Shares of Income Investor recommendation Snap-on
First, a recap. For the first quarter, sales were down 1% to $593.5 million, attributed to an unfavorable foreign currency exchange. But earnings came in well ahead of expectations as diluted EPS increased 19% to $0.37 quarter over quarter. The company attributed the strong results to cost reductions, since it was able to buy raw materials from lower-cost regions and sell products with higher profit margin. In terms of an outlook, no quantification of sales or earnings targets was mentioned, since the company does not offer earnings guidance.
In the longer term, sales have grown slowly but consistently for at least the past five years. Earnings growth has been somewhat steady, with some peak years such as 2000 and 2002 (since Snap-on is a bit more exposed to cyclical industries). Overall, on an annualized basis, both sales and earnings have grown approximately 7% over the past five years. Nothing to write home about, but steady nonetheless.
In terms of product mix, approximately 60% of sales stem from the Tool segment, which includes hand and power tools and related tool storage items. The Equipment segment makes up the remaining 40% and consists primarily of automotive equipment sold to mechanics, as well as other industrial diagnosis and service equipment. Overall, the majority of products are sold to vehicle service and the repair realm of industrial professionals. Clearly, there is a significant degree of cyclical automotive and industrial exposure to Snap-on's businesses.
With no other apparent pure-play competitors, Snap-on goes head-to-head with certain operating divisions of larger industrial firms such as Stanley Works
One thing I really like is that cash flow from operations has been about double net income over at least the past three years. Capex levels have also been running below reported depreciation and amortization, so free cash flow has tended to outpace reported earnings. As such, returns on equity and capital have ranged from 10% to 20% and are currently running above the five-year average. Overall, it appears management is becoming increasingly efficient at driving profitability from existing operations.
Additionally, debt levels are quite low, with an overall debt-to-capital-ratio of just less than 17% for the most recent quarter. And the company repaid $100 million in long-term debt in October 2005 (as detailed in the most recent 10-K filing) with cash on hand.
Let's investigate what the market expects in terms of growth, or the implied growth rate baked in the stock. As I mentioned above, free cash flow has been greater than net income for the past three years; for full year 2005 I calculate it at $3.13 per share, or almost double reported diluted EPS of $1.59. Using free cash flow, a discount rate of 13%, and a terminal growth rate of 3%, I estimate that the market expects Snap-on to grow 6.6% over the next ten years. This is about the same as historical growth over the past five years, and does not appear overly aggressive.
In summary, Snap-on is a well-managed, conservatively run company. Growth prospects are not overly compelling, and it operates in cyclical industries, but I believe the valuation is much more reasonable than the 20 times forward P/E multiple listed, since free cash flow is greater than net income levels. Be on the lookout for outperformance if management finds a way to grow closer to 10% annually going forward, or if the next economic downturn is relatively benign.