After the pitch was voted on (and passed), resulting report

1. ILLINOIS TOOL WORKS
ANALYST REPORT: 7 December 2011
Emily Barr

2. 7 December 2011
ANALYST REPORT
The Company
Illinois Tool Works (ITW) is a diversified manufacturer that operates on a global scale. The company
designs and manufactures a large portfolio of engineered and specialty products, with emphasis on
value-added products that meet the needs of customers in a variety of industries. ITW has 825
decentralized business units in 57 countries and collectively holds over 19,000 global patents and patent
applications. The business units are categorized into eight reported segments and are routinely assessed
by industry-specific benchmarks and company operating principles.
Originally, the company produced and sold metal cutting products for America’s World War I. efforts.
Founded and currently based in Illinois, ITW has expanded and evolved over its history. In 1960, Illinois
Tool Works was listed on the New York Stock Exchange (NYSE) and it has displayed consistent
performance and continual innovation over its 100-year history. Acquisition activity is a fundamental
characteristic of the company’s strategy. In 2010, ITW acquired 24 companies in key industries and
influential markets. Notably, management demonstrates discipline and discernment when acquiring
business targets. At the time of this report, ITW is selling for $46.32 per share.
The Business
Illinois Tool Works uses a decentralized business model. A decentralized strategy allows business units
to be readily accessible and highly responsive to specific markets and consumers. Additionally, a
decentralized strategy enables ITW to overcome uncertainties in foreign markets. Strength in one market
helps to offset fluctuations in another. In general, products and services are manufactured and sold in the
same geographic location, which reduces foreign exchange rate risk. Revenues during fiscal year 2010
were geographically diversified. North America generated 48 percent of total revenue, while 52 percent
was generated internationally. Illinois Tool Works organizes its 825 business units into eight, externally
reported, segments: transportation, industrial packaging, power systems/electronics, food equipment,
construction products, polymers/fluids, decorative surfaces, and all other.
Transportation: transportation-related components, fasteners, fluids and polymers, as well as truck
remanufacturing and related parts and service
Major end markets: automotive OEM/tiers, automotive aftermarket
Industrial packaging: steel, plastic and paper products and equipment used for bundling, shipping, and
protecting goods in transit
Major end markets: general industrial, primary metals, food and beverage, construction
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ANALYST REPORT
Power systems and electronics: equipment and consumables associated with specialty power
conversion, metallurgy and electronics
Major end markets: general industrial, electronics, construction
Food equipment: commercial food equipment and related service
Major end markets: food institutional/restaurant, food service, food retail
Construction products: tools, fasteners, and other products for construction applications
Major end markets: residential construction, renovation construction, commercial construction
Polymers and fluids: adhesives, sealants, lubrication and cutting fluids, and hygiene products
Major end markets: general industrial, construction, MRO, automotive aftermarket
Decorative surfaces: decorative surfacing materials for furniture, office and retail space, countertops
and other applications
Major end markets: commercial construction, renovation construction, residential construction
All other: all other operating segments
Major end markets: general industrial, food and beverage, consumer durables, electronics
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company 7 December 2011
name
Month Day Year
ANALYST REPORT
Competitors
Illinois Tool Works encounters a wide variety of competitors that vary by product line, end market, and
geographic area. Many of the company’s business units operate in highly fragmented markets and
competitors range from specialized, regional companies to large domestic and foreign firms. In virtually
all segments, ITW competes on the basis of product innovation, product quality, brand preference,
delivery service and price(Illinois Tool Works, 2010).
Financials & Profitability
The industrial sector is categorized by stiff competition, which results in limited pricing power and
minimal profit margins. Within the industry, companies are often capital-intensive. Therefore, firms that
can generate the most revenue from their assets are often those with the best performing shares. In other
words, efficiency is central to success in the industrial materials industry. High asset utilization is
measured using total asset turnover (TATO) and fixed asset turnover (FATO). The table below details
several ratios gauging profitability and efficiency. While United Technologies (UTX) is not a direct
competitor of Illinois Tool Works, UTX is widely recognized as being one of the most efficient
operators in the industry. Honeywell International (HON) is a diversified manufacturer and a reasonable
comparison when considering its business strategy and total market capitalization.
ITW HON UTX
Market cap. 21.3 B 39.7 B 66.4 B
TATO 0.98 0.90 0.95
FATA 7.85 6.90 8.65
FCF/Sales % 11.85 % 9.26 % 8.34 %
ROE 17.45 % 25.46 % 22.23 %
ROIC 13.77 % 14.30 % 14.75 %
Operating margin 14.60 % 10.14 % 12.81 %
Net margin 9.96 % 6.88 % 7.76 %
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ANALYST REPORT
Overall, ITW displays strong fundamentals. The profitability and efficiency ratios listed above were
calculated by averaging financial data from annual reports spanning from fiscal year 2006 to 2010.
Illinois Tool Works has consistently generated free cash flow, ROEs above the (suggested) 10 percent
hurdle, solid operating margins, and steady earnings growth. Additionally, the company’s accounting is
conservatively stated. Cash flow regularly exceeds net income and Morningstar estimates suggest that
pretax book income and taxable income have tracked relatively closely throughout the last decade,
indicating a high quality of earnings(Landry, 2011). The table below displays several important ratios:
ITW (NYSE)
Market cap 21.3 B
Recent share price $ 47.51
52-week range 39.12 – 59.27
% Held by insiders 0.69 %
Forward P/E 10.6
P/B 2.1
PEG 0.80
D/E (market value) 0.22
Current ratio 2.02
β (average) 1.07
For the most part, these ratios portray ITW as a value investment. A PEG ratio of less than 1.0 and a low
forward P/E are common indicators of value stocks. While ITW exhibits a low PEG and forward P/E,
the P/B ratio is 2.1, which positions the equity slightly above an ideal P/B of less than 2.0. The market
value of D/E is approximately 22 percent, a relatively low percentage of ITW’s total equity, given the
industry.
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ANALYST REPORT
Economic Moat
There are two primary factors that contribute to ITW’s economic moat. The company has a unique
network effect that differentiates it from the competition. With 825 decentralized business units,
segments can quickly respond to market conditions, customer requests, and any obstacles it encounters.
Further, the range of expertise represented throughout the company enables innovation and expedient
solutions to customer problems. In other words, if a particular business unit doesn’t have the capability
to resolve an issue; it can redirect the matter to another unit, subsequently keeping revenue in the ITW
umbrella. ITW’s business units exemplify the depth and breadth of the company, an interconnected
system that is particularly difficult to replicate. Moreover, the company owns approximately 3,800
unexpired United States patents and 8,800 foreign patents pertaining to articles, methods, and machines.
A disciplined implementation of business processes is another key element to ITW’s economic moat.
ITW’s guiding principles include: decentralization, 80/20 concept, and innovation. The company uses
the 80/20 principle in an overarching fashion. The concept underlying this principle is that 20 percent of
the items account for 80 percent of the value. ITW uses this rule continuously and applies the concept to
both existing and acquired businesses. The uniform application of the 80/20 concept compels the
company to simplify and focus on the most important elements. This concept effectively reduces the
perceived complexity of any one task, unit, or product. Uses of the 80/20 rule include:
Simplifying product lines
Segmenting the consumer base
Choosing the supplier base
Designing business processes, systems, and measurements
Management
Management at ITW has an average tenure of 20 years of company service. In 2005, David Speer
became ITWs’ fifth CEO since the firm went public in the early 1960s (Landry, 2011). Speer is a 32-
year company veteran, a profile that the majority of senior managers at ITW share. Annual bonuses,
sound governance policies, and a lean management structure are characteristic of the company and all
are expected to be sustained over time.
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ANALYST REPORT
Valuation
By incorporating estimates from Value Line, Bloomberg, and Morningstar, I processed a conservative
valuation of ITW’s stock price. Value Line estimated the company’s beta at 0.95. I averaged the betas
from a number of sources and employed a beta of 1.07 when valuing the equity. Additionally, I changed
the EPS value to reflect the recent, lowered consensus. The P/E ratio and various growth rates were also
conservatively adjusted. At the time of the stock pitch, ITW was trading at $42.58 per share. As
previously stated, the stock is currently trading at $46.32 per share. The table below reflects the current
stock price.
Valuation: ITW
Source Target Price Margin of Safety
Bloomberg $ 53.40 13.3 %
Yahoo! Finance 54.00 14.2 %
Morningstar 55.00 15.8 %
Emily Barr 57.80 19.9 %
Prior to the share price uptrend, the average margin of safety (taken from the sources above) was 20.4
percent.
Sources
Illinois Tool Works 10-K Value Line
Bloomberg ITW.com
Fidelity Yahoo! Finance
Morningstar The Five Rules for Successful Stock Investing by Pat Dorsey
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