Illinois Tool Works (ITW) is one of the strongest, most diversified companies that a dividend growth investor can find in the industrial sector.
While the stock only yields close to 2% today, the company has consistently raised its dividend at a double-digit pace for many years.
In fact, Illinois Tool Works has been growing its annual payout every year since 1964 and is a member of the dividend kings group here.
Let’s take a closer look at the business to see if it could be a good fit today for a diversified dividend growth portfolio.
Investors seeking higher income can review some of the best high dividend stocks here.
Business Overview
Founded in 1912, in Glenview, Illinois, Illinois Tool Works is one of the world’s largest industrial component manufacturers, operating a total of 501 facilities in 57 countries around the globe (roughly half of sales are in North America).
ITW has grown into an extremely diversified manufacturer of specialized industrial and consumer equipment and consumables with a presence in many different end markets – automotive, construction, manufacturing, food & beverage, and more.
Illinois Tool Works consists of hundreds of businesses it has acquired over the years. It runs a unique decentralized operating structure that empowers acquired businesses to maintain most of their culture and operations while taking advantage of ITW’s resources to better serve their customers’ needs.
Its 85 subsidiaries operate through seven business segments:
Automotive OEM (21.1% of 2016 sales and 22.5% of operating income): produces plastic and metal components, fasteners, and assemblies primarily for automotive original equipment manufacturers.
Food Equipment (15.5% of sales and 17.5% of operating income): produces commercial food equipment and related services, including warewashing equipment, cooking equipment (e.g. ovens, broilers), refrigeration equipment, and more. Customers include restaurants and food retail markets.
Specialty Products (13.9% of sales and 15.7% of operating income): the businesses in this segment produce beverage packaging equipment and consumables, product coding and marking equipment, and appliance components and fasteners.
Test, Measurement & Electronics (14.5% of sales and 12.1% of operating income): sells equipment, consumables, and related software for testing and measurement of materials and structures, as well as equipment and consumables used in the production of electronic subassemblies and microelectronics.
Welding (10.9% of sales and 12.1% of operating income): sells welding equipment, consumables, and accessories for a wide array of industrial and commercial applications.
Constructuction Products (11.8% of sales and 11.8% of operating income): produces construction fastening systems and truss products used primarily in construction markets.
Polymers & Fluids (12.4% of sales and 11.2% of operating income): sells adhesives, sealants, lubrication, fluids, and polymers for auto aftermarket maintenance and appearance.
Business Analysis
It’s no surprise that a company that’s thrived for over a century and grown its payout to shareholders for over 50 years has proven highly adaptable. Specifically that means creating and evolving a successful corporate culture that can grow steadily even during economic and industry downturns.
For example, in 1985 the company adopted what it calls its “80/20” strategy in which the company began careful, data-driven optimization of its largest, fastest growing, and most profitable segments, while minimizing the costs and distractions from its 20% worst performing segments, most of which were sold off.
While this strategy was highly successful, the 600+ acquisitions over that period resulted in a bit of a bloated company, which had more than 800 regional divisions. That’s why management decided to use the recent global industrial recession, which began around 2011, to once more evolve its corporate and business structure to improve the company’s future growth and profitability potential.
The first step of this turnaround was to conduct a thorough review of its businesses and streamline its operations, consolidating from over 800 regional divisions to 85 global ones.
Next the company re-dedicated itself to only investing in the best industrial segments that had above industry average organic growth potential. That’s important because the industrial component industry generally grows in line with the world economy, or about 2% to 3% a year – hardly fast enough to support the kind of double-digit dividend growth that Illinois Tool Works’ investors have become accustomed to.
For ITW, that meant selling approximately 25% of its businesses between 2011 and 2014 that were focused on very simple, low margin (i.e. commoditized) products, such as its decorative surfaces and industrial packaging units.
The capital was then reinvested into the seven segments the company now operates, which provide it the best probability of achieving above-average organic growth over the coming years.
In fact, ITW’s management believes that its current strategy will be able to achieve organic growth (which excludes acquisitions) that’s 2.5% above its industry average.
In addition to reallocating capital to its highest margin and fastest growing segments, management launched a strategic sourcing initiative in an effort to find the lowest possible input costs that still met its high quality product standards.
That, combined with the streamlining of its supply chains and manufacturing segments, is part of the company’s long-term goal of cutting operating costs by 1% a year, which it has consistently done since the turnaround plan was launched.
Source: Illinois Tool Works Investor Presentation
Finally, the company continues to focus on trying to become a customized “one-stop shop” for its customers, offering tailored solutions to provide more value and fit their specific needs.
Combined with 16,000 patents and numerous strong industrial brands, Illinois Tool Works has been able to maintain strong pricing power that has allowed its turnaround (scheduled to be finished in 2018) to result in remarkable margin growth and market-beating total shareholder returns.
In fact, thanks to the success of its restructuring, Illinois Tool Works now enjoys some of the highest profitability in its industry, including a very high free cash flow margin that helps it to continue its impressive dividend growth streak.
Source: Morningstar, Gurufocus
This excellent profitability and returns on shareholder capital are a sign of a high-quality and experienced management team, led by current CEO Ernest Scott Santi, who took over the top job in 2012 but has been with ITW for 34 years.
Ultimately, investors count on a company’s management to optimize its capital allocation in a way that maximizes long-term growth and profitability, while still rewarding dividend lovers with secure and fast-growing payouts.
Fortunately, Illinois Tool Works has a very simple yet thoughtful capital allocation plan, which management believes can achieve long-term annual total returns of 12% to 14%; one of the highest of any blue chip dividend king.
Overall, Illinois Tool Works is a company that is built to last. The company’s disciplined management team and refocused operations certainly help, but its diverse product lines, end markets, and geographies are also a major strength.
When one market is weak, another is usually strong, smoothing out earnings and providing consistent free cash flow for the company to reinvest in the highest-returning businesses. It’s hard to see a future in which ITW no longer becomes relevant – its hands are in too many pots, most products are protected by patents and sold in slow-changing markets, and its decentralized operating structure helps its numerous businesses run more efficiently.
Key Risks
While a dividend king like Illinois Tool Works is generally a low risk stock, there are nonetheless several challenges that it will have to deal with in the future.
For example, achieving and sustaining 2.5% organic growth above the industry average could be challenging, especially because ITW is focused on not competing on price, but rather being a premium supplier.
The company’s renewed emphasis on organic growth and need to run a more consolidated operational structure (rather than letting its acquired businesses remain largely autonomous) is a deviation from the company’s prior successful growth strategy and could have knock-on effects down the road.
While the company is less focused on acquisition-driven growth than in the past, it still plans to make bolt-on acquisitions, such as its 2016 purchase of the Engineered Fastener & Connector (EF&C) division of German auto supplier ZF TRW for $450 million.
Each acquisition comes with a risk of overpaying and underachieving in terms of synergistic cost savings. Fortunately, management is highly disciplined in its approach to such deals and has decades of experience, which limits this risk.
Finally, investors should be aware that ITW spends a relatively small amount on R&D and capital spending, about 4.2% of 2016 sales.
While this may be a sign of highly efficient, application-focused capital allocation, given that rivals such as Danaher (DHR), Honeywell (HON), and 3M (MMM) spend 9% to 11% of sales on this form of internal investment, Illinois Tool Works may be forced to increase its spending in the coming years in order to compete with these large, well-capitalized rivals.
That in turn would mean lower earnings and free cash flow (FCF) growth, which could result in missing its ambitious dividend growth and total return targets.
Illinois Tool Works’ Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Illinois Tool Works’ has a Dividend Safety Score of 96, indicating that it offers one of safest and most dependable dividend on Wall Street. That’s not a surprise given its remarkable 52-year dividend growth record.
Note that the apparent occasional dividend cuts such as 1992, 1995, 1997, and 2003 were due to special distributions paid in the preceding year; the regular dividend continued growing.
This impressive dividend growth streak is courtesy of two main protective factors. The first is management’s disciplined approach to dividend growth, meaning that it keeps the earnings and FCF payout ratios at conservative levels.
Because ITW’s dividend typically only consumes 30% to 40% of its free cash flow each year, there is plenty of safety buffer to not only protect the payout during times of economic and industry distress, but also keep it growing at some of the highest rates of any dividend king.
The other major protective factor is the company’s very strong balance sheet. You can see that ITW maintains relatively low debt levels and a high current ratio (short-term assets/short-term liabilities), which mean that its cash flow easily services its debts without risking the safety of the dividend.
For example, when we compare the company’s relative debt levels to its industry peers, we see that it has a relatively low leverage (Debt/EBITDA) and very high interest coverage ratio. This combination gives it a very strong credit rating and plentiful access to very cheap debt (average interest rate of 3.1%) with which to fund future growth without risking the dividend.
Sources: Morningstar, Fast Graphs
Illinois Tool Works’ Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Illinois Tool Works’ Dividend Growth Score of 86 indicates that investors can expect stronger than average payout growth (relative to the S&P 500’s 20-year median dividend growth rate of 5.7%) to continue. That’s not a surprise given that ITW has generated some of the fastest dividend growth of any dividend paying blue chip.
You can see that the company’s dividend has grown by 13.8% annually over the last 20 years and by 14.5% per year over the last three years, representing very strong and consistent payout growth.
In fact, over the last 30 years Illinois Tool Works’ growth rate has also averaged 14.5% per year, which means that management’s long-term guidance of 10% to 12% payout growth is reasonable, especially since it appears to have a solid plan to achieve EPS and FCF per share growth along those lines and its payout ratios are at conservative levels.
Valuation
Over the past year, Illinois Tool Works shares have benefited from the end of the global industrial recession, which has resulted in shares outperforming the S&P 500 by about 20%. Unfortunately, that means that the current valuation doesn’t look all that appealing.
For example, ITW’s forward P/E of 23.1 is not only significantly higher than the S&P 500’s forward PE of 17.8, but also its own historical median value of 15.6.
Meanwhile, the stock’s 1.8% dividend yield is about equal to the market’s 1.9% yield, but much lower than ITW’s historical norm of 2.2%.
In fact, over the past 22 years ITW has offered a higher yield 53% of the time, according to Gurufocus.
That means that, despite Illinois Tool Works’ potential long-term annual total return of 11.8% to 13.8% (1.8% dividend yield + 10% to 12% annual earnings growth), which is excellent for a high quality dividend king, income investors may want to wait for a pullback.
A 15% correction would bring ITW’s stock price to about $123 per share and put its dividend yield more in line with its long-term average.
Conclusion
While Illinois Tool Works’ low dividend yield means it may not be suitable for everyone, such as retirees looking to fund living expenses with dividends, the company’s impressive track record of double-digit dividend growth over the past half century means that ITW could be considered as a core holding for a long-term dividend growth portfolio.
That being said, at the present time shares appear to be somewhat richly valued, so it may make more sense to keep Illinois Tool Works on a watch list until it reaches a better price and a slightly higher yield.
Brian Bollinger
Simply Safe Dividends
Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).
Source: Simply Safe Dividends