Illinois Tool Works Faces Headwinds—2 Alternatives Stand Out

Key Points

• JPMorgan cut its Illinois Tool Works price target by $80 due to sector-wide short-cycle demand concerns rather than company-specific weakness.
• Watts Water Technologies benefits from steady, recurring data center liquid cooling demand, posting record quarterly sales and outperforming ITW's stock this year.
• The Vanguard Industrials ETF offers a low-cost, diversified way to gain industrials sector exposure while mitigating risks tied to short-cycle companies like ITW.

Industrial component manufacturer Illinois Tool Works NYSE: ITW has faced a difficult October, with analysts at multiple firms lowering price targets or downgrading ratings. However, the reasoning behind the massive $80 price target reduction from analysts at JPMorgan Chase NYSE: JPM was less about the strength of the business overall and more about its place in the broader sector—and in the overall health of industrials names heading to the end of the year.

Though industrials stocks have generally performed well as a group this year, short-cycle businesses—those for which customers place and receive orders within a span of just days or weeks—may be experiencing decelerating demand amid a piecemeal recovery to manufacturing that has seen new orders rebound at a faster pace than production backlogs have been able to clear. While this could be bad news for ITW, there remain some companies in the sector that may still be in a favorable position.

ITW: Still a Strong Business Overall, But Demand Fluctuation Makes Now the Wrong Time

The divergence between new order growth and backlog clearance has often led to a deceleration period in the past. For Illinois Tool Works, the problem becomes exacerbated by the company's international exposure, as more than half of its revenue is generated outside of the U.S.

Short-cycle headwinds are likely to be in play for many European and Asian manufacturers as a result of the fiscal crisis in France, a contraction of industrial sector businesses in Germany, and a spotty recovery for China, among other factors.

That said, ITW still trades at a premium valuation of almost 25x earnings, and the company posted numerous strengths in its last quarterly report, including strong free cash flow conversion and the continuation of a long history of dividend increases.

Investors may not want to disregard ITW completely, only to look for other options that don't require a heavy premium and that are less likely to be exposed to risks associated with the current trajectory of customer demand. Shares of ITW have climbed by about 10% year to date (YTD).

Watts' Services and Products Have Unique Staying Power in the Data Center Infrastructure Buildout

Looking elsewhere in the industrials sector, Watts Water Technologies NYSE: WTS stands out as a flow control and process automation firm in an industry that is rapidly shifting and consolidating. WTS growth is boosted by its data center liquid cooling business, a vital but often overlooked component of AI infrastructure.

The essential element of WTS's appeal in this space—even amid concerns that new data center buildouts may be slowing—is that its cooling services are vital throughout the life of a data center, not only at the time of construction. Water management is a continual need for the AI industry and one that may be able to generate steady demand for Watts' products in a way that short-cycle-dependent firms like ITW do not experience.

Watts' is heading into the final months of the year with strong momentum from record sales of $763 million in the last reported quarter, on top of expanding full-year guidance, exceptional free cash flow conversion, and other positive metrics. Analysts are divided between Buy and Hold ratings but give the company modest upside potential based on a consensus price target of $367.70. WTS stock has significantly outperformed ITW, rising by roughly 28% YTD.

VIS: Broad Exposure to the Industrials Sector to Mitigate Short-Cycle Risk

Investors to reduce or avoid a direct investment in ITW while still building exposure to the broader industrials sector may find that the broad Vanguard Industrials ETF NYSEARCA: VIS offers a cost-efficient way of accessing long-cycle names. At the same time, it will continue to provide baseline access to short-cycle companies that could benefit as broad strength in the manufacturing space picks up.

With an expense ratio of 0.10%, VIS is an exchange-traded fund (ETF) with a low fee and a robust asset base that helps ensure ample liquidity for more active investors. VIS also provides exposure to some of the most stable and promising corners of the sector, including companies benefiting from recurring business associated with data centers, such as Watts.

VIS is not the only option when it comes to broad industrial sector funds, however, and there are other low-cost alternatives that have similar portfolios. These ways of accessing the sector are not necessarily identical, however, and particularly given unevenness across the industrials space, it may be worthwhile for investors to dig into portfolio information to assess exactly how sector-wide funds are allocating their assets.