This Tool Company is Selling: Should You be Buying?
Ankit is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Recently, Illinois Tool Works (NYSE: ITW), has entered into an agreement to divest a 51% stake in its Decorative Surfaces business to a fund managed by Clayton Dubilier & Rice (CD&R). The Decorative Surfaces business has generated strong growth in recent quarters. Therefore, I am optimistic about Illinois Tool’s structuring the deal to retain a minority stake so that it could participate in some of the continued expected improvement in the business over the near term. While this specific deal likely will be initially dilutive; I believe the three pronged strategy of portfolio optimization, business structure simplification and strategic sourcing will drive faster longer term growth and higher corporate returns that likely will benefit Illinois Tool's multiple.
Ability to Perform in Strong Headwinds
Though I acknowledge that the end market growth in industrial-land is softening, I believe that Illinois Tool is better positioned than many machinery companies and will be able to deliver continued earnings growth. Actions to consolidate businesses and reduce costs through sourcing actions should continue to yield operating margin benefits to help offset macro weakness. I continue to see ample growth opportunities for Illinois Tool in both developed and emerging markets including from potential new platforms. Going forward, I suggest investors to focus on underlying transformations rather than overlooking slow organic growth related to the weak macroeconomic backdrop.
Share Repurchases
The company has impressive track record of posting above peer group average EPS growth of ~10% over the past 10 years. This performance has been achieved with high ROIC (+17%), high average FCF conversion (+100%), and a balanced capital allocation that includes nearly ~60% of FCF being returned to shareholders over this period of time. Going forward, I expect the company to use a good chunk of cash from the divestiture to repurchase shares and offset dilution. I believe this shareholder friendly move will continue above peer group average performance over the next several years.
Valuation: Neither Overvalued Nor Undervalued
The following table summarizes the expected EPS growth , forward PE and Dividend yield of Dover Corporation (NYSE: DOV), Danahar Corp. (NYSE: DHR) and Illinois tool:
|
Company |
Expected EPS growth (next year) |
Forward PE |
Dividend Yield |
|
Dover |
13.5% |
10.96 |
2.4% |
|
Danahar |
12.1% |
15.07 |
2.5% |
|
Illinois tool |
9.7% |
13.44 |
2.5% |
Companies like Dover and Danahar are competing in a portion of Illinois Tool's total business. For example; Dover's electronics manufacturing products compete with those produced by Illinois Tool Works' Power Systems & Electronics segment whereas Danahar's tools and automobile components compete with products made by Illinois Tool Works' Construction Products and Transportation segments. Illinois Tool is trading at a forward P/E which is lower than Danahar's but higher than that of Dover's. I believe visibility is high over construction business segment as recovery in construction business is expected which justifies the premium valuation of Danahar and Illinois Tool from Dover’s. And as Danahar has more exposure than Illinois tool in this segment, I believe discounted valuation over Danahar’s is pertinent. Therefore, in my view, Illinois tool is fairly valued as of now but I expect the company's recently taken initiatives to provide edge to the valuation in the near term.
I am confident in the company’s ability to achieve relatively high incremental margins. Continued high quality execution on costs and focus on driving higher organic growth should result in healthy EPS growth over the next several years. Use of the company’s solid balance sheet for M&A and share buybacks could drive additional upside. I believe the implementation of longer-term initiatives including business simplification, strategic sourcing, and portfolio management is a key step in driving shareholder value creation. Although I expect these initiatives to take some time in bearing fruit, I am confident that the improvements will be phased in over time, and this is a good start that should be viewed as a positive for the stock.
ankitagrawal has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend 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.If you have questions about this post or the Fool’s blog network, click here for information.
