Where the 80/20 Rule Rules

06/30/2008 12:00 am EST

Focus: STOCKS

Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar DividendInvestor, says Illinois Tool Works is a very well-run manufacturer that handles acquisitions as well as it manages its businesses.

Illinois Tool Works (NYSE: ITW) is typical among industrial peers, with a low [dividend] payout ratio and 2.3% yield, but the excellence with which it reinvests retained earnings results in perennially high dividend growth and total returns.

For the past 20 years, ITW has managed its business around the basic tenet that 80% of a firm's profits come from 20% of its customers-dubbed the "80/20" rule. By streamlining its 800-plus business units with this principle, ITW has been able to manage its most profitable customers and products with laser-like precision.

Although not the first or only firm to implement the concept, ITW has become one of the most successful practitioners of the 80/20 model, having recorded 11% annual earnings growth during the past decade and an average 15% return on capital.

ITW's success is not simply because of its proficiency in applying the 80/20 rule to its legacy businesses, but rather its ability to employ the demanding process across newly acquired businesses.

After an acquisition, ITW breaks the newly acquired entity into several small, autonomous business units, each with its own sales force, engineering team, and manufacturing line. This decentralized operating structure is the antithesis of the typical industrial acquirer's philosophy of consolidating activities into centralized operations to reduce expenses.

ITW's methodology complements the 80/20 principle by keeping each business close to the core customers, which in turn allows the company to serve the needs of its most profitable customers more effectively than a larger, more centralized business could.

Acquisitions have played (and will continue to play) an important role in augmenting ITW's earnings growth. The company has completed an average of 34 acquisitions per year over the past decade, paying roughly one time sales for the targeted business. The company focuses on niche markets where it believes it can differentiate itself and expand margins with its disciplined business model.

On average, ITW has been able to double the operating margins of its acquired businesses, increasing margins from 10% to nearly 20% in just five years.

Modest use of debt, powerful free-cash-flow generation, and consistently high profitability place ITW among the [financially] strongest US industrial companies. Debt/capital stands at roughly 20%, and the dividend payout ratio is a very well-covered 31%.

We think that by expanding into higher-growth geographic markets, ITW can boost long-term internal growth to 5% to 6% per year from 4% historically. With returns on equity averaging 18% over the past decade, we expect a combination of internal growth, acquisitions, and possibly share buybacks to continue generating average annual dividend growth of 10% or better.

Though ITW's payout is modest, at our "buy" price of $44.50, the stock would yield a market-beating 2.5%, with the prospect of average annual total returns of 12% to13%. (It closed above $46 Friday-Editor.)

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