Having doubled in price since the trough in early March Stanley Black & Decker (NYSE:SWK) stock has had a great run in the last several months. Moreover, it now trades on at more than 32 times current earnings so it's not a superficially cheap stock. As such, investors now have reason to ask whether it's still a good value. I happen to think the answer to that question is yes. Here's why.
Understanding Stanley Black & Decker
Probably the best way to understand the investment case behind the stock is to look at the following chart. As you can see below, the company's gross profit margin (the profit margin after cost of sales is taken out) and operating margin (profit margin after cost of sales, operating expenses, and depreciation and amortization are taken out) have both fallen significantly in recent years.
However, you can also see that sales, general, and administrative (SG&A) expenses as a share of revenue have also fallen in recent years. In other words, management has actually done a good job of controlling SG&A costs, but margins have continued to fall.
In fact, the problems the company has faced in the last few years have come down to a combination of unfavorable foreign exchange movements, cost increases due to tariffs related to the U.S. trade conflict with China, and commodity cost increases.
Management estimates these external headwinds cost the company around $370 million in 2018 and $445 million in 2019. Considering that operating profit was $1.76 billion in 2019, it's clear that the headwinds have been a major drag on profits.
It then follows that an investment case can be built for the stock on the basis of the following:
- A gradual dissipation of the external headwinds will lead to substantial margin expansion in the coming years.
- Ongoing revenue growth, including a recovery from the COVID-19 induced slump.
Fortunately, there's a strong case for both of these assumptions.
Headwinds can dissipate
All of the external headwinds look like they are temporary in nature. First, no one can accurately predict where exchange rates will head, so Stanley will not necessarily face unfavorable rates in the future.
Second, many of the rising raw material costs, such as steel, had already started to come down in 2020 even before the COVID-19 pandemic spread from China. Moreover, history suggests that commodity costs are cyclical -- high prices induce more production, which often leads to a price correction.
Third, Stanley has been taking aggressive measures to get around tariffs by shifting manufacturing and sourcing product away from China. For example, management has been very vocal in outlining an aim to make up to 65% of the products it sells in the U.S. right in the U.S.
All told, it's entirely possible that Stanley can get back to a 15% operating margin in a couple of years and mark a good recovery from the 13.6% achieved in 2019.
Recovery and ongoing growth
The external cost headwinds have masked an impressive period of revenue growth. It's been driven by a mix of mid-single-digit organic revenue growth and a series of attractive acquisitions, such as the Craftsman brand from Sears and the tools business from Newell Brands in 2017.
The idea was to expand Craftsman sales outside of its traditional sales channels connected to Sears, and generate cost and sales synergies with the former Newell businesses. As such, management sees the company as the consolidator of choice in the tools industry.
Meanwhile, Stanley already owns 20% of lawn and garden products company MTD, with an option to buy the remaining 80% beginning in the summer of 2021. Given the renewed interest in the sector caused by stay-at-home measures, MTD offers good potential for Stanley to invest in a growth industry.
In terms of the company's recovery from the impact of the COVID-19 pandemic, it appears that everything is going just fine. For example, at the end of August management issued an SEC filing outlining a significant upgrade to its revenue planning assumptions.
Management now expects "high-teens organic growth in Tools & Storage versus the prior planning assumption of low to mid-single digit organic growth" for the third quarter. This is likely to result in total third-quarter "planning assumption of 7% to 10% organic growth and a second-half assumption of low to mid-single-digit organic growth, above the high end of the prior second half range of -7.5% to flat."
Stanley appears to have good momentum behind it; CEO Jim Loree spoke at a recent Morgan Stanley conference and outlined how the company's industry leadership in e-commerce had benefited sales. Moreover, the stay-at-home measures have encouraged DIY work, and the company's security business is benefiting from a renewed emphasis on health and safety.
A stock to buy?
Trading around 19 times 2021 earnings estimates and with the potential for a combination of margin expansion and revenue growth thereafter, Stanley continues to look like a good value.
The company has good sales momentum going into the third quarter, and its management continues to structure the company for growth while cutting costs. All told, Stanley Black & Decker stock remains an attractive stock for investors.