SWK – Significant Step Up in Cash Flow and Still Cheap

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Graham Copley / Nick Lipinski

203.901.1629/203.883.1927

gcopley@/nlipinski@ssrllc.com

February 19th 2015

SWK – Significant Step Up in Cash Flow and Still Cheap

  • Stanley has been a cheap stock on our model for some time, driven by a sub-trend return on capital profile. The company is undervalued by more than it is under-earning, giving it a slightly positive value on our skepticism index – the market is skeptical as to whether SWK returns will improve (consensus implies a very conservative 1% growth in EPS in 2015).
  • This skepticism is warranted to a certain extent by Stanley’s middle of the pack revision history, though some of this is skewed by the $5B Black & Decker merger and the dilutive Niscayah Security acquisition but the trend has markedly improvedover 2014, results came in above the initial quarterly estimate by 3% on average as Security stabilized.
  • There was a significant step up in cash flow generation in 2014, and with acquisitions on hold until at least 2016, dividends should continue to grow (11% CAGR since 2011) and share repurchases will accelerate (~$0.10 tailwind in 2015 as part of a $1B authorization).
  • The Security segment appears to have passed a point of inflection and should not be a material drag on the company going forward, while the core tools business (CDIY) has continually gained share in Europe and North America, growing well in excess of the underlying markets. Management admitted growth here will likely moderate, but the brand franchise remains dynamic, and a pickup in US housing and construction (roughly a 30% exposure for SWK) has the potential to sustain the momentum.
  • Our model suggests a “normal” value of $135 based on a long term 11% ROC trend.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

Stanley has been a cheap stock on our model
for some time
, driven by a sub-trend return on capital profile. Capital increased fourfold after the Black & Decker merger, but earnings have been slower to ramp up. The stock is cheaper than the level of under-earning would imply, giving it a slightly positive value on our skepticism index – the market is skeptical SWK returns can improve (consensus implies a very conservative 1% growth in EPS in 2015). Dealing first with the Black and Decker integration and then with the Niscayah (European security) acquisition, Stanley’s recent history of beating estimates is less than stellar and perhaps justifies this skepticism – but the trends here have been notably better over the past year as the Security segment has stabilized (Exhibit 2).

Exhibit 2

Source: Capital IQ, SSR Analysis

Stanley’s struggles over 2012 and 2013 stemmed largely from Niscayah integration issues, but historically the company has employed M&A as a key part of its growth strategy (Exhibit 3), and not every deal can be seamless. After a spending spree from 2010-2013, a moratorium was placed on further acquisitions until at least 2016, which frees up the company’s growing cash flow to be increasingly returned to shareholders – dividends per share have grown by 11% annually since 2011, and the company expects share repurchases will be roughly a $0.10 tailwind in 2015 (part of a $1B share repurchase program).

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 6

Source: Capital IQ, SSR Analysis

Still Plenty of Valuation Support

The stock has moved off of its valuation lows, but there is still plenty of upside on our model. The stabilization of the Security segment removes a key source of downside risk and we would expect Stanley’s return on capital to continue to trend higher from here. “Normal value” on our model, based on the long term ROC trend in Exhibit 8, is roughly $135 a share.

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Capital IQ, SSR Analysis

Security Margins on the Rise

The Security segment has been a weight on the stock for the better part of three years, but seems to have passed a significant inflection point over 2014. Attrition rates have stabilized, the chronically underperforming European geographies have been divested (Spain mostly, but also Italy), and it is now anticipated that this segment will be a modest source of earnings growth moving forward. The issue in Spain was mainly structural – financial institutions accounted for the majority of sales in the country and the Spanish banking sector’s troubles have been well chronicled (roughly a third of the banking branches in the country have shuttered in the past year).

Exhibit 9

Source: Capital IQ, SSR Analysis

Housing & Construction – Where the Upside Is

Our initial work on SWK highlighted the company’s exposure to US housing & construction (~30%). These markets have made some progress since that time, but remain well off the prior peaks, notably so in the residential area – these are summarized in Exhibit 10.

Exhibit 10

Source: US Census Bureau, SSR Analysis

Note in Exhibit 2, that “Shipments of Construction Materials & Supplies” is an outlier in terms of retracement of the drop from peak, having come nearly all the way back from the lows of the late 2000s. This suggests that the apparatus is in place for a more meaningful recovery to take hold. Outside of reasonable comebacks in non-residential spending (though there is still plenty of runway for growth here), there has been broader weakness across the board in the housing markets.

If we think about the drivers of residential construction:

  • Home prices have been rising steadily and are approaching the 2007 peak, which should incentivize building – Exhibit 11
  • Diesel prices have tumbled with crude after having averaged nearly $4.00 per gallon for the bulk of the post-recession period, so a major driver of construction costs has now fallen by about 25% – Exhibits 12 and 13
  • Rising interest rates could be an impetus for prospective purchasers; the average 30 year mortgage rate in the US remains historically subdued, though in the past this rate has moved fairly quickly on speculation of Fed tightening (as seen in the mid 2013 spike) – Exhibit 14
  • Demand is the monkey wrench in the housing analysis, as homeownership rates continue to decline in key demographics, and for the US as a whole the rate has fallen below the 1980-2000 average (perhaps a period of more normalized housing demand) – Exhibit 15

Exhibit 11

Source: FHFA, Bloomberg, SSR Analysis

Exhibit 12

Source: EIA, US Census Bureau, SSR Analysis

Exhibit 13

Source: US Census Bureau, SSR Analysis

Exhibit 14

A Note on Currency

Stanley effectively overcame currency headwinds in the latter half of 2014 and the company appears well positioned to offset further dollar strengthening (hedges in place, cost controls, price actions, and volume leverage). Major currency exposures are the Brazilian real, Canadian dollar, and Argentinean peso.

Exhibit 15

Source: Company Presentations

SWK Relative Sector Position, SSR Four Dimensional Framework

The center circle of Exhibit 16 is the confluence of the factors we look for – inexpensive, over-earning stocks with a history of positive revisions and cash distribution growth. A stock could be close to the middle in the Return on Capital & Valuation quadrant, but a perpetual optimist with no dividend growth and so less centered in the others. The Black & Decker merger and Niscayah acquisition are impacting SWK’s results here, notably in the ROC and Earnings Revisions quadrants.

Exhibit 16

Source: Capital IQ, SSR Analysis

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