Undervalued Dividend Growth Stock of the Week: Illinois Tool Works Inc. (ITW)

With stocks, there’s a concept I’ve learned to harness.

If you fight it, you’ll probably lose.

But if you instead let it go to bat for you, you’ll likely end up very successful.

That concept is easy to remember.

I’ll share it with you…

Winners win, losers lose.

Investors sometimes look for great values in the market, only to end up buying stock in poor businesses because they were available at low prices.

And they forgo investing in the truly world-class businesses because they’re worried about paying too high of a price.

If you invest in loser companies, you’ll lose alongside them.

But if you buy winner stocks, you’ll also win.

Warren Buffett said it best:

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

I’ve done my best to heed these words as I’ve invested my savings into wonderful companies over the years.

Jason Fieber's Dividend Growth PortfolioAs a result of that, I’ve amassed a six-figure collection of businesses in my personal stock portfolio, which I call my FIRE Fund.

I call it that because the five-figure and growing passive dividend income it generates on my behalf allowed me to achieve financial independence and retire early (FIRE).

I was able to reach FIRE at only 33 years old, all on a very middle-class salary working at a very regular job.

I’m not retired in my 30s, living the life of my dreams.

And I lay out how I did all of that in my Early Retirement Blueprint.

The crown jewel of that Blueprint is the investment strategy I’ve used to get here.

That strategy is dividend growth investing, which basically involves buying stock in businesses that pay growing dividends.

Almost by the very nature of DGI, you’re kind of limiting yourself to wonderful businesses because of the way growing cash dividend payments to shareholders require the underlying profit growth in order to fund that behavior.

You can’t write checks that can’t be cashed. And so can’t write ever-larger checks for decades on end if they can’t be funded.

It’s almost impossible to run a loser company while simultaneously paying out growing cash dividend payments for years on end.

You can see what I mean by checking out the Dividend Champions, Contenders, and Challengers list, which has compiled invaluable data on almost 900 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.

However, even winners can’t be purchased at any price.

If you repeatedly buy great stocks at stratospheric valuations, that will eventually catch up to you. 

You might not lose outright. But you won’t win as much as you could have or should have.

However, if you can buy a winner stock after its valuation has come back down to earth – this means other investors who bought at higher prices have experienced what it’s like to be caught up in that – you can do really well over the long term.

Even with great stocks, you have to be careful with valuation.

You should thus strive to buy high-quality stocks when they’re undervalued.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.

This is all relative to what would otherwise be possible if the same stock were fairly valued or overvalued.

That higher yield comes about due to the way price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

The higher yield then goes on to positively impact total return, leading to greater long-term total return potential.

Total return is comprised of capital gain and investment income (via dividends or distributions). The higher yield leads to more investment income on the same invested dollar.

Plus, total return is given another possible leg up due to the “upside” that’s available when the price paid is favorable against estimated intrinsic value.

If you pay a price well below what intrinsic value is, you have that additional prospective capital gain, which is on top of the organic capital gain that will naturally come your way as a great business becomes worth more over time.

The stock market might not be great at accurately pricing stocks over the short term, but price and value do tend to more closely correlate with one another over the long run.

These dynamics have a way of reducing risk, for it’s plainly less risky to pay a lower price for the same exact asset.

And you introduce a margin of safety when undervaluation is present.

That limits the downside, which is important because no investor is prescient.

Unforeseen circumstances can and often do occur. Paying a price at or way over fair value doesn’t offer you any protection against events like mismanagement, lawsuits, new competition, product recalls, etc.

Fortunately, these advantageous conditions aren’t terribly difficult to spot.

Fellow contributor Dave Van Knapp has made that spotting process even easier via a system he put together, which is part of an overarching series of articles (or “lessons”) on the strategy of dividend growth investing.

See Lesson 11: Valuation for more on that.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Illinois Tool Works Inc. (ITW)

Illinois Tool Works Inc. (ITW) is a diversified, global manufacturer that operates across dozens of business divisions to produce a broad range of industrial products and equipment.

The company reports across seven segments: Automotive OEM, 23% of FY 2017 revenue; Food Equipment, 15%; Test & Measurement and Electronics, 14%; Specialty Products, 14%; Construction Products, 12%; Polymers & Fluids, 12%; and Welding, 11%.

From adhesives to arc welders, this is an A-Z company that’s globally exposed (with operations spanning 57 countries) to just about every industry you could possibly imagine.

They touch almost every end market that exists, which means investing in this company is akin to investing in the global economy as a whole.

And this is a winner, folks.

That’s partly evidenced by the outstanding dividend growth track record.

The company has increased its dividend for 44 consecutive years.

This is a time period that stretches right through numerous financial disasters and stock market crashes, including the most recent financial crisis and ensuing Great Recession.

If the length of the track record isn’t impressive enough, let’s look at pace.

The 10-year dividend growth rate is sitting at 11.6%.

Outstanding in and of itself, it gets even more amazing when you consider the fact that dividend growth has actually been accelerating over the last decade.

The most recent dividend increase, which was announced back in August, came in at over 28%!

This double-digit dividend growth is also coming on top of a very appealing yield of 3.34%.

The stock’s yield is about as high as I’ve ever seen it, by the way.

For context, the five-year average yield is 1.9%.

So the current yield is more than 140 basis points higher than its own five-year average, and it’s also obviously well above the broader market.

As such, you’re looking at an above-average yield and above-average dividend growth.

That’s a winning combination.

With a payout ratio of 53.5% (using TTM EPS that factors out a one-time tax charge for Q4 2017), you’re looking at a very sustainable dividend that’s likely to grow at a rate in line with (or slightly in excess of) EPS growth moving forward.

The good news with that is, the company is growing EPS at a nice clip.

Of course, estimating future EPS growth is altogether different than looking at past EPS growth. The past is known; the future is not.

However, estimating future profit growth is imperative to not only judging future dividend growth, but it’s also vital to valuing a company and its stock.

In order to build that future expectation, we’ll take a look at what the company has done over the last decade in terms of top-line and bottom-line growth, before comparing that to a near-term professional EPS growth forecast.

Blending a demonstrated long-term track record with a professional workup for the near term should give us a pretty good idea as to where this company is going.

Illinois Tool Works generated $15.869 in revenue for FY 2008, which slightly decreased to $14.314 billion in FY 2017.

We’re basically talking flat revenue here, but that’s not because they’re struggling with sales.

The company divested itself of certain businesses over the last decade, with the 2014 sale of its industrial
packaging business (Illinois Packaging Group) for $3.2 billion to the Carlyle Group being particularly notable. Top-line growth over the last few years has actually been solid.

Meanwhile, earnings per share advanced from $2.91 to $6.59 over this period, which is a compound annual growth rate of 9.51%.

I used adjusted EPS for FY 2017 due to the sizable one-time tax charge that artificially skewed the GAAP numbers for last fiscal year.

This is a great long-term growth rate, which is right in line with the 8-10% annual EPS growth goal that management has laid out for itself.

The bottom line was greatly aided by a combination of buybacks and margin expansion.

And those buybacks were greatly aided by the aforementioned sale of IPG, as Illinois Tool Works allocated part of that capital to fund a major buyback in conjunction with the sale.

The outstanding share count dropped from almost 450 million shares to about 370 million shares between FY 2013 and 2015. And seeing as how the stock was priced much lower during this time frame, it turned out to be pretty prudent.

For further perspective on this, the outstanding share count is down by approximately 33% over the last decade. That’s massive.

Moving forward, CFRA is predicting that Illinois Tool Works will compound its EPS at an annual rate of 10% over the next three years, citing tax reform, improving margins, solid execution, and buybacks.

This shouldn’t be a surprise considering what’s unfolded over the last decade, along with what management guides for and targets.

That rate of EPS growth should allow for like dividend growth (i.e., low-double-digit dividend growth for the foreseeable future). I see a worst-case scenario being high-single-digit dividend growth moving forward, outside of a major global economic meltdown.

Looking at the company’s financial position, the balance sheet appears to be quite strong.

The long-term debt/equity ratio, at 1.63 is high due to low common equity (negatively impacted by treasury stock); however, an interest coverage ratio of over 14 indicates a good financial position with no issues whatsoever.

The company has long sported robust profitability, and the numbers have only gotten better of late.

Over the last five years, they’ve averaged annual net margin of 14.63% and annual return on equity of 32.98%.

Illinois Tool Works operates in a highly decentralized fashion, which allows it to react quickly to changes and customer needs. It’s basically just a vast collection of small businesses with minimal oversight at the corporate level.

This has long been a winning strategy, and this is a winner stock.

The stock is up almost fourfold over the last decade, and the recent results have been outstanding – indicating much more winning to come.

But with the stock down over 20% YTD, this could be a great opportunity to get into a winner without paying too high of a price…

The P/E ratio is sitting at 16.04 (using adjusted TTM EPS), which compares very favorably to the stock’s own five-year average P/E ratio of 19.7.

It’s also well below the broader market’s P/E ratio.

I mentioned earlier that you’re getting an above average-yield along with the above-average dividend growth. Well, it looks like you’re getting that at a below-average multiple.

The multiple on cash flow is sitting at well under 17, which looks very good next to the three-year average P/CF ratio of 20.0.

And the yield, as noted earlier, is substantially higher than its own recent historical average.

So the stock does look cheap here. But how cheap might it be? What would a reasonable estimate of intrinsic value look like? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 8%.

That DGR is on the high end of what I allow for, but I think this is one of the few stocks that warrants that kind of forecast.

It’s been delivering for over four decades, and I don’t see anything that would indicate it won’t continue to deliver strong dividend increases for many more years to come.

Keep in mind, that DGR is well below the demonstrated 10-year EPS and dividend growth rates, and it’s also well below the forecast for future EPS growth (which is in line with management’s target).

As such, I think the 8% DGR is actually slightly conservative when you look at that.

The DDM analysis gives me a fair value of $215.00.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

I’m coming up with an estimate of intrinsic value that is significantly higher than where the current price is at, which I don’t think is too crazy when we remember the fact that this stock was priced at almost $180 earlier this year.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at, which adds balance, depth, and perspective to our conclusion and final valuation.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates ITW as a 4-star stock, with a fair value estimate of $148.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates ITW as a 3-star “HOLD”, with a 12-month target price of $145.00.

I came in high, but all three of us agree that the stock is cheap here. Averaging the three numbers out gives us a final valuation of $169.33, which would indicate the stock is potentially 41% undervalued right now.

Bottom line: Illinois Tool Works Inc. (ITW) is a high-quality global manufacturer of various industrial products and equipment, touching on almost every end market across the world. With more than four decades of dividend raises, a recent 28% dividend increase, a rare yield sitting well over 3%, and the possibility that shares are 41% undervalued, this could be one of the most compelling opportunities available in the market for dividend growth investors.

— Jason Fieber

Note from DTA: How safe is ITW’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 90. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, ITW’s dividend appears very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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