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Better Buy: Illinois Tool Works or 3M?

By Lee Samaha - Feb 28, 2020 at 6:44AM

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A look at Illinois Tool Works' stock prospects in the context of 3M's valuation and prospects in 2020.

It's interesting to compare the performance of multi-industry industrial stocks Illinois Tool Works (ITW -0.13%) and 3M (MMM 0.19%) over the last few years. The two used to be pretty much correlated but the divergence since the spring of 2019 has been remarkable. Both companies have suffered the ill wind of the decline in the industrial economy, but ITW's self-help initiatives have led to it significantly outperform 3M -- a company whose most disappointing performances in recent years have actually come from its least cyclical businesses. Let's take a closer look at Illinois Tool Works and 3M to find out which is the more attractive stock.

An image of a bull and a bear doing battle.

Image source: Getty Images.

End markets not helping

Illinois Tool Works, 3M, and other industrial companies have been battling some challenging end markets in 2019. It's no secret that the industrial economy is in a tough place right now, with particular weakness in key end markets like automotive, trucking, and oil and gas. On the fourth-quarter earnings call, ITW CEO Ernest Scott Santi described it as "an industrial demand environment that went from decelerating in the first half of the year to contracting in the second half of the year." 

Indeed, ITW's management started its fiscal-year 2019 predicting organic revenue growth of 1% to 3% for the full year, only to end up with a decline of 1.9%.The deterioration in its end markets can be seen in a breakout of its year-over-year growth by segment. Growth in the automotive sector has been in negative territory for over year and the highly cyclical welding segment's growth turned negative through 2019.

The one major bright spot in the fourth quarter was the "test and measurement and electronics" segment, which benefited from the cyclical bounce in semiconductor spending that's been observed by others

Illinois Tool Works growth by segment.

Data source: Illinois Tool Works. Chart by author.

The growth outlook is a little better in 2020 with management expecting organic revenue growth of 0% to 2% for the full-year (3M also expects 0% to 2% organic revenue growth in 2020) and EPS of $7.65 to $8.05 compared to $7.74 in 2019. It's an anemic growth environment at best. 

The case for buying Illinois Tool Works

That said, investors don't buy stocks with just a one-year-out view. On the earnings call, Santi emphasized that ITW could grow at an annual rate of 3% to 5% over the long term. The expectation is that ITW can outgrow global GDP growth of some 2% to 3% over the long term.

Moreover, the company continues to generate underlying margin expansion through its enterprise initiatives -- a series of measures aimed at expanding margin by simplifying businesses, pruning unprofitable product lines, taking on supply chain initiatives, and focusing on its key customers using the 80/20 principle (whereby around 20% of its customers do 80% of its business). 

You can see the positive impact on margin of these initiatives in the following chart. For reference, 100 basis points, or bp, is equal to 1%. Therefore, the 120 bp generated in 2019 would have, all other things being equal, led to an operating margin increase of 25% compared to 24.3% in 2018. In fact, if you exclude restructuring expenses, operating margin increased to 24.4% -- a very credible result considering total revenue declined 4.5% in 2019.

Illinois Tool Works margin expansion.

Data source: Illinois Tool Works. Bp = basis points. Chart by author.

All told, the bullish case for ITW is that its enterprise initiatives -- management expects another 100bp of margin improvement in 2020 -- will lead to ongoing margin expansion. And when the global industrial economy picks up, so will ITW's revenue growth and margin expansion prospects.

In comparison, 3M needs to make its restructuring plans work and demonstrate that it can return its healthcare and consumer segments back to the kind of growth its management expects, even as it battles many of the same cyclical headwinds that ITW is facing.

3M or ITW?

The first answer is probably neither. The second answer is if 3M can demonstrate progress on its restructuring efforts and start to deliver earnings in line with guidance on a consistent basis, then the stock is interesting. However, trading on nearly 20 times its current earnings, it's hardly a good value for the assumptions you will need to make before buying the stock.

Meanwhile, ITW's valuation simply isn't giving investors a lot of upside to compensate for the risk that its margin expansion growth might slow. A quick look at valuations reveals that the premium that 3M once held over ITW and its sector has now turned into a discount.

 ITW PE Ratio Chart

ITW PE Ratio data by YCharts

All told, both these stocks are worth monitoring with a view to buying in at some point, but the heightened risk around their near-term prospects and their valuations relative to their earnings prospects make them ones for the watch list, rather than the buy list.

Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends 3M. The Motley Fool has a disclosure policy.

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Stocks Mentioned

3M Company Stock Quote
3M Company
$149.66 (0.19%) $0.28
Illinois Tool Works Inc. Stock Quote
Illinois Tool Works Inc.
$213.17 (-0.13%) $0.28

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