EUR 850.00 For Business Accounts Only

Morningstar | ITW is a Well-Run, High-Quality Portfolio of Businesses with a Runway for Steady Margin Expansion

After taking a fresh look at Illinois Tool Works, we slightly lower our fair value estimate by about 5% to $140 from $148, primarily due to a more conservative midcycle margin assumption. That said, our long-term views on valuation remain relatively unchanged, particularly as it concerns ITW’s fundamental growth and margin drivers. Our current valuation represents about 17 times our 2019 GAAP EPS estimates, or about 12 times our 2019 EBITDA estimates (about the midpoint of analysts’ current estimates). Furthermore, while we maintain our narrow moat rating, we raise our stewardship rating to Exemplary, given the firm’s record of institutionalized, proven operational excellence, which we predict will result in an increasing ROIC profile relative to historical experience. We also maintain our stable moat trend and medium uncertainty ratings.

We view ITW as a well-run collection of moaty businesses. The firm’s operating model emphasizes its most important customers where it can offer the maximum amount of differentiation through its products and services. The firm has also fostered a decentralized, entrepreneurial culture but maximizes efficiency through techniques like product line simplification. These principles have allowed ITW to expand GAAP operating margins by 370 basis points to 23.7% in 2017 in just three years, as well as contribute to high returns on invested capital, including goodwill, of about 24.3% in 2017.

While it’s admittedly hard to separate out its sources of competitive advantage from its proven 80/20 operating model, we think ITW’s primary moat sources include switching costs, followed by some intangible assets and, to a lesser extent, scale-based cost advantage. The company focuses on niche markets, with most of its activities centered on resolving its most important customers’ pain points. ITW’s products and services are designed to reduce customers’ costs, either through ease of use, which cuts down on training costs; ensuring compliance with environmental and safety standards through quality products; or eliminating steps in a manufacturing process or parts in an assembly. In our view, these factors create powerful switching costs.

ITW also has a rich patent portfolio; long-term customer relationships, which inform its product development pipeline; a history and reputation for incremental but effective innovation; and deep technical expertise in specialized niches. These factors allow ITW to play at the high end of its markets, as evidenced by its products’ premium pricing. We also believe these factors evidence attractive intangible assets.

As for our valuation, we see myriad drivers that should propel ITW toward positive organic growth, including growing production of lightweight, electronic vehicles, food health and safety regulation, urbanization and industrialization in developing economies, demand for materials testing, and concerns related to food product authenticity. Aside from market gains, moreover, we believe ITW can increase its share in certain businesses based on higher-quality offerings that lower customers’ potential total cost of ownership. We don’t believe the firm’s margin expansion story is over, either, particularly as ITW continues focusing on its most important customers and most profitable opportunity, while continuing to simplify its product line. By 2021, we believe ITW can improve GAAP operating margins by 300 basis points from 2017 levels.

The firm also pays about a 2.8% dividend yield, and the dividend has steadily increased for 55 years. ITW also regularly returns cash to shareholders in the form of buybacks. At a cheaper price, we’d be buyers of the stock and believe ITW deserves a place on an investor’s watchlist.