Is Illinois Tool Works a Buy?

Now is the time to start looking at industrial stocks like Illinois Tool Works (ITW +2.24%). It may seem counter-intuitive to suggest buying stocks in the sector just as many of them are about to report third-quarter earnings characterized by rising raw material price inflation and COVID-19-related supply chain issues. However, the sector has sold off recently, and many of the headwinds will likely dissipate. Meanwhile, end-market demand remains good. So does that all add up to make ITW a buy right now?

Illinois Tool Works in 2021

The quickest way to understand what kind of year ITW has had is by looking at management's guidance updates.

The economic recovery in 2021 has been stronger than anticipated, and revenue guidance has been hiked twice throughout the year. In normal circumstances, strong growth usually translates into margin expansion for industrial companies, and that's why ITW management raised margin guidance in April during the first-quarter earnings presentations.

Image source: Getty Images.

However, during the second-quarter earnings presentation in July, management lowered margin guidance even though revenue guidance was raised. The reason came down to rising raw material cost increases eating into margins. In April management estimated full-year raw material cost inflation (in ITW's case, steel, resins, and chemicals) would be 7%, a figure three times what management had expected entering 2021.

CEO Scott Santi said on the earnings call, "For the full year, we expect price/cost impact to be dilutive to margin by about 100 basis points, which is 50 basis points higher than where we were as of the end of Q1. " For reference, 100 reference points are equal to 1%.

Data source: Illinois Tool Works presentations.

It's likely to get worse

Unfortunately, a slew of industrial companies has already noticed that conditions worsened in the third quarter. For example, Monish Patolawala, the CFO of ITW's fellow multi-industry industrial 3M (NYSE: MMM), told investors in September that he saw unprecedented inflationary pressures that were causing inflation to outpace price increases. Meanwhile, FedEx shocked the market when it disclosed labor shortages related to the difficulties in reopening the economy and renewed COVID-19 infections. 

It's easy to imagine ITW will be similarly impacted. In a nutshell, the difficulties come down to a combination of reopening teething problems, the Delta variant of the COVID-19 virus, and strong demand creating rising raw material and supply chain costs.

As ever, the market wasted no time selling off 3M and ITW as these pressures built up. In addition, the likelihood of reduced margin/earnings guidance on the third-quarter earnings calls is rising.

Data by YCharts

The case for buying Illinois Tool Works stock

The bulls' case argues that, although the next couple of quarters are likely to see inflationary pressures, these issues will prove temporary. History suggests that commodity producers will find ways to expand supply given higher prices, and cooling in China's real estate market will take some pressure off of commodity prices. 

In addition, end-market demand remains strong at the moment, so ITW is likely to see a temporary pushout in revenue rather than losing it. Moreover, its self-help margin expansion actions, known as its "enterprise initiatives," are on track to deliver 100 basis points of margin expansion in 2021.

In this line of thought, now is an excellent opportunity to buy into a great company with an excellent history of margin expansion. 

Is Illinois Tool Works a buy?

The recent dip in the share price is moving the stock closer to a valuation where investors can feel more comfortable initiating long-term positions.

Data by YCharts

However, as you can see above, the stock still isn't quite at a level where it looks like a good value historically. As a result, it remains on the watch list in the upcoming earnings season, especially as market volatility could be ahead.