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What To Expect From an Investment in Illinois Tool Works

joshua is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Despite missing analysts' expected earnings and revenues this quarter, Illinois Tool Works (NYSE: ITW) surpassed everyone's expectations by recently announcing the authorization of a $6 billion buyback plan and a 10% increase in the quarterly dividend. Based on today's market cap, $6 billion is good for 20% of the company and a major catalyst for future returns.  

Below, I have provided a review of the company's cash flow statement, what I consider to be the most important financial statement and the one that ultimately will help investors understand when and from where Illinois Tool Works' will get the money to make such a large purchase.

What more could you want?

Shares of Illinois Tool Works shot up to their highest 52-week valuation after the buyback announcement but have retracted some and now trade for $73.73 per share. Based on trailing EPS, shares don't look particularly expensive at a Price/Earnings (P/E) ratio of 14.03 but based on soft demand in North America, this years earnings are expected to be lower bringing the forward P/E up to 15.5.  Not too much respect for a company that had an Return on Equity (ROE) of 27.89% and a return on invested capital of 18.38% last year. 

Net income growth over the last three years has averaged 44.7%, well above the industry average of 17.7%, and even more impressive considering the company's healthy net margins of 15.6%.  

To put the buyback into perspective, $6 billion is close to triple the company's annual net cash from operations and more than double the current cash on hand.  With that in mind, this program is going to take some time to develop but will benefit shareholders significantly over the next few years.  In addition to flat out making more money for investors, buybacks effectively allocate more assets to each share.  Mr. Market may decide one day to value a company based on one of many different metrics but long-term, a high ROE will drive anyone's shares higher and especially when a lower share count means those returns translate into a higher Earnings Per Share (EPS).  And herein lies the beauty of a buyback.  Using assets to buy back shares decreases the shares outstanding and equity account which in-turn increases the company's leverage and returns.  

This also does wonders for the company's dividend plan.  The most recent announcement increased dividends by 10% per share but, coupled with the buyback plan, the company may not have to increase the amount of cash required to pay more to each share.  Going forward, this insulates the dividend returns from further revenue and margin pressures.

A look at other industrial conglomerates

Illinois Tool Works has many large competitors but two of its main market peers are General Electric (NYSE: GE) and Honeywell (NYSE: HON).

General Electric is far more diversified than Illinois Tool Works' but fails to compare to Illinois Tool in almost every operational and growth ratio that could be used for comparison.  The company has only sporadically bought back shares with only 22% (on average) of operating cash flows used for them and dividends combined.  Shares are up from their 2009 lows but don't look too shareholder friendly considering the high percentage of retained earnings being held by the company to generate below average returns.

Honeywell is closer in market size and also similar in growth and returns but lagging a little on margins when compared to Illinois Tools.  Honeywell has a 1.89% dividend yield and trades at its 52-week high of $84.53 per share

Despite challenging market conditions, Honeywell beat earnings last quarter while also increasing margins by 30 basis points to 16.1%.  I don't doubt the company's ability to grow, but shares are priced much higher than Illinois Tools  and don't appear to offer an advantage based on any operational metric.  There is no buyback program and cash flows relative to the companies market cap are also much lower than those at Illinois Tool Works.

Bottom line

If Illinois Tool Works wasn't a compelling buy before, it just became one on the heels of the recently announced buyback program and dividend increase.  Compared to many of its peers, the company is returning more to shareholders and has a significant advantage in the way of higher margins.  The company's earnings miss appears to have the market worried but margins increased and the current valuation, coupled with the buyback program, set shares up for long-term and above average advances.  

joshua kubiak has no position in any stocks mentioned. The Motley Fool recommends Illinois Tool Works. The Motley Fool owns shares of General Electric Company. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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