Stanley Black & Decker's (SWK) stock reacted positively to the recent fourth-quarter earnings report. Still, it was more of a relief that they weren't as bad as the market might have expected rather than an affirmation that they demonstrated progress. The stock is attractive for long-term investors, but you must be patient and tolerant of the potential for some near-term bad news if you buy in. Here's why.
Stanley Black & Decker in 2023
The company's earnings collapsed in 2022 and came in significantly lower than management expected at the start of the year. For example, management started the year forecasting adjusted earnings per share of $12 to $12.50 for 2022, only to end up with just $4.62.
The company's problems lie in a combination of stronger-than-expected raw material costs, supply cost inflation, and a rising-rate environment putting severe pressure on housing-related discretionary spending for items such as DIY tools. As such, Stanley finds itself in a position where it has to dramatically reduce inventory in a weak sales environment. You can see the extent of its problems in its operating profit margin -- down from 16.9% in 2021 to 8.4% in 2022 and down from 11.4% in the fourth quarter of 2021 to a meager 1% in the same quarter of 2022.
The recovery plan
CEO Don Allan outlined the company's recovery plan during the recent earnings call:
- Focus on cash flow generation "through inventory reduction to assist with ongoing debt deleveraging."
- "Sequential improvement in our gross margins" as the company delivers on its supply chain transformation aimed at cutting annual costs by $1 billion by the end of 2023 (the company already did $200 million of this in 2022), and a further $1 billion across 2024 & 2025.
- Win market share across all its significant categories in its tools & outdoor business -- to this end, management ramped research & development spending by 25% to $350 million in 2022 and has new product introductions in cordless power tools and electric-powered outdoor equipment.
These aims play into management's "base case" assumptions for 2023 and what management believes it could hit in 2024.
Stanley Black Decker's base case
The base case implies it will get worse before it gets better. The table below highlights how management sees 2023 panning out. As you can see, the bulk of the inventory correction takes place in the first half, while profit margins should improve in the second half, with earnings noticeably better.
All these assumptions result in management's guidance for adjusted EPS of $0 to $2 in 2023, with free cash flow of $500 million to $1 billion. Then, turning to 2024, Allan held out $5 in EPS as potentiality based on annualizing the "couple of dollars" of EPS in the second half of 2022, adding in some seasonality from outdoor sales and "you're probably trending something for 2024 that's closer to $5."
|
Stanley Black & Decker Metric Guidance |
First Half 2023 |
Second Half 2023 |
|---|---|---|
|
Operating Margin |
Low single digits |
Mid single digits to high single digits |
|
Inventory |
$500 million reduction |
$250 million to $500 million |
|
Adjusted EPS |
($0.75) in the first quarter |
"close to a couple of dollars." |
Data source: Stanley Black & Decker presentations.
Putting it all together, the valuation case for Stanley Black & Decker, assuming $5 in EPS in 2024, puts it on 19 times EPS in 2024. Moreover, there's probably upside potential to the $5 coming from the supply chain transformational cost initiatives -- $1 billion is assumed for 2023. Although Allan didn't precisely outline how the remaining $1 billion would be split between 2024 and 2025, he said it would "probably get about $500 million or so of that in each year."
Assuming interest rates peak at some point in 2023 or 2024, Stanley could end 2024 on a price-to-earnings ratio of 19, with around $500 million in annual cost cuts to come, margin improvement in process, and a housing market in recovery mode boosting DIY tools sales.
Image source: Getty Images.
A stock to buy?
It's an interesting scenario. However, Stanley's base case in 2023 could quickly be negatively impacted by further deterioration in DIY tool sales. Moreover, there's no guarantee it won't have to cut prices to reduce inventory in a weakening sales environment. As such, the stock will only suit investors who can tolerate volatility or are bullish on a recovery in the U.S. housing market in 2023. Given the stock's sensitivity to housing market conditions and the company's need to aggressively reduce inventory in the first half, it makes sense to hold off buying until there's more clarity on both issues before buying in.
