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5 Things the Market Missed From Illinois Tool Works' Earnings

Lee Samaha, The Motley Fool

It's been an up-and-down earnings season so far for the industrial sector, with ongoing strength in areas such as aerospace being offset by weakness in automotive and (to a lesser extent) housing and construction. While the specific exposure of certain companies such as say, Honeywell International or United Technologies led to impressive first-quarter earnings, multi-industry industrials such as 3M (NYSE: MMM) and Illinois Tool Works (NYSE: ITW) have nowhere to hide. However, there are a number of reasons to believe that the latter can bounce back after its disappointing quarter. Here are five of them.

1. It maintained its guidance

Despite lowering its full-year organic revenue growth outlook to a range of 0.5% to 2.5% from the previously forecast range of 1% to 3%, Illinois Tool Works' maintained its full-year EPS guidance range of $7.90 to $8.20, which would amount to growth of 4% to 8%. Of course, maintaining a guidance range doesn't mean the company is still on exactly the same track -- after all, the range straddles a number of outcomes.

That said, even at the low point of the range, Illinois Tool Works trades at a forward P/E ratio of 19.4, and assuming it hits its target of converting around 100% or more of net income into free cash flow (FCF), it trades at a similar price-to-FCF multiple. It's certainly not as good value as it looked a few months ago, but if you view 2019 as another step toward the company's five-year outlook, then the stock will be attractive for long-term investors. 

2. The sales picture improved during Q1 

It's one thing to look at a set of earnings and FCF forecasts; it's another thing to believe in them. That said, Illinois Tool Works management served notice that its sales trends were improving through the quarter.

"Sales started out a little slow across the board in January before picking up the pace in February and March," said CEO Scott Santi during the earnings conference call. And CFO Michael Larsen expanded on that theme when he asserted that sales were also sequentially better in April, so "everything appears to be on track."

A car production line.

Illinois Tool Works needs automotive production to stay solid in 2019. Image source: Getty Images.

In addition, even though organic sales declined 1.5%, there was one less shipping day in the quarter than there had been in Q1 2018. Excluding this impact, organic revenue would have been about flat. Moreover, the comparisons with 2018 will get easier in the second half.

3. Its forecasts are based on conservative automotive sector guidance

Illinois Tool Works and 3M both have significant exposure to the automotive sector, and they both suffered in Q1 as a consequence. However, one key difference between the two companies is that 3M's near- and long-term forecasts for sales in that segment have had an optimistic look about it for some time, and the stock has been worth avoiding as a consequence. 

In contrast, Illinois Tool Works' management tends to be conservative with guidance, and its automotive forecast for 2019 is a case in point. Larsen outlined that leading industry forecaster IHS is predicting "[global] auto production to be down 6% in the first half, followed by 4% growth in the second half," but the company's guidance for the second half assumes "no growth in auto production in the back half of the year."

4 and 5. The pricing environment and underlying margin improvement look favorable

The last two points are best articulated with the help of the following chart. As noted above, the company's guidance is for organic growth of 0.5% to 2.5%, and this is expected to be accompanied by a 100 basis point expansion in operating margin from 2018's 24.3% around 25.3%. In fact, management cited the improving margin outlook as a reason why it maintained its earnings guidance even though the revenue growth outlook is weaker.

Two factors give confidence on this matter, and both can be seen in the chart of margin expansion below.

Illinois Tool Works Margin Expansion

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

First, the company's ongoing "enterprise initiatives" continue to do the heavy lifting in terms of margin expansion. In a nutshell, they are self-help initiatives involving simplifying businesses, selling unprofitable ones, paring down low-margin products, and focusing on its key customers. Management continues to expect a 100 basis point margin expansion from enterprise initiatives in 2019.

The second point is that the price/cost trend is improving. In fact, Larsen said that "at this point, price/cost margin impact is essentially neutral" and he went on to disclose that "we saw positive price in all segments" as pricing was "slightly ahead of our expectations" in the quarter. On the cost side, raw material costs are "moderating" so don't be surprised if Illinois Tool Works sees some margin contribution from price/cost in the coming quarters.

Looking ahead

All told, the company certainly had a better quarter than 3M and others, and it looks set for a bounce back in growth in the second half. That said, there's still some uncertainty regarding conditions in its end markets, and the stock is no longer as cheap as it was a few months ago. It's probably not a stock most investors will want to pile into right now, but it's definitely one to monitor with a view to buying on any significant sentiment-led weakness.

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