More Growth and Income for the Taking

Last week I let you in on the secret of a great American company, building an iconic brand, whose stock should be a bedrock investment for your portfolio.

This week I've found another company, larger than its Indiana neighbor, that has the same characteristics I find admirable and investable: solid earnings and balance sheet, steady growth, the ability to react to changing markets under seasoned management, and right now, a reasonable, if not underappreciated, valuation.

Most importantly, this company is poised to continue a tradition of generating steady profits and income to our portfolios, and like the products it manufactures, this is a stock built to last.

It's a company we should jump on right now to benefit for the long term. Indeed, when people talk about a manufacturing revival occurring in the United States, they are talking about companies like this one...

Let me introduce you to this old-fashioned American manufacturer with very modern returns...

Outstanding Value with Downside Protection

Like Thor Industries, Inc. (NYSE: THO) stock which we discussed last week, Illinois Tool Works, Inc. (NYSE: ITW) is an old-fashioned, iconic American manufacturer.

ITW is a diversified manufacturer of value-added equipment such as automotive fasteners, test and measurement equipment, food equipment, polymers and fluids, welding equipment, construction products, and packaging equipment.

ITW is much larger than its Indiana neighbor, Thor, however. Its market cap sits at $36 billion.

In 2014, the company generated more than $14 billion revenue, operating income of more than $2.5 billion, and net income of $4.57 to $4.65 per share (it had earned $3.49 per fully diluted share through 9 months compared to $2.70 per fully diluted shares a year earlier).

Earnings per share (EPS) jumped 27% in 2014 and is expected to come in at $4.57 to $4.65 per share, which gives the company a healthy 20x PE. While such a PE is above the market multiple, it is consistent with the company's growth rate. In 2014, ITW stock moved in line with the S&P 500 and rose by 12.8% to close at $94.70 per share.

Management has maintained growth while limiting downside economic and sector risks. Fortunately, ITW has limited exposure to energy markets in a time when those markets are likely to remain volatile.

ITW is a market leader in each of its business sectors and focuses on organic growth and margin expansion while making opportunistic acquisitions when they add value.

There's even more to the ITW success story...

The True Value in a Company Like ITW

Free cash flow is the most important indicator of a company's earnings power and financial health. It is also the most difficult number for a company to fudge and is the one number I always look at to determine how a company is really doing.

By that standard, ITW is doing extremely well. ITW generated free cash flow of $2.16 billion in 2013 and $1.92 billion in 2014 and is expected to generate $2.4 billion of free cash flow in 2015, according to analysts at Barclays.

The key to the company's success is its management's proven ability to improve margins.  Operating margins at the company are targeted to move above 20% in 2015, which is extremely impressive for a company with the size and diversity of ITW, and a credit to management's ability to empower the leaders of its various divisions to run their businesses effectively.

ITW has been very aggressive in providing added value to investors by using borrowed money to finance stock buybacks. But unlike many others, ITW still maintains a strong balance sheet.

Over the last two years the company was much more aggressive in borrowing money to finance a big stock buyback program. Over the past year alone, long-term debt increased from $2.8 billion at December 31, 2013 to $6.0 billion at September 30, 2014, causing its total debt to total capitalization ratio to increase from an extremely conservative 26.1% in 2009 to a more moderate 39.5% in 2013.

All of this debt was incurred to finance the purchase of $4.0 billion of stock in 2014.

ITW bought back 18.5 million shares at an average price of $80.94 per share in the first quarter of 2014 ($1.5 billion), 17.2 million shares at an average price of $86.01 per share in the second quarter of 2014 ($1.5 billion), and 5.8 million shares at an average price of $85.35 per share in the third quarter of 2014 ($495 million).

ITW purchased another $500 million of shares in the fourth quarter, bringing the total for the year to the aforementioned $4 billion.

For fiscal 2015, ITW is targeting $1.5 billion of buybacks, which it can easily handle with its current balance sheet and cash flow. The stock is currently trading well above the prices at which the company repurchased these shares, but with the stock trading at 20x earnings the buybacks will likely taper off.

For shareholders looking for an additional reason to buy shares in this American manufacturer, the deep cash flows and still-solid balance sheet provide a value-added kicker that bumps up our profits and yields...

ITW "Quietly" Delivers Consistent Double-Digit Returns

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Over the last five years, the company has increased its dividend from $1.25 in 2009 to $1.60 in 2013, in line with earnings.  The dividend should continue to grow at a healthy pace along with earnings over the next couple of years.

Of course, investors have come to expect increases from this "dividend aristocrat," which has raised its dividend annually since 1964.

ITW has provided EPS guidance for 2015 of $5.15 to $5.35, up 12% to 16% from 2014. This is based on a combination of organic growth and margin improvement.  It also takes into account a $0.15 per share hit from the stronger dollar.

ITW enjoys two strong advantages heading into 2015: limited exposure to dollar weakness and limited exposure to energy markets. This should allow the stock to outperform the S&P 500 in 2015. That may prove cold comfort if the S&P 500 drops in 2015 as I expect it to do, but over the longer haul, ITW should produce stellar returns as management continues to deliver.

ITW is a stock for the long run, and should be a core long-term holding for investors.

About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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