Don't underestimate Stanley Black & Decker (NYSE:SWK). It's been a tough few years for the company, but if you can look beyond the headline numbers, the future looks bright. Its management has been doing a very good job of laying a foundation for future growth. Let's take a closer look at the case for buying the stock.
The investment proposition
The strongest case centers around two complementary arguments:
- Operating margin will recover to previous levels thanks to cost-cutting actions and a dissipation of the significant headwinds of recent years (foreign exchange, tariffs, commodity cost increases).
- Growth initiatives taken by the company will drive revenue growth once the economy is in recovery mode.
A graphical depiction of the challenges noted in the first point can be seen below: External headwinds -- around $370 million in 2018 and $445 million in 2019 -- have significantly reduced operating income margin in recent years.
To put these figures in context, back in 2017, the industrial company generated adjusted earnings before interest and taxes (EBIT), or operating profit, of $1.88 billion with a margin of 14.8%. If it can get back to 2019 levels of revenue of around $14.5 billion by 2022 and return adjusted operating margin back to the 2017 14.8% level, then it could be generating $2.1 billion in adjusted EBIT in 2022.
Based on the current enterprise value (market cap plus net debt), Stanley Black & Decker's EV to EBIT multiple would be around 13.4 in 2022, making it look like a good value on a historical basis.
Will Stanley Black & Decker get there?
Projections are one thing, and achieving them is another. However, in this case there's good reason to believe that Stanley Black & Decker is on the right track. Management is forecasting that tariff and foreign-exchange headwinds will only be $150 million in 2020, compared to $445 million in 2019. Moreover, commodity costs have come down, and management has significant cost-cutting measures in place over the next few years:
- Going into 2020, management had planned for $200 million in cost savings with $180 million to be realized in 2020.
- In response to the COVID-19 impact, management plans for $1 billion in cost cuts with $500 million to be realized in 2020.
- Management has ongoing "margin-resiliency" plans in place, intended to generate $300 million to $500 million in operating-margin improvement by 2022.
By margin resiliency, management simply means using technology (automation, analytics, artificial intelligence, and technology) to drive procurement savings and generate production efficiencies.
To be clear, $100 million to $150 million of the planned margin-resiliency actions for 2020 are included in the $500 million cuts due to COVID-19, and some of the COVID-19 cuts (furloughs, salary cuts, etc.) will be reversed when sales come back. Nevertheless, there is still a significant opportunity for the margin-resiliency actions to generate sustainable cost savings.
CFO Don Allan spoke at a recent UBS conference and discussed how the company was moving "manufacturing away from China into the U.S., into New Mexico and other Asian countries, such as India." He said that "we'll end up probably having close to 65% of what we sell in the U.S. we'll be making in the U.S." Since Allan believes the use of technology will mean shifting production to the U.S. from China will be production-cost neutral, then the benefits of avoiding tariffs on producing in China should drop through into Stanley Black & Decker's bottom line.
While 2020 is clearly going to be a year of decline -- organic sales are expected to be down 15% to 20% in the second quarter -- it shouldn't detract from the good work management has been doing to drive revenue growth. For example, Stanley Black & Decker has been consolidating the tools industry by buying the Craftsman tools brand from Sears Holdings, and the Irwin and Lenox (plumbing and electrical tools) brands from Newell Brands in 2017. You can see a breakdown of profit in 2019 in the chart below. Tools and storage make up the majority.
In addition, the security segment (a business that management is open to divesting) may well generate growth opportunities in the aftermath of the pandemic, as owners seek to make their buildings safer. Meanwhile, the industrial segment's growth will return with an improvement in industrial production.
A stock to buy?
Many of the cost headwinds that hit the company in recent years are likely to disappear in the coming years. Operating margin should expand in tandem with a recovery in sales from a trough in 2020. The COVID-19 pandemic has certainly hit earnings growth, but if you are confident in a global recovery in the next few years, then the stock is worth buying for the long-term upside potential.