The Better Buy in Industrial Stocks
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If you believe as I do, that the economy is on a path of recovery, there are certain sectors that should benefit. Specifically companies in the industrial sector usually benefit from higher demand. With this in mind, I recently ran a screen on The Motley Fool CAPS Screener to look for industrial companies that had the following characteristics: 2%+ dividend yield, 10%+ EPS growth in the last 3 years, at least a 4 star CAPS rating. Of the companies that the screen returned, there were two familiar names that I wanted to investigate further: Eaton (NYSE: ETN) and Illinois Tool Works (NYSE: ITW). Both companies provide products that aid in industrial production, but which is the better buy?
|
Name |
Price |
P/E On '12 Earnings |
Growth Expected |
PEG |
|
Eaton |
$44.91 |
9.91 |
8.94% |
1.11 |
|
Illinois Tool Works |
$56.33 |
13.29 |
10.88% |
1.22 |
On the surface, it looks like these two are fairly even. Eaton seems like the better value because of its lower PEG ratio. However, over time Illinois Tool would lower its PEG ratio quicker because of its faster growth rate. With a turnaround in the economy seemingly occurring, investing in the faster growing company would make more sense. Though the PEG today is slightly higher, the faster growth rate of Illinois Tool is the deciding factor. (Eaton – 1, Illinois Tool – 2)
You can sometimes get an idea if the company will beat earnings expectations going forward, by what they have done in the past. Companies that beat earnings expectations seem to continue this streak until analysts realize they keep missing estimates. When companies beat earnings expectations, the stock usually gets a pop in price. These two companies have very similar records, in the sense that Eaton beat estimates on average by just 0.40% in the last year, and Illinois Tool beat earnings on average by just 0.125%. Since any one quarter could have changed these numbers to switch the winner, we'll call this a tie. (Eaton – 1, Illinois Tool – 1)
While earnings are important, I always like to compare the free cash flow generation of companies. Since free cash flow is what pays for dividends, this is an important metric. In the last year, Eaton generated $0.038 of free cash flow per $1 of assets. By contrast, Illinois Tool generated much more at $0.089 of free cash flow per $1 of assets. This additional cash flow generated by Illinois Tool can be used to increase the dividend, for share repurchases, or for earnings positive acquisitions. (Eaton – 1, Illinois Tool – 2)
Where dividends are concerned, it's not enough to just look at current yield. Investors want to know about dividend growth and the company's payout ratio. Let's see how the two companies stack up:
|
Name |
Yield |
Dividend Growth |
Free Cash Flow Payout Ratio |
|
Eaton |
3.38% |
10.37% |
37.00% |
|
Illinois Tool |
2.56% |
11.80% |
40.49% |
This is a close race, but because of the higher current yield, similar growth, and FCF payout ratios, it seems that Eaton is the better bet. (Eaton – 2, Illinois Tool – 1)
Last but not least, we need to see how each company is doing with their debt management. Each company again has very similar characteristics, but Eaton has the slightly lower relative debt load. Eaton's long-term debt is 18.83% of total assets, versus Illinois Tool shows 19.40% of long term debt. (Eaton – 2, Illinois Tool – 1)
It's a tie! Both companies end up with a score of 7. As our tiebreaker we'll turn to the Motley Fool CAPS community. On CAPS, Eaton scores a perfect 5 out of 5 stars, Illinois Tool scores 4 out of 5. With the better CAPS ranking, Eaton is our winner. With similar growth profiles, similar balance sheets, and similar earnings performance, I would normally go with the CAPS community. However, on this one I'm going to disagree and say I believe that Illinois Tool represents a better opportunity. The deciding factor is cash flow. Illinois Tool generates more than double the free cash flow of Eaton. Over time, this additional cash flow plus the company's higher expected earnings growth should prevail. Though Illinois Tool pays a slightly lower dividend, if the company can maintain this higher free cash flow level, they can afford to pay out more in dividends. In addition, this higher free cash flow can be used to repurchase shares which would drive even better performance. It's a close one, but ITW seems like the better deal to me.
MHenage 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.
