Illinois Tool Works, Inc. (ITW) November 15, 2017 Industrials Diversified Industrials Stock Rating Sell

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1 The Henry Fund Henry B. Tippie School of Management Sam Norman Illinois Tool Works, Inc. (ITW) November 15, 2017 Industrials Diversified Industrials Stock Rating Sell ITW has achieved revenue growth and margin expansion in recent years due to a strengthening economy and growth in industrial activity. We believe that continued economic strength will enable further growth and margin expansion through However, our expectations for a slowing economy beginning in 2020 limit ITW s upside potential at its current price of $ Drivers of Thesis We project that U.S. GDP will grow by an annual rate of roughly 3% through 2019, allowing for near-term organic growth and margin expansion. However, we believe that GDP growth will slow to 2-2.5% beginning in 2020, limiting growth in the medium-term. Our model assumes that total revenue will grow at a 5-year CAGR of 3.5% throughout the forecast horizon, driven by 4.2% compound annual growth through We project that revenue growth will slow to roughly 2.5% annually in 2020 and 2021 based on our expectations for weaker economic growth. We project that COGS and SG&A expense as a percentage of sales will each decline by 50 basis points in 2018 due to strong demand and internal cost reduction. However, we believe that declines in COGS and SG&A as a percentage of sales will be limited to 25 basis points in 2019 and 10 basis points in 2020 and 2021 due to weaker demand across the company s endmarket segments. Risks to Thesis Investment Thesis Target Price $ Henry Fund DCF $ Henry Fund DDM $ Relative Multiple $ Price Data Current Price $ wk Range $ Consensus 1yr Target $ Key Statistics Market Cap (B) $53.39 Shares Outstanding (M) Institutional Ownership 82.4% Five Year Beta Dividend Yield 2.00% Est. 5yr Growth 9.70% Price/Earnings (TTM) Price/Earnings (FY1) Price/Sales (TTM) 3.82 Price/Book (mrq) Profitability Operating Margin (TTM) 24.0% Profit Margin (TTM) 16.1% Return on Assets (TTM) 14.2% Return on Equity (TTM) 46.3% ITW is highly reliant on growth in overall economic and industrial activity. Higher-than-expected economic growth through 2019 or sustained economic strength through 2021 would be detrimental to the accuracy our model assumptions and investment thesis. Earnings Estimates 0 Year E 2018E 2019E P/E ROE EV/EBITDA EPS $7.32 $5.16 $5.73 $6.67 $7.20 $7.84 Source: Bloomberg growth 94.5% (29.5%) 11.0% 16.2% 8.0% 8.9% 12 Month Performance Company Description ITW S&P 500 Illinois Tool Works is a diversified manufacturer of 30% specialized industrial products and equipment. 25% The company s operations are organized in seven 20% reportable segments: Automotive OEM, Food 15% Equipment, Measurement and Electronics, 10% Welding, Polymers and Fluids, Construction 5% Products, and Specialty Products. ITW s 0% -5% -10% businesses serve customers domestically and abroad, with operations in 57 countries and six continents. The company reported total revenue N D J F M A M J J A S O of $13.6 billion in fiscal 2016, 55% of which came Source: Yahoo Finance from customers located outside of the U.S. Important disclosures appear on the last page of this report ITW Industry Sector

2 EXECUTIVE SUMMARY The Henry Fund recommends a sell for Illinois Tool Works (ITW) based on a target price of $ ITW has been in existence for over 100 years as a global manufacturer of industrial products and equipment. The company serves customers in a diverse set of end market industries and has proven to be a consistent and reliable operator through numerous economic cycles. In recent years, ITW has shifted its traditional M&A growth strategy to an enterprise strategy of organic growth and internal cost reduction. We believe that ITW s operational strategy will allow for strong organic growth and margin expansion through 2019 due underlying economic strength. However, our expectations for weakening economic activity in 2020 and 2021 drive our target price below ITW s current share price of COMPANY DESCRIPTION ITW is a diversified manufacturer of industrial products and equipment serving customers in over 50 countries. The following chart shows the percentage of the company s revenue received from domestic and international customers in its latest fiscal year. In addition to its geographically diverse customer base, ITW receives revenue from a wide variety of end market industries. The company categorizes revenues into one of seven reportable segments: Automotive OEM, Food Equipment, Measurement and Electronics, Welding, Polymers and Fluids, Construction Products, and Specialty Products 1. The following chart shows each segment s contribution to total revenue in fiscal For forward valuation, our analysis examines each of these segments individually based on their unique growth drivers. More information about each segment and our revenue projections can be found below. Automotive OEM Revenue from Automotive OEMs accounted for roughly 21% of total revenue in fiscal Automotive OEM revenue has grown at a 3-year CAGR of 6.1% since 2013, including 5.1% organic revenue growth in ITW earns Automotive OEM revenue through the sale of components and fasteners to top-tier, global automotive OEMs. The company s products within this segment include plastic and metal components, fasteners, and assemblies for automobiles and light trucks. Demand within this segment is driven largely by the levels of automotive production around the world 1. Domestic and international auto production has increased rapidly since 2009, aided by economic recovery throughout the world. Global automotive production totaled roughly 91 million units in 2016 and is expected to grow to roughly 107 million units by This forecast results in a global growth rate for automotive production of roughly 2.3% annually 2. More information about the global automotive production outlook and sources of production growth can be found in the following chart. Page 2

3 Global Automotive Production Outlook kitchen ventilation equipment. In addition, the company offers maintenance and repair series on its food equipment. Demand for the company s food equipment is derived from growth in the restaurant and food service industries. Dynamics in consumer behavior continue to be favorable for commercial food service establishments. Consumers in the U.S. are choosing to eat away from more than ever, as shown in the chart below. Shares of Total Food Expenditures, Source: IHS Markit Automotive Industry Outlook Historically, ITW has leveraged deep engineering relationships with key global auto OEMs to achieve segment growth above that of automotive production. ITW s management believes that the company has the potential to achieve 3-4% of above-market growth in its automotive OEM segment due to its strong business portfolio and customer relationships 3. We believe that this projection is somewhat ambitious in the long-run, but is achievable in the near-term given our expectations for a strong economy and steadily growing auto production market. Our model assumes that Automotive OEM revenue will be limited to 4% in Q4 of 2017 due to shortterm weakness in global auto builds as describe in ITW s Q earnings call 4. However, we believe that automotive OEM revenue will return to strong growth at 5% in 2018 and 4% in We believe that automotive production will level out in 2019 with the greater economy and limit Automotive OEM growth to 2.5% in 2020 and Source: USDA Economic Research Service This trend is also becoming common worldwide, leading to expectations for growth in the food service and retail food industries moving forward. The following chart shows projected growth among global foodservice and retail markets through Estimated Growth in Worldwide Food Service and Retail Food Equipment Revenue from Food Equipment accounted for roughly 16% of revenue in fiscal 2016 and has grown at a 3-year CAGR of 1% since The company also achieved organic revenue growth at 2.8% in fiscal 2016 within its Food Equipment Segment 1. ITW is an industry-leading provider of commercial food equipment differentiated by innovation and integrated service offerings. The company s Food Equipment segment primarily serves the restaurant, food service, and food retail industries through product lines that include ware washing, cooking, refrigeration, food processing, and Page 3 Source: Emerson Climate Technologies: Food Industry Forecast Through 2020 ITW s management team targets 2-3% above-market organic growth in its Food Equipment segment 3. We believe that this above-market growth is achievable in a

4 strong economy due to the company s portfolio of industry-leading food equipment brands. We believe that the global food service and retail industry will grow by roughly 3% annually through Our model assumes that the company will achieve 1% above-market growth throughout this period, resulting in revenue growth projections of 4% in Q4 2017, fiscal 2018, and fiscal We believe that a slowing domestic and global economy will limit Food Equipment growth to 2.5% in 2020 and Test, Measurement, and Electronics Test, Measurement, and Electronics products accounted for roughly 15% of revenue in fiscal This segment has shrunk at a 3-year CAGR of -3.2% since However, organic revenue grew by 1.8% in fiscal ITW s Test, Measurement, and Electronics segment produces equipment, consumables, and related software for testing and measuring the physical properties of materials and structures. This segment also produces equipment and consumables used in the production of electronic subassemblies and microelectronics. ITW s Test, Measurement, and Electronics segment sells to firms in a wide variety of industries including electronics, general industrial, industrial capital goods, and consumer durables markets. We believe that overall economic activity is the best barometer of this segment s growth potential, as customers come from a diverse set of cyclical end market industries. The following chart shows recent trends in domestic and international GDP growth, as well as future growth projections according to the International Monetary Fund (IMF). We believe that U.S. and global economic growth will remain strong around 3% in through We believe that economic growth will slow to roughly 2-2.5% beginning in ITW s management team believes that its Test, Measurement, and Electronics segment has above-market growth potential of 2-3% 3. We believe that ITW s Test, Measurement, and Electronics products offer technological capabilities that will command 1-2% above market growth in periods of economic expansion. Based on this belief and our previously disclosed economic forecasts, we believe the ITW s Test, Measurement, and Electronics segment revenues will grow by 5% in the remaining quarter of 2017, 4.5% in 2018 and 2019, and 3% in 2020 and Specialty Products ITW s specialty products segment accounted for roughly 14% of total revenue in fiscal Specialty product revenues have shrunk at a 3-year CAGR of -2.1% since However, this segment reported organic revenue growth of 1.2% in The specialty products segment is focused on diversified niche market opportunities including beverage packaging equipment and consumables, product coding, marketing equipment and consumables, and appliance components and fasteners. This segment primarily serves the food and beverage, general industrial, consumer durables, printing and publishing, and industrials capital goods markets. We believe that revenue growth in the specialty products segment is also best forecasted based on overall economic growth and industrial activity. ITW s management team targets 1-2% above market growth in its Specialty Products segment 3. However, we believe that these figures are ambitious given the commodity-like qualities of ITW s specialty product line. We believe that the presence of substitutes will limit growth in this segment to that of the U.S. and world economy. As such, we believe that revenue from the Specialty Products segment will grow by 3% through 2019 and 2.5% throughout the remaining forecast horizon. Source: International Monetary Fund Page 4

5 Construction Products Construction products accounted for approximately 12% of total revenue in fiscal 2016 and have shrunk at a 3-year CAGR of -2.1% despite 3% organic growth in ITW is a supplier of engineered fastening systems and solutions for customers in residential and commercial construction markets. Therefore, the company s revenue from construction products is highly reliant on strength in residential and commercial construction markets. U.S. total construction spending has grown steadily in recent years due, in large part, to a recovering economy. The following chart shows total construction spending in the U.S. since Polymers and Fluids Polymer and Fluid revenue accounted for roughly 12% of total revenue in fiscal This segment has shrunk at a 3-year CAGR of -5.3% but achieved 1.3% organic growth in ITW s Polymers and Fluids business is a branded supplier to niche end market industries. Businesses in the Polymers and Fluids segment produce polymers, adhesives, sealants, lubrication, cutting fluids, and fluids used for auto, industrial, and commercial aftermarket maintenance. This segment primarily serves the automotive aftermarket, general industrial, and construction markets. We believe that Polymers and Fluids revenue will generally track growth in the underlying economy. While the company targets 1-2% above market growth in this segment, we believe that its product offerings have many substitutes and limit the segment s growth to that of the overall market 3. As such, our model predicts that ITW s Polymers and Fluids segment will grow by 3% through 2019 and 2% thereafter through Welding Source: U.S. Census Bureau Dodge Data & Analytics Construction Outlook predicts that total U.S. construction starts for 2018 will climb by 3%, following a 4% rise in We believe that 3% total construction growth is sustainable through 2019 due to our expectations for continued economic growth. However, we believe that construction market growth will slow to 2.5% beginning in ITW s management team targets 1-2% above-market growth within its Construction Products segment 3. We believe that 1% above-market growth is attainable during periods of economic growth. However, we believe that the Construction products segment will return to market growth as the construction market slows in Our model predicts that Construction Products revenue will grow by 4% through 2019 and 2.5% thereafter. Welding revenue accounted for approximately 11% of total revenue in 2016 and has shrunk at a 3-year CAGR of % since However, ITW s welding segment has performed well year-to-date in 2017 and reported 4% organic growth in Q ITW offers welding equipment and specialty welding consumables to customers in the general industrial market including fabrication, shipbuilding, energy, construction, and capital goods industries. In addition, the company offers value-added welding data analytics that can be implemented to improve welding productivity. Organic welding revenue growth is highly reliant on overall levels of industrial activity in the United States and abroad. Welding revenues typically track growth in overall industrial activity. U.S. industrial activity has remained near record highs throughout the past year. The following chart shows recent trends in the U.S. Industrial Production Index. Page 5

6 U.S. Industrial Production, 2007-Present Margins and Profitability ITW has consistently expanded margins in recent years due to growing demand and internal cost cutting. The following chart shows the company s margin performance in its last three fiscal years. ITW Annual Margin Performance, Source: Federal Reserve Economic Data (FRED) Strength in U.S. industrial markets has been accompanied by growing worldwide industrial production. The following chart shows trends in the world industrial production index. World Industrial Production Index, 1995-Q Gross Margin 40.12% 41.16% 41.94% Operating Margin 19.96% 21.40% 22.53% Net Margin *20.34% 14.17% 14.96% *High net margin in 2014 due to income from discontinued operations Source: ITW Annual Filings We expect that margin growth will continue in the future as strong consumer demand is met with a continued focus on business structure simplification. Our model assumes that COGS and SG&A as a percentage of sales will each decrease by 0.5% in 2018, 0.25% in 2019, and 0.1% in 2020 and The following chart shows our model s final revenue and EPS estimates compared to analyst consensus estimates. Revenue Estimate Summary ($mm) Source: Yardeni Research We predict that U.S. and worldwide industrial activity will continue to grow with the broader economy. In particular, we believe that industrial production will track economic growth at roughly 3% through 2019 and 2-2.5% in 2020 and ITW targets 2-3% above-market growth in its Welding segment 3. We believe that 1.5% above-market growth will achievable through 2019 due to economic strength and growing industrial activity. However, we predict that above-market growth will dissipate in 2020 and 2021 as the domestic and worldwide economies slow. Therefore, our model assumes that welding revenue will grow by 4.5% through 2019 and 2.5% thereafter through E 2018E 2019E 2020E 2022E Henry Fund Estimates 14,218 14,802 15,377 15,764 16,161 Analyst Consensus 14,213 14,773 15,207 15,803 16,707 Source: Bloomberg, Henry Fund Estimates EPS Estimate Summary 2017E 2018E 2019E 2020E 2022E Henry Fund Estimates $6.67 $7.20 $7.84 $8.28 $8.73 Analyst Consensus $6.60 $7.18 $7.73 $8.40 $9.32* *Includes only one analyst estimate Source: Bloomberg, Henry Fund Estimates Company Analysis ITW has fueled decades of profitable growth as a go-to problem solver for some of the largest industrial manufacturers in the world. The company boasts a Page 6

7 portfolio of over 17,000 granted or pending patents and continues to innovate new ways to apply known science. Beginning in 2012, ITW instituted an enterprise strategy focused on an 80/20 management process, which aims to uniquely satisfy the needs of the company s largest and most profitable customers while minimizing the cost, complexity and distractions of serving small customers. As part of this enterprise strategy, ITW has placed a renewed focus on organic growth that differs from the company s historical strategy of M&A growth. The following chart shows the company s organic revenue growth in recent years for each of its operating segments. Historical and Projected Margins, E ITW Organic Revenue Growth, Automotive OEM 8.9% 5.8% 5.1% Food Equipment 3.4% 3.4% 2.8% Test, Measurement, and Electronics 1.5% -5.2% 1.8% Specialty Products -0.3% -2.3% 1.2% Construction Products 2.2% 3.7% 3.0% Polymers & Fluids -1.2% -2.0% 1.3% Welding 0.7% -7.6% -9.1% Total Revenue 2.6% -0.4% 1.2% Source: ITW Annual Filings We believe that ITW will achieve particularly strong organic revenue growth through 2019, with more modest organic growth thereafter as economic growth slows. Our model only projects organic revenue growth and assumes that total revenue will grow at a rate of 4.6% in 2017, 4.1% in 2018, 3.9% in 2019 and 2.5% in 2020 and The company s 80/20 enterprise strategy has also allowed for margin expansion as the company focuses on its largest and most profitable customers. We expect margin expansion to continue throughout the forecast horizon, as the company continues to optimize its business structure and focus on its most profitable customers. Our model assumes that quarterly COGS as a percentage of sales will decline on a year-over-year basis by 50 basis points in Q and fiscal 2018, 25 basis points in 2019, and 10 basis points in 2021 and In addition, we expect quarterly SG&A as a percentage of sales to decline by 50 basis points through the end of 2018, 25 basis points in 2019, and 10 basis points in 2020 and The following chart provides more information about historical margins and our model s margin assumptions throughout the forecast horizon. Source: ITW Annual Filings, Henry Fund Estimates ITW s various business lines and broad customer base are key contributors to the company s reputation as a steady and reliable industrial manufacturer. ITW has operated through over 100 years of economic cycles and is among the S&P 500 Dividend Aristocrats after growing its annual dividend for over 25 consecutive years. In addition to diverse product lines and end-market customers, the company benefits from a flexible capital structure with debt composing only 13% of enterprise value. This capital structure allowed the company to cover its annual interest expense by roughly 13 times in 2015 and In addition, ITW maintains a stable outlook from credit rating agencies and an A+ credit rating from S&P. As mentioned, ITW has a long history of growing annual dividends each year. The company typically raises its dividend in the fourth quarter of each fiscal year. Our model assumes that dividends will grow by 3% in the fourth quarter of each year beginning in Q Our model assumes that the higher dividend paid in each Q4 will be maintained throughout the first three quarters of the subsequent year. Our model also assumes that the company will return $1 billion to shareholders each year through share repurchases. Overall, we believe that ITW has proven to be a stable operator within a diversified set of end-market industries. We believe that the company will continue to experience organic revenue growth and margin expansion throughout the forecast horizon, with particularly strong performance through However, we believe that a turning economic cycle will limit growth in 2020 and Page 7

8 RECENT DEVELOPMENTS 3Q 2017 Earnings Report On October 23 rd, 2017, ITW reported 3Q adjusted EPS of $ This figure represented 3.7% outperformance over the analyst consensus EPS estimate of $1.65. The earnings outperformance was due largely due to a 4% increase in year-over-year revenue and an operating margin increase of 1.3% year-over-year. Organic revenue growth was positive in six of seven segments, including 5% growth in the company s Specialty Products segment, 4% growth in Welding, and 4% growth in the Construction segment. ITW also raised its 2017 full-year EPS guidance to a range of $6.62 to $6.72, while including annual operating guidance of approximately 24.5% 4. Our model results in a full-year EPS estimate of $6.67 for 2017, which falls within management s EPS guidance range. Our model assumes that 2017 operating margin will be 24.3%, only slightly less than management s operating margin guidance of 24.5%. We believe that our EPS and operating margin estimates are appropriate given each figure s proximity to management s guidance through nine months of Tax Reform Optimism U.S. Industrials had a median effective tax rate of 31% in 2016, the fourth highest out of eleven sectors in the S&P 500 index 6. The industry s current tax burden brings significant optimism about potential tax reform. Industry optimism surrounding potential tax reform stems from proposals of 20% federal tax rates and the immediate write-off of depreciable assets. In 2016, ITW s federal tax rate was 35% and the company paid an effective tax rate of roughly 30% after the effects of state taxes, non-taxable foreign income, and tax benefits provided to U.S. manufacturers. Our model assumes that the company s tax rate will remain at its 2016 effective rate throughout the forecast horizon. We believe that current tax reform proposals will face difficulty in gaining legislative approval and, if reform is accomplished, it will be with significant concessions that dilute the effects of tax reform for industrials operators. INDUSTRY TRENDS U.S. and Worldwide Economic Growth The industrials sector has benefitted from domestic and international economic growth and strong industrial activity throughout Strengthening domestic and global economic indicators have particularly boosted investor optimism towards diversified industrial manufacturers, as these firms tend to be highly reliant on overall economic and industrial activity for growth. We project that U.S. GDP will grow at an annual rate of roughly 3% through 2019, driving continued strength in industrial activity. We also expect international economies to remain strong through We project that U.S. and worldwide GDP growth will begin to slow in 2020 and In particular, we expect U.S. and worldwide GDP growth to slow to 2-2.5% annually in 2020 and We believe that ITW will experience strong growth through 2019 due to domestic and international economic activity. However, we believe that revenue growth will slow beginning in 2020 due to a turning economic cycle. As such, our projections are less optimistic than analyst consensus estimates in 2020 and Focus on Portfolio Optimization Diversified industrials manufacturers have recently placed a strong emphasis on portfolio optimization as opposed to historical strategies of aggressive M&A growth. While M&A remains a growth driver within the industry, ITW and other others industry participants continue attempts to shift from low-margin, cyclical, commodity businesses to higher-growth, higher-margin businesses. In many cases, companies are seeking higher margins through technologically superior product offerings. ITW has invested roughly $225 million annually in R&D since 2014, focused primarily on innovating products for the unique needs of the company s largest customers. ITW s targeted R&D efforts are backed by its 80/20 management strategy, which places a strong emphasis on serving customers at a local level. This strategy has been a key component of the company s operating margin improving by over 6% since the strategy s introduction in We believe that ITW s customer-focused Page 8

9 operational strategy allows the company to respond rapidly to changing market dynamics and is a distinct advantage relative to industry peers. We believe that the company s 80/20 management process and product portfolio optimization will enable further margin expansion throughout the forecast horizon (see company analysis section for more details about margin growth assumptions). MARKETS AND COMPETITION ITW offers a wide range of products and serves a diverse group of end markets, many of which are fragmented. The company s competitors vary by product line, end market, and geographic area. In general, ITW s competitors include numerous regional or specialized companies, as well as large U.S. and non-u.s. companies or divisions of large companies 1. In each of its segments, ITW differentiates itself from competitors based on product innovation, product quality, brand preference, and service delivery 1. These competitive dynamics have led larger industry competitors to focus on product portfolio optimization in recent years to shift from lower-margin, cyclical, commodity products to differentiated, higher growth, higher margin businesses. These business lines typically involve the introduction of technological advancements to traditional products. In response to this changing market dynamic, ITW has invested roughly $225 million annually in R&D spending since The company s current and prior investments in its product portfolio have resulted in industry-leading brands within each of ITW s business segments. We believe that the company s longstanding reputation and brand name recognition, coupled with its international footprint, provide a competitive advantage relative to smaller competitors. Our expectations for above-market growth in ITW s segments point to growing market share and pricing power throughout the forecast horizon. We believe that these competitive advantages will allow for margin growth in the coming years, particularly through Industry Life Cycle Stage The diversified industrials industry is mature, as industry growth is highly reliant on overall economic activity. The industry has historically tapped into M&A markets to achieve growth above that of the underlying economy, which we expect to continue in the future. However, we expect that M&A activity will become more selective and targeted during our forecast horizon. Many firms, including ITW, have pivoted to an internal growth strategy centered on portfolio optimization, penetration in existing markets, and internal cost discipline. Excluding a roughly $400 million acquisition in 2016, ITW s M&A-related expenditures have trailed off in recent years due to the company s new enterprise strategy implemented in ,800 1,600 1,400 1,200 1, ITW Acquisition Activity, ,547 Source: Bloomberg We believe that ITW and other industry participants will continue to complete targeted acquisitions in the years to come. However, we do not include acquisition growth in our model due to the company s focus on growing its internal business units. We believe that diversified industrial manufacturers will remain reliant on overall economic activity for growth. Our model projects that ITW will achieve above-market growth through 2019 due to further implementation of its 80/20 enterprise strategy and growing market share. While we believe that ITW has above-market growth potential in the short-term, we believe that the industry s maturity limits long-run growth potential to growth in the underlying economy. Peer Comparisons Cash Paid for Acquisitions ($mm) 1, ITW is most directly comparable to several other large, U.S.-based, diversified industrial manufacturers. While the company s peers cater towards a broad range of end markets, the industry tends to trade in unison based on underlying economic and industrial strength. Our analysis includes a peer group consisting of Eaton Corp. (ETN), 723 Page 9

10 Roper Technologies Inc. (ROP), Fortive Corp. (FTV), Parker Hannifin Corp. (PH), Ingersoll-Rand PLC (IR), and Dover Corp. (DOV). The following chart shows important operating and valuation statistics for ITW and its diversified industrials peers. Mkt. Cap ($B) Peer Group Operating Statistics TTM Revenue ($B) Gross Margin (TTM) Operating Margin (TTM) ITW % 23.4% ETN % 12.6% ROP % 27.5% FTV % 21.2% PH % 12.6% IR % 12.3% DOV % 12.2% Source: Bloomberg Peer Group Valuation Statistics Forward Forward Dividend EV/EBITDA P/E P/S Yield ITW % ETN % ROP % FTV % PH % IR % DOV % Average % Source: Bloomberg ITW leverages its strong product portfolio, existing customer relationships, and 80/20 enterprise strategy to achieve higher margins than most industry peers. ITW trails only ROP in terms of operating margin due to ROP s focus on technologically advanced industrial automation products that command higher margins from customers. ITW s strong margins are rewarded by investors in the market through the company s above-average multiples relative to industry peers. We believe that ITW s premium relative to most diversified industrial peers is warranted based on the company s history of stability and margin strength. We believe that the company will continue to command above-average price multiples based on our expectations for strong organic growth and margin expansion through GDP ECONOMIC OUTLOOK Source: U.S. Bureau of Economic Analysis U.S. GDP grew at an annual rate of 3% in the third quarter of 2017 after growing at an annual rate of 3.1% in Q2 8. We project that U.S. GDP will grow by 3% annually through 2019, with slower growth at a rate of roughly 2-2.5% in 2020 and GDP is an important economic indicator for ITW and other diversified industrial manufacturers whose revenue growth is highly correlated with overall economic activity. Our model s projections for slower revenue growth in 2020 and 2021 are the result of our expectations for a slowing economy in these years. Our expectations for a peaking economic cycle in 2019 explains most our model s deviation from analyst consensus in 2020 and Interest Rates Source: FRED Interest rates have risen throughout 2017 due, in large part, to two Federal Reserve rate hikes. The target Federal Funds rate is currency % and 10-year treasury rates currently sit at roughly 2.4% 9. We project that the Federal Reserve will increase the target rate once more in 2017 Page 10

11 and twice in 2018, resulting in a target Fed Funds rate of % by the end of We expect 10-year treasury rates to rise to roughly % by the end of Rising interest rates have the potential to disrupt further economic growth. However, we believe that the market is expecting these rate hikes in the near-term based on the Federal Reserve s transparency concerning policy goals. Therefore, we do not expect short-term economic disruptions based on rising interest rates. However, we believe that economic growth will slow in 2020 due, in part, to higher interest rates slowing overall activity. As such, we expect weaker earnings growth for ITW towards the end of our five-year forecast horizon. Industrial Production Index Source: FRED The U.S. industrial production index is a key indicator of strength in the overall industrials sector. U.S. industrial production reached all-time highs in November of 2014, but has remained near these all-time highs in recent months. According to the Federal Reserve, the U.S. Industrial Production Index was in September of We expect industrial production to remain strong in the near term, as firms benefit from continued economic growth. However, we believe that industrial production will begin to decline beginning in We believe that declining industrial production beginning in 2020 will decrease demand for ITW s products, limit revenue and margin growth, and lead to less earnings growth in 2020 and PMI Manufacturing Index Source: Institute For Supply Management The PMI manufacturing index compiled by the Institute for Supply Management is an indicator us U.S. manufacturing strength. PMI measured at 58.7% in October of 2017, a slight decrease from the September reading of 60.8% 11. However, surveyed executives cited expanding business conditions that indicate the PMI figures will remain strong in the near-term. We believe that the U.S. manufacturing sector will remain strong through 2019, as a growing economy and renewed support for U.S. manufacturing foster a favorable business environment. However, we believe that manufacturing strength will begin to trail off in 2020 due to a slowing economy. Due to these expectations, our model assumes more sluggish growth for ITW during the second half of our five-year forecast horizon. INVESTMENT POSITIVES ITW has proven to be a diversified operator within a broad array of end-market industries, which has allowed for stability through numerous economic cycles and annual dividend growth for over 20 years We expect that ITW s 80/20 management process will allow for continued organic growth and margin expansion We believe that organic growth and margin expansion will be particularly strong through 2019 due to our expectations for 3% growth in the underlying economy in the near-term Page 11

12 INVESTMENT NEGATIVES As a diversified industrial manufacturer, ITW s growth potential is limited by the industry s maturity and saturation of viable end market industries The company s growth is extremely reliant on strength in domestic and international economies We believe that U.S. economic growth will slow beginning in 2020, which limits the company s growth potential in the second half of our forecast horizon VALUATION Our revenue growth assumptions are derived from our quarterly, segment-specific revenue growth projections described throughout this report. Our segment-specific revenue growth projections result in projected total revenue growth of 4.6% in 2017, 4.1% in 2018, 3.9% in 2019, 2.5% in 2020 and We project COGS as percentage of sales based on the company s COGS as a percentage of sales in its latest fiscal year. Our model also includes quarterly declines in yearover-year COGS as a percentage of sales of 50 basis points through 2018, 25 basis points throughout 2019, and 10 basis points through Our model s SG&A as a percentage of sales figure is based on the company s SG&A as a percentage of sales in its most recent fiscal year. Like COGS, our model includes our expectations that quarterly, year-over-year SG&A as a percentage of sales will decline by 50 basis points through 2018, 25 basis points in 2019, and 10 basis points throughout the remaining forecast horizon. Depreciation and amortization expenses are projected based on historical depreciation rates of PP&E and amortization rates of intangibles. Interest expense is based on the firm s estimated cost of debt and total debt included on the balance sheet. Our model assumes that ITW will grow its dividend by 3% in the fourth quarter of every fiscal year beginning in Q Our model assumes that ITW s quarterly dividend will remain constant for the first three quarters of the next fiscal year before the dividend is again raised in the subsequent Q4. Our model also assumes that the company will repurchase $1 billion worth of shares in each year of the forecast horizon. We assume that ITW will invest in capital expenditures for fixed assets at an annual rate of 2% of sales. This projection is based on ITW s historical capex rate as a percentage of sales, which is typically around 2%. ITW s pretax cost of debt is estimated by adding an appropriate credit spread to the risk-free rate. The chosen credit spread is equal to the spread between the 30-year Treasury and 30-year cost of borrowing for A+ rated industrials firms (ITW is A+ rated by S&P). We estimate the company s cost of equity using the CAPM. We use the current 30-year treasury rate of 2.77% as a proxy for the risk-free rate. Our model assumes a beta of 1.077, which is ITW s five-year weekly beta. We also assume a market risk premium of 4.8%. Our DCF model yields a target price of $ based on these assumptions. Relative valuation yields a target price of $ based on P/E ratios of companies in ITW s peer group and our model s EPS estimates. We believe that the DCF model and relative valuation are the most appropriate measure of value for the firm. However, we also created a DDM model that yielded a target price of $ Our final target price of $ is slightly below the analyst consensus target price of Our target price is lower than analyst consensus mainly because of our expectations for a slowing economy in 2020 and 2021, which limit revenue growth near the end of our forecast horizon. KEYS TO MONITOR Moving forward, domestic and worldwide GDP growth will be an important factor in ITW s operational success. We believe that U.S. GDP growth will remain strong at roughly 3% through However, we project that economic growth will slow to 2-2.5% by Longer-than-expected economic expansion would counteract important assumptions in our valuation model and point to undervaluation at our target price. The results of U.S. corporate tax reform efforts will also be an important factor to monitor moving forward. We believe that proposed reforms will either be rejected or become less business-friendly throughout the legislative process. Therefore, our model assumes that ITW s marginal tax rate will remain constant throughout the forecast horizon at the company s 2016 tax rate. However, Page 12

13 a changing corporate tax rate would significantly affect our model s final valuation. Lastly, our model assumes that the company s 80/20 management process will continue to decrease quarterly COGS and SG&A expenses (as a % of sales) by 50 basis points through 2018, 25 basis points in 2019, and 10 basis points in 2020 and 2021, respectively, on a year-over-year basis. These assumptions have a significant impact on our final valuation and the company s quarterly margin performance should be closely monitored to assess the accuracy of our model s margin assumptions. included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report. REFERENCES 1. ITW K 2. IHS Markit: Automotive Industry Outlook (Oct. 2016) 3. ITW Investor Presentation (2016) 4. ITW Q Earnings Call 5. Dodge Data & Analytics: 2018 Construction Outlook 6. Bloomberg 7. Ernst & Young Capital Insights: Diversified Industrials 8. U.S. Bureau of Economic Analysis (BEA) 9. U.S. Department of the Treasury: Daily Treasury Yield Curve Rates 10. U.S. Federal Reserve 11. Institute for Supply Management: October PMI Report 12. USDA Economic Research Serivce 13. Emerson Climate Technologies: Food Service Forecast Through U.S. Census Bureau 15. Federal Reserve Economic Data (FRED) 16. Yardeni Research: Global Industrial Production (Nov. 2017) IMPORTANT DISCLAIMER Henry Fund reports are created by student enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa s Tippie School of Management. These reports are intended to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures Page 13

14 Revenue Decomposition Q FY 2016 Q Q Q Q4 2017E FY 2017E Q1 2018E Q2 2018E Q3 2018E Q4 2018E FY 2018E Q1 2019E Q2 2019E Q3 2019E Q4 2019E FY 2019E For the Period Ended 12/31/16 12/31/16 3/31/17 6/30/17 9/30/17 12/31/17 12/31/17 3/31/18 6/30/18 9/30/18 12/31/18 12/31/18 3/31/19 6/30/19 9/30/19 12/31/19 12/31/19 Revenue by Segment Automotive OEM 773 2, , , ,546 Food Equipment 532 2, , , ,302 Test & Measurement and Electronics 487 1, , , ,223 Specialty Products 456 1, , , ,038 Construction Products 386 1, , , ,797 Polymers & Fluids (Adhesives, Sealants, Lubrication & Cutting Fluids) 408 1, , , ,822 Welding 361 1, , , ,668 Intersegment Revenues (4) (20) (5) (6) (4) (4) (19) (5) (6) (4) (4) (18) (5) (6) (4) (4) (18) Total Revenue 3,399 13,599 3,471 3,599 3,615 3,533 14,218 3,614 3,747 3,763 3,678 14,802 3,754 3,892 3,909 3,821 15,377 Segment Percentage of Total Revenue Automotive OEM 22.74% 21.06% 23.85% 22.78% 21.99% 22.75% 22.84% 24.06% 22.98% 22.18% 22.95% 23.03% 24.08% 23.01% 22.21% 22.97% 23.06% Food Equipment 15.65% 15.52% 14.32% 14.70% 15.19% 15.66% 14.97% 14.30% 14.68% 15.17% 15.64% 14.95% 14.32% 14.70% 15.19% 15.66% 14.97% Test & Measurement and Electronics 14.33% 14.52% 13.83% 14.42% 14.52% 14.47% 14.32% 13.88% 14.48% 14.58% 14.53% 14.37% 13.96% 14.56% 14.67% 14.61% 14.45% Specialty Products 13.42% 13.86% 13.34% 13.61% 13.78% 13.29% 13.51% 13.20% 13.47% 13.63% 13.15% 13.36% 13.08% 13.36% 13.52% 13.04% 13.25% Construction Products 11.36% 11.83% 11.38% 11.81% 12.17% 11.36% 11.69% 11.37% 11.80% 12.16% 11.35% 11.67% 11.38% 11.81% 12.17% 11.36% 11.69% Polymers & Fluids 12.00% 12.43% 12.27% 12.14% 12.01% 11.89% 12.08% 12.14% 12.01% 11.88% 11.77% 11.95% 12.04% 11.91% 11.78% 11.67% 11.85% Welding 10.62% 10.93% 11.15% 10.70% 10.46% 10.68% 10.74% 11.19% 10.74% 10.50% 10.72% 10.78% 11.26% 10.80% 10.56% 10.78% 10.85% Intersegment Revenues -0.12% -0.15% -0.14% -0.17% -0.11% -0.11% -0.13% -0.13% -0.16% -0.10% -0.10% -0.12% -0.13% -0.15% -0.10% -0.10% -0.12% Total Revenue % % % % % % % % % % % % % % % % % YoY Growth Automotive OEM 25.69% 13.25% 26.22% 22.39% 3.92% 4.00% 13.37% 5.00% 5.00% 5.00% 5.00% 5.00% 4.00% 4.00% 4.00% 4.00% 4.00% Food Equipment 0.00% 0.67% -0.40% -1.12% 0.92% 4.00% 0.87% 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% Test & Measurement and Electronics -2.60% 0.25% 3.45% 2.37% 1.74% 5.00% 3.11% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50% Specialty Products -0.44% 0.00% -1.07% 1.24% 4.40% 3.00% 1.89% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% Construction Products 2.12% 1.39% 2.86% 0.24% 6.02% 4.00% 3.26% 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% Polymers & Fluids (Adhesives, Sealants, Lubrication & Cutting Fluids) 1.49% -1.23% 1.91% -1.35% 2.84% 3.00% 1.55% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% Welding -8.61% -9.94% -0.51% 2.67% 4.71% 4.50% 2.78% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50% 4.50% Intersegment Revenues % % 25.00% % % -3.00% -5.60% -3.00% -3.00% -3.00% -3.00% -3.00% -3.00% -3.00% -3.00% -3.00% -3.00% Total Revenue 3.79% 1.45% 6.02% 4.90% 3.43% 3.95% 4.55% 4.12% 4.11% 4.09% 4.11% 4.11% 3.88% 3.88% 3.88% 3.88% 3.88%

15 Income Statement Q Q Q Q Q4 2017E Q1 2018E Q2 2018E Q3 2018E Q4 2018E Q1 2019E Q2 2019E Q3 2019E Q4 2019E For the Period Ended 12/31/16 3/31/17 6/30/17 9/30/17 12/31/17 3/31/18 6/30/18 9/30/18 12/31/18 3/31/19 6/30/19 9/30/19 12/31/19 Revenue 3,399 3,471 3,599 3,615 3,533 3,614 3,747 3,763 3,678 3,754 3,892 3,909 3,821 Cost of Goods Sold 2,006 2,004 2,087 2,094 2,068 2,068 2,154 2,161 2,134 2,139 2,228 2,235 2,207 Gross Profit 1,393 1,467 1,512 1,521 1,466 1,545 1,593 1,602 1,544 1,615 1,664 1,674 1,614 Depreciation Expense Amortization Expense Selling General and Administrative Expenses Litigation Expense (Income) (80) Operating Income ,021 1, Loss/(Recovery) on Impair of Intangible Assets Interest Expense Other Non-Operating Expenses (Income) (47) (4) (10) (10) (15) (16) (16) (16) (16) (16) (17) (17) (17) Income Before Income Taxes Income Tax Expense (Benefit) Income Before Extraordinary Items Loss (Benefit) from Discontinued Operations Net Income Period End Shares Outstanding Weighted Average Shares - Basic Basic Earnings Per Share ($) Dividends Per Share

16 Balance Sheet Q Q Q Q Q4 2017E Q1 2018E Q2 2018E Q3 2018E Q4 2018E Q1 2019E Q2 2019E Q3 2019E Q4 2019E For the Period Ended 12/31/16 3/31/17 6/30/17 9/30/17 12/31/17 3/31/18 6/30/18 9/30/18 12/31/18 3/31/19 6/30/19 9/30/19 12/31/19 Current Assets Cash and Equivalents 2,472 2,493 2,496 2,785 2,748 2,889 3,078 3,215 3,287 3,456 3,685 3,860 3,969 Accounts Receivable - Trade 2,357 2,534 2,629 2,672 2,450 2,638 2,737 2,781 2,551 2,741 2,843 2,889 2,650 Inventories 1,076 1,158 1,199 1,225 1,119 1,206 1,248 1,275 1,164 1,252 1,297 1,325 1,210 Prepaid Expenses and Other Deferred Income Tax Asset (Short-Term) Assets Held For Sale Total Current Assets 6,123 6,430 6,570 6,912 6,567 6,988 7,328 7,537 7,263 7,715 8,100 8,350 8,098 Noncurrent Assets Long Term Investments Property Plant & Equipment - Net 1,652 1,674 1,726 1,759 1,764 1,771 1,780 1,788 1,795 1,803 1,814 1,824 1,832 Deferred Income Tax Asset (Long-Term) Other Intangible Assets 1,463 1,411 1,366 1,319 1,271 1,225 1,180 1,136 1,094 1,055 1, Goodwill 4,558 4,605 4,675 4,732 4,732 4,732 4,732 4,732 4,732 4,732 4,732 4,732 4,732 Other Noncurrent Assets ,097 1,119 1,120 1,145 1,188 1,193 1,166 1,190 1,234 1,239 1,211 Total Noncurrent Assets 9,078 9,099 9,352 9,402 9,344 9,316 9,307 9,262 9,185 9,163 9,164 9,126 9,055 Total Assets 15,201 15,529 15,922 16,314 15,911 16,304 16,635 16,799 16,447 16,878 17,264 17,477 17,154 Current Liabilities Accounts Payable - Trade Short-Term Borrowings Accrued Expenses 1,202 1,149 1,172 1,231 1,197 1,225 1,270 1,275 1,246 1,272 1,319 1,325 1,295 Dividends Accrued/Payable Other Current Liabilities Deferred Income Tax Liability (Short-Term) Income Taxes Accrued/Payable Total Current Liabilities 2,760 2,875 2,826 2,867 2,670 2,840 2,947 2,970 2,799 2,963 3,073 3,097 2,920 Non Current Liabilities Long Term Debt 7,177 7,205 7,360 7,439 7,243 7,382 7,460 7,475 7,241 7,385 7,472 7,492 7,255 Deferred Income Taxes (Liabilities) Other Noncurrent Liabilities Total Noncurrent Liabilities 8,182 8,156 8,322 8,421 8,186 8,335 8,436 8,446 8,183 8,336 8,447 8,462 8,195 Total Liabilities 10,942 11,031 11,148 11,288 10,856 11,176 11,383 11,416 10,983 11,299 11,519 11,559 11,115 Stockholder Equity Common Stock 1,199 1,195 1,205 1,216 1,229 1,243 1,256 1,269 1,283 1,296 1,309 1,322 1,336 Treasury Stock (14,638) (14,871) (15,095) (15,336) (15,586) (15,836) (16,086) (16,336) (16,586) (16,836) (17,086) (17,336) (17,586) Accumulated Other Comprehensive Income (1,807) (1,643) (1,516) (1,407) (1,407) (1,407) (1,407) (1,407) (1,407) (1,407) (1,407) (1,407) (1,407) Retained Earnings 19,505 19,817 20,180 20,553 20,818 21,129 21,490 21,857 22,175 22,526 22,929 23,338 23,696 Total Shareholders Equity 4,259 4,498 4,774 5,026 5,055 5,128 5,253 5,383 5,465 5,579 5,745 5,917 6,039 Total Liabilities and Shareholders Equity 15,201 15,529 15,922 16,314 15,911 16,304 16,635 16,799 16,447 16,878 17,264 17,477 17,154