Considering the rally that Illinois Tool Works' (ITW 0.27%) stock has enjoyed over the past month following an impressive second-quarter earnings report, the thought that its stock could fall once again is at odds with the better outlook management shared during its conference call. But multiple risks remain on the horizon for the equipment maker, with these three among the most immediate threats.
Innovative designs have made the automotive OEM division a key component of growth. Photo source: Illinois Tool Works.
Global economies are slowing
Although the U.S. accounted for 42% of Illinois Tool Works' operating revenue in 2013, the success of the business is still tied to the global economy, and despite initially encouraging reports, the expansion world economies were experiencing has now stalled.
Will the U.S. follow global economies down? Data: Illinois Tool Works' 2013 10-K filing.
According to Markit Economics, preliminary purchasing managers' data indicates that manufacturing activity fell from 51.8 in July to 50.8 in August, its lowest level in over a year. China barely managed to stay in expansion mode with a 50.3 reading (anything above 50 indicates activity is growing; below that, it's contracting), and analysts fear the country's manufacturing activity will miss growth expectations for 2014.
ITW's business tends to be a cyclical one, and if global markets head into a recession again, it could easily pull down the domestic economy. The U.S. stock market is already in what some would call bubble territory, soaring well above levels achieved prior to the "tech wreck" in 2000 and the financial and housing markets' collapse in 2007. Illinois Tool Works stock has soared even higher since the Great Recession.
With geopolitical turmoil heating up over Russia's activities in Ukraine, and the effects of sanctions starting to be felt -- the Russian ruble, for example, recently hit historic lows against the dollar while credit to Russian companies has all but dried up -- economic activity will broadly be affected. EU markets may also be hurt by sanctions just as much if not more than Russia's as 10% of just its agricultural exports go to the country, but economic activity has been slowing for some time, and the second quarter saw growth essentially come to a halt.
Latin America is also slowing, and economists say the region's largest economy, Brazil -- which is primarily ITW's main market -- went into a technical recession over the course of the first six months of 2014, with GDP shrinking 0.6% in the second quarter following a 0.2% decline in the first.
Auto growth may be peaking
Despite a blowout month for auto sales in August, which surprised analysts with their strength (half the growth in the Commerce Dept.'s seasonally adjusted retail sales numbers came from autos), some are now wary that what the companies are doing is pulling sales forward from future periods. Incentives and attractive financing; the growth of long-term financing deals -- eight years is now not uncommon -- and rising sub-prime leases mean the automakers have set themselves up for an unsustainable pace.
With the automotive OEM segment being one of Illinois Tool Works' largest divisions, the potential for future weakness does not bode well.
Automotive OEM revenue has been the engine for higher growth. Data: Illinois Tool Works 2013 10-K filing.
China, for example, has been one of the machinist's best-performing regions for autos, with segment sales rising 22% last quarter, but according to Bloomberg News, the Chinese auto market as a whole began to sag in July. Although retail passenger vehicle deliveries rose 11.5%, that was below the 14% recorded in June, and taken in context with a slowing Chinese economy, you can't necessarily expect them to rebound later in the year. Indeed, they slowed to 8.5% in August.
One-time items have bolstered performance
Illinois Tool Works has been realigning its business to focus on what it does best. It's concentrating on the 20% of its businesses that drive 80% of its sales; sold half its interest in its decorative surfaces business as part of a drive to shed those operations that have become commoditized; and this year divested its industrial packaging business, a component of its operations that contributed 10% of its operating income and 14% of revenue. ITW has a stated goal of reducing the 800 or so businesses it operates to around 120, while also reorganizing its operating segments to simplify its structure. It still wants to make acquisitions, but fewer in number and of higher quality.
Though it has been largely successful to date, ITW's quarterly performance has been enhanced by non-recurring items. Proceeds from sales of assets, for example, have been used to finance stock buybacks.
It used an existing share repurchase agreement to buy back 50 million shares last year to offset the impact the divestiture of its industrial packaging division would have on its income per share from continuing operations. When Carlyle Group bought the business for $3.2 billion, a portion of the proceeds were used to fund repurchases.
With operating revenues rising just 3.5% last quarter, the lower share count from the year ago period helped boost per share earnings by $0.36, putting them 7.5% higher than they would have been.
Organic sales only rose 1.4% in the second quarter, a weak performance that came lower than the first quarter, though management does expect them to come in 2% to 3% higher for the full year. Income from discontinued operations added nearly $1 billion to the ledger sheet.
Illinois Tool Works is looking for its welding division to turn around. Photo: SXC.hu.
They may be positioning the company for a better future, but the headline numbers aren't telling the whole story.
Foolish takeaway
There's no doubt that Illinois Tool Works is a different, even better, company today thanks to the changes being made to reform its business.
But for the equipment maker's stock to continue its upward trajectory, Illinois Tool Works can't pause for breath just yet. It will be held captive by larger forces beyond its control, so getting across the finish line with its restructuring program will help ensure it can ride out any economic storm.
