Enterprise Initiatives Will Still Propel ITW's Margin Trajectory

Senior Equity Analyst

Joshua Aguilar

Revenue segments as reported by the company.

Automotive OEM

Food Equipment

Test & Measurement and Electronics

Welding

Polymers & Fluids

Construction Products

Specialty Products

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We view Illinois Tool Works as a well-run collection of moaty businesses. The company focuses on niche markets, with most of its activities centered on resolving its most valuable customers’ pain points. ITW’s products and services are designed to reduce customers’ costs, either through ease of use, which cuts down on training costs, ensuring compliance with environmental and safety standards through quality products, or eliminating steps in a manufacturing process or parts in an assembly.

Unlike its competitors, ITW's innovation efforts are incremental, often adding small but effective twists to its product lines, allowing it to spend far less on research and development. Further, a number of patents and trade secrets protect its intellectual property. These factors allow the company to charge a premium relative to competitors’ products, which we believe will contribute to our expected 2023 GAAP operating margins of about 25%.

We think the operating margin expansion story will continue, particularly as ITW continues narrowing its focus on its most important customers and simplifying its product line by eliminating stock-keeping units. We model an over-300-basis-point improvement in GAAP operating margins from 2022 levels by 2027, to over 27%. We also believe ITW’s continued focus on the markets it knows best will help generate positive organic growth. ITW’s end markets have several attractive long-term secular trends, including the advent of lightweight electric vehicles, growing food health and safety regulations, increased demand for energy-efficient products, an increasing shortage of skilled labor in the United States, and increased urbanization and infrastructure development in emerging economies. 

We think ITW’s emphasis on customer-backed innovation should allow it to continue gaining decent market share from competitors, particularly on the strength of its differentiated offerings. While some competitors may exhibit faster growth characteristics, we like ITW’s focus on predictable, high-quality growth and its unwillingness to compromise its strategy for the latest trend.

Business Strategy & Outlook

We assign Illinois Tool Works a narrow moat. While it’s admittedly hard to separate out its sources of competitive advantage from its proven 80/20 operating model, none of the firm’s segments has fallen below its cost of capital in recent history, even as they mostly operate in vastly different end markets. We surmise that this consistent level of outperformance would be difficult without some inherent moat sources. We think ITW’s primary moat sources include switching costs, followed by some intangible assets and, to a lower extent, scale-based cost advantage. 

We think the firm’s automotive OEM segment, which mostly produces plastic and metal components and fasteners, garners a narrow moat. ITW is a niche supplier of these components. These components are highly engineered and help solve customer pain points like vibration or safety standards, which we think contributes to the segment’s switching costs. For example, ITW Drawform, one of its stamping brands, uses a process known as progressive stamping when customers require high volumes of asymmetrical parts along with unique features, like brake calipers. This process, moreover, also allows customers to keep their production costs low. However, progressive stamping is a complex process that requires precision so that the metal aligns within a few thousandths of an inch as each movement takes place. 

With the advent of autonomous vehicles, an increasing focus on lighter-weight vehicles, as well as increased connectivity options, we expect vehicle order complexity will increase over time. We think these trends should reinforce the segment’s switching costs, particularly amid shrinking engineering resources at automotive OEMs amid cost pressures. Smaller, more fuel-efficient engines, for example, generate more noise and vibration. We posit that few vendors at scale can consistently meet high customer demand for automotive components made of lightweight composite materials while still meeting regulatory safety standards. Traditional rubber-only isolators used by competitors, for example, work poorly on fuel-efficient engines, as they experience premature fatigue. One patent-protected solution ITW developed was its WaveShear isolation spring, a hybrid rubber-metal design that effectively damps sound and lowers vibration across a wider temperature range. 

Currently, ITW estimates that the total addressable market of differentiated component content is about $230 per vehicle, as opposed to the $15,000 total bill of material for an OEM. The firm’s current content is nearly $31 of the $230 available content, or over 13% market share. We think the firm has successfully introduced its components and significantly increased their vehicle presence based on valuable intangible assets, including: long-term auto OEM relationships, a long track record of success, and deep technical expertise like injection molding or design drawing. Unlike competitors, ITW generally takes existing applications and innovates them, which also affords its products appreciable patent protection. In injection molding, for example, ITW has developed a cartridge piston that dispenses multipart fluids. Sealing certain adhesive cartridges can be very difficult, like with certain types of cement. Fluids can be very fine in nature and seep between a seal and cartridge wall. Previous piston iterations with these types of seals were cost-prohibitive. Incremental innovation as with this injection molding process saves ITW massive amounts of R&D it would otherwise have to spend to stay competitive. For the overall firm, ITW estimates that half of its revenue is covered by patents or trade secrets. 

Based on scuttlebutt we’ve received from a former competitor, the fastener business is often unattractive from a working capital perspective. Specifically, a customer can cancel orders during an economic slowdown, even if a vendor has produced the inventory. Even so, we calculate that the automotive OEM business has averaged strong returns on capital in the 30s and remained at similar levels through the industrial recession or periods of negatives sales growth, which we think speaks to the strength of its differentiated, niche strategy.

We think ITW’s food equipment segment also merits a narrow moat. End markets range from restaurants and hotels to hospitals and universities. Market share across all these end markets ranges from 20% to 30%. Even though we estimate segment-level ROICs, including goodwill, have been more volatile than some of its other segments, they’ve still safely exceeded their cost of capital. ITW’s brands by reputation make some of the best food equipment in the industry, like its Vulcan brand’s salamander broiler. Salamander broilers’ heat capabilities far exceed those of conventional ovens, so they’re more efficient, but they also allow for more broiling precision. Encouragingly, primary cooking equipment like broilers are consistently where operators allocate a plurality of their operating budget, and we expect this to continue.

Foodservice Equipment & Supplies, a well-known-trade magazine, awarded Vulcan’s charbroilers “best in class” for multiple consecutive years. Factors for these awards include product quality, value, design and aesthetics, service and support, sales representation, inventory and availability, and information availability. Importantly, FE&S bestows these awards from surveys sent to food-service operators, dealers, and consultants based on the factors that they consider most important. Vulcan’s products, in turn, are generally priced at a premium relative to the market. 

Even though many of ITW’s food equipment products have premium pricing, they also lower customers’ total cost of ownership, which we think evidences switching costs. For example, while ITW’s Hobart dishwashers are also ranked “best in class,” they also save on energy, water, and labor savings. While the upfront cost for a Hobart dishwasher may be more expensive than hiring several human dishwashers, a Hobart dishwasher can wash a rack of dishes in three minutes compared with the one and a half to two hours it would take on a household appliance, or dry a rack of dishes in one minute compared with the 30-40 minutes it would take in a domestic dishwasher. Other models, like under-counter dishwashers, occupy less space, which is an important consideration in restaurants. Even so, an appreciable portion of quick-service restaurants and retail chains are still using hand-washing, suggesting a larger runway for growth. 

Finally, the food and hospitality industry also faces stringent food safety standards and increasing regulation enforcement, a major pain point. For example, food slicers are one of the first places examined by health inspectors. About 80% of listeria cases can be traced back to a slicer that’s not cleaned properly. Hobart has the only heavy-duty slicer that can be completely broken down for deep cleaning by using a knife removal tool. Features like these, in our opinion, create a stickier equipment product, because they ensure food safety compliance. 

As for its test/measurement and electronics segment, which serves a variety of end markets, we also believe it merits a narrow economic moat rating. We think a reputation for service and reliability is important in this segment. The segment’s brand Instron’s salesforce, which performs material testing, has exceptionally high levels of expertise. Given its consultative sales process, we think it’s important that over 50% of its employees have engineering backgrounds or come from technical fields. Capital equipment represents a majority of Instron’s sales, and this large installed base of equipment has sensors that require proper calibration, for example. Instron has a net promoter score of 70, comparable to Apple and Amazon. We believe this evidences its brand’s stickiness.

We think switching costs, furthermore, are evident in Instron’s higher-margin service and parts revenue, which constitute about 37% of 2018 sales. Switching costs exist, given the importance of customers ensuring quality control and product safety in their respective businesses, either to preserve brand integrity (beverage industry) or an inherent high cost of failure (aerospace). Instron’s machines, for example, test an epinephrine injection device’s force of travel when in use. These tests have potential life or death implications given the need to deliver the allergy drug expeditiously. Trends toward increasing regulation, moreover, only serve to reinforce these switching costs in our view. Examples of explicit and quantifiable switching costs include training costs ITW helps its customers save. Incremental and proprietary innovation driving down training costs includes simple-to-use mounted digital touchpads to both operate testing machinery and provide remote technical support. 

We think the welding segment earns a narrow moat rating. On average, we estimate that welding is the firm’s highest-return business, with ROICs in the 50s, as well as being ITW's highest-margin business for several years, which we expect will continue over the length of our explicit forecast. Given its focus on the most differentiated portions of the market, the segment also has one of the firm’s strongest patent portfolios, with more than 3,800 granted or pending in total for ITW. We suspect it’s also the segment with the largest proportion of sales protected by intellectual property, alongside specialty products. Other intangible assets here include trusted brands commanding premium pricing, as well as high-quality channel relationships, as in ITW’s other segments. 

From our understanding, moreover, ITW’s welding tools are uniquely set up for ease of use, reducing training costs related to learning more complex pieces of equipment. A survey of third-party review sites confirms that welding machines like the Hobart Handler 140 are some of the best metal inert gas welding machines for welding beginners. These machines are versatile and suitable for multiple applications, like working on an automobile chassis, household repairs, or heavier farm projects. On Hobart’s direct website, 98% of respondents claim they would recommend this specific product to a friend. Finally, we think ongoing shortages of skilled labor and integrating data analytics in welding products reinforce these switching costs. 

We give polymers and fluids a narrow moat rating, based on intangible assets and switching costs. Intangible assets include strong brands like Densit, Devcon, and Plexus, as well as strong channel relationships. Densit, for example, sells widely used grout in several industries, including wind, marine, and oil and gas, among others. The Ducorit grout Densit sells is pumpable, exhibits extremely high bond strength, is erosion-resistant, and doesn’t mix with seawater, all which eliminate the risk of downtime. The solution outlasts the useful life of an offshore wind turbine, for example (over two decades), and can be applied at low temperatures as low as 1 degree Celsius. 

Switching costs exist given customers’ reduced costs. Like ITW’s other segments, its polymers and fluids segment’s products eliminate steps in customers’ manufacturing process, reduce the number of parts in an assembly, or improve the quality of assembled finished goods. These are turnkey solutions, where ITW’s experts oversee the application process and are carried out according to quality-control guidelines. Take the example of a slag dryer, used for drying materials with a certain humidity or granularity for grinding of ores, building materials, metallurgy, and chemicals. Severe wear from extreme temperature fluctuations and abrasion, however, can accelerate the need for a dryer shell’s replacement. However, both epoxy and steel, from our understanding, are poor solutions to this problem, lasting at most up to one year. That said, replacing an early defective shell is expensive. ITW’s Densit team lined a dryer with a solution and improved the life expectancy by four to eight years.

We assign ITW’s construction products segment a narrow moat rating. The construction segment mostly targets the engineering fastening system niche of the global construction industry. We estimate returns on invested capital have typically averaged in the 30s.. Intangible assets here include well-regarded brands like Paslode and Ramset, strong channel relationships (Home Depot or Lowe’s, for example), and a rich patent portfolio. Its cordless nail gun, for example, has more than 100 patents associated with its product. Relatedly, incremental innovation efforts focus on differentiated cordless technologies. Using a historical example, Ramset sells a cordless concrete tool powered by self-contained natural gas that was derived from its Paslode wood-fastening tools. 

Switching costs exist here due to customer pain points, as well as strict building codes related to seismic or energy-efficiency requirements. Some of the elements seen in other segments are also in play here, including a shortage of skilled labor. The ease of use of these products saves valuable time and in turn, means contractors are willing to pay a premium for them. For example, according to a survey of various third-party reviews, weight is a big factor when choosing a nail gun. These machines can weigh up to 10 pounds, making it very difficult framing anything overhead for any length of time. The Paslode 902400 specifically weighs less than five pounds without sacrificing performance—it doesn’t freeze, overheat, and has replaced multiple compressor-driven nail guns on construction sites across the United States. The most comparable nail guns in terms of performance (specifically, 1,200 nails per fuel rod), however, weigh about 3 pounds more. Generally, Paslode makes some of the lightest cordless models on the market. Some models, from our understanding, require Paslode-only nails, making it a little more difficult to swap out with competitors’ models. In Paslode’s other nail gun models, loading nails is very user-friendly, with a quick and easy-to-open magazine latch.

Finally, we think ITW’s specialty products segment also merits a narrow moat rating. This segment serves a smorgasbord of end markets, including the food and beverage, consumer durables, general industrial and industrial capital goods (air transport industry), printing and publishing, and medical devices industries, among others. We think commonalities, however, include its strong intangible assets, with a significant proportion of revenue stemming from substantial patent protection, as well as strong customer relationships, particularly with the food and beverage industry. Specialty products has an ITW-leading 3,722 granted and pending patents. ITW also has some strong brands in Hi-Cone and Zip-Pak. 

Hi-Cone, for example, was created by ITW organically in the early 1960s, operating for over 50 consecutive years. Hi-Cone both manufactures multipack ring carriers, as well as the equipment and parts that creates these products. Most of Hi-Cone’s customers have been with the business since its infancy and value its ability to use the minimum amount of material that still highlights the brand, as well as deliver product with minimal lead times. Hi-Cone’s machines can produce up to 2,400 cans or 1,500 bottles per minute. Hi-Cone also allows customers to differentiate their can packaging between channels , while minimizing additional costs. Segment operating margins, moreover, are nearly 2.5 times that of comparable peers, which we partially attribute to economies of scale, giving ITW cost advantage in Hi-Cone’s business. While ITW’s product line simplification is an operating tactic, we believe Hi-Cone’s focus on a specific niche of the market allows it to generate a higher volume of orders relative to competitors, as with Hi-Cone’s emphasis on small multipacks ranging from four to 12 containers. We believe this provides this business with favorable unit economics.

In our view, switching costs are also evident here. There are several pain points associated with a packaging operation. For example, traditional packaging requires line changeovers every eight to 15 minutes. However, as with many other industries, skilled labor shortages remain a problem. This places significant pressure on customer margins. Patented packaging technology (what Hi-Cone calls Fanfold), however, allows for continuous production of up to 10 hours. Other reasons switching costs exist are environmental regulations. Industry players have traditionally poorly managed waste from plastic packaging. Hi-Cone introduced nontoxic, photodegradable material in all its carriers, which in ultraviolet sunlight, easily breaks apart and eliminates entanglement risks. We estimate returns on invested capital in this segment have averaged in the 30s.

Narrow

Economic Moat

Illinois Tool Works

Illinois Tool Works, Inc. engages in the manufacture of industrial products and equipment. It operates through the following segments: Automotive OEM, Test & Measurement and Electronics, Food Equipment, Polymers & Fluids, Welding, Construction Products, and Specialty Products. The Automotive OEM segment produces components and fasteners for automotive-related applications. The Test & Measurement and Electronics segment manufactures equipment, consumables, and related software for testing and measuring of materials, structures, gases and fluids. The Food Equipment segment supplies commercial food equipment and provides related services. The Polymers & Fluids segment provides adhesives, sealants, lubrication and cutting fluids, janitorial and hygiene products, and fluids and polymers for auto aftermarket maintenance and appearance. The Welding segment furnishes arc welding equipment, consumables and accessories for a wide array of industrial and commercial applications. The Construction Products segment makes construction fastening systems and truss products. The Specialty Products segment manufactures beverage packaging equipment and consumables, product coding and marking equipment and consumables, and appliance components and fasteners. The company was founded by Byron L. Smith in 1912 and is headquartered in Glenview, IL.

Earnings data Q4 2023

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Illinois Tool Works, Inc. engages in the manufacture of industrial products and equipment. It operates through the following segments: Automotive OEM, Test and Measurement and Electronics, Food Equipment, Polymers and Fluids, Welding, Construction Products, and Specialty Products. The Automotive OEM segment produces components and fasteners for automotive-related applications. The Test and Measurement and Electronics segment manufactures equipment, consumables, and related software for testing and measuring of materials, structures, gases and fluids. The Food Equipment segment supplies commercial food equipment and provides related services. The Polymers and Fluids segment provides adhesives, sealants, lubrication and cutting fluids, janitorial and hygiene products, and fluids and polymers for auto aftermarket maintenance and appearance. The Welding segment furnishes arc welding equipment, consumables and accessories for a wide array of industrial and commercial applications. The Construction Products segment makes construction fastening systems and truss products. The Specialty Products segment manufactures beverage packaging equipment and consumables, product coding and marking equipment and consumables, and appliance components and fasteners. The company was founded by Byron L. Smith in 1912 and is headquartered in Glenview, IL.

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