average 17.44% since 2001 and has been in a steady uptrend since the dip during FY 2009. Their ROCI has averaged a very solid 14.4% since 2001 and has rebounded nicely since FY 2009. For ROE and ROCI I don't necessarily look for any absolute values, rather I like to see stable or increasing levels over the long term.
Revenue and Net Income:
Since the basis of dividend growth is revenue and net income growth, we'll now look at how ITW has done on that front. Their revenue growth since 2001 has done fairly well at 6.2% per year and their net income has been growing at a 12.2% rate. Since their net income has been growing faster than revenue, their net income margin has increased from 8.7% to 16.0% between FY 2001 and FY 2012. Over that time, ITW only suffered a decline in revenue and net income during FY 2008 and FY 2009 but has grown every other year. Considering how tied they are to the strength of the economy, this isn't troubling. I love seeing the net income on a steady rise because it means the company is turning more dollars of sales into profits.
The average of all the valuation models gives a target entry price of $49.65 which means that Illinois Tool Works is currently trading at a 25.9% premium to the average.. I've also calculated it with the highest and lowest valuation methods thrown out. In this case, the DCF and DDM valuations are removed and the new average is $47.31. ITW is trading at a 32.1% premium to this price as well.
Assuming that ITW can grow their earnings and dividends at the rates that I assumed you're looking at solid returns over the next 10 years. In 2023, EPS would be $7.66 and slapping an average PE of 15.16 gives a price of $116.14. Over the next 10 years you'd also receive $20.35 in dividends for a total return of 185.86% which is good for a 8.13% annualized rate. If you purchase at my target entry price of $49.65 your projected 10 year total return is 233.93% for an annualized return of 10.64%.
Overall, I would say that Illinois Tool Works is currently fairly valued. With an improving economy, ITW will come along for the ride. They've been through several recessions and other macro issues before and come out unscathed and I expect them to continue doing so. Their dividend growth is a little lumpier than most dividend growth companies, but that's due to the cyclical nature of their business. When the economy is humming along, the dividend growth follows. In FY 2005 through 2008 they averaged 23.22% annual dividend (arithmetic average) increases but they also saw very poor growth in 2008 and 2010. With ITW it's hard to purchase when the economy is doing great. I expect the dividend growth to be higher than normal over the next few years as the economy gets back on track.
Using the historical dividend yield, PE, and PS ratios, the average valuation or fairly valued price would be around $60.89 and the high valuation price would be $72.36. It's currently trading right around the fair valuation price which I feel is about right. A dip down to around $57 would get me interested in initiating a position but I would need a pretty big drop to work on getting a full position. The markets have seen very little volatility and resistance in their march up to record highs so far this year. I think both of those are likely to change, and if anything maybe the "Sell in May and go away" will give us some opportunities.
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Some other links to stock analysis on Illinois Tool Works can be found here and here.
What do you think about Illinois Tool Works as a DG investment at today's prices?