Snap-On: The Future Looks Promising

Snap-On Inc. (SNA) is one of our favorite long-term investment recommendations from our extensive equity coverage universe. To be sure, the manufacturer of automotive repair tools and diagnostic systems has felt the brunt of the economic firestorm. The effects of the global downturn may have reached a climax in 1Q09 as demand trends weakened further from an already softening base in 4Q09. The U.S., Spain, and France were just a few of the end markets where Snap-On didn't exactly light it up in terms of volume; to the contrary net sales declined in these areas from 6.0% to 40.0%. Organic net sales fell in all of the company's business segments, the most pronounced pullback being in the Commercial & Industry Group segment.

Franchisees are struggling to sell big ticket items (tool storage), though this is a trend that became embedded in the early stages of 2008. On the other hand, the deceleration in the Commercial & Industry Group segment caught us and management by surprise; demand in areas like government and aerospace were not robust by any measure owing to limited visibility into an economic recovery. The standout was the Diagnostic & Information Group segment, where despite a significant drop in volume the operating margin expanded north of 600 bps year over year as management maintained a keen focus on the RCI process improvement initiative.

Without a doubt Snap-On will continue to navigate a rocky sea for the foreseeable future; our modeling has the business returning to a modest degree of normality in 3Q09. In 2H09, currency should be less of a headwind and de-stocking actions at international distributors, which weighed unfavorably on 1Q09, should have played out in full. The stock, in our estimation, incorporates no appreciation for the long-term potential of the business (8.6x est. FY10 earnings/4.3x trailing EV/EBITDA; these are multiples that are well below historical averages, the S&P 500, and others in the tool manufacturing sector who lack strong balance sheets and competitive advantages.

Story Beneath the Headlines

Industry

The market dynamics for Snap-On are about to change, in some respects drastically as OEM dealers close amid the non-functionality of the business models at General Motors (GM) and Chrysler. Should 4,000 plus dealerships evaporate, per industry forecasts, it may be a positive to Snap-On as repair services transition to the aftermarket. After all, individuals must have their cars serviced, and technicians arriving at aftermarket shops will need the resources to meet new business. For Snap-On, the opportunity is to sell more tools and diagnostics equipment to these technicians. In our view, the company has significant brand awareness and product offerings that are best in class.

Balance Sheet

Fresh off a $300.0 million debt issuance at interest rates we deem attractive (amidst the market hysteria), Snap-On has a solid capital structure that will allow for investment in overseas capacity (namely China) and in new products to keep the competitive gap wide. Capital expenditures are planned at a reasonable $60.0-$70.0 million for FY09, down from a prior forecast by $10.0 million. The annual dividend payout of $70.0 million looks safe as Snap-On displays strong free cash flow prospects. Approximately $150.0 million in floating rate debt matures in 2010, with repayment being made using proceeds from the recent debt issuance, still leaving ample cash for potential acquisitions or share repurchase program. Moody's and S&P assign Snap-On investment grade ratings on its long-term debt and commercial paper (can't say this for others in the sector), thereby making cost of funds compelling and easy to raise should the need arise.

Authored by Brian S. Sozzi, an Equity Research Analyst for Wall Street Strategies, Inc. (www.wstreet.com) covering companies in the Retail (hardline and softline) sector.

Disclosure: None

Comments

[TraderRob:]

We may see a pop in sales for "best in breed" brands in many sectors of retail. Snap-On has been producing professional grade wrenches dating back to the 1920's and have since integrated the brand into a wide spectrum of shop tools and equipment. Tax rebates and cuts from the stimulus will allow some middle income earners a one-time pop in disposable income that should benefit brands like Snap-On. Dire economic times inspire many to plunge into DIY projects instead of taking the car to the shop, causing the return on investment of "Lifetime Warranty" products like Snap-On to become more attractive.

Apr 29 11:59 AM

[Birdsnest:]

Not sure that I agree with your thesis regarding growth in tool sales as auto dealers close and technicians move to aftermarket repair shops. Auto mechanics typically own their own tools and take them with them to their new job. This is simply a locational transfer of existing tool stocks and not really an opportunity for incremental sales. Indeed, total automotive tool use is probably more function of total aggregate miles driven (down) adjusted for long term shifts in auto quality (better), adjusted for DIY leakage (up sharpley, driving down aftermarket repairs and maintenance). These combined factors would seem to me rather negative for Snap-on.

Apr 29 12:16 PM

[Wall Street...:]

I love your line of thinking Rob, and appreciate the insight. One great thing to keep in mind too is the relatively high barriers to entry to tool manufacturing, especially for the products being put out by Snap-On. I have always seen a level of innovation from them that has gone unrivaled by others.

-Brian


On Apr 29 11:59 AM TraderRob wrote:

> We may see a pop in sales for "best in breed" brands in many sectors
> of retail. Snap-On has been producing professional grade wrenches
> dating back to the 1920's and have since integrated the brand into
> a wide spectrum of shop tools and equipment. Tax rebates and cuts
> from the stimulus will allow some middle income earners a one-time
> pop in disposable income that should benefit brands like Snap-On.
> Dire economic times inspire many to plunge into DIY projects instead
> of taking the car to the shop, causing the return on investment of
> "Lifetime Warranty" products like Snap-On to become more attractive.

Apr 29 01:14 PM

[Wall Street...:]

I like those insights, do you work in the automotive repair industry? The one thing I wonder is if dealers subsidize the tools for their technicians, in some cases I would have to assume they do. My thinking here, as it pertains to the Snap-On opportunity, is that technicians would have to invest in more capital intensive goods (like the diagnostics, etc) rather than regular hand tools. I would certainly welcome any added insight.

-Brian


On Apr 29 12:16 PM Birdsnest wrote:

> Not sure that I agree with your thesis regarding growth in tool sales
> as auto dealers close and technicians move to aftermarket repair
> shops. Auto mechanics typically own their own tools and take them
> with them to their new job. This is simply a locational transfer
> of existing tool stocks and not really an opportunity for incremental
> sales. Indeed, total automotive tool use is probably more function
> of total aggregate miles driven (down) adjusted for long term shifts
> in auto quality (better), adjusted for DIY leakage (up sharpley,
> driving down aftermarket repairs and maintenance). These combined
> factors would seem to me rather negative for Snap-on.

Apr 29 01:17 PM

[bcncv:]

Snap-On makes some great tools, and I still own some that my grandfather bought many years ago. They're the best tools in the family, and they really do last forever.

I'm not sure I'd own it as an investment though. Although I haven't studied the stock as closely as you, I feel like they're fighting a trend of car manufactures creating lower maintenance cars, and younger generations that are less interested in maintaining their own vehicles. I don't know anything about their international sales, but I don't imagine the super high quality / super high price combo will sell well in many growing emerging markets either.

Although if they declared a special dividend of a new ratchet set, I'd buy stock in a heartbeat :-)

Apr 29 01:50 PM

[Wall Street...:]

Thanks for the color, the feedback is much appreciated. I think the opportunities for Snap-On lays in China and in the aftermarket. Dealer service bays are going away (see GM announcement), meaning business is going to have to be picked up somewhere. Perhaps technicians open their own garages. It's all high level thinking I suppose. In the meantime, I am pulling for the special dividend! :)


On Apr 29 01:50 PM bcncv wrote:

> Snap-On makes some great tools, and I still own some that my grandfather
> bought many years ago. They're the best tools in the family, and
> they really do last forever.
>
> I'm not sure I'd own it as an investment though. Although I haven't
> studied the stock as closely as you, I feel like they're fighting
> a trend of car manufactures creating lower maintenance cars, and
> younger generations that are less interested in maintaining their
> own vehicles. I don't know anything about their international sales,
> but I don't imagine the super high quality / super high price combo
> will sell well in many growing emerging markets either.
>
> Although if they declared a special dividend of a new ratchet set,
> I'd buy stock in a heartbeat :-)

Apr 29 02:01 PM

[jacflash:]

"Younger generation" DIYers don't buy Snap-On tools. They never have. They go to Sears and buy Craftsman tools and get 98% of the quality (and on hand tools, 100% of the no-nonsense lifetime guarantee and made-in-USA pride) for 30% of the price.

And that, right there, is the pushback on some of the case for SNA. Their distribution model requires huge HUGE margins, which they get from pro mechanics because having Snap-On tools is a status symbol, a professional badge, the mark of a pro versus just some guy who messes around with cars.

And yes, big diag equipment tends to belong to the shop, but those red tool chests full of $80 wrenches belong to the mechanic, who probably spent years paying off the loans Snap-On gave him to buy all that stuff (we're talking $30k or more here). They go where he goes, and unless you see a lot of new independent shops opening -- I don't -- I'm having trouble seeing any sort of big-growth case for SNA in the US.

And overseas... without the long-entrenched shop culture supporting the pro mechanic = snap-on user dynamic, I think it's going to be very hard for them to get traction without drastically altering their distribution model.

Apr 29 02:03 PM

[Birdsnest:]

Agree with jacflash; he is dead-on regarding the dynamics of the pro mechanic and the need for massive margins to support the existing SNA business model. As for my meager insight, my father-in-law happens to be a Snap-on dealer. One added factor is financing, briefly noted by jacflash. Much, if not most, of the financing for those red tool chests full of very pricy tools is bourn by the franchised dealers themselves, rather then secondary financing. Dealers often extend their own installment credit to their customers as many of the mechanics have sub-prime credit histories and are more transient. Write-offs happen to be soaring at the moment as mechanics find themselves between jobs or with lowered incomes due to lower repair volume. I would guess that many of Snap-on’s dealers are unlikely to make it through this cyclical trough. This could lead to a more junior set of dealers upon eventual cyclical recovery. There is a great deal of relationship building in the pro tool industry which is difficult to build yet easily destroyed.

Apr 29 02:51 PM

[Allan Frain:]

Agree with jackflash. Comparable quality at a fraction of the price wins in the market hands down.

Never being able to justify Snap-On as a do-it-yourselfer, I have inquired in the professional shops I do business with. They cannot justify the expense, either. Further, tool costs are more about loss than tool failure--in a shop environment tools are tools--not trophies. The quality of the work output reflects the quality of the technicians, not the value of their tools.

Apr 29 03:07 PM

[Wall Street...:]

Awesome insights everyone. It's on the ground assessments like these that are very critical in proper analysis. I am still upbeat on SNA, but am certainly open to healthy debate.

Apr 29 05:01 PM

[Alfredo Mar...:]

I would have to respectfully disagree that Snap On is a good investment right now.

Snap On makes some great tools, but they really are like Tiffany jewelry, it's all about the status symbol. They make a few "have to own" diagnostic type tools, but most of it really is about the "bling". In a down economy, that's the last market I would want to invest in. A mechanic can get by just fine with much less.

Also, technicians in emerging markets simply cannot afford Snap On's products. A complete set of wrenches costs around $800, a good sized tool chest costs $10,000. An well-paid American has a hard time swinging that even with financing . How in the world could a mechanic in China or India afford that?

Also, dealerships are the bread and butter for Snap On. My guess is at least half of all the dealerships currently open will close down. As was stated above, mechanics take their tools with them, so new independent shops opening doesn't necessarily mean new tool sales. Also, a lot of these laid off technicians will just sell their tools and find different jobs.

Snap On is heavily dependent on financing, it's essentially a bank disguised as a tool company. With job uncertainty in the automotive industry, mechanics will have a hard time taking on thousands of dollars in debt if there's a good possibility they may get laid off next week.

It may be a good long term play at the current pricing, but to me your looking at least 5 years before you see any real returns.

Apr 29 05:54 PM

[Veneratio:]

One question...

Why aren't you personally invested in Snap-On?

Apr 29 10:35 PM

[DumbAss:]

Hi folks,
Great comments all round. As a bit o a car DIYer, I completely agree with these comments - In my humble opinion, Sears/Craftsman is the first option (if you still have transportation to get you there) and it nearly always has what you need.

SnapOn is occasionally useful for a specialty tool though. For DIYers there can be a barrier in getting the truck to come to a residence as opposed to a shop (you would have to go wait outside a shop to meet the truck), and if you resort to the web (slower) for a specialty tool from SnapOn, you may end up finding cheaper options on the web even for special tools.

I have never quite understood the business model of not lowering some barriers and broadening appeal a bit more.

Therefore the catalog is a great read, but to be used minimally.

Apr 30 05:41 AM