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Morningstar | Even With Tepid Top-Line Growth, Our Optimistic Long-Term Outlook for ITW Remains the Same

Narrow-moat Illinois Tool Works had a soft third quarter and the stock responded in kind, declining over 3% as of this writing. That said, after reviewing our model for various puts and takes and management's guidance for the remainder of the year, we raise our fair value estimate to $148 per share (from $147 previously), or about 19 times our full year 2018 revised $7.65 GAAP estimate (which is down about 2 cents from our previous estimate). This is at top end of management’s guided EPS range of $7.55-$7.65. The fair value estimate raise, however, is effectively less than $1, and is exclusively due to the time value of money. Even with softness in certain portions of ITW’s end markets, we continue to be impressed with management’s ability to expand operating margins, which rose 30 basis points year over year (net of a 2017 legal settlement) to 24.6%. We expect operating margins to finish the year at about the midpoint of management’s guidance of between 24% and 25% (24.3% specifically).

Organic revenue grew a mere 2% year over year, which was completely offset by an unfavorable currency impact (unlike other industrial peers, ITW doesn’t hedge). The absolute organic percentage change year over year, however, doesn’t tell the whole story. North America specifically exhibited strong top-line organic growth of 4% year over year, but this was offset by both Europe (which declined 1% organically) and Asia Pacific (which declined 2% organically). We’re not completely surprised by some of this near-term weakness, which we expect to last in both the Chinese and European automotive end markets for some time. We’ve started hearing this is a recurring sore spot for other industrials with this type of exposure, such as wide-moat 3M, which reported similar issues yesterday.

Management reported that the weakness in the European automotive market is due to new emission regulations that went into effect in the quarter. As a result, European auto production declined 5%, following 4% growth in the second quarter. In China, depressed consumer sentiment, as well as diminished availability of financing, led the firm’s Chinese business, which was up 12% in the front half of the year, to flat growth this quarter year over year. We asked one of our auto analysts about this and he echoed the same rationale, which forms the basis for why we think this weakness should continue at least into the earlier part of next year. Even so, new product launches in the auto aftermarket was an important contributor to the region’s strong year-over-year top-line growth, and the automotive segment's presence in the region than that of others.

Despite these international challenges, the firm was able to deliver EPS of $1.90, and while earnings can be manipulated, free cash flow increased 17% year over year against an 11% increase in EPS, and the firm converted an impressive 116% of its net income into free cash flow. Aftertax returns on invested capital, inclusive of goodwill, moreover, improved a resounding 4 points to 28%, and the firm is expecting to close the year out between 27% and 28% (versus 24.3% the previous year). For investors, we expect automotive margins to hold steady for full-year 2018 relative to last year. Finally, we expect that ITW can manage tariffs through pricing actions that should offset raw material cost increases, particularly as only 2% of the firm’s inventory spending is sourced from China.