Why Illinois Tool Works Might Sell a Chunk of Itself

Back in September, Illinois Tool Works (NYSE: ITW  ) announced that it was initiating a plan to sell off its industrial packaging segment. According to management, the company plans on finding a buyer so that it can deploy capital into its core businesses. Rumors suggest that the transaction could exceed $3 billion and includes some big names like The Carlyle Group (NASDAQ: CG  ) and The Blackstone Group (NYSE: BX  ) . Let's dig into the company's numbers and discover exactly what this segment and its potential sale might mean for Illinois Tool Works investors. 

What is the segment, anyway?
Hearing the phrase "industrial packaging," you might think first of building crates for shipping nails and screws. Though this is partially true, it only touches on a part of what the segment does.

In its 10-K filing, the company says that 27% of the segment's end sales in 2012 were dedicated to the general industrial market (i.e. miscellaneous goods.) However, 22% of segment sales came from primary metals; food and beverage shipments accounted for 10%; and construction made up 9%, with the remainder being allocated among various areas. 

In order to meet the demands of its clients, the company produces a variety of products used to make shipping goods possible. To this end, the segment produces steel and plastic strapping, plastic stretch film, and paper and plastic packaging materials that make shipping safer.

Packaging is a big deal
Packaging means a lot to Illinois Tool Works. In 2012, the company's industrial packaging segment brought in revenue of $2.41 billion, a 2.1% decrease from the $2.46 billion it received a year earlier. This means that the segment accounted for 13.5% of the company's 2012 consolidated revenue.

Although revenue for the segment declined for the year, management was pleased to report that its operating income rose significantly. From 2011 to 2012, operating income increased by 13.3% from $249 million to $282 million; this showed an operating margin that rose from 10.1% to 11.7%. On a consolidated basis, this means that the segment's profits rose from 9.1% of operating income to 9.9%.

Why would Illinois consider this kind of sale?
Part of being a successful business is buying up operations that grow the business without significantly impairing its margins. However, being successful sometimes means knowing when to make trade-offs for the betterment of the overall business.

If the rumors are correct, Illinois Tool Works will likely receive no less than $3 billion for its industrial packaging segment, should a deal be struck. This currently amounts to 8.5% of the company's market capitalization, and it would increase the company's cash position to more than $6 billion. With such a large cash hoard, it's likely that management will feel comfortable putting a fair portion of those dollars into some of its other operations in an effort to maximize shareholder value.

Currently, the two most appealing segments for the company to consider are its Transportation segment and its Power Systems & Electronics segment. Collectively, these parts of the business made up 37.4% of revenue in 2012 and had operating margins of 15.8% and 20.4%, respectively.

However, it wouldn't be out of the question for management to shift some portion of its cash toward developing its Other segment as well. This catch-all segment saw a rather impressive operating margin of 18.1% last year, down slightly from 18.2% the year before.

What's this deal mean for Carlyle or Blackstone?
Carlyle and Blackstone are two of the largest investment companies in the world. As of the end of 2012, Carlyle's Private Equity segment had assets under management (AUM) of $53 billion, while Blackstone was nipping at its heels with $51 billion. Historically, both have jumped at the opportunity to buy an existing business or segment of a business, take it private, improve its operations, and spin it back off into the market. 

This is likely what management is hoping to do with the industrial packaging segment at Illinois Tool Works. How much of a return is it likely to get from something as mundane as packaging, though? Possibly a lot!

Looking at Packaging Corporation of America (NYSE: PKG  ) , the $6 billion market cap producer of industrial and consumer packaging materials, we might be able to get some insight into Carlyle or Blackstone's potential plans.

In 2012, Packaging Corp. brought in revenue of $2.84 billion. Using its current market cap, we see that the company trades at 2.1 times sales. Applying this to the packaging segment of Illinois Tool Works would imply a potential value of $5.07 billion. That's quite a hefty return if you ask me!

Keep in mind that as a stand-alone company, Packaging Corp. has spent literally all of its resources on improving its business. As such, its operating margin in 2012 stood at 15.6% -- this is far higher than Illinois Tool Works's. If Carlyle or Blackstone hope to achieve such a nice return on the market, they will have to improve the segment's operations significantly. 

Foolish takeaway
Currently, there is no deal between Illinois Tool Works and any of its potential suitors. If a deal is struck, however, the $3 billion-plus that the company will likely receive should allow it to significantly improve its underlying business. If the acquiring private equity firm can improve the segment's fundamentals drastically, then its investors will also be happy. Market participants might be happy as well when the healthier operation is sold off in a few years.

If a deal does not materialize, however, shareholders of Illinois Tool Works can find comfort in knowing that the company does have a segment that it can improve in the future -- and in doing so, increase shareholder value.

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