The recent results from multi-industry manufacturer Illinois Tool Works (NYSE:ITW) served to highlight many of the difficult decisions investors are facing right now. It's an uncertain macro-economic environment, and there are likely to be significant differences in terms of which industries bounce back first in a recovery. In this context, valuing stocks is becoming a difficult exercise. Let's take a look at these factors in the course of analyzing the case for buying stock in ITW.

A car production plant.

The automotive market remains the single biggest earnings generator for the company. Image source: Getty Images.

Three key considerations

Let's get straight into the specifics:

  • The uncertainty around the depth of the decline in the second quarter and the subsequent recovery is leading to a wide variance in earnings projections for 2020.
  • Valuing stocks needs to be done in the context of the highly unusual nature of 2020 earnings.
  • Investors are looking to avoid companies with heavy exposure to industries that are likely to suffer in the near term, or that might be structurally challenged in the long term due to the COVID-19 pandemic.

Illinois Tool Works' earnings projections

In a completely understandable move, management withdrew its previous 2020 guidance, but it did give investors an indication of what its full-year operating margin ranges would be under different revenue decline scenarios. The outcome ranges for operating profit in 2020 in the last row of the chart are shown below. For reference, ITW generated $3.4 billion in operating profit on $14.11 billion worth of sales in 2019.

As you can see below, the outcome is likely to range between a low of $1.8 billion to a high of $2.51 billion.

Scenarios Based on Management Estimates

 Full-Year Revenue Decline of 15%

Full-Year Revenue Decline of 20%

Full-Year Revenue Decline of 25%

Revenue

$12 billion

$11.3 billion

$10.6 billion

Operating margin

19%-21%

18%-20%

17%-19%

Operating profit

$2.27 billion to $2.51 billion

$2.03 billion to $2.26 billion

$1.8 billion to $2.01 billion

Data source: Illinois Tool Works presentations. Author's analysis.

Valuation

The bulls will argue that the industrial company is better run than it was coming out of the last recession (see operating margin expansion in the chart). Indeed, CEO Scott Santi has been relentless in restructuring the company over the years. 

That said, ITW's valuation appears to leave room for error, even in the most positive scenario. For example, the projected operating profit range of $1.8 billion to $2.51 billion implies a 2020 price to operating profit range of 20 times to 28 times operating profit -- a wide range of outcomes for investors to consider. 

The chart below shows that at the low point of operating income after the last recession, ITW's price to operating profit ratio wasn't higher than 16 times operating profit. Taken superficially, this implies that ITW is overvalued right now. ITW's valuation suggests the market is already assuming a relative short recession with a bounce back in earnings coming.

ITW Operating PE Ratio Chart

Data by YCharts

Specific end markets exposure

Investors in the industrial sector are concerned with the automotive original equipment (OEM), commercial aerospace, and oil and gas markets in the near term. Over the long term, oil and gas, commercial aerospace, and anything related to travel/hospitality would also be a concern.

ITW has exposure to these markets through its automotive OEM segment (sales are expected to decline by a whopping 60%-70% in the second quarter). In addition, food equipment has exposure to the restaurant sector -- during the earnings call, CFO Michael Larsen said the segment's sales would go "down in that 35% to 45% range here in the near term." In addition, the welding segment has exposure to the kinds of heavy industries that are connected with energy capital spending -- note the decline in the 2015-2016 period when the price of oil slumped.

Illinois Tool Works organic revenue growth.

Data source: Illinois Tool Works presentations.

The following pie chart shows operating income in 2019, and given that automotive OEM and food equipment were actually the biggest income generators, it's understandable that ITW is going to take a significant near-term hit. The deeper question is whether these end markets will bounce back, and with what strength.

Illinois Tool Works operating income by segment.

Data source: Illinois Tool Works presentations.

Is Illinois Tool Works a buy?

ITW is a great company with an enviable record of margin expansion, and it's led by a very strong management team. However, the market appears to have priced it with an assumption of a recovery in mind, so there's little room for error if things go wrong. Moreover, there's a lot of uncertainty around its end markets -- something reflected in the wide range of its earnings outlook. 

All told, investors should probably be looking for stocks that are priced with a lasting recession in mind, rather than one with positive assumptions already baked into its valuations. For now, ITW remains on the watch list.