Stanley Black & Decker Has the Right Tools for Continued Growth
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The $4.5 billion, all stock merger between Stanley Works and Black & Decker in 2010 created the leader, by market capitalization and revenue, of the hand and power tool industry. The acquisition of Black & Decker by Stanley Works to create Stanley Black & Decker (NYSE: SWK) is an example of one of the four components of the strategy it has been executing since 2002. In addition to achieving growth through acquisitions, this strategy aims for reduction of customer concentration risk, growth in the percentage of total sales derived from emerging markets (primarily Latin America), and improved efficiency of its supply chain.
Revenue and net income have grown by 14% and 15%, respectively, since 2001 as a result of the acquisition strategy and the growth rate of revenue has been pumped up to more than 20% since 2006. Unfortunately, profitability has suffered and operating income and net income growth have not kept pace, with operating margin falling to 8.9% in 2011 from a peak of 13.8% in 2007 and net margin falling to 6.5% in 2011 from a peak of 7.5%, also in 2007. I expect that reductions in manufacturing capacity and staffing from the union with Black & Decker will lead to cost savings and a return to normalized margins.
The second component of the company’s growth strategy is increased penetration of faster growing emerging markets. This strategy increases risk but also will create intrinsic shareholder value if executed well. Latin American revenue has grown to about 8% of the total in 2011 from only 2.7% in 2009 while revenue from Asia represented 7% of the total in 2011 from 5.7% in 2009. Future growth in these regions constitutes a significant opportunity to boost sales in the coming decade.
The tool business was dramatically altered when Black & Decker and Stanley Works merged in 2010 as they were each other's primary competitor. Danaher Corp. (NYSE: DHR), Snap-On Inc. (NYSE: SNA) and Makita Corp. ADRs (NASDAQ: MKTAY) remain as the main competition to the company with each of these competitors addressing a portion of Stanley Black & Decker's total business. One of Danaher’s three segments is consumer and professional hand tools, Snap-On competes in the professional tool market, and Makita is primarily in the portable electric power tools segment. At a recent price of about $63 per share, Stanley Black & Decker trades at a lower forward valuation than Danaher, Snap-On, and Makita, which recently traded at $52, $60, and $34 per share, respectively.
At its recent price, Stanley Black & Decker is at a forward multiple of 10.7x the midpoint of its EPS guidance of $5.88 per share, which excludes M&A expenses. Snap-On does not provide explicit earnings guidance so it trades at a forward price to estimated earnings ratio of just under 12x. Danaher’s midpoint EPS guidance is $3.30 per share and its forward PE is 15.8x, while Makita’s EPS guidance is $2.67, which yields a forward PE of 12.7x at the recent price of $34 per share. Stanley Black & Decker’s EPS growth rate for next year is 12.2% so it carries a 0.9x price to earnings to growth (PEG) ratio, which is less than Snap-On and Danaher, both at 1.0x. Snap-On’s growth rate is estimated at 11.7% while Danaher has guided 16.6% growth in EPS for next year. Makita has forecast declining EPS for next year so it does not have a meaningful forward PEG. The PEG multiples are all very comparable so Stanley Black & Decker’s 0.9x multiple is attractive relative to its peers. Given that its future growth rate of 12.2% is lower than Danaher’s and only slightly higher than Snap-On’s, I view it as the best value at these share prices.
Stanley Black & Decker could meet forecast earnings growth because it will benefit from a recovering U.S. economy and from its cost reduction efforts from recent acquisitions like Niscayah and the 2010 merger. Severe economic weakness in Europe and Asia, which constitute a growing portion of their business, could derail Stanley Black & Decker’s growth. I currently believe this scenario is still more unlikely than not, so I am marginally confident that Stanley Black & Decker will be able to reach its growth potential by continuing to execute its strategy.
The fair value of Stanley Black & Decker using discounted free cash flows is more than $71 per share assuming a forward growth rate of only 5%, which is significantly below the historic growth rate of more than 11% since 2006. This scenario provides a margin of safety that anticipates a likely modest but not severe decline in the European and Asian economies in the next several years. The potential upside share price is about $78 assuming 10% free cash flow growth based on stronger worldwide economic performance and if the company continues to execute its strategy. These fair value estimates imply current share undervaluation of between 12% and 24%.
For investors willing to accept the risk of severe European and Asian recessions in the next 12-18 months, Stanley Black & Decker offers potential share price appreciation approaching 25%. And because the dividend payout is currently less than 45%, more conservative investors with long term horizons can safely capture the current 2.6% yield while waiting for the world economy to rebound as the company executes its proven strategic growth initiatives.
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