Stanley Black & Decker May Be Surprisingly Cheap

By Stephen D. Simpson, CFA | January 27, 2012 AAA

Every once in a while it's a good idea for investors to broaden their horizons and re-examine some ideas of the past. While I have been spending a fair bit of time on industrial supply companies and overseas toolmakers like Atlas Copco and Techtronic, it may be the case that there's an interesting stock here in the States. More to the point, Stanley Black & Decker (NYSE:SWK) has some challenges and real risks, but looks surprisingly cheap after its latest earnings report.

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The Consummate Noisy Quarter
Unfortunately, assessing Stanley's quarter takes a fair bit of work for all of the moving parts. The company reported revenue growth of almost 16%, with 6% organic growth from a 5% volume increase and a 1% price increase. This was a pretty solid result. Breaking it down, the Construction/DIY business saw 4% reported growth (or 8% organic growth after excluding Pfister), Industrial was up more than 11% (7% organic), while Security was up almost 47% as reported, but flat on an organic basis.

Margins were a real headache. Reported gross margin slid a full point as the company continues to see input cost inflation. Operating income was reasonably good, but how good depends on how much you wish to adjust the numbers. On an as-reported GAAP basis, operating income rose 21% and the operating margin expanded about 40bp. Strip out some M&A charges and the growth bumps up to 27% and the margin expansion is a full 150 basis points. (For related reading, see Owners Can Be Deal Killers In M&A.)

On a segment basis, CDIY saw a 19% increase in profits, Industrial a 25% increase and Security a nearly 38% increase. All of that said, this is below what management had led investors to expect. At the bottom line, Stanley Black & Decker would have missed estimates by about $10 without a lower tax rate; about half of that miss can be tied to lower-than-expected margins in CDIY and Security.

Construction Will Come Back ... Someday
Stanley Black & Decker is clearly leveraged to a recovery in residential and commercial construction, as more than half of the company's revenue base is in these markets. To that end, there are some encouraging signs, but it's still very early. More than a few stock theses have fallen apart, in the past couple of years, on the idea that a construction recovery was "just around the corner."

Still, appreciate at least one detail about this company: as much as it depends on the housing and construction markets, the company produced about $700 million in free cash flow last year. That's not bad for a company heavily exposed to an industry down in the dumps.

More M&A Makes Sense ... To a Point
This is a company committed in large part to growth by acquisitions. That certainly makes sense to a point. While Stanley Black & Decker has leading tool brands, companies similar to it, such as Snap-On (NYSE:SNA), Makita (Nasdaq:MKTAY), Techtronic, Emerson (NYSE:EMR) and Hitachi (NYSE:HIT), actually have pretty small shares; there's a huge amount of the market that goes to a diverse array of tiny companies collectively called "other" in industry share graphs. Selective deals in this pool make imminent sense.

Further expansion in the not quite as fragmented security business likewise makes sense. Stanley has a strong business in the mechanical side of security, where it competes with the likes of Ingersoll Rand's (NYSE:IR) Schlage, but could look to take on companies like Tyco (NYSE:TYC), Siemens (NYSE:SI) and Honeywell (NYSE:HON) in the more advanced (and annuity-like) monitoring segment.

The risk, though, is that the company goes even further afield in pursuit of diversification and growth. Though this has worked for some companies, it has failed miserably for many others. Stepping out into follow-on markets, like specialty fasteners, makes sense, but the Street is not likely to reward more daring moves.

The Bottom Line
With Stanley Black & Decker's core markets still struggling, it would make sense that investors have shunned the name to some extent. To that end, there looks to be upside in these shares. There is a catch, though, with the company's future margin leverage.

If management can do what it says it can (and what it couldn't do this quarter), mid-to-high single digit free cash flow growth seems quite achievable and with it a price target near $100; it's a classic risk-reward set-up. By the time that investors know management can deliver those margins, the stock will have already run, but the risk of disappointment and stock price stagnation is quite real. Nevertheless, it's a more interesting company today than many investors may otherwise assume. (For related reading on free cash flow, see Free Cash Flow: Free, But Not Always Easy.)

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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