Stanley Works SWK
July 07, 2010 - 9:44pm EST by
flyer
2010 2011
Price: 51.76 EPS $3.29 $5.28
Shares Out. (in M): 160 P/E 15.7x 9.8x
Market Cap (in $M): 8,302 P/FCF 0.0x 0.0x
Net Debt (in $M): 1,947 EBIT 974 1,353
TEV ($): 10,249 TEV/EBIT 10.5x 7.6x

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Description

 I. THESIS

Stanley Black & Decker ("SWK" or the "Company") has a fair value of up to $76/share with downside of $43/share, representing upside of 47% versus downside of -17%, from the current share price of $52. This implies an upside/downside ratio of almost 3x, a highly favorable risk/reward skew.  While the downside valuation is based upon a sum-of-the-parts analysis using trough level 2009A EBITDA, fair value employs a more appropriate mid-cycle EPS and multiple valuation methodology.  What makes the upside case particularly compelling, is the detailed $350 MM cost synergies associated with the BDK acquisition laid out by the Company in addition to its high operating leverage and recent headcount reductions (20% of pro forma staff) that poise SWK to generate substantial EPS upside as the economic cycle and Company volumes improve.  Note that this valuation assumes no pricing increases. 

II. COMPANY OVERVIEW

Stanley Black & Decker was formed on March 12th, 2010, through the combination of The Stanley Works and Black & Decker Corp.  Its three segments manufacture and distribute products and services to residential and commercial markets in the U.S. (65% of sales), Europe (25% of sales), Canada, Latin America, Asia and Australia (combined 10% of sales). The Company's three segments include: 1) Construction & Do-It-Yourself ("CDIY"); 2) Industrial; and 3) Security. 

 III. BUSINESS DRIVERS & EARNINGS MODEL

The earnings of SWK's units rely primarily on three main drivers: 1) product pricing; 2) selling volumes and 3) high fixed cost structures.  Note that pricing is relatively stable for all businesses, growing low single digits for all segments.  Therefore, if pricing has only helped operating margins, the margin declines since 2007 have been attributable to volumes, which underscores the high fixed cost nature and operating leverage of these businesses (with the exception of SWK Security and its ever increasing margins).

Note that capacity utilization is not disclosed by either legacy SWK or BDK, but because pricing has remained relatively stable and positive throughout the downturn, the data becomes somewhat irrelevant, as capacity does not appear to be meaningfully impacting pricing.

On a relative basis, all three of legacy SWK's business segments are generally better businesses than legacy BDK's business, as evidenced by their superior operating margins and marginally greater pricing power.  The Security business has not only become the largest segment, but its Company-leading margins have steadily improved throughout the economic downturn despite its first year of organic volume decline in 2009 (-8%).  However, the CDIY and Industrial segments have experienced massive organic volume declines of -30%+ since peaking in 2007.

IV. EARNINGS OUTLOOK

2010E ($3.29):  Assuming no pricing growth, volume growth of 4% and $90 MM of cost synergies (per management), the 2010E EPS estimate is $3.29 before BDK integration and restructuring costs; including these items, 2010E EPS comes to -$0.03.          

2012E ($6.33):  Assuming no pricing growth, annual volume growth of 4% (per management), 2012E EPS is $6.33.  This accounts for the full $350 MM of cost synergies and PF interest expense and D&A. Notice how even without pricing growth, moderate revenue growth and fixed cost removal have a large impact on EPS.  Furthermore, note that between 2007 and 2009, SWK let approximately 4,450 employees go, or 20% of the pro forma Company's combined workforce, which should provide a substantial amount of additional operating leverage in the future.  Furthermore, note these EPS assumptions include no share buybacks or debt / interest expense reduction.

V. VALUATION

1. SOTP - PUBLIC COMPARABLES / PF CURRENT EBITDA: $43/share - $60/share

Given SWK's multiple business lines, a sum-of-the-parts analysis properly values each line separately.  Applying the average multiple of each separate peer group to each respective business segment's 2009A EBITDA generates a price of $43/share ("Base Case" column).  With the full $350 MM of synergies, fair value increases to $60/share ("Base Case" column).  However, while the public comparable multiples are similar to SWK's historical averages, 2009's sharp volume and margin compression have created what is approaching trough level EBITDA, and this valuation methodology therefore understates SWK's mid cycle earnings power and fair value for its stock.

2. PF 2012E EPS / MID CYCLE MULTIPLE: $76/share

This is the most relevant valuation methodology of the three and therefore reflects the target price or fair value.  Given that SWK is a very cyclical business with a substantial amount of operating (and financial) leverage, the appropriate way to value the company is to apply mid-cycle earnings power to a historical mid-cycle multiple.  Assuming no pricing growth, 4% volume growth and $350 MM of cost synergies, 2012E EPS is $6.33/share. Applied to a mid-cycle EPS multiple of 12x (both 5-yr and 10-yr average), this generates a stock price of $76/share, upside of 47%.

VI. INVESTMENT PROS

1. Operating & Financial Leverage: Should 2009 prove to be the trough of the economic cycle and SWK's volumes, the Company would benefit substantially from its heavy operating leverage as a manufacturer (cost structure comprised heavily of facilities, equipment and staff). Additionally, financial leverage currently sits at 3x 2009A EBITDA, which will substantially increase EPS growth as volumes and operating profit improve.

2. Working Capital Opportunity: While not included in our valuation analysis, management has claimed it can increase annual cash flow generation by up to $600 MM by employing its SFS inventory management system to the legacy BDK business; this represents 2x of management's 2010E free cash flow estimate of $300 MM. Note that since 2006, SWK has steadily doubled its inventory turnover to 8x with SFS; this is also double BDK's current turnover of 4x, illustrating the improvement potential.

3. Historical Margin Expansion: Management has demonstrated a consistent ability to squeeze costs and improve margins 500 to 1300 bps (600 BPS average) from its 6 major acquisition targets since Nov-05, supporting SWK's ability to generate $350 MM of cost savings with the legacy BDK business. Additionally, note that per the SWK/BDK S-4, Chairman Archibald receives a $45 MM payout if these synergies are achieved by 2012, which will clearly lead him to focus on the synergies above all else.

VII. INVESTMENT CONS

1. Profit Repatriation: As a result of the BDK acquisition, SWK has repatriated $2.1 BN of profits, for which the tax liability is currently unknown. Assuming a worst-case-scenario 38% marginal tax rate, this could reduce earnings and cash flow by up to $800 MM, or $5/share.

2. Steel and Raw Material Price Exposure: Steel represents a strong portion of SWK's cost structure (13% of 2009 sales), and with steel prices increasing 7% Q-o-Q in Q409, costs could therefore erode almost 100 bps of operating margin in 2010E. However, note that 85% of cost increases are generally passed on to customers with a 6 month lag.

3. Convertible Notes - Equity Purchase Contracts: Per SWK's 2009 10K, the Company funded its $546 MM acquisition of HSM in 2007 with $330 MM of forward equity purchase contracts ("EPC"), for which the proceeds would not be received until 5/17/10. The EPCs are attached to convertible notes, which serve as collateral in the event such holders do not fork over the $330 MM of cash to purchase stock, which must be purchased at a MINIMUM of $54.23/share. This is slightly below the current price of $55.31 and would therefore be slightly dilutive for existing shareholders, but it may in part help explain the stock's underperformance relative to the equity market selloff that has occurred since SWK peaked at over $65/share on 4/29/10.

4. Renminbi Appreciation: SWK has stated that it expects a 5% Chinese Renminbi appreciation during 2010, which could lower EBITDA by $40 MM, or $0.25/share (pre-tax).

5. Customer Concentration: Pro forma for BDK, SWK's largest customer represents 12% of sales, and the U.S. home centers and mass merchants represent 24% of sales.

 

VIII. WHY DOES THE OPPORTUNITY EXIST?

1. It's a low/no growth business and synergies must be achieved to justify fair value/price target.

2. Weak brands / lack of pricing power prevent true upside to long-term earnings growth.

3. Secular declining ROIC for the business illustrate its relative weakness, and SWK will be deploying 2/3 of excess cash flow to acquisitions which will likely produce marginal ROIC investments, when the Company should be focusing on returning capital to shareholders should the returns prove higher than those for acquisitions.

IX. WALL STREET FOCUS / CONCERNS

Per SWK's recent earnings call transcripts and sell-side reports, it is clear Wall Street and investors are primarily concerned with the following:

1. Volumes (Industrial & CDIY Customer Inventories) - Investors want to know the degree of inventory restocking expected from Industrial and CDIY customers in the future, as this will drive volume growth and earnings leverage. Additionally, the Q110 earnings call contained a question comparing inventory restocking trends reported by certain general industrial competitors such as DHR and CAT to understand the potential inventory restocking for SWK's Industrial and CDIY customers. This will drive SWK volumes and operating leverage.

2. Margin Sustainability (Steel Prices) - With steel prices rising 7% Q-o-Q in Q409, investors are focused on the operating margin squeeze expected from the rise in costs (steel costs represent 13% of 2009A sales).

3. Revenue Synergies - While management has outlined in detail the expected cost synergies, SWK has been vague in terms of expected revenue synergies. As such, many questions on the Q110 earnings call related to details on sizing and areas for revenue synergies.

4. Chinese Renminbi (FX) - Management has stated an expected 5% increase in the Renminbi in 2010E, reducing operating income by $40 MM. Additionally, 35% of sales are non-U.S., and investors are generally focused on FX impact to sales and earnings.

5. Working Capital Synergies - Management has stated that run-rate free cash flow should approach $800 MM by 2012E, up from $300 MM in 2010E.  This delta is largely attributable to a working capital improvement of $300 per annum at the legacy BDK business from applying SWK's SFS inventory management system.

Catalyst

1. Synergies equal to or in excess of $90 MM in 2010E or $350 MM by 2012E.
2. Volume growth in excess of 4%.
3. Working capital improvements in excess of the $300 MM by 2012E.
4. Pricing increases in excess of 1% annually.
5. Use of free cash flow to delever and/or return capital to shareholders instead of spend on over priced acquisitions.
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