While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during recessionary conditions help give us a better sense of a dividend’s safety, the balance sheet is an extremely important indicator as well.
Companies with high amounts of debt, cyclical business operations, and inconsistent cash flow generation could find themselves in a cash crunch if demand unexpectedly weakens and they have overextended themselves. They will always cut the dividend before missing a debt payment, so monitoring cash and debt levels is important.
ITW’s balance sheet is in reasonably good shape. As seen below, the company has $7.8 billion in debt compared to $3 billion in cash on hand, but its net debt / EBIT ratio is a modest 1.7x. This means that ITW’s net debt could be covered with about 1.7 years of EBIT, which seems quite reasonable for a business with such consistent cash flow generation.
Source: Simply Safe Dividends
Overall, ITW appears to be an extremely secure source of income and is one of our favorite blue chip dividend stocks.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
ITW’s Growth Score is 70, meaning its dividend’s growth potential ranks much higher than most other dividend stocks. ITW’s relatively low payout ratios, consistent cash flow generation, and diversified growth opportunities support the rating. The company has also increased its dividend for 52 consecutive years, easily securing its spot on the dividend aristocrats list.
As seen below, ITW’s dividend has compounded by 13% per year over the last decade and by 5% per year over the last five years. ITW raised its dividend by 13% in the third quarter of 2015, and the company expects earnings per share to grow by 10-12% per year looking beyond 2016. If management hits the company’s objectives, the dividend seems likely to continue growing at a similar pace (8-12% per year).
Source: Simply Safe Dividends
Valuation
Excluding the impact of foreign currency exchange rates, ITW trades at about 16.5x forward earnings guidance and has a dividend yield of 2.4%. The company’s earnings are expected to grow by 7% next year (10% excluding foreign currency headwinds) and 10-12% per year beyond 2016. The stock’s multiple seems reasonable here for a high quality industrial business, especially if the company executes on its organic sales growth goal (2% faster than global GDP).
If ITW can deliver high single-digit earnings growth, the stock could deliver annual total returns of 10-12%. You should never blindly accept management’s guidance, but ITW has established a goal of delivering 12-14% annual total returns, assuming global growth doesn’t slow. Regardless, double-digit annual return potential doesn’t sound too bad in today’s market.
Conclusion
Illinois Tool Works Inc. (NYSE:ITW) looks like a reasonable candidate for long-term dividend growth investors to consider. The company has some sensitivity to industrial markets, many of which are currently weak, but its consumer-facing businesses (around 60% of total sales) and consumables sales help provide cash flow stability. ITW’s decentralized management structure and sales diversification by end market and geography will also help the company remain a force for years to come.
The dividend is in excellent shape and appears to offer 8-12% annual growth going forward. While ITW’s 2.4% dividend yield isn’t enough for investors living off dividends in retirement, the stock’s double-digit annual total return potential is attractive in today’s market environment.
Disclosure: None
