Like many conglomerates, ITW’s massive sales base contains good and bad businesses. As seen below, management has pointed out that about 45% of the company’s total revenue is healthy and expected to report organic sales growth of 6% in 2015. However, 40% of sales are not yet ready for sustainable, profitable organic growth and need some help.
Source: ITW Investor Presentation
ITW’s reported revenue has declined over the last three years as a result of the company’s portfolio management activities. From 2013-2014, ITW divested 32 businesses that generated $4.9 billion of revenue because they were operating in commoditized markets where profitable growth was harder to come by.
From 2014-2016, the company expects to exit an additional $350 million of revenue by exiting commoditized product lines to allow its divisions to focus on more profitable opportunities.
While sales have declined as a result of these moves, ITW’s profitability has soared. As seen below, the company’s operating margin and return on invested capital both increased over 500 basis points compared to 2012.
Source: ITW Investor Presentation
With profitability measures nearing their 2017 goals, more attention will turn to management’s objective to have a majority of revenues ready to grow by the end of 2016. The company hopes to achieve organic sales growth at least 2% higher than global GDP going forward while maintaining excellent profitability and delivering 12-14% annual shareholder returns (dividend yield plus earnings growth).
We confess that sluggish global growth trends, particularly within ITW’s industrial-facing businesses, could challenge the company’s abilities to hit its 2017 targets – lower sales growth would likely mean less operating leverage, and most of the low-hanging fruit from portfolio management activities has already been picked.
With that said, ITW’s operations would still be generating very strong 20%+ returns on capital, providing plenty of opportunity to compound earnings and the dividend.
The business earns high returns largely because management has (for the most part) successfully identified differentiated products in favorable markets with long-term growth opportunities. The company’s decentralized structure allows its business divisions to continue operating like small businesses, but with the full backing of ITW’s resources and financial benefits.
Over time, Illinois Tool Works Inc. (NYSE:ITW) has built up a portfolio of nearly 20,000 patents and applies for roughly 1,500 patents per year. The company’s intellectual property further strengthens its competitive lock on the customer relationships it has and the differentiated products it sells.
ITW’s diverse product lines, end markets, and geographies also add to the company’s quality. When one market is weak, another is usually strong, smoothing out earnings and providing consistent free cash flow for the company to reinvest in the highest-returning businesses. It’s hard to see a future in which ITW no longer becomes relevant – it’s hands are in too many pots, most products are protected by patents and sold in slow-changing markets, and its decentralized operating structure helps its numerous businesses run more efficiently.
