Stanley Black & Decker is Still Not Cheap Enough

The latest results from Stanley Black & Decker (NYSE: SWK  ) probably left investors feeling they had been hit by one if its power tools. The company lowered full-year earnings-per-share guidance by more than 10% to $4.90-$5.00, causing the market to immediately punish the company by selling its' shares off by more than 14%. Has the market overreacted, making right now the ideal time to step in and buy? 

Stanley Black & Decker disappointsTo understand what happened, you must go back to the company's strategic growth plan outlined earlier in the year. In brief, the idea was to generate an extra $850 million in run rate within three years.

Source: Investor Relations Presentations

Fast forward to the last set of results, and the company was forced to reduce earnings and free cash flow guidance. Essentially, it blamed half of the earnings- guidance reduction on slower-than-expected margin improvements in the security market (particularly in Europe), and lower growth expectations in its construction do-it-yourself and industrial markets. The latter two divisions saw weakness due to a slowdown in emerging markets, and the effects of the US government sequestration and shutdown.

Emerging market and government weakness temporary?Eagle-eyed readers will note that the weak spots are in areas that are key elements of the strategic growth initiative. Moreover, the weakness in the emerging markets is especially worrying because the company is planning to generate great leverage out of a relatively low level of plant investment.

One of the ideas behind its 'mid-price-point growth  program' for 2014 is to start to compete with more moderately priced products, because traditionally it sold to the top 10%-20% of the market within the emerging markets. On the conference call, management declared that they felt the emerging market slowdown was:

 "..a slight temporary deceleration, we believe, associated with some macroeconomic pressures we are seeing in these geographies."-Quarterly Conference Call

And for these reasons, the company is not going to make any significant adjustment to its emerging market plans. All told, if the weakness in emerging markets turns out to be lasting, then the company is likely to disappoint next year with a key element of its growth plan.

Two of the key companies to follow in this regardare Whirlpool (NYSE: WHR  ) and General Electric's (NYSE: GE  ) home & business segment which contains its household appliances segment. GE recently reported an impressive 7% growth in revenue for this segment, with household appliances rising 11%. GE and Whirlpool are both interesting, because we are approaching the 10 year anniversary of the peak years of the US housing bubble. In other words, many of the appliances that GE and Whirlpool then will enter their replacement cycles.

Indeed, in its third-quarter outlook, Whirlpool upgraded its North American growth expectations for the full-year, but lowered guidance for Asia, and Latin America. This is the second quarter in a row that Whirlpool has done this. Interestingly, Whirlpool raised guidance for its European region.

Full Year Industry Demand Assumptions	Q1 Outlook	Q2 Outlook	Current Outlook
North America	2% to 3%	6% to 8%	9%
Europe, Middle East & Africa	Flat	Flat to -2%	Flat
Latin America	3% to 5%	1% to 3%	1%
Asia	3% to 5%	Flat	-2%

source: Investor Relation Presentations

Whirlpool raised its full year EPS guidance, but this is mainly due to relatively better performance within developed markets, and particularly North America. Moreover, Whirlpool only generates 4.2% of current sales from its Asia region compared to 55% from North America.

Turning back to Stanley Black & Decker, its difficulties in the public sector couldn't have been unexpected, and they may prove temporary, but it does call into question the future plan to generate $100 million in run rate from the US Government.

No security in security for Stanley Black & DeckerHowever, the deeper concern must be with the slowness of margin expansion in the security division. The problems appear to relate to its acquisition of Swedish security company Niscayah. On the conference call, management outlined three structural issues with regards the integration

• Management underestimated the extent on which Niscayah relied on referrals from its previous parent company Securitas

• Niscayah's senior management team left, and Stanley Black & Decker was forced to replace them and rebuild a sales force

• Niscayah previously had a 'legacy systems integration' rather than the kind of recurring revenue model favored by its US acquirer, and changing it takes time

In short, these issues are slowing the pace of margin improvements in security. It's easy to hear about problems in Europe and quickly conclude that they are macro-related, but note that these issues appear to be company specific. In other words, if Stanley Black & Decker can resolve them internally, then there should be upside to come.

The bottom lineFrankly, I think investors should give the company the benefit of the doubt over the emerging market and US government issues because they may well be temporary. In any case, company expectations have now been lowered so any resolution of these 'temporary' issues should now offer upside potential. However, since much of growth depends on the emerging markets, investors have a right to be concerned. Whirlpool may be a better option for investors looking to avoid emerging market uncertainty.

Stanley Black & Decker's management outlined that it now expects 3% to 4% organic growth in the second half compared to expectations for 6% previously. Free cash flow guidance for 2013 was cut by 20% to $800 million. In addition, for 2014 the management discussed 4% to 6% in organic revenue growth, and a conservative looking 7% to 9% in earnings growth.

 

Cautious investors may well wait to see evidence of improvements with the Niscayah acquisition before jumping in. To be fair, this is a management versed in integrating companies, but on a forward P/E of more than 15 times, this stock is unlikely to be bought by people attracted to its current single-digit earnings forecast.

Whirlpool is Still Good Value

Investors in home appliance manufacturer Whirlpool (NYSE: WHR) have seen a near-90% rise in its share price over the last year, and many of them must feel tempted to take some profits. But the company has a number of positive things happening for it in 2013. And  if it continues to execute in moving towards hitting its long-term targets, Whirlpool could have plenty of upside left.

Whirlpool upgrades guidance

In line with many other companies in the current reporting season, Whirlpool reported that North American conditions were strengthening, while Europe remained weak and Asia weakened somewhat. Indeed, a quick look at its updated expectations for industry demand tells the tale:

Industry Demand Assumptions	Previous Outlook	Current Outlook
North America	2% to 3%	6% to 8%
Europe	flat	flat to -2%
Latin America	3% to 5%	1% to 3%
Asia	3% to 5%	flat

Source: Company presentations.

Eagle-eyed readers will note that only the forecast for North American was raised, but the good news is that this is the key region for the company. Whirlpool generates nearly 55% of its revenues from North America, and a graph of its regional profits illustrates that its importance:

Source: Company accounts.

With regard to revenue, North America makes up nearly 54.8%, with Latin America contributing 25.3%, EMEA around 15.4%, and Asia with only 5.2%. For those of you worried about a potential slowdown in China’s housing market, the good news is that Whirlpool is not particularly exposed.

For this reason alone, the stock is more attractive than home-improvement toolmaker Stanley Black & Decker (NYSE: SWK). A large part of Stanley Black & Decker’s growth prospects come from its strategic growth initiative. The plan involves aiming to increase revenues by $350 million within emerging markets, and China makes up a big part of its growth intentions. Although Stanley Black & Decker has a similar exposure to Whirlpool in North America, the market won’t waste any time in marking down the former if its growth prospects diminish in China.

The really good news for Whirlpool investors was that its overall guidance was upgraded. Ongoing diluted EPS forecasts were raised to $9.50-$10.00 from $9.25-$9.75 previously. Equally importantly, its forecast for free cash flow was raised to $650 million-$700 million from $600 million-$650 million. Some investors have worried about Whirlpool's lack of cash flow generation in recent years, but given ongoing margin expansion, the company looks set for strong growth in free cash flow.

The three reasons why Whirlpool’s prospects will get better

Firstly, its ongoing productivity improvements and restructuring are seeing genuine improvements in margins. Whirlpool’s long-term target is to get operating margins up to 8%, and on current trends, that looks achievable.

Source: Company accounts.

The second reason is that the U.S. is approaching the 10-year anniversary of the housing market boom. This is important, because the large number of appliances bought at the top of the market will increasingly need replacements.

For example, here is the data on total home laundry product shipments from the Association of Home Appliance Manufacturers:

Source: Association of Home Appliance Manufacturers.

Obviously, home-improvement stores like Home Depot (NYSE: HD) and Lowe’s will also be beneficiaries from these trends. Indeed,  in a  sign that the cycle is turning, Home Depot is starting to see its professional sales outpacing its consumer revenues. Moreover, the segments of its sales that outperformed in the last quarter involved things like kitchens, electrical, décor, lighting and hardware. These trends are positive for Home Depot because they imply an increased willingness among consumers to spend on discretionary items. Moreover, they are the kinds of goods that Whirlpool sells.

The final reason is that the housing recovery is encouraging new housing construction. This is good news for Whirlpool, because it will spur sales growth 6-9 months down the line as new homeowners start to purchase home appliances. In addition, this trend could boost profits, because the types of appliances bought by new homeowners tend to carry higher margins.

The bottom line

In conclusion, Whirlpool has some very positive trends in its favor. If it hits the targets of expanding operating margins and cash flows, then the stock can appreciate from here. Analysts have it on a consensus forecast EPS of $11.85 for 2014. This puts the stock on a forward valuation of less than 11 times earnings, as I write. That number looks too cheap. Provided the company hits expectations, Whirlpool shares represent a good value  for long-term investors.

Time to Buy Stanley Black & Decker?

There are three positive earnings drivers to look out for with Stanley Black & Decker( NYSE: SWK), and if they all come together in 2013, then this stock has significant upside potential. It is a nice mix of value and growth.The company offers a nice mix of improving end markets, ongoing cost savings from synergies created via acquisition integration, and it has a strategic growth initiative in place in order to drive revenue growth and return on capital. In this article, I want to look at how these three facets are playing out so far this year.

End market prospects

The recent results were a mixed bag, as estimates were missed but the full year guidance for EPS and free cash flow was maintained at $5.40-$5.65 and $1 billion, respectively. The strength in its mix of business is undoubtedly coming from its construction and do-it-yourself (CDIY) segment and it is set to continue. Meanwhile, its security and industrial segments have more subdued prospects this year.

A breakdown of segmental profits in the quarter.

The results were superficially disappointing. Organic revenue declined 1% overall, and it was only the 4% contribution from acquisitions that caused the top line growth of 3%. Moreover, cash outflows were greater than expected in the quarter and its core CDIY segment saw flat revenue. It gets worse. Security revenue fell 1% on an organic basis as did industrial revenue. So, is this a story of declining organic growth and an over reliance on acquisitions? And where does the confidence to maintain full year guidance come from?

The 2013 guidance is for mid-single digit revenue growth in CDIY, and flat to low single digit growth for security and industrial, respectively. With regards to CDIY, there were three issues of which two look like they will be rectified in due course.

Firstly, there is a late start to the North American outdoor season which was primarily caused by the weather. Secondly, there has been some temporary weakness in Latin America due to a variety of reasons. Interestingly, Whirlpool (NYSE: WHR) said a similar thing about the region, and in particular with Brazil. Both of these companies are arguing that this is a temporary setback and Whirlpool shareholders should take heart from the positive trends expressed for Latin America in these results. Sequentially, things got better in Q1 and this gives confidence that Q2 will be better for both companies.

The third issue is -- you guessed it -- Europe, but investors need to recall that comparisons are likely to get easier going forward. Security’s exposure to Europe is worrying (and there was some temporary weakness in the Nordic regions), but an extra $15 million of cost synergies from the Niscayah acquistion are expected. This should help out margin growth. It’s a similar story with industrial where moderate U.S. growth is hopefully going to offset weaker conditions in Europe.

Another company displaying confidence in the North American outlook is Masco (NYSE: MAS). This is more of a leveraged play on new housing construction, and its margin expansion and operational leverage opportunities will come from new builds, but its repair and remodeling market is also expected to grow moderately. Frankly, I think the latter tends to key off the former, and as long as there is good turnover in housing, then prospects will get brighter for all the companies discussed here.

Acquisitions working well

The scorecard over its acquisition strategy over the last few years is positive. It has been a difficult few years for housing and construction related stocks, but I think it has done the right thing in trying to drive cost synergies with its acquisitions. As discussed above, there is an extra $15 million to come from Niscayah (security) which should bring the total for 2013 to $50 million, and management is currently evaluating the potential for increasing the targets for 2014.

Strategic growth initiative

I’ve haven’t got the room to discuss this in great depth here, but investors wanting more color on this can find it in an article linked here.

A graphical summary of the plan to increase revenue by $850 million and profit by $200 million within three years is shown below.

Its early days, but the plans were declared as being ‘on track’. Indeed there was a bit of extra investment in this program although there was no adjustment to the targeted CapEx/Revenue figure of 2.5%-3.5%.

The bottom line

This is an attractive proposition and if it can hit its $1 billion in free cash flow, then the stock would be generating nearly 6% of its enterprise value (based on the current share price of $77). This is cheap for a company expected to grow revenue in mid-single digits and earnings in the mid teens for the next few years.

Ultimately, investors will have to price in the uncertainty that it will hit these targets. If you are positive on the global economy, then this stock is going to give you some upside potential and I think a target price in the mid $80’s is not unreasonable. A good GARP candidate.