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Here's Why You Should Hold on to Illinois Tool (ITW) for Now

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We issued an updated research report on Illinois Tool Works Inc. ITW on Mar 19. A vast customer base in various end markets, gains from 80/20 business process and sound capital allocation strategies are key drivers for the company. On the flip side, risks related to international operations, high debts and industry competition remain concerning.

The industrial tool maker, with a market capitalization of approximately $58.4 billion, currently carries a Zacks Rank #3 (Hold).

Below, we briefly discuss the company’s potential growth drivers and possible headwinds.

Factors Favoring Illinois Tool Works

Share Price Performance and Earnings Estimates Revision: Illinois Tool Works’ financial performance remained better than expected over the last four quarters with an average positive earnings surprise of 4.16%. In the last reported quarter, the company’s earnings of $1.70 per share exceeded the Zacks Consensus Estimate by 4.94%.

In the last six months, the company’s shares yielded 15.7% return, outperforming 10% gain of the industry.

In the last 60 days, nine brokerage firms raised the company’s earnings estimates for 2018, while five increased for 2019. However, estimates for both the years were lowered by one brokerage firm. Currently, the stock’s Zacks Consensus Estimate is pegged at $7.71 for 2018 and $8.39 for 2019, representing growth of 5.6% and 4.9% from their respective tallies, 60 days ago.

Near- and Long-Term Growth Potential Solid: Illinois Tool Works operates through seven business segments — Test & Measurement and Electronics, Automotive OEM, Polymers & Fluids, Food Equipment, Welding, Construction Products and Specialty Products — largely minimizing its risks of loss from the poor performance of any group. Also, a vast customer base in various end-markets, including automotive original equipment manufacturer, automotive aftermarket, general industrial, commercial food equipment, construction and others, is beneficial. Moreover, its 80/20 business process will help it achieve higher operating margins, better capital efficiency and solid return on invested capital.

For the first quarter of 2018, the company anticipates GAAP earnings to be $1.80-$1.90 per share. Organic revenues are expected to grow 3-4% in the quarter. For the full year, GAAP earnings guidance has been increased to $7.45-$7.65 per share, reflecting 40 cents growth at the mid-point. The increase reflects the positive impact of tax rate cuts to 25-26% and forex gains.

Over the long term (2018 to 2022), the company anticipates organic revenue growth to be 3-5%, operating margin to be in excess of 25%, incremental margin to be 35% and earnings per share to grow 8-10% in each year. Also, after-tax return on invested capital is projected to be above 20%. Free cash flow will likely be more than 100% of the net income.

Capital Allocation Strategies: Illinois Tool Works follows sound capital allocation strategies, under which it makes meaningful acquisitions for business expansion, invests for the enhancement of its organic growth and rewards shareholders handsomely.

Over time, acquisitions have helped in the development of the company’s core segments while creating new platforms for expanding long-term growth opportunities. Since it got acquired in July 2016, the Engineered Fasteners and Components business has strengthened the company’s Automotive OEM business.

The company remains committed toward returning value to shareholders. It raised quarterly dividend rate by 20% in August 2017 and intends to increase the dividend payout rate from 43% to 50% of free cash in August 2018. Earlier, the company expected the dividend rate increment in 2020. However, this increment is still subject to the company’s board approval.

Factors Working Against Illinois Tool Works

Threats From International Expansion: Global expansion has exposed Illinois Tool Works to risks rising from adverse movements in foreign currencies. Also, uncertainties in economic growth of the countries served can severely impact its businesses. Its products are sold in 56 countries. Notably, it sourced nearly 56% of its revenues from its international operations.

Huge Debts Raise Concerns: Illinois Tool Works’ long-term debt was approximately $7.5 billion exiting the fourth quarter of 2017. We believe, if unchecked, huge debt levels will increase its financial obligations and hence, prove detrimental to its profitability.

Industry Competition: Illinois Tool Works faces stiff competition from companies offering similar products and services or those producing different items for same uses. Also, difficulties or delays in research and development or production and services, apart from the failure of new products and technologies in the market, might hurt its competitive edge.

Some key players in the industry, sporting a Zacks Rank #1 (Strong Buy), are Applied Industrial Technologies, Inc. AIT, Dover Corporation DOV and Roper Technologies, Inc. ROP. You can see the complete list of today’s Zacks #1 Rank stocks here.

In the last 60 days, earnings estimates for each of these stocks improved for the current year and the next year. Also, average positive earnings surprise for the last four quarters was 10.97% for Applied Industrial, 7.26% for Dover and 3.12% for Roper.

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