This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

David versus Goliath ... times two
For two years running, the scrappy Bulldogs of Butler University (Indiana) took on the best the NCAA basketball establishment could throw at them. Granted, both times they lost the championship -- but didn't you cheer them just the same? Of course you did. Because America loves an underdog. And that's why I know you'll love this week's latest David and Goliath story: Standpoint Research's recommendation to buy Illinois Tool Works (NYSE: ITW  ) (coincidentally, located just next door to Indiana.)

Over the past week, not one but two of the biggest names in "establishment" investment banking have come out against ITW. First Goldman Sachs told you to sell the stock on Aug. 9. Then again yesterday, Bank of America / Merrill Lynch said the same thing. Undaunted, Standpoint Research came out yesterday and told investors to buy ITW anyway -- because regardless of what the professional stock pickers are telling you -- it's a bargain.

Stand-who?
Standpoint Research. Oh, don't tell me you've never heard of them. I've been writing about Standpoint for years, regaling you with the tale of how this "Cinderella story" of stock picking has been outperforming the big boys left and right, beating 96% of the investors we track on CAPS. At the same time as B of A and Goldman went suddenly "shy," and stopped providing their ratings to Briefing.com for public review, Standpoint is one of the stand-up analysts that's put its reputation on the line -- and its recommendations out there for everyone to see.

This week, Standpoint is taking a hard look at bargain-priced dividend stocks, made cheap by last week's sell-off. It's upgraded Chevron (NYSE: CVX  ) and given Medtronic (NYSE: MDT  ) a clean bill of health. And according to the analyst, ITW is another bargain: "one of the more stable and safe industrial names ... suited for those looking for a less risky cyclical name. ITW is diversified with more than 800 business units spread out across more than 50 countries around the world."

ITW is also, according to the analyst, reasonably priced: "trading at 12X trailing twelve months earnings and 10X estimates for next year." (By way of comparison, rival General Electric (NYSE: GE  ) shares cost nearly 13 times earnings, and Manitowoc (NYSE: MTW  ) is "priceless" -- because without profits, it has no P/E at all. Another rival, Cooper Industries (NYSE: CBE  ) , costs a bit less than ITW, but pays an inferior dividend of just 2.3%.)

As far as ITW's prospects go, most analysts have the stock pegged for 13% annual earnings growth over the next few years. Standpoint notes that ITW has already doubled its revenue from $10 billion to $20 billion (2012 estimate) since 2003. Going forward, "ITW now sees organic growth of 6.5%-7%," but because "margins are fully expected to return to highs over the next couple of years," that should allow earnings to grow much faster than revenue. The company's also engaged in an aggressive share repurchase program, buying back 2% of its shares outstanding last quarter alone. And as you know, the fewer shares left outstanding, the fewer slices of pie ITW's total profits get sliced into.

Illinois Tool Works: Buy these numbers?
So far, so good. But now -- if you'll forgive me for the head fake -- I'm going to tell you why I think Standpoint is going to imitate the Butler Bulldogs again ... and go down to defeat on ITW.

The problem, in a nutshell, is free cash flow: ITW just isn't generating enough of it. You see, when Standpoint tells you that ITW earned enough profit over the past year to give it a P/E of 12, that's true. Problem is, actual free cash flow at the company fell quite a bit short of ITW's $1.9 billion in GAAP net income. In fact, over the past 12 months, ITW generated less than $1.1 billion worth of free cash flow. And for a company currently valued at $22.3 billion, that works out to a P/FCF ratio of 20.

Foolish takeaway
Fools, I'm a fan of Standpoint. (I'm also an Indy resident, and a Bulldogs booster.) But I can't let either of these facts influence my opinion, or lead me to tell you to buy a stock that looks overpriced. At 20 times free cash flow, a 13% growth rate, and a dividend yield of 3.2%, that's just how Illinois Tool Works looks to me today: overpriced.

My advice: Much as it pains me to admit it, I think B of A and Goldman are right about Illinois Tool Works. Standpoint may be a "Bulldog" -- but ITW is just a dog.

Fool contributor Rich Smith does not own (or short) any company named above.You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 468 out of more than 180,000 members. The Motley Fool has a disclosure policy.

The Motley Fool owns shares of Medtronic. Motley Fool newsletter services have recommended buying shares of Chevron and Illinois Tool Works. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


Read/Post Comments (2) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 16, 2011, at 12:05 PM, pl2358 wrote:

    Unfortunately, you, the author, have failed to see all of the numbers and how they stack up with ITW.

    ITW has traditionally been an "expensive" stock to own, because of its high price to cash flow. While the number is high, take a look at why and how the trend is working...

    ITW has come off of two of the worst years in recent memory, 2009 and 2011. The company needed to pay off debt, having become more debt-laden than management wanted, and so their free-cash flow is reduced. Additionally, they have paid for several companies with cash, not share-diluting offerings of ITW shares to the new companies. This will cause their free-cash flow to go down, but for good reason.

    ITW's cash flow over the first 6 months of 2011 is up 10 times the amount for 2009. While it is not preventing their P/FCF ratio from being high, it is an excellent example of how ITW's management team is strengthening the company's balance sheet by generating positive free cash consistently for the first time in two years as well as increasing the flow. In the face of the purchases that the company has made, including ITW buying a significant amount of it's own shares back, that shows a commitment to growing the company, which is what any investor would look for.

    I really don't care what any pontificator in particular says about a stock; the numbers never lie. At it's current price, while seeming as "expensive" as ever, because the company is growing it's dividend, earnings, and cash flow, it is a solid, if not excellent investment if management is capable of growing like they plan.

    And, except in abominable market situations like 2008-2009, ITW's management has shown they can exceed even their own expectations, delivering the goods to their shareholders.

    Disclaimer: I am long on ITW, and own shares of ITW

  • Report this Comment On August 16, 2011, at 12:08 PM, pl2358 wrote:

    My post incorrectly stated that ITW free cash is up 10 times for 2011 from the same period in 2009.

    That post should say for the first 6 months of 2011, fress cash is up 10 times from the same period in 2010.

    My apologies for the error.

    Disclaimer: I am long ITW, and own shares of ITW

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