In today's volatile market, one of the most comforting investments can be a tried and true company that can perform even during a weak economy. Illinois Tool Works (ITW 0.05%), commonly known as ITW, is putting up solid results despite a slowdown in demand across its end markets.
What's more, ITW is a Dividend King with 53 consecutive years of dividend raises. Here's why this is a fairly simple, yet incredibly well-run company that is worth investing in now.
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ITW's margin narrative is stronger than ever
ITW is a diversified industrial conglomerate that operates across seven key segments: automotive, food equipment, test and measurement and electronics, welding, polymers and fluids, construction products, and specialty products. Despite its vast portfolio, you probably haven't heard of many ITW brands because most of the products it sells aren't targeted toward consumers, but rather toward industrial and commercial customers.
Like other industrial conglomerates, ITW benefits from the growth of the broader economy, which it can't control. But it can control the efficiency of its operations, forecasting, and supply chain management. For several years now, ITW has been a margin story. A higher operating margin can come from higher sales and price increases. But it can also come from operational improvements.
ITW released its Q3 2023 results on Oct. 24. They didn't disappoint as ITW posted a 26.5% quarterly operating margin and updated its full-year operating margin guidance to a range of 25% to 25.5%. If ITW hits that goal, it would mark an all-time high for the company and support the narrative that it can hit its 2030 goal of a 30% operating margin.
ITW Operating Margin (Annual) data by YCharts
ITW's margin growth comes from within
Looking at the operating margin over the course of several years and varying economic conditions is a great way to measure ITW's ability to navigate challenges, display pricing power, manage costs, and deliver results even when demand is working against it.
If we take a closer look at ITW's Q3 performance, we see that the operating margin improvements were mostly a result of structural improvements, not growth in ITW's end markets.
ITW's Q3 operating margin represents a 200 basis point improvement from Q3 2022, 140 basis points of which came from enterprise initiatives. Free cash flow came in at $856 million, a 40% increase, and was easily enough to cover buybacks and dividend payments. In many ways, it's more impressive when a company posts growth the hard way rather than simply benefiting from a good economy.
A high operating margin can also provide the wiggle room needed to implement price cuts necessary to offset slower demand. And it can provide the extra income needed to support buybacks and dividend increases, which is exactly what ITW is doing.
ITW is guiding for $9.55 to $9.95 in full-year earnings per share. It is converting over 100% of its free cash flow to net income, which is supporting $1.5 billion in share buybacks for the year. It is also paying record-high dividend payments. In August, ITW announced a 7% dividend raise, bringing its quarterly dividend to $1.40 per share.
Two challenges worth considering
Illinois Tool Works is putting on a masterclass of margin improvement. But it would be a mistake to ignore the company's slowing growth or the stock's valuation. Like most companies, it is dealing with higher labor and energy costs. It's also hard for all of its segments to be performing at full strength all the time. About 25% of ITW's portfolio is undergoing a structural slowdown, particularly on the electronics and semiconductor side.
"I think consumer electronics remains fairly weak," said CFO Michael Larsen on the Q3 2023 earnings call. "On the semiconductor side, you'll recall that we've talked about an expectation from industry experts, I'll call them, as well as our customers, that there would be a reacceleration of demand here in the second half of this year, and that now looks like it's been deferred probably until sometime next year."
One strategy ITW has used to boost margins despite slowing growth has been higher pricing to offset higher costs. Repeated price increases are usually unsustainable. Unsurprisingly, ITW said it expects more normal pricing after the first half of next year. But it also said that raw material costs and other elements of the cost equation have stabilized. "We're not seeing significant deflation at this point, but we're also not seeing anything close to the inflation we've seen over the last two years," said Larsen. "So, that's kind of the good news here."
In terms of the stock's valuation, its price-to-earnings (P/E) ratio of 21.9 certainly isn't cheap. But it's also not terribly expensive relative to the S&P 500 P/E ratio of 24.6 or ITW's historic 10-year median of 22.8. And given that ITW is a far better business today than it has been for the majority of the last decade, there's a good argument that it should trade above its historic average.
A stock you can count on no matter the market
As long as Illinois Tool Works keeps its margin narrative alive and well, it should continue delivering value to shareholders through dividends, buybacks, and higher earnings, which in turn should support a higher stock price. The company is balanced and reliable, and it has some of the best fundamentals of any Dividend King. For all these reasons, I believe ITW has what it takes to be a foundational portfolio holding.
