The Company

Illinois Tool Works (ITW) is a diversified manufacturer that operates on a global scale. The company designs and manufactures a large portfolio of engineered and specialty products, with emphasis on value-added products that meet the needs of customers in a variety of industries. ITW has 825 decentralized business units in 57 countries and collectively holds over 19,000 global patents and patent applications. The business units are categorized into eight reported segments and are routinely assessed by industry-specific benchmarks and company operating principles.

Originally, the company produced and sold metal cutting products for America’s World War I. efforts. Founded and currently based in Illinois, ITW has expanded and evolved over its history. In 1960, Illinois Tool Works was listed on the New York Stock Exchange (NYSE) and it has displayed consistent performance and continual innovation over its 100-year history. Acquisition activity is a fundamental characteristic of the company’s strategy. In 2010, ITW acquired 24 companies in key industries and influential markets. Notably, management demonstrates discipline and discernment when acquiring business targets. At the time of this report, ITW is selling for $46.32 per share.

The Business

Illinois Tool Works uses a decentralized business model. A decentralized strategy allows business units to be readily accessible and highly responsive to specific markets and consumers. Additionally, a decentralized strategy enables ITW to overcome uncertainties in foreign markets. Strength in one market helps to offset fluctuations in another. In general, products and services are manufactured and sold in the same geographic location, which reduces foreign exchange rate risk. Revenues during fiscal year 2010 were geographically diversified. North America generated 48 percent of total revenue, while 52 percent was generated internationally. Illinois Tool Works organizes its 825 business units into eight, externally reported, segments: transportation, industrial packaging, power systems/electronics, food equipment, construction products, polymers/fluids, decorative surfaces, and all other.

Transportation: transportation-related components, fasteners, fluids and polymers, as well as truck remanufacturing and related parts and service

Major end markets: automotive OEM/tiers, automotive aftermarket

Industrial packaging: steel, plastic and paper products and equipment used for bundling, shipping, and protecting goods in transit

Major end markets: general industrial, primary metals, food and beverage, construction

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ILLINOIS TOOL WORKSANALYST REPORT: 7 December 2011

Emily Barr

ANALYST REPORT

7 December 2011

Competitors

Illinois Tool Works encounters a wide variety of competitors that vary by product line, end market, and geographic area. Many of the company’s business units operate in highly fragmented markets and competitors range from specialized, regional companies to large domestic and foreign firms. In virtually all segments, ITW competes on the basis of product innovation, pdelivery service and price

Financials & Profitability

The industrial sector is categorized by stiff competition, which results in limited pricing power and minimal profit margins. Within the industry, companies are often capital-intensive. Therefore, firms that can generate the most revenue from their assets are often those with the best performing shares. In other words, efficiency is central to success in the industrial materials industry. High asset utilization is measured using total asset turnover (TATO) and fixed asset turnover (FATO). The table below details several ratios gauging profitability and efficiency. While United Technologies (UTX) is not a direct competitor of Illinois Tool Works, UTX is widely recognized as being one of the most efficient operators in the industry. Honeywell International (HON) is a diversified manufacturer and a reasonable comparison when considering its business strategy and total market capitalization.

Power systems and electronics: conversion, metallurgy and electronics

Food equipment:

Construction products:

Polymers and fluids:

Decorative surfaces:and other applications

All other:

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Economic Moat

There are two primary factors that contribute to ITW’s economic moat. The company has a unique network effect that differentiates it from the competition. With 825 decentralized business units, segments can quickly respond to market conditions, customer requests, and any obstacles it encounters. Further, the range of expertise represented throughout the company enables innovation and expedient solutions to customer problems. In other words, if a particular business unit doesn’t have the capability to resolve an issue; it can redirect the matter to another unit, subsequently keeping revenue in the ITW umbrella. ITW’s business units exemplify the depth and breadth of the company, an interconnected system that is particularly difficult to replicate. Moreover, the company owns approximately 3,800 unexpired United States patents and 8,800 foreign patents pertaining to articles, methods, and machines.

A disciplined implementation of business processes is another key element to ITW’s economic moat. ITW’s guiding principles include: decentralization, 80/20 concept, and innovation. The company uses the 80/20 principle in an overarching fashion. The concept underlying this principle is that 20 percent of the items account for 80 percent of the value. ITW uses this rule continuously and applies the concept to both existing and acquired businesses. The uniform application of the 80/20 concept compels the company to simplify and focus on the most important elements. This concept effectively reduces the perceived complexity of any one task, unit, or product. Uses of the 80/20 rule include:

Management

Management at ITW has an average tenure of 20 years of company service. In 2005, David Speer became ITWs’ fifth CEO since the firm went public in the early 1960s year company veteran, a profile that the majority of senior managers at ITW share. Annual bonuses, sound governance policies, and a lean management structure are characteristic of the company and all are expected to be sustained over time.

ANALYST REPORT

7 December 2011

Overall, ITW displays strong fundamentals. The profitability and efficiency ratios listed above were calculated by averaging financial data from annual reports spanning from fiscal year 2006 to 2010. Illinois Tool Works has consistently generated free cash flow, ROEs above the (suggested) 10 percent hurdle, solid operating margins, and steady earnings growth. Additionally, the company’s accounting is conservatively stated. Cash flow regularly exceeds net income and Morningstar estimates suggest that pretax book income and taxable income have tracked relatively closely throughout the last decade, indicating a high quality of earnings (Landry, 2011). The table below displays several important ratios:

ITW (NYSE)

Market cap 21.3 B

Recent share price $ 47.51

52-week range 39.12 – 59.27

% Held by insiders 0.69 %

Forward P/E 10.6

P/B 2.1

PEG 0.80

D/E (market value) 0.22

Current ratio 2.02

β (average) 1.07

For the most part, these ratios portray ITW as a value investment. A PEG ratio of less than 1.0 and a low forward P/E are common indicators of value stocks. While ITW exhibits a low PEG and forward P/E, the P/B ratio is 2.1, which positions the equity slightly above an ideal P/B of less than 2.0. The market value of D/E is approximately 22 percent, a relatively low percentage of ITW’s total equity, given the industry.

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ANALYST REPORT

7 December 2011

Valuation

By incorporating estimates from Value Line, Bloomberg, and Morningstar, I processed a conservative valuation of ITW’s stock price. Value Line estimated the company’s beta at 0.95. I averaged the betas from a number of sources and employed a beta of 1.07 when valuing the equity. Additionally, I changed the EPS value to reflect the recent, lowered consensus. The P/E ratio and various growth rates were also conservatively adjusted. At the time of the stock pitch, ITW was trading at $42.58 per share. As previously stated, the stock is currently trading at $46.32 per share. The table below reflects the current stock price.

Valuation: ITW

Source Target Price Margin of Safety

Bloomberg $ 53.40 13.3 %

Yahoo! Finance 54.00 14.2 %

Morningstar 55.00 15.8 %

Emily Barr 57.80 19.9 %

Prior to the share price uptrend, the average margin of safety (taken from the sources above) was 20.4 percent.

Sources

Illinois Tool Works 10-K Value Line

Bloomberg ITW.com

Fidelity Yahoo! Finance

Morningstar The Five Rules for Successful Stock Investing by Pat Dorsey

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