Updated on December 6th, 2019 by Nate Parsh

At Sure Dividend, we often talk about the merits of the Dividend Aristocrats. We believe this exclusive group of stocks broadly have strong brands, consistent profits even during recessions, and durable competitive advantages. These qualities allow the Dividend Aristocrats to raise their dividends every year, regardless of the state of the economy.

Of the 500 stocks comprising the S&P 500 Index, just 57 qualify as Dividend Aristocrats.

Each year, we review all 57 Dividend Aristocrats. The next in the series is Illinois Tool Works (ITW). Illinois Tool Works is not just a Dividend Aristocrat, it is a Dividend King as well. The Dividend Kings are a smaller group of companies with 50+ consecutive years of dividend increases. You can see all 27 Dividend Kings here.

If the Dividend Aristocrats are among the best stocks in the market, then the Dividend Kings are even better for long-term dividend growth.

Business Overview

Illinois Tool Works has been in business for more than 100 years. It started out all the way back in 1902, when a financier named Byron Smith placed an ad in the Economist. At the time, Smith was looking to invest in a “high class business (manufacturing preferred) in or near Chicago.” A group of inventors approached Smith with an idea to improve gear grinding, and Illinois Tool Works was born.

Today, Illinois Tool Works has a market capitalization of $56 billion, and generates annual revenue of nearly $15 billion. Illinois Tool Works is composed of seven segments: Automotive, Food Equipment, Test & Measurement, Welding, Polymers & Fluids, Construction Products and Specialty Products.

These segments have performed very well against its peers.

Source: Investor Presentations

This has allowed Illinois Tool Works to achieve “best of breed” status in its industry.

Illinois Tool Works’ portfolio is concentrated in product segments that each hold growth potential of 2%+ above the average in their respective markets. The overarching strategic growth plan for Illinois Tool Works is to continuously reshape its business model, when necessary. The company frequently utilizes bolt-on acquisitions to expand its reach.

At the same time, it has conducted more than 30 divestments in commoditized, low-growth product lines. Illinois Tool Works routinely trims businesses and adds new ones, to maintain a growth trajectory over time.

Growth Prospects

Illinois Tool Works reported third quarter results on October 25th. For the third quarter, the company generated revenue of $3.48 billion, which was 3.7% less than the company’s revenues during the previous year’s quarter. This revenue decline was expected by the analyst community, though actual results were $70 million lower than consensus estimates. Currency exchange negatively impacted results by 1.8% and organic revenue was lower by 1.7%.

Despite the revenue decline, the company increased earnings-per-share 6% to $2.04, which was $0.09 above estimates. This was possible due to a combination of higher operating earnings (due to margin growth outpacing Illinois Tool Works’ revenue decline), a lower tax rate, and the positive impact that the company’s share repurchases had on its per-share performance.

Except for Polymers & Fluids, which had organic growth of 1%, each division within Illinois Tool Works saw declines versus the same quarter a year ago. Illinois Tool Works also reaffirmed guidance for the year.

Source: Investor Presentations

Illinois Tool Works guides for revenues of $14 billion to $14.2 billion, a 4.7% decrease from the previous year. On the other hand, earnings-per-share in a range of $7.55 to $7.85 during fiscal 2019, represents a projected increase of 1.3% from 2018 at the midpoint of guidance. The company expects $1.5 billion in share repurchases during the year, which will also help boost earnings-per-share growth.

Overall, we expect 6% annual EPS growth over the next five years, comprised mainly of revenue growth and share buybacks.

Competitive Advantages & Recession Performance

Illinois Tool Works has a significant competitive advantage. It possesses a wide economic “moat”, which refers to its ability to keep competition at bay. It does this with a massive intellectual property portfolio. Illinois Tool Works holds over 17,000 granted and pending patents.

Separately, another competitive advantage is Illinois Tool Works’ differentiated management strategy.

The company has employed a management process called “80/20”. This is an operating system that is applied to every business line at Illinois Tool Works. The company focuses on its largest and best opportunities (the “80”), and seeks to eliminate costs or divest its less profitable operations (the “20”).

At the same time, Illinois Tool Works has a decentralized, entrepreneurial corporate culture. This also sets the company apart from the competition. Illinois Tool Works empowers its various businesses with significant flexibility, to customize their own approaches to serving customers in the best way possible.

One potential downside of Illinois Tool Works’ business model, is that it is vulnerable to recessions. As an industrial manufacturer, Illinois Tool Works is reliant on a healthy global economy for growth.

Earnings-per-share performance during the Great Recession is below:

2007 earnings-per-share of $3.36

2008 earnings-per-share of $3.05 (9% decline)

2009 earnings-per-share of $1.93 (37% decline)

2010 earnings-per-share of $3.03 (57% increase)

That said, the company remained highly profitable during the Great Recession. This allowed it to continue increasing its dividend each year during the recession, even when earnings declined. And, thanks to its strong brand portfolio, the company recovered quickly. Earnings-per-share soared 57% in 2010. By 2011, earnings-per-share surpassed 2007 levels.

Valuation & Expected Returns

Using the current share price of $175 and the midpoint for earnings guidance of $7.70 for the year, Illinois Tool Works trades for a price-to-earnings ratio of 22.7. Given the company’s cyclical nature, we feel that a target price-to-earnings ratio of 17 is appropriate. This is slightly below the company’s historical average.

In the past 10 years, the stock held an average price-to-earnings ratio of 17.8. As a result, Illinois Tool Works is currently overvalued. Returning to our target price-to-earnings ratio by 2024 would reduce annual returns by 5.6% over this period of time. Aside from changes in the price-to-earnings multiple, future returns will be driven by earnings growth and dividends.

We expect 6% annual earnings growth over the next five years. In addition, Illinois Tool Works stock has a current dividend yield of 2.4%.

Total returns would consist of the following:

6% earnings growth

5.6% multiple reversion

2.4% dividend yield

Illinois Tool Works is expected to return just 2.8% per year through 2024.

Projected returns result in a hold recommendation on Illinois Tool Works, though the company’s ability to raise dividends through multiple recessions is impressive. The company now has 56 consecutive years of dividend growth after increasing its dividend 7% for the October 9th payment.

Final Thoughts

Illinois Tool Works is a high-quality company, and an even better dividend growth stock. It has a strategic growth plan that is working well, and shareholders have been rewarded with rising dividends for over 50 years.

The stock also has a decent yield, which could make it an appealing choice for long-term dividend growth investors. Shares are not attractively priced at the moment, and it is likely the company will struggle if and when a recession occurs.

Illinois Tool Works is a classic example of a great company, but not a stock to buy right now. Despite its status as a Dividend King, we suggest investors wait for a better entry point prior to purchasing shares of Illinois Tool Works.