Illinois Tool Works Offers Sharp Short-Cycle Recovery Exposure, But A Robust Valuation

The problem with saying that “valuation always matters” is that there’s a “when?” part that often goes unsaid. Illinois Tool Works (ITW) has finally started looking a little “mortal” recently with the shares underperforming the broader industrial space since my last update, a bit curious perhaps given the company’s exceptional near-term growth leverage and demonstrated margin excellence.

The long-term track record is still firmly in ITW’s favor, and this isn’t a name I’d bet against. Still, this is a company with less long-term historical organic growth than you might assume, and I’m modestly concerned that the company’s relatively less-attractive end-market exposures may create some modest headwinds. My bigger issue remains valuation – priced for a mid-single-digit total annualized long-term return, I just don’t see enough opportunity here to favor it over other industrials, even with the superior margins and quality ITW offers.

 

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Illinois Tool Works Offers Sharp Short-Cycle Recovery Exposure, But A Robust Valuation

Illinois Tool Works Continues To Defy Gravity, Now Trades At A Rich Sector Premium

There’s no question that Illinois Tool Works (ITW) has a cadre of loyal long-term investors, and that loyalty has been earned by years of reliable business performance and margins that are superior to its rivals in pretty much every business in which it participates. Illinois Tool Works has never been particularly strong on growth, but it doesn’t tend to attract investors who want that. Moreover, with the company choosing to forgo margin maximization during the trough, the company may well be able to capture some incremental market share and revenue growth during the recovery.

The problem is valuation, and that problem has become even more acute with another 30% move in the share price since May. I know we are in a period where some are arguing that low interest rates mean that valuation no longer matters. If that’s your position, good luck to you. I’ve seen too many cycles to concur, and even throughout Japan’s long period of low interest rates, valuations have still mattered. Where most high-quality industrials (3M (MMM), Dover (DOV), Eaton (ETN), Fortive (FTV), Honeywell (HON), et al) are priced for mid-single digits annualized returns, ITW has fallen closer to the low-single digits.

 

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Illinois Tool Works Continues To Defy Gravity, Now Trades At A Rich Sector Premium

Reputation, Strategic Differentiation Supporting Illinois Tool Works

I’m not a fan of investment buzzwords (for instance, I think “dividend king” is moronic), but words like “cyclical” and “defensive” do at least give investors a simple shorthand for thinking about companies.

But then, it’s never really that simple. Take the case of Illinois Tool Works (ITW). It’s both defensive (with incredible margins) and cyclical, and that cyclicality is going to lead to some eye-popping revenue contraction in the coming quarters as the company absorbs the brunt of downturns in markets like autos, food equipment, welding, and non-residential construction.

Likewise, ITW isn’t afraid to break from the pack and manage its business in a decidedly non-defensive way – instead of worrying about minimizing decremental margins for a few quarters, ITW is going to pass on significant structural changes and is instead going to focus on taking share from smaller competitors whose scale, liquidity, or other operational attributes are forcing them to play defense.

I frankly love this move. I wish I loved the valuation as much. That’s a familiar complaint with me and this stock (and with many others who follow ITW), but it’s still relevant. Even if I assume ITW’s strategy works and they can gain share sufficient to allow them to grow the top line at rates similar to high-quality peers like Dover (DOV), Honeywell (HON), or Parker Hannifin (PH), I just can’t get the numbers to work. Of course, I thought that back in late December, and it didn’t keep the stock from outperforming its peers by better than 12%.

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Reputation, Strategic Differentiation Supporting Illinois Tool Works

Illinois Tool Works Is A Margin Beast, But The Valuation Is A Little Scary

Maybe the worst thing I can say about Illinois Tool Works (NYSE:ITW) as a company is that it’s kind of dull and that it underinvests in R&D – something management likely would disagree with. Otherwise, we’re talking about an incredibly well-run conglomerate that is very diversified across the globe (albeit a little light toward China) and across end-markets (albeit a little heavy toward auto). Management’s 80/20 system has generated proven results for years and very very few companies can produce these kinds of margins and returns on a sustained basis.

I thought ITW had some “best of the rest” attributes back in April, largely on the strength of its margins, but the shares have done quite a bit better than its peer group since then – climbing more than 15%, handily surpassing the performance of the industrial sector as well as many other well-regarded (or formerly well-regarded) multi-industrials like Eaton (NYSE:ETN), Honeywell (NYSE:HON), 3M (NYSE:MMM), Parker-Hannifin (NYSE:PH). Dover (NYSE:DOV) and Danaher (NYSE:DHR) are among the few to beat ITW’s performance over that period, though Danaher really isn’t a true peer anymore.

At this point, I can’t really sign off on the valuation Illinois Tool Works is getting. Sure, I understand that investors are taking positions ahead of an expected 2020 rebound, and I also get that high-margin stocks get high multiples. I also understand that once the Street picks a favorite/safe haven, they’ll run it to unsustainable valuations (as happened with 3M). So, while I could maybe stretch my valuation methodology far enough to say it’s not hugely overpriced, a mid-single-digit prospective return is just too low for me.

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Illinois Tool Works Is A Margin Beast, But The Valuation Is A Little Scary

Middleby Doing Better On A Core Basis, And Valuation Reflects That

With much-improved performance in the residential business and decent growth in commercial foodservice, Middleby (MIDD) has come back into investors’ good graces, with the shares up better than 25% over the past year. I liked Middleby better when the restructuring efforts were still in process and recovery in the business (and sentiment/perception) was still up for debate, and now I find the valuation more demanding for a company that I believe is too large to significantly outgrow its markets on an organic basis.

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Middleby Doing Better On A Core Basis, And Valuation Reflects That

Stanley Black & Decker Comes Back With A Stronger Report

A weak, and poorly-received, fourth quarter put Stanley Black & Decker (SWK) in a hole, and while the shares have lagged industrial peers over the last year, the performance since my last update has been noticeably better. With a strong first quarter driven in very large part by the tool business, Stanley’s guidance for 2019 certainly looks more attainable than just three months ago. While I still see risks in the second half of the year from weaker than expected “general industrial” markets, Stanley should be poised to benefit from gradual improvement in auto demand later this year and some self-directed gross margin improvement efforts.

I’m not as interested in the valuation/share price opportunity as I was in January, as the stock has risen more than 20% since then (roughly doubling its peer group). I’m concerned that the market and industrials in particular are ahead of themselves now and I’d prefer to wait for a better entry price before starting a position here.

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Stanley Black & Decker Comes Back With A Stronger Report

Lincoln Electric Still Looking Wobbly, But That's What Buying Opportunities Often Look Like

Situations like the one Lincoln Electric (LECO) presents to investors today are why investing isn’t easy – the business has clearly slowed and there are valid reasons to think it may slow further. And yet, as seen in industry segments like Japanese automation, the market often prices in bottoms and recoveries well ahead of the fact. Lincoln Electric shares look undervalued today, and this is one of the better-run industrials I’ve ever followed, but the company is also starting to expand into some areas that could increase the overall operating risk. All told, I think this is a name to start considering, but investors need to keep their eyes open to the risks of a broader sell-off.

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Lincoln Electric Still Looking Wobbly, But That's What Buying Opportunities Often Look Like

ITW's Margins Seem To Be Holding Up Well As Growth Slows

With the blizzard of earnings reports from April 25, and those that came before, it seems clearer to me that shorter-cycle industrial companies are facing a much more challenging growth environment. In addition to the surprisingly weak revenue number from 3M (MMM) (down 1.1%), Sandvik’s (OTCPK:SDVKY) SMS business saw a 1% decline, and Stanley Black & Decker (SWK) saw a 3% decline in its Industrial segment, while all of the discrete automation companies have seen growth slow.

Considering all of the above, the 1.5% contraction at Illinois Tool Works (ITW) this quarter isn’t so shocking or alarming. Perhaps even more important, particularly relative to 3M and Sandvik’s SMS business, is that ITW’s margins held up better – lending some support to the idea that ITW is a company built more for margins and returns than growth, which isn’t such a bad thing when growth gets scarce.

Industrials have rallied since I last wrote about Illinois Tool Works on growing optimism that 2019 growth will be stronger than expected, and ITW has actually outperformed its peer group. Although I don’t have any particular objections to ITW as a hold, I don’t find the valuation exciting enough to start a position here and I still see more risks that growth in North America will slow as 2019 moves on.

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ITW's Margins Seem To Be Holding Up Well As Growth Slows

3M Decimated On Autos, Electronics, And Execution

Thursday’s first quarter earnings report was the worst day for 3M (MMM) shareholders in a long, long time, as a huge double-digit miss at the segment profit line drove a double-digit decline in the share price. While 3M is not going to burn down, fall over, and sink into the swamp, the shares are going to be in the penalty box for a while, and management needs to prove convincingly that they can not only improve margin execution, but restructure the business in the direction of both great margins/returns and at least decent growth.

3M’s valuation is much more reasonable than it has been in some time, but it’s fair to ask and wonder if turning around this supertanker is going to be a longer process. If the problems really are confined primarily to auto and electronics, this is a name to investigate further, but I don’t think investors need to make a snap decision for fear of missing out, as the concerns about 3M’s growth and execution capabilities have been building for a while and won’t go away in quarter.

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3M Decimated On Autos, Electronics, And Execution

Lincoln Electric's Results Highlight Some Of Today's Macro Modeling Challenges

Lincoln Electric (LECO) remains one of the most-respected companies I follow in the industrial space; even analysts who are negative on the shares for whatever reason usually feel compelled to acknowledge its strong share, variable cost structure, attractive ROIC history, and solid strategy. That said, the shares have basically traced the performance of the average industrial over the past year, lagged the sector over the past two years, and significantly lagged over the last five years – a phenomenon I attribute more to the high valuation the company has often enjoyed rather than any long-term reduction in business quality.

As far as considering the shares today, I’m not quite sure what to think. I see growing risks from macro headwinds in a number of important end-markets, but I don’t think my long-term growth assumptions are all that heroic and the shares look priced more or less in line with a lot of other industrial names that I believe to be less well-run. I think Lincoln shares may not do all that great in 2019 unless there is a favorable resolution to the U.S.- China trade issues and there’s re-acceleration in multiple end-markets, but as a long-term holding today’s price is at least okay in my book.

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Lincoln Electric's Results Highlight Some Of Today's Macro Modeling Challenges

Weak Growth And Robust Expectations Create Headwinds For Illinois Tool Works

Quality is all well and good, and Illinois Tool Works (ITW) certainly has that, but growth and margin leverage tends to drive share price performance and ITW looks to be in shorter supply where those are concerned. Meaningful exposure to softer end-markets like auto, “general industrial”, non-residential construction, and electronics are headwinds to me, and I’m not sure there’s a lot that ITW management can do to repeat the meaningful past improvements in operating margins. On top of all that, the valuation is not all that cheap at this point.

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Weak Growth And Robust Expectations Create Headwinds For Illinois Tool Works

Strong Results And Good End-Market Make Dover More Of A Standout

This was a really strong quarter for Dover (DOV) in a period when investors really want to hear that conditions in the broader economy aren’t as bad as hoped. Between stronger than expected revenue, strong orders, and decent margins, Dover is in good shape, and the company should benefit from its better relative end-market exposures. A lot is riding on the company’s restructuring program (where expectations are already pretty high) and the valuation isn’t all that cheap, but Dover looks like it will emerge from this reporting cycle as one of the stronger names.

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Strong Results And Good End-Market Make Dover More Of A Standout

Atlas Copco's Better Fourth Quarter Offset By Ample 2019 Uncertainties

The past year (2018) was a relatively rare year where Atlas Copco (OTCPK:ATLKY

) underperformed its industrial peers, as worries mounted throughout the year about the company's semiconductor-exposed Vacuum Technique business. Performance has improved on a relative basis over the last few months, though, as investors start considering whether semiconductor orders may recover in 2019 and whether other industrial markets may not slow as much as feared.

I'm still in the camp that thinks economic growth will slow more noticeably in North America, Europe, and China as 2019 goes on. Atlas Copco may well outperform in that environment (it certainly did in the fourth quarter), but investors considering the shares have to accept the risk of conditions getting worse before they get better. Atlas Copco isn't a clear-cut bargain today, but it's close enough (and seldom gets truly cheap) that I'm tempted to take the risk.

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Atlas Copco's Better Fourth Quarter Offset By Ample 2019 Uncertainties

Stanley Black & Decker's Guidance Doesn't Bode Well For Industrials

Seen by many investors and analysts as a relatively safer play in industrials for 2019, Stanley Black & Decker (SWK) was hammered (down 15%) after reporting earnings, as investors saw more than a few alarming items in the company’s guidance pertaining to some major industrial end-markets. Given the acknowledgement of weakening conditions in key markets like autos and residential housing, not to mention some limits on pricing amid ongoing cost pressure, I expect investors are going to be paying much closer attention to names like Illinois Tool Works (ITW), Ingersoll-Rand (IR), and 3M (MMM) in this earnings/guidance cycle.

As for Stanley Black & Decker itself, the shares do look undervalued, but the back-end loaded guidance for the year and the margin challenges make it a tough call right now, as there could be at least one more cut to guidance before this is over. I’d also note that Stanley Black & Decker hasn’t exactly been a standout either when it comes to metrics like free cash flow growth, despite ongoing cost reduction efforts.

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Stanley Black & Decker's Guidance Doesn't Bode Well For Industrials

A Better Quarter From Colfax, But Plenty Of Work Still To Do

Healthier demand in manufacturing and heavy industry is positive tide that is lifting a lot of boats these days, and Colfax (CFX) too is seeing some benefit. While the company continues to go through a painful adjustment process in its Air & Gas Handling business, the trend should start to improve relatively soon and there seems to be room for more growth in multiple end-markets. Management also seems to be more inclined to restructure and buy back shares rather than add a new business group, and that looks like a smart decision on balance for the time being.

I’ve been clear in the past that I have serious doubts about this business; I am not sold on the long-term value of the Air & Gas Handling business and I think the company will struggle to make real headway in welding. That said, low expectations, a relatively high short ratio, and improving end-market trends, coupled with what looks like responsible decisions on the part of management, does support value here even after a decent run over the past couple of months.

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A Better Quarter From Colfax, But Plenty Of Work Still To Do

Fortive On Target In The Second Quarter And Doing Yet Another Deal

Investors can’t say that Fortive (FTV) management doesn’t deliver on its promises – management at this diversified multi-industrial said they wanted to deploy at least $6 billion into M&A that would skew the company toward more higher-margin recurring revenue, and they have done exactly that. While second quarter earnings were a little choppy, they basically met expectations and the turbulence seen in some of the businesses wasn’t all that different than what comparable multi-industrials like Illinois Tool Works (ITW) and Dover (DOV) saw in their operations.

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Fortive On Target In The Second Quarter And Doing Yet Another Deal

Heavy Machinery Supporting Good Growth At Lincoln Electric

The recovery in heavy equipment was a little slower to show up relative to the overall industrial recovery, but companies like Caterpillar (CAT), Deere (DE), and Cummins (CMI) have been reporting strong revenue growth on the back of strong demand for heavy machinery. Add in healthy commercial construction activity and recoveries in mining and oil/gas, and Lincoln Electric (LECO) is looking at a generally favorable backdrop.

It seems like some of the worries about an imminent end to the cycle have faded, and Lincoln Electric shares have done alright since the first quarter – up about 7% in what has still been a dicey market for industrial stocks. Although the shares don’t look very cheap on an absolute basis, there is some relative value here and Lincoln Electric’s leverage to later-cycle markets could give it more beat-and-raise (and more outperformance) potential from here.

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Heavy Machinery Supporting Good Growth At Lincoln Electric

Illinois Tool Works Loses A Little Luster

A quarter ago I said I preferred Honeywell (HON) and Eaton (ETN) to Illinois Tool Works (ITW), and in the three months since Honeywell and Eaton have outperformed Illinois Tool Works by about 10%. Now, Illinois Tool Works shareholders are left to digest a second straight disappointing quarter - while ITW hit the organic revenue growth target this time, segment EBIT missed expectations by a few percentage points and management lowered guidance.

I'm not too surprised that Illinois Tool Works is seeing higher than expected cost pressures; if anything, that's a theme this quarter in the industrials. I'm more surprised, though, by what looks like weaker results in areas like auto and electronics relative to peers like 3M (MMM), Danaher (DHR), and Stanley Black & Decker (SWK). With weaker prospects for beat-and-raise quarters across the industrial/multi-industrial landscape, I'm more worried about the risk of re-rating in the second half of 2018 (multiples shrinking back toward historical norms).

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Illinois Tool Works Loses A Little Luster

Stanley Black & Decker Still Not Getting Much Benefit Of The Doubt

Between worries about retail demand, construction spending, auto build rates, and input costs (including tariffs), Stanley Black & Decker (SWK) still hasn’t been getting all that much love. This is part and parcel of the challenges of “buying the dip” as I outlined in my prior piece, though Stanley has only modestly underperformed industrials in general over the past three months (though Snap-on (SNA) has been much stronger), the year-to-date performance is still pretty weak and there are valid reasons to worry that management’s guidance for the second half is too aggressive.

I do see some near-term risks, but I think the valuation is pretty interesting. I do believe the Craftsman acquisition creates some interesting opportunities, and I likewise think Stanley has the option to deploy capital into potentially value-enhancing transactions within fastening. Against that “interesting” valuation, though, is the reality that this company’s track record with respect to ROIC and margin improvement are not great and there are execution risks to consider.

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Stanley Black & Decker Still Not Getting Much Benefit Of The Doubt

Dover's Core Doing Okay And New Management Brings New Options

I’ve never hid the fact that Dover (DOV) is not among my favorite companies, and over a longer-term holding period, you’d still have done better with names like 3M (MMM), Illinois Tool Works (ITW), Fortive (FTV), Danaher (DHR), and Ingersoll-Rand (IR). That said, Dover shares have been performing meaningfully better on a relative basis over the past couple of years, first with the recovery in the energy sector, then the spin-off of Apergy (APY), and what I believe is building optimism about what a change at the top (a new CEO) could mean in terms of self-improvement.

My complaints about Dover have largely centered around low margins/elevated expenses, weak returns on capital, and a collection of businesses with iffy long-term strategic value. New CEO Richard Tobin seems eager to start work on the expense side of the equation, and I wouldn’t rule out the possibility of management shuffling the deck a little further down the road (selling some businesses and perhaps buying some new ones). While I’m warming up to Dover from a strategic perspective, the valuation still isn’t all that enticing to me, though a longer run of this industrial up-cycle could certainly generate some upside to my expectations.

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Dover's Core Doing Okay And New Management Brings New Options