Stanley Black & Decker Earnings Analysis

One of the most consistent investment themes of 2014 so far has been that developed markets have gotten relatively stronger, while emerging markets have weakened. Therefore, what to do about Stanley Black & Decker ? The stock looks like a good value, and there are plenty of reasons to like it, but a large part of its growth prospects depends upon emerging markets. With that said, what are home improvement peers like Whirlpool  and Snap-on Incorporated  saying about end markets, and what should Fools consider before buying into Stanley Black & Decker?



Why emerging markets matter to Stanley Black & Decker
Back in October, investors were treated to an eye-watering mid-teens slump in the stock price as the company lowered its full-year 2013 guidance by more than 10%. The problems in 2013 were focused on the difficulty in raising margins in its security segment (particularly from its acquisition of Swedish security company Niscayah), and weaker growth expectations from its industrial and Construction Do-It-Yourself, or CDIY, segments. In particular, emerging markets had slowed, and sequestration effects had hit U.S. governmental revenue.


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Is Whirlpool a Buy?

If you like the recovery in the US housing market then you probably like the household appliance makers too. Indeed, the recent results from home goods manufacturer Whirlpool   served notice that the industry is in strong shape. However, is all the good news already priced in? Whirlpool is up nearly 35% year to date, is it now time to take some profits? How does it compete against other consumer goods companies, such as General Electric    and Stanley Black & Decker, for your investment dollars?

Whirlpool increases guidance
The recent third quarter results were pretty upbeat. For the second quarter running, Whirlpool increased its full-year earnings per share and free cash flow guidance.

Full-Year Guidance	First Quarter	Second Quarter	Current
EPS	$9.25-$9.75	$9.50-$10.00	$9.90-$10.10
Free Cash Flow (million)	$600-$650	$650-$700	$690-$710

source: company presentations

Note that the mid-point of EPS guidance has risen by 5.3%, but free cash flow estimates have gone up by 12%. This indicates Whirlpool's opportunity to grow cash flow in excess of its earnings growth. In the long-term it aims to generate revenue growth of 5%-7%, earnings growth of 10%-15%, operating margin of 8% (which it reaffirmed it would deliver in 2014), and free cash flow generation of 4%-5% of revenue.

To put these numbers into context, Whirlpool's operating margin (excluding restructuring costs) was 7.6% in the quarter, and the forecasted free cash flow for 2013 would represent around 3.8% of revenue. In other words, there should be more to come next year in terms of earnings and cash flow as Whirlpool approaches its targets.

Believing the numbers
However, it's one thing for a company to have targets and another for investors to believe it can hit them. In the case of Whirlpool, Foolish investors have a number of reasons to be positive.

First, the company is seeing growth accelerate in the right areas. Here's a look at how its industry demand assumptions have changed this year.

Full Year Industry Demand	First Quarter	Second Quarter	Current
North America	2%-3%	6%-8%	9%
Europe	flat	flat to (2%)	flat
Latin America	3%-5%	1%-3%	1%
Asia	3%-5%	flat	(2%)

source: company presentations

Clearly, it's a story of North America strengthening while the other regions are weakening. The good news is that Whirlpool generates most of its profit from North America anyway.

Source: company presentations

Whirlpool generates less than 5% of its sales from Asia, so the weakness in emerging markets that DIY equipment maker Stanley Black & Decker reported recently doesn't apply so much to Whirlpool. Stanley Black & Decker's problem is that emerging market expansion is expected to make up $300 million of its expected $850 million revenue increase over the next three years. Moreover, it is having some integration issues with its acquisition of a European security company, Niscayah.

Second,  the housing market is coming up against the 10 year anniversary of the boom years. If you figure that household appliances have a working life of around 10 years then there should be a significant amount of machines that need replacement in the next few years.

Indeed, the National Association of Home Builders Remodeling Index indicates strength for the industry.

Source: National Association of Home Builders

Third, the rest of the industry is reporting positive results as well. For example, General Electric saw an 11% rise in its appliance sales in the last quarter. In fact, GE has accelerated its appliance sales growth throughout the course of the year, and this nicely mirrors how Whirlpool has increased its North American growth estimates.

	First Quarter	Second Quarter	Third quarter
GE Appliance Sales Growth	3%	8%	11%

source: company presentations

Where next for Whirlpool?
The next few years look good for Whirlpool, provided the US housing recovery stays on track. Moreover, the stock looks to be a good value. For example, the 2013 free cash flow forecast of around $700 million represents 5.3% of Whirlpool's enterprise value.

Furthermore, if the company hits its target of an 8% operating margin then it will be generating significantly more cash flow in future years. With the housing recovery looking like it is still in its early innings there is more upside to come for Whirlpool.

Is Home Depot Stll Good Value?

Investing in anticipation of a housing recovery has been one of the best trades of the last year, but with things like the home improvement stores Home Depot (NYSE: HD) and Lowe’s Companies (NYSE: LOW) hitting new highs is it time to start thinking about reducing your weighting in the sector?

My rationale in asking this question is not to question the validity of the housing recovery but rather to highlight the fact that there may well be other stocks related to it that are have better valuations. Moreover a recovery in the U.S. housing market usually precedes recoveries in other areas of the economy where investors may find investment opportunities.

Home Depot and Lowe’s Companies report

Home Depot’s recent results were certainly better received--initially at least--than Lowe’s Companies, but no matter; both stocks rose afterwards. The truth is that the market has woken up to the housing recovery and wants a piece of investing in it. As for the results, Home Depot continued its recent tradition of raising full year guidance.

Here is how Home Depot has tended to hike guidance over the last few years.

As the housing recovery as strengthened so Home Depot has continued to upgrade its full year revenue estimates. It is now three quarters in a row that it has done this, and in this set of results it noted that its pro business had started to grow quicker than its consumer business. This is a positive sign of recovery, as pro sales are seen as more discretionary-based.

Furthermore the recovery it is seeing in its end markets is becoming geographically spread with areas that were at the epicenter of the housing crisis (California, Florida, Arizona, etc) starting to recover as well.

With that said there were some challenges in the quarter with the spring weather starting a lot later than last year. This made comparables for things like garden and outdoor products a lot lower for Home Depot. However, it said that April saw a strong snap back in growth following a weak March, and May is similarly strong so far.

It was a similar story with Lowe’s Companies. It reported comparables down 10% in March, with April rising 10% and May continuing the positive momentum. In addition, the weather affected its outdoor comparables so that they were down 7%, with indoor rising 3%.

In fact the message from the macro front was pretty much the same. The key operational difference between the two is that Lowe’s has execution risk/return from its reset program. I’ve discussed this initiative in more length in a previous article. Lowe’s is aiming to complete the resets by the end of the year and announced that the percentage increased from 30% to 50% in this quarter. Unfortunately the weather effects helped to ensure that inventory normalization only increased from 20% to 30%, but if what both these companies are saying comes true, then this number should increase in future for Lowe’s.

A note of caution

In summary, both these stocks have upside from a recovering housing market and upside prospects in the current quarter as spring weather finally kicks in. Moreover, Lowe’s should see some upside potential as the benefit of the resets drops into the bottom line.  So, why the note of caution?

My only concern here is that these stocks have come a long way, and now most investors will have somewhat priced in a housing recovery. A look at their evaluations suggests that they are at levels above what they were when the housing industry entered a recession in 2006.

LOW PE Ratio TTM data by YCharts

Frankly I think that momentum and ongoing positive news on housing is going to take these stocks higher. However, investing is about trying to find the optimal ways to generate returns from your views. With this in mind I think it is time to look beyond the evaluations at the home improvement stores and look at some of the wider housing and construction plays.

Two housing and construction plays

Housing recoveries usually predate construction related improvements. New housing projects get developed which leads to new commercial construction. In this regard I think Whirlpool (NYSE: WHR) and Stanley Black & Decker (NYSE: SWK). The interesting thing about Whirlpool is that it offers upside from its push to increase margins. Given that home improvement stores are reporting good numbers it is reasonable to expect that Whirlpool will see a strong spring too. Moreover, we are hitting the 10 year anniversary of the peak of the housing boom so the replacement cycle should start to kick in soon as well. The stock trades on a forward PE of 13.3x and traditionally generates large cash flows.

Turning to Stanley Black & Decker, this stock has upside potential from a housing recovery and a strategic growth initiative with which it intends to generate growth via expanding in selected verticals while benefiting from ongoing merger synergies.

 Its recent results were a bit disappointing, but like Whirlpool it was affected by some temporary weakness in Latin America (both companies argued that it will rectify in future quarters) and from the weather effects of a late spring. At the time of both these companies results I was slightly skeptical over the weather argument but now that Home Depot and Lowe’s have confirmed its effect and, more importantly, argued strongly that growth will come back.I think this is a good sign for Stanley Black & Decker. Moreover the stock trades on trades on a forward PE ratio of 14.6x and is forecasting $1 billion in free cash flow this year.