Illinois Tool Works: Maintaining Returns In A Transition Period (NYSE:ITW)

2024 is a year of transition for Illinois Tool Works (NYSE:ITW) with a change in leadership and a new corporate initiative to sustain their impressive record of total shareholder returns. Christopher A. O’Herlihy took over as CEO in January, after serving in various roles with the company over the course of 35 years. He is only the 8th CEO in the 113-year history of the company, showing the company’s long-term focus and commitment to stability. O’Herlihy took over from current non-Executive Chair of the Board E. Scott Santi, who tripled the company’s EPS and market cap without significantly increasing revenues over his 11 years as CEO. Annual compounded total shareholder returns averaged 16.8% over that period. ITW was able to deliver that impressive growth by focusing on margin expansion, investing in their best businesses and divesting smaller, lower performing units.

Each of ITW’s operating segments now boasts operating margins that are at least 9% higher than their peers when adjusting for amortization in the Testing & Measurement and Electronics, which acquired MTS at the end of 2021. The company will now turn to organic growth to drive the next decade of shareholder returns as the margin expansion phase nears its end.

Changing Focus to Next Phase

ITW has announced their strategic goals for 2030, targeting 4% average organic growth per year. The company expects to drive growth by working closely with customers to identify new product opportunities, minimizing uncertainty in the product development process. The corporate website gives the example of interviewing 100 framers to develop the cordless pneumatic nail gun. At the 2024 Citi Global Industrial Tech and Mobility Conference, CFO Michael Larsen pointed out that five out of the seven business segments were already on pace to deliver the 4% growth in 2024. He further broke the growth down into price (1-2%), market share gains of 1%, and 2% customer innovation.

Larsen made clear that acquisitions were still on the table, but indicated that ITW needed the right opportunity where they feel that margins can be expanded by 10 to 15%. He indicated that the 2021 acquisition of the MTS Test & Simulation business for $750 million was a good example of the sort of acquisition they are targeting, pointing out that they are already seeing margins expansion in the business. The MTS Test & Simulation business had operating revenue of $422 million in 2022 and operating margins of ~5.5% prior to the sale, so adding 10% to the margin would mean the purchase is generating an ROI of at least ~9% two years after closing without even taking growth and additional margin expansion potential into consideration.

ITW has steadily increased the debt on their balance sheet over the last two decades, but they have the capacity to do a deal worth several billion dollars since their debt to EBITDA ratio is still under 2. Acquiring a company like MKS Instruments Inc. (MKSI) with a $7 billion market cap would increase the debt to EBITDA ratio to a manageable 3.5. There is a decent chance that ITW does a smaller deal in the next couple of years, and they are disciplined enough that it shouldn’t be a major risk for missing their growth targets.

Consistent Capital Returns

ITW generated $3.08B of free cash flow in 2023 and had an average free cash flow of $2.5B over the previous five years. The 3-year average free cash flow has grown at a compound annual rate of 4.4% since 2012, which is solid but not spectacular. However, they have used part of that cash flow to consistently buy back shares, helping to drive EPS growth.

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The company plans to complete ~$1.5B in share repurchases in 2024, the same amount they purchased in 2023, and they will still have another $3.45B authorized under their 2023 repurchases program at the end of the year. There were 296.9 million shares outstanding as of the last 10-Q on June 30, 2024, less than half the split-adjusted count of 604.5 million shares outstanding 20 years ago.

Dividend King

ITW is committed to using their free cash flow to fund dividend growth. The company increased the quarterly dividend to $1.50 per share last month, with a record date of September 30 and a payment date of October 11. The current dividend yield is 2.46%, in line with the yield over the last decade. ITW has increased their dividend payout for 61 consecutive years and the dividend has grown at a compound annual rate of 12.6%. The current payout ratio is around 54%, low enough to be relatively safe in an economic downturn.

Overall, ITW has a good business model as evidenced by their healthy margins and the management team has done a good job allocating capital. There is some risk that the company will not be able to deliver on the new 4% organic growth rate, but overall the fundamentals are sound, and the company should continue to grow for the foreseeable future. As a shareholder, I plan to continue to hold my position in ITW, the only question is if I should add to the position at the current price.

Valuation is Key

ITW has stated that they expect free cash flow conversion to be nearly 100% of net income and the company has issued updated guidance for 2024 EPS to come in between $10.30 and $10.40, which equates to a P/E ratio of 23.4 at Friday’s closing price of $243.60. That valuation feels rich, but opportunities to buy quality companies like ITW at a discount are rare, and high growth rates can compensate for a premium purchase price if held long enough.

Consider ITW’s target EPS growth rate of 9-10% through 2030. Starting with 2024 earnings at $10.40, the 10% growth rate would equate to EPS of ~$18.40 in 2030, which would be a P/E ratio of 13.2 based on a $243.60 cost basis. If the market priced shares at a P/E of 20, that would have shares priced at around $370. Further, if the company can deliver their target dividend growth rate of +7%, dividends through 2030 could add up to over $45, or around $41 in present value if discounting at the current treasury rates. That seems like a good deal if the company can deliver on the high end, but what about a more conservative scenario?

Let’s assume ITW starts with $10.30/share earnings in 2024 and struggles to grow margins and sales, delivering EPS and dividend growth of only 2% through share repurchases. In this case, 2030 earnings would be around $11.60 and the P/E on a cost basis of $243.60 would be 21. Dividends paid over the period would come out to ~$39, or $36 of present value. This scenario would underperform Treasuries, so investors clearly need to assume growth to justify the current share price.

A middle of the road scenario with ITW delivering EPS growth of 6% would result in 2030 earnings of $14.70 and a P/E of 16.6 based on the current share price. An intermediate dividend growth rate of 4% would see dividend payouts of ~$7.60/share in 2030 and total dividends paid of ~$41.50, with a yield on cost of 3.1%. Investors would likely be looking at only average returns in this case.

EPS and Dividend Projections Based on Company Guidance

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This exercise shows that ITW must deliver on their current 2030 EPS growth target of 9-10% for investors to achieve a significant return at current prices.

Conclusions

ITW has consistently rewarded shareholders over a long period of time, and there is no reason to believe that will change any time soon. I initiated a position in ITW at $130 when the COVID panic drove shares down briefly in March 2020 and would love to own more shares at the right price. The current share price doesn’t leave a large margin of error if the company can’t continue to deliver 9-10% EPS growth. To assure better odds of achieving reasonable returns, I would look for a share price closer to $210 before buying more shares of ITW.