2023-11-21 12:14:38 ET
Summary
- Stanley Black & Decker's revenue growth is expected to benefit from easing inventory destocking headwinds, leading to improved orders and sales in FY24.
- The company's margins are projected to continue improving, with a focus on inventory reduction and productivity improvements, aiming to return to historical gross margins of 35%.
- The company's long-term growth prospects are positive, driven by investments in product innovation, market activation, and targeting secular trends like electrification.
Investment Thesis
Stanley Black & Decker, Inc. (SWK) has faced headwinds over the last couple of years thanks to the badly timed acquisition of MTD Holdings just before the housing market started correcting. The company also faced headwinds from high inventory levels both at factories and in channels as the end markets slowed. This adversely impacted its topline and margins. These challenges resulted in a management change and the company launched an ambitious cost-cutting program in mid-2022. The company's margins bottomed in Q4 FY22 and have been improving sequentially since then.
Looking forward, revenue growth should benefit from channel inventory destocking coming to an end, which should result in improved orders and sales for SWK in FY24. In addition, as margins and profitability improve, the company should increase focus on driving growth through investments in product innovation, and market activation, and targeting secular trends like electrification, driving revenue growth re-acceleration.
On the margin front, the company's margins should continue to improve with the help of its inventory reduction actions and productivity improvements which should help the company to return to its historical 35% gross margins in the coming quarters. The valuation appears attractive on the company's normalized earnings potential. As the margins continue to improve and the revenue returns to growth, I believe the stock can see a good upside from current levels over the next couple of years. So, I am rating SWK's stock a buy.
Revenue Analysis and Outlook
After benefiting from strong DIY and professional demand in retail and e-commerce channels in FY20 and FY21, the company's organic sales turned negative in FY22 as the tough macroeconomic environment and rising interest rates started impacting end-market demand. This trend has continued in the recent quarters.
In the third quarter of 2023, the company's net sales declined 4% Y/Y to $3.953 billion, driven by a 4% Y/Y decline in organic sales and a 1% impact from the Oil & Gas business divestiture which more than offset a 1% favorable impact of FX translation. Segment Wise, Tools & Outdoor sales decreased 4% Y/Y with a 5% Y/Y decrease in organic sales due to lower consumer outdoor and DIY market demand. This decline was somewhat offset by price increases and U.S. retail point-of-sale demand driven by strength in professional demand. In the Industrial segment, net sales decreased 4% Y/Y as the 2% Y/Y decline in organic sales and a 3% impact from the Q3 2022 Oil and Gas business divestiture more than offset a 1% favorable impact of FX translation.
Looking forward, I believe we are close to the bottom and revenue should start recovering from the next year onward.
If we look at both the segments' results, it appears that inventory destocking was a major factor behind revenue decline. In Tools & Outdoor business, Tools business (ex-Russian business exit) was up Y/Y while Outdoor was down 23% Y/Y. What is happening in Outdoors is after the last couple of years of extraordinarily high demand with people investing in their homes during lockdown, the demand is now returning to normalized levels. As the channel partners adjust to the normalizing demand they are also reducing inventory levels to better match the current demand levels. So, while the Point of Sale is lower than what it was in the last couple of years, SWK's sales are even lower due to channel partners reducing inventory. The same thing is happening in the Industrial segment as well. Within this segment, engineered fastening organic revenues were up 6% Y/Y, including aerospace growth of 29% Y/Y and automotive growth of 9% Y/Y as the company benefitted from cyclical recoveries in these markets. However, its attachment tools business, which is also a part of this segment, witnessed an organic revenue decline of 26% Y/Y due to customer destocking.
Now the good thing is destocking can't continue forever and once the channel inventory reaches the desired level the company should start getting orders in line with end-market demand. For Attachment Tools, management expects destocking to be complete as we exit 2023, and for Outdoors, I believe we should see destocking ending sometime next year.
So, even if end-customer demand doesn't improve meaningfully in FY24, the headwind from inventory destocking fading should result in improved orders and sales for SWK in FY24.
Another revenue headwind that the company witnessed in recent quarters was due to a sharp decline in margins and profitability. To limit its margin decline, it had to focus on cost reduction and curtail some of the market activation investments for its new products. Usually, the company sees 2x to 3x end-market growth and has a good history of gaining share. With margins and profitability improving swiftly, I believe the focus should turn back to driving growth through product innovation, market activation, and focusing on secular growth trends. One good example of product innovation to capture secular growth trends is the passenger car market. Electrification is expected to meaningfully increase the addressable market for SWK with a potential of 3x to 6x higher content spend per vehicle and SWK is investing in product innovation to capture this opportunity.
As margins continue to improve and reach historical levels, investments to drive growth should also increase helping the company's revenue growth outperform end-markets.
Overall, I have an optimistic view of the company's growth prospects in the coming years.
Margin Analysis and Outlook
In FY22 and early FY23, the company's margin growth was adversely impacted by deleveraging from organic revenue declines, raw material inflation, and significant production curtailments to slow finished goods manufacturing in response to elevated inventory levels at factories.
However, in Q3 2023, benefits from the company's supply chain transformation and inventory reduction efforts were able to offset the impact of lower organic revenue. As a result, the company witnessed a 290 bps Y/Y expansion in adjusted gross margin to 27.6%. Moreover, the adjusted operating margin also saw a notable improvement, with a 210 bps Y/Y increase to 8.3%.
Segment wise, the Tools & Outdoor segment adjusted operating margin improved by 250 bps Y/Y as lower inventory-related costs, savings from supply chain transformation, and lower shipping costs effectively offset the impact of lower organic revenue. The Industrial segment adjusted operating margin increased 110 bps Y/Y benefitting from continued price realization and cost control. Overall margin improvement across its segments resulted in a Y/Y expansion in adjusted operating margin for the company.
Looking ahead, I expect continued cost reduction and productivity improvement to help the company's margin.
Due to high demand as well as supply chain disruptions in the previous years, the company was carrying higher than normal inventory at its plants. As demand started to normalize and supply chain conditions improved, the higher-than-normal inventory created production inefficiencies negatively impacting margins. Further, most of this inventory was purchased at higher prices as the last couple of years saw raw material and component price inflation due to rising commodity prices and supply chain disruptions in the last couple of years. So, as this higher-priced inventory made its way through P&L, it adversely impacted margins.
However, the good news is management has done a really good job in terms of inventory reduction and is on track to reduce ~$1 bn in inventory in FY23 with an additional $400 to $500 mn per year reduction targeted for the next couple of years. This resulted in meaningful margin improvement as FY23 progressed and I am expecting the company to return to its historical 35% gross margins as the progress in this regard continues.
The company is also doing a good job in terms of reducing procurement spend, exiting low-volume SKUs, and footprint rationalization which should also help margins in the medium to long run.
Valuation and Conclusion
SWK is currently trading at a 20.22x FY24 consensus EPS estimate of $4.53 and a 13.82x FY25 consensus EPS estimate of $6.62.
Prior to COVID, the stock used to trade at high teens forward P/E multiple. As it reaches its normalized margins and growth rate by FY25, I don't see a reason why it can't achieve a similar high-teen multiple. So, there is a good upside for investors who can hold the stock for the next couple of years.
The stock has a 3.53% forward dividend yield. So, investors are also getting paid while they wait for margins and growth to return to normalized levels. Overall, the company has made good progress in terms of recovering its margins in the last few quarters and, as the margin continues to improve and the revenue returns to growth, the stock can move higher. Hence, I have a buy rating on the stock.
For further details see:
Stanley Black & Decker: An Interesting Turnaround Bet