Illinois Tool Works

Illinois Tool Works reported second-quarter organic sales growth of 4.5% year over year, and management raised full-year revenue and earnings per share guidance.

Why it matters: ITW is explicitly trying to kickstart its sales growth after a decade of internal efficiency initiatives that slowed it. ITW's strong volume growth this quarter was paired with record profitability on 40 basis points of operating margin expansion, showcasing its customer-backed product suite and “80/20" operating model. However, we believe results are primarily driven by improving demand in cyclical segments such as Welding (14% organic growth) and Test & Measurement (10%).

Bottom line: We expect to raise wide-moat ITW's $219 fair value estimate by a low-single-digit percentage. ITW historically trades at a premium multiple because investors trust management to outperform within mature industrial businesses. The most recent results strengthen that argument, but we don't view this as a structural step-change in ITW's growth profile. Our model already incorporates mid-single-digit sales growth that translates into high-single-digit EPS growth through moderate margin expansion. We would like to see more evidence on the execution front to give the firm more credit in our long-term forecasts, but we expect to raise near-term inputs.

We raise our fair value estimate for wide-moat ITW to $249 per share, from $219, to reflect our more bullish expectations for ITW's near- and long-term growth. We value ITW at approximately 22 times our 2026 adjusted earnings estimate.

Although we don’t buy that the company’s organic growth rate will experience a steep upwards inflection, over our explicit forecast we model ITW to grow its top-line in the mid-single digits on the heels of a number of short- and long-term demand trends. In the coming years, demand for ITW’s products could be bolstered by the uptick in construction in the coming years, we expect demand for ITW’s construction products to be bolstered by the uptick in construction activity within the US from infrastructure bills and the reshoring of supply chains. And, in the coming decades, we think ITW will be a beneficiary of the urbanization and industrialization of developing nations, rising global regulations driving efficiency and safety standards, and the growing use of electronics.

We believe mid-single-digit top-line growth can translate into high-single-digit EPS growth from margin expansion due to modest operating leverage and continued efficiency gains through leveraging its purchasing scale and refining its product portfolio. The firm has a number of maintainable operating characteristics contributing to the improvements in its margin and return profiles, namely its decentralized business model, Customer-Back Innovation framework, and 80/20 Front-To-Back Process. Management discloses that its direct interfacing with the customer has added a few points to organic growth each year. The company handily beats the vast majority of its peers in terms of quality, and we think it has set itself up for growth above that of its end markets. Even so, we model ITW’s long-term growth rate in the mid-single digits because it operates in a number of end markets with somewhat weak growth potential.

ITW had been laser-focused on eliminating low-returning businesses and product lines since 2012, and the firm’s returns on invested capital inclusive of goodwill have risen from the midteens to the high 20s as a result. Management recently shifted the firm's strategy back toward organic growth. Nevertheless, we think ITW can maintain returns in the high twenties, comfortably beating its cost of capital.

We assign Illinois Tool Works a Morningstar economic moat rating of wide, based on switching costs and intangible assets. ITW’s returns on invested capital have fallen below its cost of capital only once since the company’s IPO in 1978, and the firm even generated profits each year during the Great Depression. We are confident that ITW will continue to outperform its cost of capital over the next two decades, thanks to its strong understanding of customer needs and effective use of research and development.

We believe ITW’s automotive OEM segment carves a narrow economic moat rating through switching costs and intangible assets. We estimate the segment generates returns on invested capital in the high teens, greater than each of its public automotive component peers Lear, Aptiv, and BorgWarner. We believe it can comfortably outearn its cost of capital over the next decade, but we are hesitant to assign the segment a wide economic moat rating because it is capital intensive and cyclical.

Switching costs for ITW’s vehicle components include the lead time and expense of designing and testing the vehicle with a new supplier. ITW also benefits from long-term auto OEM relationships and deep technical expertise formed by working closely with such customers for numerous decades.

We think ITW’s food equipment segment merits a wide economic moat rating carved through intangible assets and switching costs. We estimate that the segment has generated returns on invested capital averaging in the low 40s over the last decade, handily beating Middleby, Electrolux Professional, and John Bean Technologies, its closest public peers.

The segment boasts some of the strongest brands within the commercial food industry. Many were founded over a century ago, like Hobart, founded in 1917, and Vulcan, founded in 1865. Foodservice Equipment & Supplies, a well-known-trade magazine, awarded Vulcan’s broilers “best in class” for multiple consecutive years. Factors for these awards include product quality, value, design and aesthetics, service and support, and inventory availability. Vulcan’s products, in turn, are generally priced at a premium relative to the market.

ITW’s food equipment segment has a substantial servicing business, representing around 30% of segment sales, which we believe illustrates the segment’s switching costs. Commercial kitchen equipment has high upfront costs and long useful lives. Once a piece of equipment is installed, we think it makes little sense to purchase a replacement.

We assign ITW’s test & measurement and electronics segment a wide economic moat rating based on switching costs and intangible assets. The segment generates high-teens returns on capital, outearning close peers like Ametek, Fortive, and MKS Instruments.

We think time-tested performance and brand strength are deciding factors for customers in this segment because of the high cost of failure associated with the functions ITW’s equipment performs. ITW owns a number of market-leading brands such as Instron material testing, Texwipe contamination control, and Brooks flow control equipment. We don’t think it makes financial sense to switch equipment that is specified into complex, highly regulated customer operations.

ITW’s welding segment merits a wide economic moat rating stemming from intangible assets and switching costs. We estimate the segment generates ROICs in the low 50s and margins over 1,000 basis points higher than those of peers ESAB and Lincoln Electric.

ITW’s flagship brand, Miller, was founded in 1929 and operates in an oligopoly with ESAB and Lincoln Electric. Brand preference is quite prominent within the welding industry; US welders tend to form a strong preference for either Miller or Lincoln, referring to them as “Blue” and “Red,” respectively. We also think there are switching costs that stem from the specific training required to use branded welding equipment and consumables.

We assign ITW’s polymers & fluids segment a narrow economic moat rating carved through intangible assets. The segment generates high-teens returns on invested capital, greater than those of its close peers 3M, DuPont, and Chemours. ITW owns a number of strong brands such as Rain-X repellants, Devcon industrial adhesives, and Permatex auto repair products.

We assign ITW’s construction products segment a wide economic moat rating primarily carved through intangible assets and switching costs. The segment targets the fastening niche of the global construction industry. We estimate returns on invested capital have averaged in the high 20s over the last few decades.

Strong brands such as Paslode cordless nail guns, Tapcon concrete anchors, and Buildex self-drilling screws were created to ease the construction process and comply with strict building codes. We think these brands’ time-tested performance over many decades has created substantial pricing power; the segment boasts the highest margins out of its peer group. We believe substantial intellectual property backs much of ITW products’ technical superiority.

Switching costs are present in the form of the training required for contractors to become adept at efficiently using ITW-branded equipment. Time on site is costly and saving a few seconds per hole drilled can add up over the course of a project.

We believe ITW’s final segment, specialty products, merits a wide economic moat rating based on switching costs and intangible assets. This segment serves the food and beverage, air transport, packaging, and medical device industries and has produced mid-20s ROICs over the last decade, which we think stems from its phenomenal margin profile, tripling that of its closest peers in Ball Corporation, Amcor, and Berry Global.

We think switching costs are present in ITW’s hot melt, packaging, HVAC, and aircraft support equipment. Much of this equipment is specified into the operations of customers and generates MRO revenue over decades.

ITW’s long-term incentive plan is based partially on the company’s return on invested capital, a metric we think encourages management to grow the business responsibly and efficiently.

ITW’s entrepreneurial culture permeates the firm and would take considerable effort for a competitor to replicate. ITW focuses heavily on internal promotions as learning the ins and outs of its operating framework takes considerable training.

The firm has sold off many low-growth, low-returning businesses in the last decade, positioning itself to experience growth above its historical norm.

ITW’s growth profile has not meaningfully improved from a decade ago, a period during which ITW’s organic top line grew below GDP.

ITW’s hyperfocus on margins and returns on invested capital have hampered the company’s spending for growth. Some returns have to be sacrificed in the short term to grow the business, otherwise the business risks lagging behind competitors.

ITW still has too many business units even after a decade of divestitures. Operating disparate businesses can hide the growth of its stronger units.