Stanley Black & Decker Q2 2022 (SWK) Results: Quarter Kitchen Sink, Buy
Since my last article on Stanley Black & Decker, Inc. (NYSE:NYSE: SWK), stocks significantly underperformed the market. Obviously my timing was off, but we’ll see if the underlying thesis is still intact. For For starters, SWK shocked the market by lowering its earnings forecast from $9.50-$10.50 to $5.00-$6.00 in response to consumer demand and its expected price increases. This is the worst level since FY13, which printed an EPS figure of $4.98.
In a way, this validates the bearish thesis that SWK will need to overcome excess inventory. Analysts fear that SWK will lose sales not only due to weak consumer demand, but also due to competition. If this is the case, management will find it even more difficult to raise prices to keep up with competitors and thus establish price equilibrium in the market.
Obviously, the move from $3 billion to $6.6 billion will take time to materialize. While it’s not as simple as carrying more than double its normal number of units over its historical trend, there’s inflation pricing built into that. Nonetheless, it makes sense to understand why there is a significant erosion in gross margin from the levels the business has historically enjoyed.
Of course, weak demand combined with commodity headwinds through April 2022 will also keep gross margins under pressure. Management indicated that this process would take approximately three to four quarters. Assume a minimum of four quarters given the large excess of inventory relative to its historical trend. Based on the second quarter conference call, the main issue is in Tools & Outdoor, where revenue is expected to compress significantly:
“Organic revenue is expected to decline to mid-to-high with margins declining year-over-year.”
This scenario, in my mind, is a perfect storm and we are in the middle of a recession. We can see that even the industry leader, Techtronic Industries Co. Ltd. (OTCPK: TTNDY), owner of Milwaukee, is under pressure with its stock down almost 45% from its highs, quite similar to SWK. However, TTNDY management says organic growth remains robust despite the macroeconomic environment. I think this clearly highlights SWK’s underperformance and means they have their work cut out for them.
Capital allocation has also been difficult. Total debt has reached a staggering $11.2 billion, which is above average leverage. Additionally, SWK implemented an accelerated buyout in early 2022, but has since stalled the buyout until cash flow performance normalizes. In other words, the company made the fundamental mistake of buying back shares at a high price, eliminating the possibility of buying them at levels well below $100 per share.
So, to sum it up, the bears should take a bow for calling out the SWK’s poor performance and questionable lack of foresight. The question now, however, is where do we go from here?
Is the kitchen sink indoors?
Hard to say for sure, but there’s a good chance that management gave us the kitchen sink given the severity of the drop in profits. It’s not every day that management who are used to being the stewards of shareholder value revises TTM Diluted EPS from $11.05 to $5.50 year over year, this which represents a reduction of 50%. Unless the economy falls into a deep and prolonged downturn, I think the company’s operating performance will bottom out here in 2022.
At the macro level, overall US construction spending is hovering around all-time highs, housing starts remain strong in 2022, and commodity prices appear to have peaked in March/April. These tailwinds already exist in SWK’s performance, but commodity disinflation is expected to significantly benefit gross margin in 2023.
More internally, one leg of the transformation is SWK’s oil and gas business (acquired in 2010 for $445 million and formerly known as CRC-Evans). In 2021, the segment generated approximately $140 million in revenue, and while the amount of the sale is undisclosed, SWK will incur impairment ranging from $125 million to $200 million. At face value, the loss is about a third of the acquisition price, but keep in mind that SWK put these assets up for sale at a time when oil prices were trading above $100 and higher the barrel. Generally, valuations of oil and gas assets tend to move in sync with energy prices. So while I’m not making a prediction on the price of oil, I think the timing of this trade is pretty good. The sale also allows management to focus its attention on its two main business units, namely consumer products and industrial tools.
The industry also continues to be a bright spot, with segment revenue up 8% from 2021. Additionally, management expects there will still be significant growth due to the strong recovery of its end markets, in particular aerospace and automotive:
“achieve high single-digit or low double-digit organic growth, driven by innovation, pricing and cyclical upturns across much of the portfolio.”
Regarding cost reductions, management outlined various ways to improve performance (which I emphasize in italics).
- Product price increases combined with disinflationary pressures on raw materials align with a gross margin target of over 35%. I agree, especially since this is consistent with historical levels.
- Reduce operating costs for cumulative savings of $1 billion by the end of 2023 and $2 billion over the projected three years through supply chain simplification, general and administrative expenses and company overhead. Possible, but cost reductions often come from layoffs which can hurt employee morale, increase turnover, and weaken customer/product knowledge.
- Elimination of debt to improve leverage and reduce net interest costs. Very doable. As SWK goes through its inventory, it would have to provide inordinate working capital to reduce its debt balance and interest expense. Maintaining an investment grade credit rating will support the valuation of its shares.
Currently, investors are working below the base line of around $5.5 EPS. Management specifically identified that once it executes all of these items, EPS should return to $7 or more. I think it’s doable, but it’s up to management to restore investor confidence. Earnings estimates call for some normalization by Q2 2023:
At $100 per share, $7 EPS equates to about 14x earnings, which sells at a slight discount to the 17x forward earnings of the S&P 500. My best guess is that the quarter sinks from cuisine is official and that the stock will continue to “bottom out” around current levels before rising again in 2023.
Since we are already in a recession, the argument is about its duration and depth. For the economy in general, I think there is more pain to come even in 2023. Optically, SWK’s next quarter will be even worse as it appears to be moving through its excess inventory. However, management has already outlined a hard-to-swallow scenario for shareholders, and it’s worth making it public for everyone to see. Although SWK is not without risk, I prefer to be long when there is blood in the streets. How do you think SWK will perform? Let me know in the comments section below. As always, thanks for reading.