Some companies are so diverse that they seem easy to model. Illinois Tool Works (ITW 1.23%) is one of them. Its management sets goals for organic revenue growth in terms of basis points over global Gross Domestic Product growth. Unlike 3M, it does not produce consumer nondurables and is not as internationally diverse, so Illinois Tool Works cedes the honor of making nearly everything for everyone to that company. But serving just about every industry that involves assembling things -- it does little business with extractive or process industries -- is diversity enough.
Illinois Tool Works' limited exposure to mining, energy, and metallurgy suggests that organic sales growth should perform better than the 2% premium over global GDP growth that management is targeting by the end of 2017. Furthermore, the company's business mix tilts toward the automotive sector (19% of 2014 revenue), which should be an attractive positioning at least through 2016. Revenue will also benefit if construction activity accelerates. Illinois Tool Works has not relied as heavily on China to drive growth as many industrial groups have, and it should suffer less as Chinese demand softens. It earned 57% of its 2014 revenue outside the U.S., so it will experience negative forex comparisons throughout 2016, but this is irrelevant to management's organic revenue target.
Yet for the first nine months of 2015, organic revenue declined by 0.3%. The main culprits were the measurement and welding divisions, but even without them, organic revenue would have risen 2%, less than half management's target of 2% above global GDP growth, which is estimated to have been 2.7%. And the Q3 report suggested that there could be further deterioration, with a forecast of organic revenue growth for the full year between zero and negative 1%.
Illinois Tool Works' growth is hampered by its significant commitment to Europe, where pricing is difficult and demand soft: This is especially evident in its welding, polymers and fluids, and test, measurement and electronics businesses. The company's operating units seem to favor margin over revenue growth, a strategy that is difficult to pull off in a competitive, low-growth environment. Even though nine-month operating margins rose 155 basis points, operating income fell 0.6%. Non-operating items accounted for a nine-month increase of 1.4% in net income from continuing operations, boosted to an 11.7% EPS gain by share repurchases.
The company has restructured enthusiastically: Nine-month net income was reduced by more than $1 billion as a result of operations sold since September 2014. Further pruning could be in order, although it may not be so easy to find buyers for European operations in particular, where efforts to maintain margins seem to be having the greatest effect on revenue. Management's goal of an operating margin of 23% by the end of 2017 seems to be inconsistent with revenue growth, at least in Europe.
This could result from Illinois Tool Works' "80/20 business process," which structures its operations to "satisfy the needs of [its] largest and most profitable customers and eliminate the costs, complexity, and distractions associated with serving smaller, less profitable customers." These customers might be attractive now, but they might not remain so: They could be losing share to competitors who eschew the European tendency to protect margin at the cost of incremental sales. This aspect of Illinois Tool Works' strategy is defensive -- an awkward stance in a low-growth environment. And it belies the company's stress on the independence of its operating units, which should, after all, be best able to judge which customers offer the potential to maximize income, which is more important than maximizing margin.
Illinois Tool Works cannot be an easy company to manage. Structuring policies and incentives for such a large, dispersed, and disparate collection of essentially autonomous units is probably not really possible. Its prospect of failing to meet its 2017 targets should cause a rethink of the policies it currently has in place.
