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My Top Under-Appreciated Dividend King to Buy in October

Motley Fool - Sun Oct 8, 2023

When scanning the list of companies that have paid and raised their dividends for over 50 consecutive years -- colloquially called Dividend Kings -- investors often focus on recognizable names and high yields. Companies like Coca-Cola, Procter & Gamble, and Johnson & Johnson are considered safe and reliable brands by many.

A Dividend King you may never heard of is Illinois Tool Works(NYSE: ITW). Commonly known as ITW, the industrial conglomerate has dozens of brands across seven key segments: automotive, food equipment, test & measurement and electronics, welding, polymers & fluids, construction products, and specialty products.

Here's why ITW is an underappreciated Dividend King worth buying in October.

Sparks fly off of a circular saw in a factory.

Image source: Getty Images.

A recipe for success

No matter the specific company or industry, the classic industrial-conglomerate model (think General Electric, Honeywell International, Mitsubishi, Koch Industries, etc.) is focused on achieving diversification and synergies across a variety of brands. With access to several end markets, a well-run industrial conglomerate can unlock growth while reducing the volatility that comes from a market cycle or exposure to cyclical industries.

ITW's business model is similar to other major industrial conglomerates. But ITW's key differentiating factor is its execution. The company has done a phenomenal job of growing its operating margin, which currently sits at 24.6%. A little over 10 years ago, the company's operating margin was below 15%.

ITW Operating Margin (TTM) Chart

ITW Operating Margin (TTM) data by YCharts.

An operating margin of 24.6% is extremely high for a company that sells basic products that simply don't have the brand power of, say an Apple phone or Nike sneaker. The high-operating margin can be attributed to ITW's strategy, supply chain, inventory management, and ability to allocate capital across its portfolio of brands.

Having a high operating margin is advantageous in today's high interest rate and inflationary environment because it leaves room for price cuts and discounts (if needed). Despite challenging conditions, ITW reiterated its goal to achieve a 30% operating margin by 2030. And last quarter, it posted 9% growth in operating income, marking the first time the company earned over $1 billion in operating income in company history.

ITW is well rounded

ITW is growing its business well in China, particularly in its biggest segment -- automotive. On its Q2 earnings call, ITW indicated that its products for electric vehicles (EVs) in China are doing well as the country's growing middle class embraces EV adoption. Supply chain disruptions have given the company a sizable backlog to work through, which bodes well for short-term growth.

The key for ITW is that it has a few segments doing especially well, but it also has no segment that is doing poorly. Oftentimes, you'll see a conglomerate with a weak brand whose underperformance is offset by a very strong brand.

A classic example is Yum! Brands(NYSE: YUM), which owns KFC, Pizza Hut, and Taco Bell. If you listened to Yum! Brands earnings calls over the last few years, you would have heard repeated weakness from Pizza Hut, a decent but not great performance from KFC, and consistent strength from Taco Bell, which essentially carried the entire company.

That's simply not the case with ITW. The company's biggest advantage is its seven strong segments. A segment like automotive, which has the lowest margins of the bunch, is growing quickly. So it can be a key contributor to top-line growth even if its segment margin lags the rest of the company.

In sum, ITW embodies the perfect industrial conglomerate.

An excellent balance sheet

ITW's second-best quality after its operating margin is its balance sheet.

ITW Net Total Long Term Debt (Quarterly) Chart

ITW Net Total Long Term Debt (Quarterly) data by YCharts.

As you'd expect from a growing company, ITW's total net long-term debt has steadily increased over the last decade, but its financial debt-to-equity is at a 10-year low of just 0.11, meaning the company operates with very little leverage.

Having a healthy balance sheet is especially important in today's high interest rate environment. A good way of checking to see if a company's debt is manageable is to look at the size of its interest expense relative to other expenses and how much earnings and cash flow it is bringing in.

ITW Total Interest Expense (TTM) Chart

ITW Total Interest Expense (TTM) data by YCharts.

As you can see in the chart above, ITW's interest expense is less than half its capital expenditures and less than a tenth of its operating expenses. For even more context, consider that ITW paid $1.58 billion in dividends over the last 12 months. All told, the company's balance sheet is excellent, and the company has a more than manageable interest expense that allows it to support organic growth, make acquisitions, pay dividends, and buy back stock.

Driving shareholder value

Speaking of buying back stock, ITW's third best quality is its relentless buybacks. Being a Dividend King is one thing. But it's much harder to raise the dividend year in and year outand support an expensive buyback program.

Earlier, I mentioned Coke, P&G, and J&J as some well-known Dividend Kings. Nothing against those companies, but they don't even come close to the pace of buybacks that ITW has demonstrated over the last 10 years.

ITW Shares Outstanding Chart

ITW Shares Outstanding data by YCharts.

ITW has reduced its outstanding share count by nearly 30% in the last decade, which boosts the earnings per share (EPS) and makes each share more valuable. Organic earnings growth paired with well-executed and affordable buybacks is an excellent way to ensure a stock can justify going up in price without becoming overvalued.

ITW is a top-notch Dividend King

ITW checks all the boxes for a stock worth buying and holding forever. It has an excellent strategy with clearly defined goals centered around margin expansion. It has a rock-solid balance sheet, which leaves it less impacted by rising interest rates. And finally, it generates plenty of extra earnings and cash to support operational improvements and reward shareholders.

Add it all up, and ITW is a high-quality business that's worth a look.

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Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple and Nike. The Motley Fool recommends Johnson & Johnson and recommends the following options: long January 2024 $47.50 calls on Coca-Cola and long January 2025 $47.50 calls on Nike. The Motley Fool has a disclosure policy.

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