After hitting an all-time high on July 31, Illinois Tool Works (ITW) stock fell over 4% last week. The sell-off likely had less to do with the company’s results and guidance, which were excellent, and more to do with the stock’s run-up in recent weeks.

Let’s dive into the quarter to see how ITW’s business is doing and why the diversified industrial conglomerate remains an excellent buy now.

The ITW investment thesis
ITW’s strategy is straightforward and effective. The company’s 2030 performance goals call for a 30% operating margin and an over 35% return on invested capital (ROIC). The company expects high margins and a high ROIC to drive 9% to 10% annual earnings-per-share growth, 7% annual dividend growth, and free cash flow over 100% of net income, which would support dividends and buybacks. These excellent goals act as a yardstick for investors to measure ITW’s performance and ensure it is delivering on its promises.

Another core element of ITW is its status as a Dividend King that has paid and raised its dividend for over 52 consecutive years. ITW’s track record of paying a growing dividend is another incentive to hold the stock through periods of volatility.

On Friday, ITW’s board approved a 7% increase to its dividend and a new $5 billion stock buyback program. The quarterly dividend is now $1.40 per share, and the annual dividend is $5.60 per share.

Despite the sizable raise, ITW only has a forward dividend yield of 2.3% because the stock price has grown at a faster rate than dividend raises. But the company still deserves a lot of credit for being able to afford big dividend raises year after year.

All told, the company’s 2030 targets provide a mid- to long-term reason to invest in ITW, while its dividend provides a reliable form of quarterly passive income.

Doing more with less
The interesting part of ITW’s 2030 goals is that there isn’t a focus on revenue. Quite the opposite, in fact. Rather, the company is focused on generating more profit per dollar in sales.

Wall Street has rewarded ITW’s strategy. The stock is up an impressive 437.6% over the last 15 years, which is far better than the S&P 500’s gain of 261.1%. Yet surprisingly, ITW’s revenue was actually lower in 2022 than it was in 2007. However, its operating income was up over 50%, and net income doubled during that time period.

The above chart is a textbook example that the stock market can reward companies in certain sectors differently than others. In the industrial sector, especially when it comes to larger companies, revenue growth often takes a back seat to dividend and earnings growth. This makes sense given that investors in these stocks are mainly looking for value and income.

A balanced business
The secret to ITW’s impressive conversion of revenue to operating income and net income is its complex, diversified, yet decentralized business where each segment operates as a business within the ITW umbrella. The below table shows ITW’s performance by segment for the first half of 2023.

This table shows each segment’s revenue and operating income as a percentage of the total business for the first half of 2023.

A few things stand out in these tables. The first is that the company’s largest segment by revenue has the lowest operating margin. It’s not necessarily a bad thing — this is just how automotive OEM has historically operated. If you added up the revenue and operating income of the other seven segments, you’d find that they average a whopping 26.8% operating margin, which is within striking distance of ITW’s 2030 goal and goes to show how efficient the majority of the business is.

Another unique quality of ITW’s business is the balance between the segments. Each segment makes up between 10% and 20% of revenue and operating income. This is unusual, as with most diversified industrials there are one or two dominating segments (think aerospace for Honeywell or construction and energy for Caterpillar).

There’s some crossover with ITW’s segments. But in general, each one depends on unique end markets. So ITW is really seven different highly efficient, well-run businesses that together make the parent company less vulnerable to downturns, which in turn supports dividend growth and buybacks.

Sleep well at night with ITW stock
ITW remains an excellent long-term buy. The company does a good job of setting expectations and holding itself accountable to hit those goals. Each of its segments is performing well. The relative size of each segment ensures that ITW can take a hit in a segment or two without derailing the business.

ITW has been a market-outperforming stock despite a lack of revenue growth. Even if ITW lags the broader market’s performance in the short term, the long-term outlook looks bright, and the stock should remain a passive income powerhouse that is perfectly suited for risk-averse investors.

— Daniel Foelber

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Source: The Motley Fool