Stanley Black & Decker Inc. (NYSE: SWK). Stanley has an experienced management team that is focused on improving efficiency. It proved that by delivering better-than-expected results during the Great Recession. Stanley will also benefit from being relevant and having innovative, market-leading products. While much of consumers’ recent spending has focused on food and cleaning supplies, it has helped Stanley that Lowe’s and Home Depot have been open for business and many consumers have used their time sheltering at home to take on home improvement projects.
After the crisis, we expect a specific emphasis on enhancing the Craftsman brand and improving financial strength. We expect CEO James Loree and the senior management team to extend their record of innovation in the tool businesses, boost profitability in the security business, and improve the operating efficiency, cost structure, cash conversion and financial strength of the overall enterprise. We expect a 50/50 allocation of capital between acquisitions and the return of cash to shareholders.
One long-term question is whether new acquisitions can generate adequate returns on investment to reward shareholders. Management is aiming to maintain cash flow ROI of 12%-15% over time, compared to 13% in 2014 and 2015, 9% in 2013, and 10% in 2012. The company reached 16% in 2016, 14% in 2017, 12% in 2018, and 14% in 2019. We ultimately expect the company to focus on acquisitions that have higher margins and stronger growth prospects than the core operation, and that will help to consolidate the Tool business, expand the Engineered Fastening businesses, build the Lawn & Garden businesses, and raise the company’s presence in emerging markets to more than 20% of sales. Working capital efficiency is also a priority for the company; we expect management to deliver working capital turnover above 10-times over the long term. The company delivered a very impressive 10.6-times in 2016. Excluding acquisitions, turns were flat in 2017, about 8.8-times in 2018 and 9.9-times in 2019.
We like the acquisitions of the Craftsman brand and Newell tools, which includes Irwin Tools and Lenox. We see a lot of opportunity to expand the Craftsman brand, especially with Craftsman’s reputation in lawn mowers and trimmers and SWK’s growing expertise in battery technology. (On that subject, we experienced a power outage over the summer and our DeWalt flashlight, powered by a 20 volt battery, was in use constantly and never showed the slightest loss of brightness.)
On December 16, Stanley raised some of its ‘planning assumptions’ for the fourth quarter and the full year of 2020. SWK now expects 4Q organic growth approaching 10%, up from prior guidance of 3%-5%.
The company is seeing strong demand in Tools & Storage, which is, by far, the biggest of the three divisions. Sales through U.S. Retail stores rose 22% in the quarter through December 5. Sales at Home Depot and Lowes have been very strong. The Commerce Department reported Advance Retail Sales for the month of November on December 16. Year-over-year sales of building material, garden equipment and supply dealers were up 18.7% in November.
The company also said that it is seeing better performance in the Engineered Fastening and Attachment Tools portion of the Industrial business.
SWK expects the strong 4Q sales to contribute to an increase in operating margin to ‘historically strong’ levels, as we saw in 3Q. The updated planning assumption the company provided is that they now expect full-year operating margin dollar growth of 7%-9% compared with the previous expectation for mid-single digit growth.
Stanley also said that they expect full year free cash flow to exceed $1 billion compared with a previous assumption of $800-$900 million.
The company will report 4Q earnings on January 28.
EARNINGS & GROWTH ANALYSIS
We are also increasing our estimate for Industrial sales.
Our full-year operating income estimate is now $2.09 billion, up from $2.04 billion previously, and $1.9 billion before the 3Q earnings release. Our estimate is now higher than the company’s $1.94 billion operating profit in 2019.
We are also boosting our 2021 EPS estimate to $9.50 from $9.25, on our expectation for slightly stronger sales than we had been forecasting. We are modeling sales of about $15.2 billion, compared with $15 billion previously. We now project operating income of about $2.16 billion, up from $2.1 billion.
Before the COVID-19 crisis, we had expected earnings to grow at a compound annual growth rate of 10% over the next five years. We do not like to tinker with our growth rate. In any case, it is good to have a roadmap of what a company is hoping to accomplish. We see this as an impressive growth rate for a mature business, though it is at the lower end of the company’s pre-COVID-19 objective to grow EPS 10%-12% from 2016 to 2022. This is based on 4%-6% organic revenue growth, and total revenue growth of 10%-12%, which aimed to take the total to $22 billion in 2022. That growth was expected to be enhanced with approximately $5-$7 billion from acquisitions. The focus of future acquisitions is likely to be on further consolidating the tool business, engineered fastening and infrastructure, and building the Lawn & Garden business. We believe that when the time comes, management will be looking for businesses with operating profitability over 15% and the ability to generate value that is greater than simply repurchasing shares, which will likely require a cash flow return on investment in excess of 12% for strategic acquisitions and more than 15% for bolt-on acquisitions. We also expect long-term growth to be boosted by an emphasis on emerging markets, although management will need to see hefty returns to justify the risk. We expect share repurchases and steady dividend increases to resume post COVID-19, supported by free cash flow exceeding net income. Stanley has been very successful in working capital management and we expect that to continue.
FINANCIAL STRENGTH & DIVIDEND
The company ended 3Q20 with $683 million in cash and equivalents, up from $298 million at the end of 4Q19. SWK doesn’t normally maintain big cash balances. As a mature company it needs to manage working capital very efficiently and it has access to commercial paper markets in most environments.
Total debt was $4.7 billion or 31% of total capital. The company ended 3Q with an additional $3 billion of capacity under its $3 billion commercial paper program.
In April of 2020, Stanley amended the covenants on its $3 billion of revolving credit facilities (which back up the commercial paper program) to allow for additional restructuring and other charges related to the pandemic and to lower the minimum interest coverage ratio from 3.5-times to 2.5-times.
In 2014, management reduced debt to 1.9-times EBITDA from 2.9-times at the end of 2013. Management’s goal is to maintain debt at 2-times to 2.3-times. The company ended 2015 at 1.8-times, 2016 at 1.9-times, 2017 at 1.8-times, 2018 at 2.6-times and 2019 at 2.1-times.
As a result of the company’s significant M&A activity, goodwill and intangibles, represented 60% of total assets at the end of 1Q20, dwarfing tangible assets. The company suspended M&A activity as a result of the COVID-19 crisis. In the 3Q call management said that it had removed the ‘pause’ on M&A and share repurchases, but expressed that its priority was for reducing debt.
As of the end of 2014, Stanley’s post-retirement benefits had a balance-sheet liability of $750 million. The balance was $670 million at the end of 2015, $644 million at the end of 2016, $629 million at the end of 2017, $595 million at the end of 2018 and $609 million at the end of 2019. The company made cash contributions of approximately $60 million in 2015, $57 million in 2016, $67 billion in 2017, $45 million in 2018 and $48 million in 2019. The company expected to contribute about $38 million in 2020.
The company has access to a $3.0 billion commercial paper program and a credit facility of similar size that exists to back up the CP program. The company used proceeds from the remarketing of preferred equity units to repay short-term debt in 2Q. There was $3 billion of capacity on the commercial paper program at the end of 3Q. The company entered into amendments which ease the covenants on the credit agreement through 2Q21.
SWK delivered $1.1 billion of free cash flow in 2019. That was 113% of net income, topping management’s goal of 85%-90% of net income. SWK delivered $976 million in 2017, which was approximately 100% of net income on an adjusted basis, which excludes a gain from divesting a business and some other one-time items. Free cash flow in 2016 was $1.14 billion, an impressive 118% of net income. Free cash flow conversion was approximately 90% in 2018 because of higher inventories associated with the launch of Craftsman tools.
In 2Q12, SWK announced a new 20 million share buyback authorization, equivalent to about $1.2 billion. Management announced plans to repurchase up to $1 billion of shares in 2014 and 2015. The company said in the 3Q call that it has removed the ‘pause’ on share repurchases, but debt repayment is their priority for capital deployment.
Management is well attuned to the importance of maintaining a dividend and high credit rating. SWK’s long-term debt is rated Baa1 by Moody’s and A by Standard & Poor’s. Moody’s has a stable outlook. S&P has a negative outlook. The company’s short-term ratings are ‘split’: a top-tier A-1 from S&P and P-2 from Moody’s.
In 2015, dividend payments were $2.14 per share. The company raised its quarterly payout to $0.58 per share from $0.55 per share with the September 2016 payment. 2016 payments were $2.26. The company is targeting a dividend payout of 30%-35% of earnings. SWK’s plan is to split its free cash flow, with half going to acquisitions and half to shareholders through dividends and share repurchases. Capital expenditures are targeted at about 3.0%-3.5% of sales.
This marked 53 consecutive years in which the company had increased the dividend. In 2017, dividends totaled $2.42 per share. 2018 dividends totaled $2.58. 2019 dividends were $2.70 per share. Our 2021 dividend estimate is $2.82 per share. Our 2021 dividend estimate is now about 30% of our increased EPS estimate.
MANAGEMENT & RISKS
The biggest near-term risk facing Stanley is that COVID-19 will disrupt business. While do-it-yourself home projects have increased, many customers don’t want a work crew in their home. If employment conditions remain difficult or if there is another wave of travel restrictions business could see additional pressure. On the plus side SWK’s big box customers Home Depot, Lowe’s and Walmart have all been open for business.
In 2016, John Lundgren retired as CEO. He was replaced by James Loree, the company’s President and COO. Mr. Loree was thoroughly groomed for this position and it was the kind of well-telegraphed, low-drama transition we like to see. Mr. Lundgren had been the company’s CEO since early 2004. He replaced former Black & Decker chief Nolan Archibald as chairman in 2013. Mr. Lundgren continued as chairman through 2016 and he remained with the company as an adviser for part of 2017. Donald Allen has served as CFO since 2009, after holding various financial positions at the company.
Jeffrey Ansell, the president of the Tools & Storage business has impressed us. His division continues to deliver impressive innovation that is based on a deep understanding of what builders and construction workers do and what they need. One answer has been lighter tools with longer lasting batteries that make it easier to complete long jobs. The Flex Volt system is making it possible for contractors to share batteries between devices. One challenge we’ve had is that amps are still important. Our experience is that a 20-volt, 1.5 amp battery that comes with a drill doesn’t do a good job driving a weed trimmer or a leaf blower. The 20-volt, 3- or 4-amp battery that comes with the bigger tool will run a drill for a long time, but adds significant weight. Mr. Ansell announced that he will be transitioning responsibilities to Jamie Ramirez. Mr. Ansell will be spending more time on personal endeavors and will stay on as a strategic advisor through 2023.
Stanley Black & Decker faces commodity price risk. In the past, the company has not been able to consistently offset input cost inflation with price increases, so volume growth, operating efficiency, and profitable acquisitions must compensate for the remaining impact. We believe that Stanley is doing an excellent job in adapting to various headwinds, most recently tariffs. Strategies include shifting production, raising prices and cutting costs to maintain margins. We look forward to a less turbulent environment in which the company’s efficiency improvements can be reflected as EPS growth. A downturn in homebuilding or a recession could pressure the demand for tools. SWK is a mature player in many developed markets, and increasing competition provides a difficult environment in which to grow market share. That said, the Tool business has an outstanding record of innovation. We think many of the consumer products would be envious of what SWK has achieved. As noted above, emerging markets represent an attractive source of growth, although the risk of market volatility in these regions is ever-present. As the company expands its international presence, currency becomes a bigger risk and a bigger analytical challenge.
Approximately 27% of the company’s revenue is related to residential repair and remodeling, 17% is tied to new-home construction, 14% is tied to commercial construction, 15% is tied to general industrial production, and about 7% is linked to automobile production. The remaining exposures are smaller. Retailers are major clients of the Security business but they are only 4% of the overall business.
Both Stanley and Black & Decker have long histories and a reputation for product quality. Their brands are staples at large home-improvement and industrial construction retailers, and maintaining a base of loyal consumers is crucial. Any decline in product quality would almost certainly dent consumer loyalty, as customers tend to feel a strong sense of attachment to their tools.
The company also has some client risk associated with its relationship with big-box retailers including Lowe’s and Home Depot, which represent 15% and 10% of sales in the Tool & Storage segment. Sales to home centers and mass merchants represented 40% of total-company revenue at the end of 2019. Stanley’s goal is to get Tools & Storage from 70% of revenue to less than 60%. One initiative is to substantially increase the lawn and garden business.
Amazon should not present a major problem for SWK, as it does for pure retailers. The online marketplace presents a bigger risk for retailers or ‘middle men’ than manufacturers. That said, AMZN’s presence will keep pricing sharp as the online retailer strives to gain market share and Home Depot and Lowe’s compete to maintain share or gain it from smaller players. One secondary risk is that increasing price transparency on Stanley products will probably push HD and LOW to develop private-label products that can be sold at lower price points than Stanley or DeWalt, and perhaps earn higher margins. This just means that SWK will need to continue to innovate if it wishes to maintain its shelf space at big-box stores. To date, it has done a pretty good job.
Stanley Black & Decker was formed from the combination of Stanley Works and Black & Decker in 2010. The company’s headquarters is in New Britain, Connecticut, where Stanley has been based. The company generated approximately $14.4 billion in 2019 revenue. SWK operates within a divisional structure, with approximately 70% of revenue coming from the Tools and Storage segment, about 14% from Security, and about 16% from the Industrial segments. Fifty five percent of revenue is generated in the U.S. The company has now paid a dividend for 144 consecutive years and raised it for 53 consecutive years.
The Tools and Storage segment generated about $10 billion of 2019 revenue, with about $6 billion from Power Tools and $4 billion from hand tools, accessories and storage products. The Security segment generated $1.9 billion of revenue, with $1.5 billion from electronic/convergent security products and services, $145 million from monitoring and services for hospitals; and $300 million from Mechanical Access, which includes automatic doors at offices, stores and restaurants. The $2.4 billion Industrial segment includes Engineered Fastening products for cars, aerospace, electronics and construction, with revenue of $1.7 billion; and the $700 million Infrastructure business includes hydraulics, as well as products and services for oil and gas pipelines.
SWK shares are up 8.3% this year and they are up 8.2% over the last 12 months. The shares are trading at 21-times our 2020 estimate and 19-times our 2021 estimate.
We believe that Stanley should trade in line with the market multiple over time. Right now (which is certainly not a normal time), the S&P 500 is trading at 22-times our 2021 estimate. On the positive side, the company has solid financial strength, an enviable record of paying dividends, an excellent record of new-product innovation, and initiatives to drive international growth, particularly in emerging markets. On the negative side, Stanley is a mature, cyclical, business that faces intense competition in its tool business, a concentration of sales among a small number of retailers, and challenges in finding attractively priced acquisition candidates to support future growth. Over the last five years, the shares have traded at an average of 19-times trailing earnings.
Here is a very rough estimate. If the company reaches our estimate of $9.50 per share in 2021 and grows at 10% for the following three years, adjusted EPS would rise to about $12.65. At 17-times projected earnings, the shares would be worth approximately $215 per share in 4 years.
Using a two-stage dividend discount model, a terminal multiple of 17-times assumes about three years of 10% growth with a 30% payout and an 8% cost of equity followed by steady-state growth of 3% along with a 75% payout and an 8% cost of equity.
Using a full dividend discount model, which incorporates a transition period between 10% growth and 3% growth, the shares would be worth approximately $170.
On December 17, HOLD-rated SWK closed at $182.09, up $2.65.