E. Scott Santi's decade-long reign as CEO of Illinois Tool Works (ITW 0.05%) will end in January 2024. Shareholders will miss him after a highly successful tenure that resulted in a fundamental transformation of the company. He will remain chairman of the board until early March and serve as a nonexecutive chairman of the board thereafter. Company veteran and current vice chairman Christopher O'Herlihy will replace him. So, what does it mean for the company's future? Here's the lowdown.
A hard act to follow
Illinois Tool Works stock is up 410% compared to 254% for the S&P 500 since the year when Santi took over as CEO. The outperformance comes down to the company's relentless focus on improving profit margins across its wide range of business segments (segments include automotive parts, welding, foodservice equipment, and electrical components to name a few). The primary method for margin improvement has been implementing its enterprise strategy for each segment. At the heart of the strategy lies the continual reshaping of its portfolio of businesses to maximize their full potential.
I'll return to the enterprise strategy in a moment, but first, here's a look at just how much Santi's tenure improved operating margins and return on invested capital.
ITW Operating Margin (TTM) data by YCharts
It hasn't been a story of revenue growth. Indeed, the company divested $5 billion of revenue over the period and cut $750 million in revenue due to so-called "product line simplification." In other words, management looked at the business and cut less profitable product lines. Those divested assets were mostly commodity-related businesses.
As such, it's more of a story of improving earnings and sweating every last bit of profitability from its businesses.
ITW Revenue (TTM) data by YCharts
In that time, the dividend per share increased from $1.52 in 2012 to $5.24 in 2022.
Illinois Tool Works' business model
The enterprise strategy emphasized continually focusing on its most profitable businesses and profit lines while divesting and exiting less profitable ones. As noted earlier, "product line simplification" has resulted in reducing costs and overhead while preparing the remaining business for increased investment and growth.
While the enterprise strategy prepares the portfolio for growth, its business model is used as the core operating system across all segments.
It has three elements. Its "80/20 front-to-back process" emphasizes focusing on its largest revenue generators, producing 80% of its revenue, and minimizing "cost and distraction" from those generating 20%. "Customer-back innovation" means a focus on innovating products based on customer feedback rather than from its research and development centers. Finally, its "entrepreneurial culture" means its businesses are run on a decentralized basis.
What's next for Illinois Tool Works
The company looks like it's in safe hands with O'Herlihy. He's been the vice chairman since 2015 and has been integral to implementing the company's enterprise strategy and business model. That said, on its Investor Day presentation in May, management outlined that the next phase of its growth would involve more offense, such as building out its organic growth capability and engaging in "selective high-quality acquisitions that extend ITW's long-term organic growth potential."
Image source: Getty Images.
Its 2023-2030 plan calls for 4% annual organic revenue growth, margin expansion generating 7% to 8% annual operating earnings growth, and 2% to 3% growth from share buybacks and acquisitions. Add these numbers together and you get 9% to 10% earnings per share growth annually. The plan looks achievable given management's (which includes O'Herlihy) track record of generating margin expansion. Management expects to improve operating margin to between 24.5% and 25.5% from 23.8% in 2022. Management anticipates enterprise initiatives improving margins by about 100 basis points (one percentage point).
The question is whether investors are willing to pay nearly 23 times the estimated 2024 earnings for stock in a company operating in a weakening growth environment. The current valuation makes it hard to argue the stock is a great value, but O'Herlihy's succession lends confidence to the company's long-term future. As such, investors should keep the stock on their watch list for a chance to pick up on any pronounced market weakness.
