SWK – Upside to Earnings and to Sentiment

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 2nd, 2014

SWK – Upside to Earnings and to Sentiment

  • Consensus estimates for SWK appear to be discounting a slowdown in the US housing and construction markets. If the 3 year CAGRs for SWK’s housing related sales drivers are sustained through 2015, all of the company’s current consensus revenue growth will be attributable to its Construction and Do-It-Yourself unit; this seems unlikely, given accretive expectations in other units.
  • We applied baseline, bull, and bear case scenarios to SWK’s key housing & construction related sales drivers to analyze the potential sales impact Exhibit 1. The baseline methodology has been fairly accurate at capturing the revenue effects of movements in underlying end markets on sales for the CDIY segment over the past two years and actually understates the impact of operating margin improvements. In 2011 and 2012, increases in CDIY sales equaled 105% of the sales-exposure-weighted growth rates in the relevant housing and construction markets.
  • If the recovery in housing and construction continues or accelerates, revenue growth and earnings are understated. As indicated in research by our colleague Rob Campagnino, the current deficit in household formation is cyclical in nature – declining homeownership rates (notably in the under 35 demographic) have stabilized and SWK should benefit as the trend turns.
  • Over the past decade, SWK has made several acquisitions and divestments to position itself for sustainable organic growth in 2013 the company placed a near term moratorium on acquisitive moves, marking a stabilization of the business structure for the first time in many years.
  • Investors are apparently skeptical about these initiatives and SWK has been undervalued for some time– our valuation model has the company trading nearly two standard deviations below its historic norm. Our normal value for SWK is around $120 a share.
  • Risks include an asset base with a high percentage of goodwill, slower margin improvement than anticipated in its European Security unit, and of course, weakness in construction markets. There is noteworthy risk for SWK in the first half of 2014, particularly Q1, which is historically seasonally light and also likely to be negatively influenced by the weather.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

At the broadest level, SWK is highly levered to the housing and construction markets, with a little over half of revenue dependent on residential and non-residential construction. The bulk of this exposure (the Security unit contributes a third of the non-residential exposure) is in the core CDIY segment which is 94% tied to these markets, mostly in the US (59% of segment sales in North America). Home starts/sales and non-residential/commercial construction all dropped sharply as the housing bubble deflated, and have shown differing levels of recovery in the aftermath. Exhibit 2 summarizes, in percentages, how much of the post-bubble losses have been retraced and what the growth rates have been over the past three years.

Exhibit 2

Source: US Census Bureau and SSR Analysis

For the data in Exhibit 1 we created three scenarios:

  1. In the bullish case, the steady recovery in construction accelerates (homeownership is currently much cheaper than renting) – we add 500 basis points to each three year growth rate
  2. In the baseline case, we assume the recovery plugs along at status quo
  3. In the bearish case, we likewise deduct 500 basis points from each growth rate

We then applied these gains to SWK’s company-provided sales exposure percentages and compared how the cumulative impact looked in relation to consensus growth estimates. If the 2011-2013 rates of increase in the housing and construction markets are sustained through 2015 (baseline case), virtually all of SWK’s consensus revenue growth over that time would be attributable to the Tool unit (Construction & Do-It-Yourself, CDIY). Given that the company expects margin improvement in the Security division and the impact of the Infastech acquisition in the Industrial unit to be jointly $0.25 accretive to EPS in 2014 alone, this seems unlikely. A decelerating construction market is necessary to reconcile consensus revenue estimates with accretive expectations in all three of SWK’s business units. In the base case we project that SWK revenue estimates are too low in 2014 by 2% and too low in 2015 by 4%.

Our (perhaps overly) bullish scenario has the three year rate of improvement in the relevant construction markets increasing by 5%. In this case, on the strength of its construction exposure alone, SWK 2015 revenues would be almost 5% above current consensus. At the average gross margin, interest, and tax rates of the past three years, this would roughly equate to an additional $1.00 on the bottom line – if you’re bullish on housing, you should be bullish on Stanley.

The methodology used has been fairly accurate at capturing the revenue impact of movements in underlying end markets on the CDIY segment over the past two years. If anything, the effect is slightly understated – CDIY revenue gains for 2012 and 2013 equaled 105% of the cumulative sales-weighted gains in the various housing and construction end markets.
See the Appendix
for a more detailed explanation of our methods.

This analysis obviously depends on an underlying thesis for the housing and construction markets – for Stanley’s part, they noted they have not factored any improvement (at least in the non-residential construction market) into their 2014 guidance. Exhibit 3 shows the time series of these markets.

Exhibit 3

Source: US Census Bureau and SSR Analysis

Why Acceleration is More Likely than Deceleration

The recovery in housing and construction post-bubble has been choppy in some instances but directionally positive. The drop-off in non-residential construction was least severe and rebounded the fastest; the commercial component, which constitutes half of SWK’s non-residential exposure, has been slower to recover, and nearly as choppy. Residential construction has been the smoothest, but permits authorized are a bit behind, and new home sales even more so. Our colleague Rob Campagnino theorizes that there is currently a deficit in household formation, supported by empirical evidence based on historical levels of homeownership and the working age population (with higher stay at home rates due to higher youth unemployment an explanatory factor). This deficit is likely cyclical, but could also represent a shift in attitudes toward homeownership or a market where renting is more economically viable than buying. Residential real estate company Trulia has compiled data for much of the country to assess markets where it is
cheaper to buy vs. rent
, and vice versa. The decision ultimately depends on factors including tax brackets, mortgage rates, and anticipated length of stay, but for the prototypical potential homeowner in the 25% tax bracket with a horizon of seven plus years and a 4.8% fixed rate mortgage, it is clearly a buyer’s market – Exhibit 4.

Exhibit 4

Source:
http://www.trulia.com/trends/vis/rentvsbuy-summer-2013/

Unemployment in the 25 to 34 year old demographic has been on the decline and dropped below 7% in January 2014 (the initial February rate is at 7% even). 35 to 44 year olds have had even better luck – the unemployment rate for this demographic is currently at 5.1%, down from 6.2% in February 2013. Moreover, real estate has been a relatively underinvested asset class since the end of the recession, particularly so in the past few years – Exhibit 5. Given the improving employment trends and the economic viability of buying vs. renting, there is no real evidence to suggest a deceleration in home sales; and Stanley itself is not predicting any improvement (or deterioration) in non-residential construction. In this light, SWK’s medium term revenue estimates seem low, as there is little support for the declining housing and construction markets needed to reconcile those estimates with segment expectations.

Exhibit 5

Source: Capital IQ and SSR Analysis

Understated, Undervalued – But Possible Risks Exist

The apparent understatement of revenue is notable considering SWK already shows one of the healthiest rates of revenue growth among comparable companies. Its valuation remains depressed and it sticks out as an outlier in Exhibit 6 which plots revenue growth versus forward P/E for a group of industry peers. There is clearly a lot of skepticism in SWK – Exhibit 7.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Our own valuation model has also pegged SWK as undervalued for some time. On our framework the company is nearly two full standard deviations below its normal value, which we have at around $120 per share (Exhibit 8). Our models are return-on-capital driven, making any reduction in the capital base significant for valuation. SWK’s listed goodwill & intangibles make up a very high percentage of the company’s total assets – Exhibit 9. This leaves Stanley very vulnerable to potential write downs, which often accompany such high profile deals as the Black & Decker merger. For reference, SWK would need to write down approximately $4 billion, or about 25% of its current total assets to bring it to fair value on our valuation framework. This high level of intangibles also suggests a drag on returns relative to industry peers – Exhibit 10. The moratorium on acquisitions should send SWK’s data point in Exhibit 10 towards the upper left quadrant over time.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

SWK’s high level of debt is also acquisition-related, and a prime reason for the current moratorium on acquisition. Debt/EBITDA was at 2.9x in the fourth quarter, and the company has committed to deleveraging its balance sheet. Exhibit 11 shows the 2013 Debt/EBITDA level as defined by SWK, and indicates a $100 million reduction in debt is necessary at current 2014 EBITDA estimates to achieve their targeted level of 2.0.

Exhibit 11

Source: Company Reports, Capital IQ, and SSR Analysis

The Security unit, in particular the European operations, presents another concern for SWK moving forward. The company acquired the Swedish electronic security firm Niscayah from Securitas in 2011, and the integration has not gone as smoothly as anticipated. Niscayah was an attractive target given the accelerating pace at which electronic security is displacing traditional manned security, notably so in Europe. Weakness has resulted from a business model that was primarily reliant on parent company referrals that obviously ceased after Securitas sold the unit to SWK. Attrition rates were in the mid teens in Q4 2013; Stanley is expecting operating margin improvements as this rate is managed towards 10%. Management has been overhauled at four of the six major markets for the unit as Niscayah is weaned off of referrals and the vertical market solutions in place in the North American market are exported to Europe. Cost reductions should also help but are not expected until the second half of 2014, which is when Stanley anticipates the transformation will gain traction.

Investment Conclusion

SWK has suffered some setbacks since the purchasing spree which began with Black and Decker, but the fundamental CDIY story remains intact and despite some further bumps in the earnings road in 2013, the company is slowly driving improving returns on capital – back towards and in our view above historic trend. There are some US centric tailwinds in housing – not only do we expect to see a more normalized household formation environment going forward, but purchasing homes is now so much more attractive than renting in most US states, and real-estate remains underinvested as sector, since the downturn.

We expect to see revenues and earnings exceed expectations for 2014 and 2015 given the housing tailwind, with earnings estimates low by around 15% in 2015, in our view. If the company can get its hands around its security business and start driving some improvements there we could see further upside. Alternatively, if the company cannot see a way to improve the security business, they should quickly sell it, something which would likely also be a positive catalyst for the stock.

Our “fair value” for SWK is $120 per share and we believe this is achievable within 12-18 months as long as the US housing market remains on an improving trend and as long as there are no more negative surprises in the security business. The other risk would be a large goodwill write-down as it would be an admission that the acquired business cannot deliver as expected.

A more detailed overview of Stanley’s business units and competitors follows herein.

Overview of SWK’s Business Segments and Competitive Environment

Security

Stanley first forayed into the Security market with its 2002 acquisition of Best Access Systems, a security access control provider. Combined with the existing automatic door and commercial hardware businesses at SWK, the unit grew to $1 billion in sales within three years. The company entered the European security market in 2011 when it purchased Niscayah. The European Security market generally tends to be more focused on manned security vs. electronic security. The three largest publicly traded Commercial Guard Services companies are located in the UK (G4S plc), Sweden (Securitas) and Spain (Prosegur). Japan’s Sohgo Security is fourth before the first North American competitor, Brink’s appears. The extent to which a company relies on manned guards as opposed to electronic security systems can be seen by looking at revenue per employee – Exhibit 12. The differences are also evident in operating margins – Exhibit 13. Despite operating in the higher margin electronics segment of the Security industry, Niscayah more closely resembled a manned security firm from a margin profile perspective prior to the Stanley acquisition, with a declining trend leaving margins hovering below 5%. The purchase of this unit exacerbated an already downward trend in SWK’s own Security unit margins. The company estimates margins will improve in 2014 through 2016, whereupon they are expected to flatten at around 16% – Exhibit 14.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

These are just a notch above margins in the Tool industry, Stanley’s core strength; the tool units of both SNA and SWK have followed similar operating margin trajectories, and could see incremental improvement with increased industry consolidation – Exhibit 15. Return on capital is less of a clear comparison, but TYC provides a good example of returns in the Electronic Security industry. Following a 2012 split into three separate businesses, the remaining Tyco (TYC) is “the leading pure play Fire & Security company.” Unburdened of the complexity and cyclicality of several divergent businesses, Tyco’s ROC saw a step change immediately following the split – Exhibit 16. Growth prospects are slightly more attractive in Security, where 4-6% growth is anticipated, versus 3-5% in the continually consolidating Tool industry.

Exhibit 15

Source: Capital IQ and SSR Analysis

Exhibit 16

Source: Capital IQ and SSR Analysis

TYC appears to be one of Stanley’s closest Security peers. Exhibit 17 below shows revenue by segment for each company. SWK will try to move its mix towards TYC’s, with perhaps less emphasis on products. This will gain steam as Stanley’s North American Security model, which places a greater emphasis on recurring monthly revenues, is exported to its European unit where the legacy Niscayah business is still operating on more of an installation model.

Exhibit 17

Source: Company Reports

CDIY – Construction & Do-It-Yourself

Exhibit 18

Source: Company Reports and SSR Analysis

At the core of SWK’s business are its hand and power tools. The company maintains leading share positions in both markets. The Hand Tools market is smaller ($4B globally), with less room for innovation; SWK has a comfortable margin (~24%) over second place Craftsman (~15%), a brand in decline. The Power Tools market is larger ($12B), more competitive (SWK and Bosch each control a little over 20% of the market with Makita not far behind), and has the strongest growth prospects, with substantial room for innovation (SWK is scheduled to release 225 “World’s Firsts” over the next three years). This segment drives the company’s overall leverage to US construction.

SWK was even more tied into construction before it sold its Hardware and Home Improvement business to Spectrum Brands for $1.4 billion in 2012. Kwikset door locks and bath fixtures such as Pfister faucets were among the brands and assets sold; they represented just 9% of revenues and SWK was quick to note the slower growth, low margin nature of these businesses. Yet despite the premium price and the diversification benefits, it is questionable why SWK would abandon a market (US housing) that was widely considered to be on the mend to pursue another (Europe in general, via the Niscayah acquisition) that remains in doubt.

Industrial

The Industrial segment contains units that operate in the two fastest growing industries (Engineered Fastening and Infrastructure) SWK competes in. As a whole, the segment is 37% levered to the Auto market (26% production, 11% aftermarket). Industrial has three sub-segments:

  1. The Engineered Fastening market is growing 6-8% annually – the Infastech acquisition bolstered the company’s offerings and contributes to the current high exposure of sales to the Asia Pacific region (44%, vs. 28% each in Europe and the America). This sub-segment is more than 50% levered to the automotive market and appears well positioned for sustained growth.
  2. Infrastructure is the smallest sales component of the three Industrial segments, at just $0.5 billion, but has a similar growth profile to Engineered Fastening, and SWK has the goal of doubling sales into the $1-$2 billion range. Oil & Gas operations are the bulk of revenues – the CRC Evans acquisition helped here. The business mix is 60% onshore, 40% offshore, and stands to benefit from increased pipeline construction in the US.
  3. Industrial & Automotive Repair is 64% industrial tools and 28% automotive aftermarket. This is mostly a domestic unit, with 53% of revenue generated in the US, but the company has done well in expanding emerging market sales, up to 19% from 13% three years ago.

Competitors

Despite the absence of industry peer SnapOn Tools in the market share tables above (Exhibit 15), SNA and SWK have historically traded in tandem, though this correlation has lessened somewhat since the completion of the Black & Decker merger (R2 of 0.6 since 2011 versus 0.8 since 2000). While on a broad level both SWK and SNA are making tools, their customer focus is quite different. The main competitive overlap between the two, given SWK’s breakdown of the global Power and Hand Tools markets, is in Industrial & Automotive Repair (at analyst conferences the company has indicated SNA is a good comp for this segment). SNA’s tools are primarily used by vehicle service and repair technicians, giving it less of a consumer focus than SWK tools. SWK’s Security business further differentiates it from SNA. Indeed, SWK company presentations list SNA only as a Tool/Industrial peer (versus Security peers including HON, TYC, UTX, and Siemens). For its part, SNA listed Stanley first among a “peer group” used for stock performance comparison in its recent 10k.

SNA faced a declining return on capital curve until the late 1990s. Around this time the company began a series of small to midsized acquisitions and the resulting consolidation has driven the trend back upward. Despite an acquisitive past decade, SWK has enjoyed no such reversal of a 30 year declining return on capital trend – Exhibit 19.

Exhibit 19

Source: Capital IQ and SSR Analysis

Ingersol Rand is an industry peer that has a similar long term return on capital trend – Exhibit 20. IR announced a spin of its own Security unit in December 2012, completing this move a year later. Stripped of this business, IR’s end market exposure is broadly similar to Stanley’s – Exhibit 21. The upside potential is in SWK’s favor, as the residential construction market has more room to grow than non-residential.

Exhibit 20

Source: Capital IQ and SSR Analysis

Exhibit 21

Source: Company Reports and SSR Analysis

IR also trades very closely with Stanley, more so than any peer, including equally-residentially minded SMG and large cap Industrials CAT and DOW. Scatter plots of stock prices are shown in Exhibit 22. These include correlations from 2000 to current day, as well as how that correlation has changed in the past few years.

Exhibit 22

Source: Capital IQ and SSR Analysis

M&A Timeline

Exhibit 23

Source: Company Reports


Appendix:

©2014, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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