Investors buy stocks for many different reasons, and differing investment philosophies can easily lead to radically diverging conclusions on the same stock. A good example is Illinois Tool Works (NYSE:ITW). The stock is interesting because it offers different things to growth and value investors, and depending on your perspective, it might fit your portfolio. Let's take a closer look.
Growth investors' perspective
In a nutshell, the company is suffering difficult end markets at present, and management has reduced its full-year organic revenue growth forecast for the last three quarters -- not something growth investors will find appealing. Growth investors usually like to see a company with some earnings momentum.
In addition, a growth investor is usually willing to pay a premium for the possibility of some upside "surprise." However, I think the downside risk is growing for Illinois Tool Works. A breakout of its segmental revenue growth demonstrates the increasing reliance on the automotive, food, and construction segments. Meanwhile, the more cyclical segments, such as welding and electronics, are struggling.
Moreover, the current earnings season is seeing some disappointing results from automotive-focused companies like BorgWarner (NYSE: BWA). The slowdown is mainly in China -- in contrast, the U.S. and EU markets appear to have strengthened slightly -- but the country represents the world's biggest auto market by sales. In addition, Illinois Tool Works' automotive segment has been outperforming the overall automotive end market, but how much longer can that continue?
In short, if current trends continue, Illinois Tool Works could see its future growth prospects challenged -- not something that appeals to a typical growth investor.
Value investors' view
In contrast, value investors will point to the intrinsic value in the stock -- even accepting some downward pressure on revenue and earnings -- and focus on the underlying transformation of the company thanks to its five-year enterprise strategy plan. In other words, even while its end markets are deteriorating, the company is improving
Management plans to increase return on invested capital (ROIC) to 20% or above by the end of 2017, while the target for operating margin is 23% with revenue growth expected to be 200 basis points above global GDP growth.
Indeed, the good news is that the company is largely on track, with margin and ROIC improving in 2016. On a less positive note, the revenue growth target is obviously something that partly depends on how Illinois Tool Works' specific end markets are growing in relation to the global economy. However, value investors may not be unduly concerned. Why not?
Well, ROIC and margin expansion are relatively more important metrics to follow for (at least some) value investors. Higher ROIC, which doesn't necessarily need revenue growth, implies a company can return more capital to shareholders -- through dividend increases and buybacks -- yet still generate the same returns. In addition, margin growth still means earnings (and usually cash flow) growth even if revenues are flat.
Throw in management's commitment to dividends -- the company boasts 50 years of continuously raising dividends -- and the company's impressive history of converting earnings into free cash flow, or FCF, and the stock becomes very attractive. As you can see in the chart below, the free cash flow generated in the aftermath of the last recession would easily have covered any recent year's dividends.
Growth or value?
Growth investors won't like the reduction in full-year revenue and earnings guidance -- the midpoint of full-year 2015 guidance was $5.25 at the start of the year, only to be reduced to $5.10 in the third-quarter results -- or the worsening trends in its end markets. The underlying improvements in margin and ROIC are a positive, but growth investors like me usually like to see top-line growth.
However, a value investor might see things differently. Assuming the company converts 100% of EPS into FCF, then the $5.10 in EPS forecast for 2015 would translate into $5.10 in FCF for 2015 -- putting the stock on an enterprise value, or EV (market cap plus net debt) to FCF multiple of nearly 21 times.
Analysts have EPS growing 8% in 2016, but even if the outlook deteriorates and EPS is flat in 2016, and again assuming a EPS to FCF conversion of 100%, you're still getting a stock on a forward EV/FCF multiple of nearly 21.
Moreover, the margin and ROIC improvements implied in the enterprise strategy plan suggest plenty of near-term upside potential if the economy turns in Illinois Tool Works' favor. Over the long term, the ROIC improvements could create substantive opportunity for the 12% to 14% shareholder returns the company is targeting.
All told, it's probably not a stock for growth investors -- unless you want to take an optimistic view on its end markets -- but value investors might like the investment proposition.
Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends BorgWarner and Illinois Tool Works. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.