Dividend Kings are an elite category of companies that have paid and increased their dividends for at least 50 years. It’s an honorable title. But not all Dividend Kings have what it takes to pay and grow their dividends over the next 50 years.
Illinois tool works (NYSE:ITW) stands out as one of the highest quality Dividend Kings. It’s the elite of the elite when it comes to growing payouts to investors. But shares of it have fallen year-to-date and have been sold off following its recent earnings report.
See why it stands out as a great stock to buy in August and keep for decades.
ITW’s recipe for success
Illinois Tool Works, commonly known as ITW, is an industrial conglomerate that owns dozens of brands serving a variety of end markets. It divides its business into seven segments: automotive original equipment manufacturing, construction products, food equipment, polymers and fluids, specialty products, test and measurement and electronics, and welding.
Products, equipment and accessories vary according to the end market. For example, commercial cooking and refrigeration equipment has nothing to do with gears for internal combustion engines and electric vehicle (EV) propulsion systems. By operating a diverse portfolio of products that vary in size and complexity, ITW is less vulnerable to cyclical downturns in a given end market or product category. The conglomerate model can also reduce redundancies and costs between segments and streamline a global supply chain and production process.
Poorly managed conglomerates may lack innovation. ITW, however, is a very well-run conglomerate. It prioritizes margin expansion over sales growth, which has led to rising profits, growing dividends, and consistent share repurchases.
ITW’s growth has slowed in recent years – culminating in a new guidance for stable organic growth in 2024. As a result, the share price is languishing at roughly the same price as three years ago.
Despite the weak top line, there are some positives worth highlighting. ITW just reported its highest Q2 operating margin ever and raised its full-year operating margin guidance to a range of 26.5% to 27% and $10.30 to $10.40 in earnings per share (EPS) for the full year. You would be hard-pressed to find a similarly sized specialty industrial machinery company with a comparable operating margin.
On the earnings call, management expressed confidence in its ability to continue to increase margins. ITW is open to acquisitions if they are suitable, but will not settle for anything less than top-tier quality.
In its May 2023 investor day presentation, ITW outlined its long-term goal of organic revenue growth of 4% to 7%, based on market and pricing growth of 1% to 2%, penetration growth 1% to 2% net market share and 2% to 3% customer support innovation, which is ITW’s term for meeting customer requests and then manufacturing products to meet those needs. In response to an analyst question on the earnings call, ITW said it was even more confident now than during its investor day presentation that it could achieve this long-term growth target.
Overall, ITW is going through a slow period, but nothing has changed in the core business or future plans. Operating margins are at impeccable levels and the company continues to manage capital well, with a return on capital employed well above historical levels – indicating that ITW is doing a good job managing debt and generating profits from capital.
A double capital return program
When an investing thesis hasn’t changed but a stock is out of favor, it’s usually a great buying opportunity. If ITW hits its 2024 guidance of $10.30 to $10.40 in earnings per share, it would have a price-to-earnings ratio of just 23.4, based on its recent share price. That’s a reasonable valuation for an excellent business.
ITW’s profits and cash flow can fund the company’s dividend and a sizable share repurchase program. ITW’s payout ratio is just 40%, which means that 40% of its profits go towards paying dividends. A payout rate from 50% to 75% would be considered healthy for a company of ITW’s caliber, so there is room to increase the dividend, even if profits remain stagnant.
Unlike many Dividend Kings with capital return programs focused almost entirely on dividends, ITW prefers a balanced approach to buybacks and dividends. In the first half of 2024, the company spent US$750 million on share repurchases and US$834 million on dividend payments.
Share buybacks can be a good way to increase EPS when organic growth is lagging, and ITW has the profitability needed to make that happen. While the company only yields 2.5% at recent prices, it’s worth understanding that it could yield about twice as much if it reallocated the funds used in buybacks to dividends.
ITW is worth buying and keeping
At first glance, ITW seems like a boring business that isn’t worth your hard-earned savings. Sales growth is not impressive and there is a limit to the margin expansion the company will be able to unlock from here. For context, it is approaching its 30% operating margin target for 2030. Eventually, EPS growth will have to come from somewhere other than improving profitability and buybacks.
The release of second quarter results was a vote of confidence that ITW understands what it is facing and what investors expect. It also validated management’s long-term outlook and how it won’t pull itself out of despair just to get a good quarter.
ITW has the necessary qualities to be a lifetime holding company. With an increasingly attractive valuation, the company stands out as one of the main Dividend Kings to buy in August.
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Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool recommends Illinois Tool Works. The motley fool has a disclosure policy.
Don’t be fooled by the drop – this dividend king is a buy in August was originally published by The Motley Fool
