Stanley Works F4Q08 (Qtr End 09/27/08) Earnings Call Transcript

Stanley Works (SWK)

F4Q08 Earnings Call

October 21, 2008 10:00 am ET

Executives

Greg Waybright - Interim VP of IR

John F. Lundgren - Chairman and CEO

James M. Loree - EVP and CFO

Analysts

Eric Bosshard - Cleveland Research Company

Sam Darkatsh - Raymond James

Peter Lisnic - Robert W. Baird & Co.

Michael Rehaut - JP Morgan

Mike Sheridan – [Cobalt Capital]

[Shitra Bandalam].

Nicole [DiBlaze]

Operator

Good morning. My name is Laura and I will be your conference operator today. At this time I would like to welcome everyone to the Stanley Works third quarter results conference call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question and answer session. (Operator Instructions)

I would like to introduce Mr. Greg Waybright, Interim Vice President of Investor Relations.

Greg Waybright

Thank you, Laura. Good morning, everyone, and thank you all for joining us on the call this morning. On the call in addition to myself is John Lundgren, Stanley’s Chairman and CEO, and Jim Loree, Stanley’s Executive Vice President and CFO.

I’d like to point out that our third quarter earnings release which was issued this morning and a presentation supplementing today's’ call which we will refer to during the call are available on our investor relations website.

This morning, John and Jim will review Stanley’s third quarter results and various other topical matters followed by a Q&A session. This entire call is expected to last approximately one hour and a replay of the call will be available beginning at 2 pm today. The replay number is 1-800-642-1687 and the access code is 57411309. As always, please feel free to contact me with any follow up questions after today’s call at my number which is 860-827-3544.

Finally, two brief comments before we proceed. One is a reminder that we issue and/or update earnings guidance on an annual basis in our press releases at the beginning of each quarter and we cannot comment on such guidance thereafter. However, if our guidance changes materially, we will issue a press release and conduct a related conference call.

Secondly, we will be making some forward-looking statements during this call. Such statements are based on assumptions of future events that may not prove to be accurate, and as such, they involve risks and uncertainties. It is therefore possible that actual results may differ materially from any forward-looking statements that we might make today, and we direct you to the cautionary statements in Form 8-K which we filed with today’s press release and in our most recent [34-F] filings.

With that, I will now t urn the call over to Jim Loree.

James M. Loree

Thank you, Greg. During the recent turbulence in the financial markets, some of the characteristics of our financial strategy have become critical success factors in today’s environment. These would be things like strong cash flow, conservative financial position, and proactive liquidity management. Certainly we’ve been able to accomplish all of those in recent years and just some of the highlights as we sit here today is our long-standing strategy to remain Single A Single Unsecured and A1T1 Commercial Paper have served us very well. We were the first industrial in the United States to issue bonds since September 10 when the dislocation began on the 24^th of September. We were able to issue $250 million of senior unsecured notes, five year paper, and we issued that at 6.2% which was just a hair over 300 over Treasury’s which in today's market looks like a pretty good coupon.

During this time our access to the commercial paper market has been uninterrupted and our commercial paper pricing today remains very attractive at about 25 to 75 basis points over the fund. We also took early and decisive action this year to enhance our liquidity. In February we upsized our revolving credit facility to $800 million from $550 million and we extended the majority out to February of 2013. In May we also increased our commercial paper line from $550 million to $800 million, increasing our capacity for short term liquidity.

Our cash flow remains strong. Our estimate remains at or slightly below $500 million. For 2009 as we look forward we see no reason to believe that is going to decrease materially. A lot of that has to do with the Stanley Fulfillment System. John will talk about that later. This is an initiative that’s been in place for many years but has gained considerable steam in the last year or two and as a result we’re getting excellent working capital performance, and our working capital terms are improved last year, they’ll improve again in 2008, in spite of a really gut-wrenching unit volume situation based on external conditions. Our dividend record has been maintained. We currently are at about a 3.5% yield and that dividend is very safe and reliable. So we are a very strong company with a solid foundation.

With that as context, let’s talk about the external environment. We all know that the economic conditions are very difficult right now with the instability in the credit markets although in recent days that looks to be stabilizing somewhat, but around the world, credit markets have created all sorts of dislocation in the economy. We see currency as very volatile right now with the euro, the British pound, the Canadian and Australian dollars all of which are currencies that we have exposure to based on our worldwide activities, all down by about 15% since the beginning of the quarter just a few weeks ago.

In the US, I don’t need to tell you folks that it’s tough, the industrial production is beginning to show big declines, capacity utilization is decreasing, housing starts are at really incredibly low levels, down 40% versus prior year. Unemployment has spiked to 6.1%, and while the slowdown is nothing new in Europe it is clearly intensifying as we went through the third quarter, with industrial production down in the Euro area, Germany, Italy, France, Spain, and so on. Steep decline in construction permits, especially in Spain, the Nordic companies, and the UK, and basically GDP slowing in all of Europe. You can see the percentage declines in Germany, France, Italy, and we too saw as lowdown in our European business in the third quarter, especially after July.

Moving on now to the quarter, we recorded earnings per share of $0.98 down 7% versus prior year. We were still able to obtain a very healthy 14% operating margin in the quarter. Revenue growth was 1%, we’ll talk more about that in a minute, but the story here was preservation of earnings per share and limiting the decline to a modest amount in the face of minus 4% organic growth and as we go through the charts I’ll give you more color on that.

The diversity of our end markets was helpful in the quarter. It certainly dampened the effect but did not negate the sales volume contraction. It’s important to note here that about a third of our business is in the residential construction, only about a third of our business in residential construction, and even within that, only about half or so slightly over half, is in the US, so about 17% total US residential construction. As you can see, we have a diverse array of other sub-segments that we are exposed to. 12% of our revenue is in commercial construction, 8% in retail, primarily through our security business, and then health care, education and government comprising about 12%. Automotive repair including the Mac business and [Sacko] about 9%, and then the remaining 24% associated with industrial which includes core industrial manufacturing type industrial as well as utilities, distribution, power, rail, oil, and gas, etc.

So we continue to have exposure to a diverse array of end markets around the world but in some respects that has been very helpful for us in terms of dampening the blow from the economic issues. Moving on now to revenues, as I mentioned, we experienced significant unit volume decline, perhaps as significant and more pronounced than in any quarter that I can recall since my time here in 1999. Beginning in 1999 we look back certainly more pronounced than any quarter in the ’90, ’91 time frame when we had an economic recession and going back all the way to 1981 to see a quarter where we had that kind of a unit volume decline and we all remember... Those of us that do remember 1981 remember that. It was a very tough economic environment. I think this one is equally as bad. The breakdown for the revenue if you look at it, the minus 7% volume decline was offset by about 3 points of price which was consistent with our expectation and organic growth in total was down 4%.

That was offset somewhat by currency which was up 2 points and acquisitions which added 3 points of revenue in the quarter, so we managed to eke out a modest 1% revenue growth in the quarter. When you look at it by segment, construction, DIY, was down 2%, industrial was flat, security up 7%, and when you step back and peel off the onion layer there and see that the organic performance was down 5% in construction DIY down 4% in security. Now I have to say with security, excluding the hardware business which is suffering the loss of its former major customer and that will anniversary in the fourth quarter. That was a $55 million loss for that business. When you look at it excluding that loss, the security portfolio performed at a 1% organic growth rate and so that at least was positive.

As we look to the fourth quarter, we can expect slightly better volume, we think probably more in the neighborhood of minus 5% to minus 6% as the hardware loss anniversaries, and we have some load in from a relatively significant win at one of our larger customers in the CDIY consumer tools and storage segment. In addition, price is likely to stay strong, if not a little bit stronger. Acquisitions are likely to pick up in the fourth quarter vis a vi the third and currency I think will probably flip to a slight negative on a year-over-year basis so all in, we expect fourth quarter sales to be approximately flat with prior year.

So moving on to gross margin, with all that negative pressure from unit volume declines, it is truly remarkable that we were able to achieve record gross margins, third quarter gross margins at this time and furthermore, we did not really experience the classic historical sequential dip in the third quarter that we do normally experience. You can see we had it in ’06, we had it in ’07, and we avoided it in ’08 and this margin rate accretion was attained with a 7% reduction in year-over-year -- [blank audio]

Operator

Excuse me, Mr. Smith?

James M. Loree

-- contributed to both the working capital reductions as well as substantial productivity and you can see even with the pricing success that we had and now I’m looking at that 3Q ’08 VPY points box, the light blue one there, where it says inflation net of pricing cost us 2.2 points in the quarter on a year-over-year basis. Even so, we didn’t recover all of our inflation although our full year estimate is still consistent with what we mentioned last time. I’ll get into that in a minute. But we were able to achieve a 1.5 point increase in productivity despite the headwind from the lost absorption from the volume and the decline in inventory decrease.

So Greg’s story on margins, I think what you see here is the fundamental shift in how we are managing the business which has evolved over the last five years or so, but as I recall back in the ’02 time frame, ’01, ’02, the gross margins often average 33% or thereabouts and today we’re knocking on the doorstep of 39% so very significant change in the company.

As we move on now to the pricing inflation update, we’ve encountered steady inflation increases in our estimates, I’m looking at the left hand side of the chart right now, throughout 2008, up to a point where we were forecasting as late as the second quarter earnings call, $150 million up from $100 million in the first quarter earnings call, and up from $75 million based on the initial guidance that we released, and over that time frame our ability to recover that inflation with pricing power and pricing execution has been strong. In fact, it strengthened during the year as we went from an 80% recovery in the beginning of the year to a 90% recovery even as the amount of inflation doubled in the estimate, and as you can see, if you look at the history there, in the ’05, ‘06 timeframe, it’s about $50 million a year, so triple that this year and the pricing has been there to protect our margins.

When we look at the sources of inflation this year for, and that’s on the right hand side of the chart, you can see that of the roughly $150 million of inflation, approximately half of that has been encountered in relation to steel, and then another $20 million in regard to freight, so two items there that have the seeds of stabilization and even slight dips have been the source of most of our inflation exposure. Now that will take a few months to work its way through into the P&L statement, but we are cautiously optimistic that in fact it’s probably the one silver lining in the backdrop of all the other issues in the economy that we probably will experience some lowering of that inflation rate as we go into ’09.

Then we have a look at SG&A. SG&A was up $23 million in the quarter and when you kind of look into that with a little more detail, you see that $11 million of the $23 million was related to acquisitions. $7 million wage inflation, salary inflation. $5 million of foreign exchange related increases. $9 million of emerging markets and other strategic investment which relates primarily to increasing the size of the sales and service force in the electronic security business was $9 million and then the cost reduction, some of which we implemented in the post 2Q earnings release accounted for a $9 million benefit, so we’re continuing to monitor and place emphasis on SG&A control. Clearly this will be a significant focus for us in the fourth quarter and as we go through 2009.

Then as it relates to free cash flow, simply put, it was a great story. Our third quarter free cash flow was up $19 million at $138 million in the quarter, a very impressive performance led by a $66 million favorable swing in working capital which we can attribute almost exclusively to the success of Stanley Fulfillment System which John will comment on in a few minutes. Then our year-to-date performance, we’re right at about the same level we were, slightly above, $4 million above, the same place we were last year, a year in which we generated a record $457 million of free cash flow and we see no reason why at this point that we can’t have another great year for cash flow, so with one quarter to go, we’re able to reiterate our total year estimate of free cash flow equal to just under $500 million and that’s a very good sign for the health of the balance sheet and our ability to pursue capital deployment both in the fourth quarter and as we go forward.

Looking at working capital in a little more detail there, as you can see from this chart, the inventory was down 7% to $571 million. That was a five day improvement. The receivables were flat with prior year, a one day improvement, and I would also note that on the receivables that are delinquencies in this area have actually improved as the year has progressed, again directly attributable to the Stanley Fulfillment System. Our accounts payable, despite the inventory decline, were up 9% and that’s largely attributable to the fact that as we were absorbing price increases that resulted in the inflation, we were requiring the vendors that were giving us increases to extend their terms with us, so those payments are in accordance with terms. Those payables are in accordance with terms and up 9% or a five day improvement.

With all that put together, we achieved a 4.8 working capital term performance, a 0.4 point improvement over prior year, and John will talk in a few moments about what drove that As we look at the balance sheet, the balance sheet is in good shape. It’s very, very consistent with the same time last year. Our debt is in the same zone. Our equity is up and our cash position is about the same and this was achieved after spending about $380 million on strategic acquisitions year-to-date.

So with that said, John Lundgren will now walk you through some more color on the Stanley Fulfillment System and touch upon some other elements of our performance and I’ll turn it over to you, John.

John F. Lundgren - Chairman and CEO

Thanks, Jim. For those on the call, I understand there may have been a minute or two of technical difficulty, particularly during Jim’s comments on market conditions and RN markets so rather than go back and trace over that, I will be sure to touch on the high points that may have been missed although they were on the visuals.

As Jim suggested, we feel the third quarter’s been a strong performance in a relatively difficult environment. An important question of course is what is driving the performance in general and the continuously improving cash flow in particular? The answer is our Stanley Fulfillment System. It is a transformation of processes, systems, as well as structure, with three very important objectives. First and foremost, we’re striving for a scalable platform that’s capable of supporting an ongoing acquisition growth strategy, in other words, a business that’s much larger than the current business we have today.

We’ve had good success with our integration history. Our business is twice the size as it was five years ago but we’re working very hard to be sure that the platform that we’re putting in place is capable of handling a business much bigger than our business today as we look down the road. Second, we’re focused on a material improvement in working capital terms. Jim’s already showed those results. That’s freeing up substantial cash for productive uses. Historically, as we’ve suggested in our press release, two-thirds of the cash has been used for acquisitions, a third has been returned to shareholders pretty much in equal proportions on the dividend and stock repurchases, and we’re suggesting or we’re looking at a slight modification to that going forward as we respond to the short term environment in which we’re working.

Any improvement in working capital terms at the expense of service would clearly be a losing proposition, so the third key objective of the SFS process is to have best in class service levels which will ultimately drive organic share gain which we’re experiencing despite the down markets. We focus on lead times, fill rates, and all forms of customer related execution. Fill rates have significantly improved from year ago levels or the levels over the last 12 to 18 months and they’re currently at or approaching record levels across virtually all our businesses, so SFS is a top knot initiative. That being said, it involves all Stanley employees from the executive office to the factory floor.

What are the elements? What’s creating the value or importantly, what are the drivers behind SFS? Specifically there are three. First and foremost, lean. We’re implementing lean throughout the plants, throughout our supply chain, throughout our entire organization with a focus on cycle time, inventory reduction, and service excellence. Each metric is systematically reported and recorded and reviewed at all levels of the organization.

Second, we’re re-engineering four processes, and we’re standardizing them company wide. We’re striving to achieve excellence in customer facing processes as well as extract the maximum efficiency from back room activities. Another way to look at that very simply is if it touches a customer or an end user, it’s done locally in the marketplace, and if it doesn’t, then it’s done one way in one place or a limited number of places across Stanley.

Last but certainly not least, we’re implementing SAP as a company-wide systems platform. We’re not implementing a big bang with insurmountable business risks. It’s a sequential execution where we’re focusing on the businesses with the greatest needs or the businesses where we’ll achieve the greatest benefits in a very logical time sequence way in terms of both expense and internal resource allocation, and the process is proceeding nicely. All of these activities are well underway or in a full implementation mode.

So let’s move briefly to some of the individual segment results. Then we’ll wrap it up and open it up for questions. Our security segment was clearly a bright spot in the third quarter. Strong revenue and profit performance in general and outstanding if we exclude the hardware business that we’ve talked about the loss of a major customer about a year ago. Specifically, revenue’s up 7%, 14% without hardware, profitability up 8% in absolute terms, it was 27% excluding the hardware loss, and the profit rate improved 30 basis points to 220 basis points without the loss of hardware. We reference that in our press release. Jim touched on it. We lost a $50 million in annual business with about a 40% gross margin just about a year ago. That will anniversary midway through the fourth quarter and we’ll move on from there, but I think it’s important to remind everybody that was a tremendous headwind that our mechanical security business faced, roughly $12.5 million worth of business a quarter since February that will anniversary in the middle of the fourth quarter.

Our convergent business performed extraordinarily well with 21% sales increase driven primarily by the Sonitrol acquisition but we continued our margin expansion with the US systems integration business, primarily as a result of the successful reverse integration of the legacy Stanley systems integration business into HSM and the thus far successful integration of Sonitrol. The mechanical access business grew 5% in total, 2% organically, excluding the impact of hardware, and as already suggested, the segment profit rate was aided both by execution in all of the businesses within security as well as productivity and pricing actions.

A brief look at our most recent acquisition. The French company, Generale de Protection, is a leading independent provider of electronic security solutions in France and Belgium, and we’re enthusiastic about this acquisition because it creates what we’ll say an HSM-like continental platform for Europe for security expansion. You’ll recall that most of our European business right now is UK-centric and this is a major geographical expansion into continental Europe.

GDP has the direct sales model to small and mid-size commercial customers. Again, the focus being on commercial or B2B. Very highly recurring monthly revenue content, approximately 60%, with a 75% customer renewal rate. Very high numbers for the industry. It’s roughly $87 million at current exchange rates and annual revenues with operating margins at or above 20%. Basically it will be earnings neutral in ’08 and a modest impact in ’09. We paid roughly $166 million or 118 million euros and just for those who follow acquisitions in the securities space, that’s roughly 33 times RMR or recurring monthly revenue or 1.8 times revenue. We think a very fair and reasonable purchase price for a good piece of business.

I would like also to remind everybody, we at Stanley have a very strong track record in our industrial tools group and in our company with good French businesses with good market positions and capable management teams. We viewed GDP as more of the same and it creates a platform for our convergent security business in continental Europe.

Looking briefly at industrial and CDIY, both markets performed negatively and certainly were impacted by the end markets in which they compete. Revenues in our industrial tools group were flat and profitability was down. The profit rate was down 40 basis points. Organic growth in total was down about 4%. Industrial and automotive repair tool revenues were handicapped a little bit as [Mycolum] did maintain its revenues in very difficult market conditions while North American revenues declined slightly. Our engineered solutions business continued to experience some nice results with growth in both industrial storage and hydraulic tools businesses domestically and abroad and the segment profit rate as I’ve already suggested declined due to both higher inflation as well as some volume pressure.

On the CDIY side, the business facing probably most headwinds of any of our businesses, revenues in total were down 2%. Profit rate declined 380 basis points from a comfortable 16.5% level down to 12.7% for the quarter with a 5% decline on organic growth. Obviously there was softness in the North American or US residential and construction markets. European organic revenues did decline as a result of slowing demand in the UK and other European markets that Jim cited in his overview, as well as the decline in our lower margin storage businesses across the company or plastic storage business sold through the home centers.

[inaudible] continue to shift towards more profitable business but the segment margin rate was negatively impacted by inflation in the third quarter as well as a continuation of weakness in the US markets. So no surprises there, but all in all, 13% operating margin on a 2% decline in revenues.

So in summary, global markets continue to be negatively impacted by unfavorable economic conditions. No surprise there, which you might have missed in the technical blackout. Jim talked about our diverse portfolio, the advantages it’s having, which does insulate us but certainly doesn’t make us immune to those conditions.

US residential construction and retail markets are soft. 33% of our total business in total is focused in construction and DIY. About half of that or 17% is in North America. The North American industrial markets contracted, particularly the US automotive market, and the European growth is continuing to slow. As Jim indicated, the slowdown in Europe happened rather abruptly. In our case or certainly in the markets we serve where normally we see a very nice strong pick up in September after a return from the August vacation period. The pick up really never took place and we don’t see the situation as any more robust or healthy in the fourth quarter.

Commodity inflation set a record high. That’s the bad news. The good news is it’s beginning to taper off and our full year 2008 estimate remains unchanged since July at about $150 million. That trend arguably could get a little better and Jim did review our estimates for recovery. Despite that level of inflation, our current estimates suggest we’ll have 90% of it recovered, which is strong pricing performance across most businesses, due largely to the brand strength and secondarily just due to a good internal process to get out ahead of it, identify where the inflation is coming from, and try to be proactive in recovering as much of it through price and productivity as possible.

Internally within Stanley, I think it’s clear the balance sheet and cash generation do provide stability and ample liquidity. I think Jim provided just what you need short term in a snapshot to reaffirm that. Our earnings guidance of $3.75 for the year is down 3% and it’s relatively stable despite the unprecedented volume decline that Jim talked about. Cash flow estimate is unchanged at near $500 million. SFS does continue to aid in terms of the positive cash flow benefits. I’ve talked about timely pricing actions where together we have that’s doing a lot to mitigate inflation and as we sit looking at the remainder of the year into 2009, we think we’ve done what we can and we are well-positioned to weather a difficult economic environment as long as it lasts in 2009.

We have good priced momentum with inflation abating as we enter 2009. We have about 60 million of carryover from gross cost actions, about $25 million of which will be incremental in 2009, and the portfolio refinements specifically the addition of Sonitrol, GDP, and XMark continue to give us a more stable earnings base less susceptible to significant economic downturns looking forward. As I’ve discussed and we’ve mentioned in our press release, our short to intermediate term capital allocation will shift as we think about repurchase within our current rating constraints, and with that we’ll open it up for questions and answers.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Eric Bosshard from Cleveland Research.