Is Illinois Tool Works Still a Buy?

Anyone who just blindly blames the economy for all industrial stocks' woes might want to take a look at the difference in performance between Illinois Tool Works (NYSE: ITW) and 3M (NYSE: MMM) over the last year. The former is up 37%, while its multi-industry peer is down 8.6% in the same period. Let's look at what Illinois Tool Works is doing right and whether it can continue.

The story on guidance 

It's no secret that the industrial sector has seen broad-based slowing in 2019; indeed, blue chip stocks like 3M and Caterpillar have both lowered full-year guidance during the current earnings season. Similarly, ITW's recent third-quarter earnings showed the signs of strain.

A bull and bear doing battle over a stock chart.

Image source: Getty Images.

As you can see below, the revenue growth outlook has been lowered through the year, and management reduced its full-year margin outlook. EPS guidance was maintained, but CEO Scott Santi acknowledged that "the combination of near-term macro uncertainties and the lingering strike at General Motors" means the final figure is more likely to come in at the lower end of guidance.

Full-Year Guidance Range Current As of Q2 2019 As of Q1 2019 As of Q4 2018
Organic revenue growth (decline) (1% to 3%) (1% to 3%) 0.5% to 2.5% 1% to 3%
Operating margin Down 30 basis points Flat to up 50 basis points Up 100 basis points Up 100 basis points
GAAP EPS range $7.55 to $7.85 $7.55 to $7.85 $7.90 to $8.20 $7.90 to $8.20

Data source: Illinois Tool Works.

Moreover, only one of its seven segments (polymers and fluids) reported organic growth in the quarter. Whichever way you look at it, the economy isn't helping the company much, just as it didn't with 3M and others that have broad-based short-cycle exposure.

Illinois Tool Works revenue growth

Data source: Illinois Tool Works.

That said, why is ITW managing to outperform?

Three reasons the stock is doing well

First, the recent bump in the price is probably down to the idea that end-market conditions aren't quite as bad as feared. Just as industrial supply company Fastenal (NASDAQ: FAST) indicated at the start of earnings season, conditions are getting worse, but the rate of deterioration didn't increase in the third quarter -- suggesting that stabilization could be on the way

Second, Illinois Tool Works continues to do a great job with expanding margin in the face of falling volumes and some pressure from rising costs -- a long-term comparison with 3M reveals much about the two companies' contrasting fortunes.

ITW Operating Margin (TTM) Chart

ITW Operating Margin (TTM) data by YCharts. TTM = trailing 12 months.

A large part of the reason comes down its so-called "enterprise initiatives" -- the company's ongoing efforts to refocus on its most profitable customers and product lines. The chart below shows how the initiatives helped offset pressure from rising costs in 2017 and 2018, and then declining volume in 2019. Meanwhile, the trend in margin remains upward.

Illinois Tool Works margin expansion. bp is basis points where 100 bp equals 1%.

Data source: Company presentations. BP= basis points.

Third, through its so-called product-line simplification (PLS) program, management continues to take the scalpel to businesses and products that are detrimental to its margin. And there's more to come, according to CFO Michael Larsen, who said on the earnings call, " ... we are looking to divest certain businesses with revenues totaling up to $1 billion and are targeting to complete this effort by year-end 2020 with about half of the divestitures in 2019."

This level of portfolio pruning stands in direct contrast to 3M's lack of significant action -- mere portfolio reshuffling isn't enough

A warning sign?

There was plenty of good news in the recent results, but as you can see in the first table above, management cut its full-year operating margin guidance, implying a weak fourth-quarter result in terms of margin.

In response to a number of analyst questions on the matter, Larsen said it came down to bringing forward restructuring projects and the possible impact of an extended strike at General Motors alongside more overall volume declines -- in short, investors need to watch for the margin outlook on the next earnings call.

Looking ahead

Analysts have Illinois Tool Works growing EPS by 5.2% in 2020 to $8.01. That puts the stock's 2020 P/E at 21.5 times earnings. That's not especially cheap, and the company will have to demonstrate it can continue to expand margin in order to grow into the valuation. It's a great company, but the upside to the stock looks limited for now.

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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends 3M and Fastenal. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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