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Why Illinois Tool Works Is Worth Buying

It's no secret that growth in the industrial sector slowed down in the second quarter -- the trend has been much in evidence in the earnings reports of industrial supply companies. A slew of them reported weakening conditions in their short-cycle businesses. Given that, as one looks across the sector, there's one stock that specifically looks like it might be worth buying now: Illinois Tool Works (NYSE: ITW).

Industrial companies gave subdued earnings/outlooks

After a difficult second quarter, many industrial companies, such as Illinois Tool Works and Rockwell Automation (NYSE: ROK) have reduced their full-year revenue and earnings outlooks. Others, among them 3M (NYSE: MMM) and Caterpillar (NYSE: CAT), told investors to expect a full-year earnings performance toward the low ends of their previous guidance ranges. Even the companies that raised earnings guidance in the wake of high-quality Q2 reports -- Honeywell International (NYSE: HON) and United Technologies (NYSE: UTX) -- said they had seen weakness in some of their short-cycle businesses. Both Honeywell and United Technologies relied on strength in aerospace to offset some disappointing results elsewhere.

Illinois Tool Works is exposed to cyclical businesses such as welding equipment. Image source: Getty Images.

How you can make money from it

But here's the thing. It's far from clear that whether we are in the midst of a brief, temporary pause in capital spending or at the beginning of protracted slowdown. If it turns out to be a blip, and capital spending bounces back fast, or at the very least stabilizes to a low single-digit percentage growth rate (in line with economists' expectations for GDP growth and industrial production growth), then there could be some upside potential for investors.

Moreover, companies that have baked the current conditions and trends into their guidance could be in a position to upgrade their near- and longer-term earnings expectations. One such company is Illinois Tool Works.

Illinois Tool Works' difficult second quarter

Illinois Tool Works total organic revenue declined 2.8% in Q2, and reported revenue fell 5.8%. The only one of its seven segments that grew organic revenue was food equipment -- and that was partly a result of a particularly easy comparison with 2018.

"We experienced a deceleration in demand across our portfolio," said CEO Scott Santi on the earnings call ".... [with Q2 revenues] approximately $85 million below what they would have been had demand helped at the level we were seeing exiting Q1." https://www.fool.com/premium/coverage/earnings/call-transcripts/2019/07/26/illinois-tool-works-inc-itw-q2-2019-earnings-call.aspx

Data source: Illinois Tool Works presentations. Chart by author.

Santi went on to explain the logic behind dialing back the company's full-year revenue and earnings outlook: "[W]e are adjusting our full-year guidance in line with conditions on the ground as they exist today. Current run rates exiting Q2 projected through the remainder of the year would result in an organic revenue decline of 1% to 3% for the full year. And as a result, we are reducing our full-year EPS guidance by 4% at the midpoint."

The reductions can be seen below.

Full-Year Guidance Range

As of Q2 2019

As of Q1 2019

As of Q4 2018

Organic revenue growth

(1%-3%)

0.5%-2.5%

1%-3%

Operating margin

Flat to up 50 bp

Up 100 bp

Up 100 bp

GAAP EPS range

$7.55-$7.85

$7.90-$8.20

$7.90-$8.20

Data source: Illinois Tool Works presentations. Chart by author. Bp = basis points. 100 bp = 1 percentage point.

Why Illinois Tool Works stands out

The question now turns to whether an investment in Illinois Tool Works would be a good way to play the theme. There are four reasons why I think it is. First, as noted above, management has explicitly baked the trends of the second quarter into their full-year guidance -- suggesting there is upside potential ahead.

Second, despite pressure on margins due to falling sales, Illinois Tool Works is still able to generate underlying margin expansion through its so-called "enterprise initiatives" -- the company's ongoing efforts to refocus on its most profitable customers and product lines. The good news is that these enterprise initiatives have more room to run. "[T]here is easily several more years of work there and opportunity there," Santi remarked during the earnings call. Contrast that with the difficulties 3M is having in dealing with declining volumes. Indeed, 3M could do well to take a look at its peer's playbook.

Data source: Illinois Tool Works presentations. Chart by author. Bp = basis points. 100 bp = 1 percentage point.

Third, as the chart above illustrates, the price/cost headwind to margin has now disappeared. "[I]f things stay broadly as they are, price/cost is on track to turn margin positive in the second half," CFO Michael Larsen said during the earnings call. That's something that will help mitigate volume weakness.

Fourth, the midpoint of the company's EPS guidance implies growth of 1.3%, and on a price-to-free-cash-flow basis, the stock looks like a good value. By way of comparison, 3M has a patchy growth record, and the time to buy Rockwell is probably when you know its architecture and software segment sales growth is about to trend upward again.

ITW Price to Free Cash Flow (TTM) data by YCharts

Illinois Tool Works is attractive over the long term due to its enterprise initiatives, and if the current weakness in industrial manufacturing turns out to be a short-term blip, then its current share price will prove to have been a good entry point for long-term investors. All told, this stock is worth buying if you are confident about ongoing economic growth.

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Lee Samaha owns shares of Honeywell International. The Motley Fool recommends 3M. The Motley Fool has a disclosure policy.


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