Snap On! Snap Off!

Snap-on has a branding power that gives it an annuity value in its market. Its tools are ubiquitous in American garages, and its reach across the globe is expanding. Its most recent 10-K just came out, and the company suffered a bit in 2001. But it still showed excellent cash flow and good management decisions. P/E of 90? Not to worry.

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By Bill Mann (TMF Otter)
April 5, 2002

Could there be a more manly company out there than Snap-on (NYSE: SNA)? This Wisconsin-based manufacturer of hand tools, power tools, and automotive shop equipment makes stuff that both professional grease monkeys and hobbyist gearheads alike prize. A garage just doesn't look complete unless it has one of those fire-engine-red rolling equipment storage carts with the Corvette-esque "Snap-on" lettering on it.

It's one of those companies that creates desire among its customer base. For bikers, Harley-Davidson (NYSE: HDI) is the one to have. In jewelry, it's Tiffany (NYSE: TIF). And in automotive tools, it's Snap-on. Can't you see the ad campaign? "Snap-on, the Tiffany of tools." Somehow I don't think that the crossover association would work, but that's exactly what the Snap-on brand is: Tiffany for grease monkeys. Past readers of this column know that I love companies that have strong branding, as having such provides investors with a strong intangible asset that can serve as a floor for the company's stock. No one has ever gotten fired for stocking a shop with Snap-on tools.

But is Snap-on a good investment? In the past decade, the company's share price has essentially doubled from $17 to $34, with about another $12 tacked on per share if an investor had been reinvesting all dividends. That's a total return for the past decade of roughly 170%, trailing the 212% return on the S&P 500 over the same period (with all dividends reinvested), a slight to not-so-slight underperformance. Still, I think it's a pretty solid company, and since its 2001 10-K came out last week, I'd like to take a look at it and throw out some comments.

Muddling through a tough year
Here's what I see: 2001 looks like it was a horrible year for Snap-on. Net profits dropped from $144 million in 2000 to $19 million in 2001, and gross receipts dropped nearly 4% from $2.1 billion to just over $2 billion. This drop breaks a string of nine consecutive years in which Snap-on showed an increase in sales. A drop of 4% does not seem to be that big of a deal (and when we finish we'll see that it really isn't), but it provides an interesting study as to how small drops in revenues can equal large changes in reported earnings. Here's what is important: Snap-on's current price-to-earnings (P/E) ratio of 90 is highly deceptive. Here's a hint: Using last year's earnings levels, Snap-on's P/E would be about 16. So a 4% drop in net sales produced (in part) a five-fold increase in P/E.

Lesson? Forget about the P/E. Look at cash flows. Here, the year doesn't look so bad. Against a price-to-free cash flow (operating cash flow - capital expenditures) for 2000 of 14, in 2001 it comes in at about 18. Why the huge difference? Well, the lower sales certainly contribute, but some of the other expenses for 2001 were extraordinary. For example, Snap-on's operating expenses increased by more than 8% at a time when the company had lower sales. Doesn't make much sense until one sees that there were more than $120 million in extra expenses related to operational improvements, which will save the company more than $40 million in 2002 alone. While we don't like to see too much under the heading of "restructuring," looking at Snap-on's financials for the last 10 years tells me that this is not a normal occurrence.

In the last decade, Snap-on has managed to increase its sales by more than 85%, or 8% per year. This is not a spectacular level of growth, but it's well above the U.S. gross domestic product (GDP) for the same time period. More impressive is Snap-on's overseas growth, up by more than 175% over the same time period to about 34% of total sales. What I like, though, is that the company in this period, regardless of the level of growth in a given year, has always been cash flow positive. I also like the fact that, though 2001 was a soft year for Snap-on, particularly in its high-end lines, gross profits remained quite stable at just over 45%. Pricing power such as this is generally the sign of a company with brand dominance.

All of this is not to belittle the fact that Snap-on did in fact have weaker results in 2001. But investing requires one not to think so much about what financial figures are, but also what they mean. A company that has shown nice economics and good growth in a mature, predictable market -- not to mention a dividend yield just shy of 3% -- should not be valued as if it were permanently impaired. At current prices, while this may not be a spectacular opportunity, it doesn't look half bad, either.

Excellent management decisions
The company made some spending decisions in 2001 that should pay off in the future. This is something that I like to see in companies: Snap-on was apparently unconcerned with the effect to its earnings of some one-time charges, and didn't really do anything to keep them from being lumpy. Right out of the gate that gives me the sense that the bookkeeping policies of the company are pretty conservative. Snap-on could have used some grooming gimmicks in 2001, but instead it made an effort to reduce both inventory and receivables numbers from 2000. These efforts have assisted Snap-on in dropping its working capital requirements from 40% of profits in 1997 down to 29% this past year. Additionally, Snap-on, though it does not have a large dependence on research and development (it's not like auto tools have rapid-fire product cycles), kept its spending essentially flat in spite of a weakening economy.

And finally, it seems that Snap-on has an altogether shareowner-friendly management team. In the past two years, the company has repurchased and retired more than 1.4 million shares, at an average cost well below current share prices. They also have an altogether sane employee stock options policy, with the average share dilution over the last three years being less than 2% per annum. The only annoying thing about this program, to my mind, is that a single employee -- the CEO -- received more than 16% of all options granted at the company, and the top five managers received more than 30%. Still, as compared to programs at other companies that have spun entirely out of control, I don't have too much problem with this.

Snap-on's stock has rocketed up more than 50% in the last six months, so the positive attributes of this company may have been fully recognized by the market at this time. Still, with a history of stability and flowing cash, Snap-on is a great company to watch.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Bill's favorite car part name of all time is the "worm gear," from Ford's Model A. Bill owns shares of Tiffany. Please view his profile for a full disclosure of his positions. The Fool has a disclosure policy.