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Stanley Black & Decker (NYSE:SWK)

Q3 2013 Earnings Call

October 16, 2013 8:00 am ET

Executives

Gregory Waybright - Former Vice President of Internal Audit

John F. Lundgren - Chairman, Chief Executive Officer and Chairman of Executive Committee

James M. Loree - President and Chief Operating Officer

Donald Allan - Chief Financial Officer and Senior Vice President

Analysts

Jason Feldman - UBS Investment Bank, Research Division

Nigel Coe - Morgan Stanley, Research Division

Richard Michael Kwas - Wells Fargo Securities, LLC, Research Division

Sam Darkatsh - Raymond James & Associates, Inc., Research Division

Mike Wood - Macquarie Research

David S. MacGregor - Longbow Research LLC

Stephen S. Kim - Barclays Capital, Research Division

Joshua K. Chan - Robert W. Baird & Co. Incorporated, Research Division

Michael Jason Rehaut - JP Morgan Chase & Co, Research Division

Liam D. Burke - Janney Montgomery Scott LLC, Research Division

Dennis McGill - Zelman & Associates, LLC

Andrew Noorigian - Vertical Research Partners, LLC

Operator

Welcome to the Q3 2013 Stanley Black & Decker Earnings Conference Call. My name is Dawn, and I will be the operator for today's call. [Operator Instructions] Please note that this conference is being recorded.

I will now turn the call over to Greg Waybright, Vice President of Investor and Government Relations. Mr. Waybright, you may begin.

Gregory Waybright

Thank you, Dawn. Good morning, everyone, and thank you for joining us for Stanley Black & Decker's Third Quarter 2013 Conference Call. On the call, in addition to myself, is John Lundgren, our Chairman and CEO; Jim Loree, President and COO; and Don Allan, our Senior Vice President and CFO.

Our earnings release, which was issued earlier this morning, and a supplemental presentation, which we will refer to during the call, are available on the IR portion of our website, as well as on our iPhone and iPad apps. A replay of this morning's call will also be available beginning at 2:00 p.m. today. This replay number and the access code are in our press release.

This morning, John, Jim and Don will review Stanley's 2013 third quarter results and various other matters, followed by a Q&A session. [Operator Instructions] And please feel free to call me with any follow-up questions after today's call.

Finally, we will be making some forward-looking statements during the call. Such statements are based on assumptions of future events that may not prove to be accurate, and as such, they involve risk and uncertainty. It's, 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 the 8-K that we filed with our press release and in our most recent '34 Act filing.

With that, I'll now turn the call over to our Chairman and CEO, John Lundgren.

John F. Lundgren

Thanks, Greg, and good morning, everybody. Just to touch on some of the highlights of the third quarter. Revenues did increase 10%, of which 4% was organic growth. The rest was the addition of Infastech, and it was partially offset by currency. Diluted EPS of $1.39, up 14% versus 3Q '12. Diluted GAAP EPS, including charges, were $1.07.

Our growth initiatives that we've talked about the last couple of quarters really continue to deliver some strong results. They contributed about 200 basis points or 2 percentage points of the growth. Both CDIY and our Industrial segments achieved some compelling top lines. Specifically, CDIY achieved organic growth of 5% at a 15% OM rate. And within our Industrial segment, Oil & Gas delivered another really strong quarter of organic growth of 32%. In Security growth, both the growth rate and the margin improved sequentially. Globally, organic growth was 1% versus prior year, driven primarily by our growth investments in the North American verticals and emerging markets, and the OM rate within Security improved 170 basis points sequentially to 12.2%, so good progress.

And as a consequence, we see no changes to our expectations for the long-term financial prospects for Security, and we believe the strategy and the programs that are in place to deliver our long-term financial objectives will get where they need to be. But we are revising our full year 2013 guidance -- EPS guidance to a range of $4.90 to $5, as a result -- primarily as a result of the slower margin recovery within Security, weakening in emerging markets and the impact of the U.S. government shutdown on near-term organic growth. So full year EPS, $4.90 to $5 and resulting free cash flow at approximately $800 million. And a lot more detail on those 2 projections and pieces of guidance from Don later on this morning.

Let's look briefly at our sources of growth because organic growth remains strong and the momentum is good. In the third quarter, volume was up 5%, bringing it to 3% on a year-to-date basis. Price was down 1%. So organic growth, as previously stated, at 4%. Acquisitions added 7%. Currency detracted by 1%, so a total revenue growth of 10%.

Looking at the organic growth year-to-date of 3%. Just it's -- where -- third quarter was not too different from year-to-date. We have a slow first quarter, as you'll recall, very robust second quarter and a healthy third quarter, which was right above the midpoint or slightly above the midpoint of our year-to-date performance. So a little bit bumpy but good organic growth on a year-to-date basis, with third quarter falling between first and second quarter. First quarter, as you'll recall, we had very little traction from our organic growth investments, but they're really starting to produce the kinds of result that we have expected.

Looking at the regions. And there is more detail in the appendix, but I think it's important to point out the U.S., our largest market, was up 3% and is up 3% year-to-date. It's still strong but it's not accelerating. Europe was down 1% in total and was down 1% on a year-to-date basis. As I think all of you know, the macro environment is more stable than it has been, but there's still certainly no tailwind and arguably, a headwind.

And within Europe, within our businesses, Security was down as, further detailed in our press release, as a combination of organizational changes and moves we're making and the macro environment. CDIY, it continues to gain share, and John Wyatt and the CDIY European team are doing a terrific job driving new distribution and share gains with product innovation and tremendous commercial efforts. Industrial within Europe was down slightly as well in -- pretty much in line with the market.

Emerging markets remain a bright spot, up 14% in the third quarter, up 8% on a year-to-date basis. Industrial and CDIY posting strong results. And Security was up nicely in emerging markets but it's from quite a small base, but we're making good progress there on our Security business in emerging markets. And the rest of the world was flat. So again, 4% organic growth on the third quarter, 3% on a year-to-date basis.

Just a quick snapshot, and I'll say some anecdotes on the specific initiatives that we've talked about for the last couple of calls. These initiatives are demonstrating results and within the third quarter, the emerging market expansion continues. We've hired about 300 people, including key country leaders and sales positions. Our distributor expansion is progressing nicely, both in the traditional and industrial channels or with that base, as well as in the modern channels in northeast Asia, where those channels are more established. That all helps us prepare for the mid-price-point product launches, which will come later this year. And the ability to launch those essential mid-priced products in emerging markets has been accelerated by 3 to 6 months through the GQ acquisition that Jim spoke to you about on the last call.

Finally, the Security verticals are gaining traction. We have order momentum building, and we've had some recent success in our K-12 and Healthcare programs on a global basis, specifically, new access card control systems in 73 schools across the country in the third quarter alone and orders in excess of $1 million at 3 hospitals. Obviously, we don't want to name them without their permission, but just as a demonstration of some meaningful points on the board with some of these initiatives. So as a consequence, we remain on track for our 3-year commitments with the organic growth program.

And finally, just a quick look inside emerging markets with some real highlights in our tools businesses: Russia, up 32%; China, 27%; Middle East and Africa, 9%; Latin America, 8%; Southeast Asia, 7%, so total emerging market growth -- tools business growth of 13%. And previously, as I said, Security's growing nicely in emerging markets as well but from a very small base.

Let me turn it over to Jim, who's going to take a deeper dive into some of the segments.

James M. Loree

Okay. Thank you, John. Starting with CDIY, another respectable quarter for CDIY, with 5% organic growth and near 15% operating margin. Revenues were $1.388 billion, up 5%. The operating profit was $207 million versus $204 million last year or up 2%. Profit rate was 14.9% versus 15.5% last year, a 60-basis-point decrease, which was largely attributable to the cost of the organic growth investments totaling 40 basis points of impact.

Organic growth was solid across virtually every region and every business unit within CDIY. PPT or Professional Power Tools was up 10%, as NPI, emerging market growth, promotions and the recovering U.S. construction market all contributed to the performance. In particular, the brushless XR and the cordless framing nailer, new products, registered significant gains. CPG or consumer products was up 5%, as outdoor continued its strength, while the innovative Matrix power tools gained share in the developed markets and new products in steam and hand vacs performed well in Europe. Emerging markets also contributed significantly to CPG's growth.

Hand Tools and Storage was up 3% organically, led by continued growth in DeWalt Hand Tools in the U.S. and positive growth in Europe.

As far as the regions, Europe was up 3%, an especially encouraging performance and their best since the euro crisis began, with share gains in a stabilizing economy and an especially strong performance in the U.K. Emerging markets at plus 10% was strong, but about 5 points of growth short of our expectation, as slowing markets, credit issues, currency volatility and in-channel congestion all took their toll. North America was up 4%, but could easily have been up an additional 2 points or so if inventory cautiousness at certain retailers and independents as a whole had not dampened shipments in September.

All in all, inventories of the larger retailers are in good shape, with some dispersion across that universe. And POS, in the aggregate, at the large customers remained healthy, so it appears that the consumer demand and construction-related activity have yet to be adversely affected by the U.S. government shutdown. So all in all, CDIY fared reasonably well in the quarter, with somewhat less growth than expected due to the emerging market slowdown and late quarter caution in the U.S. CDIY channels.

And now moving to Industrial. Industrial, too, had a respectable quarter, with 4% organic growth despite several headwinds and challenges. Operating margin at 14.5% was solid, down 90 basis points versus 3Q '12, driven primarily by organic growth investments and a slight mix down resulting from the addition of Infastech, which remains on track. Revenues were $771 million, up 25%, and operating profit was $112 million, up 18%.

Infrastructure, once again, was the star of the quarter with 23% organic growth, fueled by a 32% increase, as John mentioned, in Oil & Gas. Organic revenues and a high-margin onshore automatic welding activity drove the revenue growth in both the U.S. and the rest of the world.

Industrial & Auto Repair delivered 2% growth in the face of several headwinds, including a virtual no-show for a normal 3Q U.S. government spending, as well as Europe being down in the mid-single digits as SAP was implemented there and their major industry trade show will occur in the fourth quarter this year versus the third quarter of last year. Without these 2 discontinuities, IAR Europe would have been modestly positive. Mac Tools grew in the high-single digits, providing some offset. However, IAR's positive growth can be traced to the organic growth initiatives, with emerging markets up 13% and smart tools and storage collectively contributing about 3 points of growth.

Engineered Fastening had what appeared to be an uncharacteristically weak organic growth performance, being flat. However, underlying that story was a very difficult equipment sales comp from last year's third quarter, which resulted in equipment sales down 23%, and that was offset by fasteners up a more normal 6% organically, about 2x global light vehicle production. So the story for Industrial this quarter was a solid performance in the face of several material, but mostly temporary, headwinds.

And now I will focus on Security for a few minutes. Security is one of the drivers behind the recalibration of our outlook, with a general theme of progress but not at the pace that was expected. However, there is a definite distinction between the North America/emerging markets piece and Security Europe, with the former showing good growth and OM rates nearing but not at normalized levels and the latter taking more time to achieve desired growth and thus, profitability levels. I will delve into each one of these stories, but first, a quick overview of the segment.

Revenues were $600 million, up 3%. Organic sales were up 1%. Operating profit was $73 million, down 22%, and the OM rate was 12.2% versus 16% a year ago, but, importantly, up sequentially from 10.5% in 2Q. And this represents 170-basis-point improvement, which is moving in the right direction but just not at a fast-enough pace.

Now when we turn to the 2 pieces, starting with North America, you begin to see a reasonably positive story, with the business returning to a healthier state. And there, you can see 4% organic growth in North America/emerging markets and sequential rate improvement of 180 basis points from 13.3% to 15.1%. And without the investment in the growth initiatives or adjusting for that, the operating margin rate would have been in the mid-16s. So the organic growth, pretty positive story there, really resulting from several factors, some of which John touched on: the vertical market initiative definitely gaining traction, particularly in health care, education, also, in financial services. The automatic doors business was robust, with mid-single-digit growth. We had strong product introductions across the businesses, had a really outstanding ASIS show, which is the industry show in Chicago in September, where we showcased new products across the businesses. They were very well received by our customers, as well as our vertical solutions.

And as we mentioned earlier, the emerging markets are also contributing. So the sequential OM rate improvement on top of the growth is promising. Several key drivers for that: the vertical market mix as these systems are at above line average profitability; some improvements in field efficiency, not as much as we were looking for, but definite improvements in efficiency in North America; and then the commercial lock transition in the Mechanical Access business, now 9 months into the transition, entering a phase where the OM rates are now improving. So North America and emerging markets, about 60% of the segment is returning to a healthier state and will continue to make progress in 4Q and beyond.

And then when we focus on Europe, turning the page, the other 40% of the segment, we see a situation where organic growth is still elusive and negative, which, in turn, is slowing the sequential rate improvement and slowing our ability to get the operating margin rates back up into that zone that we're looking for. And the reality here is that the shortfalls in organic growth have gone beyond the 2-year shortfalls that we were expecting when we closed Niscayah, and they're now cutting into the margin rates. And we haven't had much help from the macro environment, although, frankly, we didn't expect much, and it is stabilizing.

So we are dealing with several structural issues, the first being historical overdependence on referrals from the mother company, Securitas, that really referred a lot of business to Niscayah back in the days when they were affiliated. So we had to rebuild the sales force almost from scratch over the last 2 years. And then we had, in various countries, weak legacy management that we had to undertake significant management replacements and changes. And then finally, we had a legacy systems integration model mindset and business model at Niscayah versus a recurring revenue model, which is what we're familiar with in North America. And then there is just the pace of change in Europe in general, which is a challenge.

And so these are all significant challenges, some of which we expected, some of which were deeper than expected. But we have a strong and capable management team in place in our Brussels headquarters for Security Europe, and although the progress is slower than desired, real progress has been made. As I mentioned, the sales force rebuild is well underway, and the France and U.K. and even southern Europe elements of this business are now performing quite well. In Nordics and Germany, Nordics being the largest region, which, fortunately for us, both decent economic environments over there, are really more self-inflicted works in progress, and we just made a significant management change, leadership change in the Nordics. And so most of the management upgrades are complete at this point in time. And we're gradually moving the model now towards a recurring revenue base model. So we should continue to see progress here in Europe, but we are not going to overcommit the pace of change at this point.

I'll now turn it over to Don Allan, who will cover the financial aspects of the quarter.

Donald Allan

Thank you, Jim. So I'd like to start with a walk through working capital and then move into cash flow. So our working capital performance was flat versus the prior year at 5.9 working capital turns, which was slightly off expectation. We expected to improve our working capital turns by about 0.4 turn in the third quarter of this year. Let me walk through a couple of the specific reasons for that variation. The first of which is that when you look at our receivables or DSO, the expectation was is that we'd be closer to a flat performance versus the prior year, but given the timing of how the revenue occurred within the third quarter, it actually drove an increase in our DSO of about 5%. We view that as a temporary situation and don't see that as a major hurdle for our objectives related to working capital and cash flow for 2013.

Second area is inventory, DSI which was flat. We did expect our DSI actually to improve in the third quarter, but due to the lower organic revenue performance in certain businesses in this third quarter versus our expectation, it caused some inventory pressure in our supply chain. And then the fourth area is the payables or DPO, which improved by 9%, and this is an area that we continue to demonstrate improvement over the last several years. This is really where the impact of the Stanley Fulfillment System and the hard work of our supply chain teams continues to demonstrate the benefits that the Stanley Fulfillment System can have on working capital as we continue to accelerate our progress there.

The end result was 5.9 working capital turn, as I mentioned, which was about 0.4 below our expectation. The vast majority of that was the combination of inventory and receivables. Our expectation for the end of the year is that we will be closer to a flat performance versus 2012 at 7.5 working capital turns versus our original expectation which was a modest improvement over 2012. And I'll walk through that in a little more detail on the next page. But our expectation is that we still believe, with all these things that we're doing through the Stanley Fulfillment System, that we can continue to work our way towards our goal of 10 working capital turns.

So moving to free cash flow. You can see the significant impact of working capital in the third quarter, which was a cash outflow of $244 million and year-to-date, cash outflow of $372 million. The good news is the expectation is, given the way that our fourth quarter works and the seasonality of several of our businesses, specifically the CDIY business, where a large portion of the revenue occurs in October and November, we believe, given that, that we can reverse the vast majority of this negative by the end of the year. However, instead of it being a slight modest positive versus our original expectation, we expect it to be flat or even a slight small negative at the end of the year. The reasons I walked through on the previous page.

The Other area -- Other category made some modest improvement. If you remember, back in July, I talked about some negatives that occurred in other that were more timing issues. We saw some of that reverse itself in the third quarter, and that trend will continue in the fourth quarter as that becomes more in line with our expectations by the end of the year.

So the question some of you might be asking is, "What's the roadmap from where we are to $800 million in free cash flow?" Well, if we start with our original expectation of $1 billion back in July, there's really 2 drivers that reduced it to $800 million. The first is our working capital expectation has dropped by about $100 million, and you'll hear on the guidance section and right after this that our earnings expectation is $100 million lower as well. Those are the 2 main drivers versus prior guidance.

But where we are today, at $150 million roughly of free cash flow, what is the path that gets us to $800 million? Well, our fourth quarter would have approximately net income and D&A of about $310 million based on current outlook. The working capital reversal of roughly $372 million, as you see up above, and then Other continuing to improve by about $50 million and then CapEx of about $80 million to $90 million would get you to roughly $800 million of free cash flow for the year. And that would be the roadmap to that expectation.

So with that, I'd like to turn to our revised outlook for 2013. Our current view of organic growth for the year is that we expect it to approximate 3%. We're year-to-date, through 9 months, at right around 3%, which means the fourth quarter is expected to be a similar number, versus our prior expectation of 4% to 5%. And I'll walk through some of the details of that in a few minutes. What that means to our EPS is that, combined with Security's slower recovery, we believe that EPS can be $4.90 to $5 this year versus our previous expectation.

So let's walk through some of the details of that. About half of the EPS reduction relates to a slower-than-expected pace of Security margin improvement versus our expectation in July. Jim did a great job walking through the detail of that a few minutes ago, so I'm sure you can understand the aspects of that in more detail. The second portion of it is related to a reduced view of organic growth, that I previously mentioned a few minutes ago, of now 3% for the year.

And there's really a couple of drivers to that. We believe that with the pressure that we're seeing in emerging markets, it's -- which is a slight temporary deceleration, we believe, associated with some of the macroeconomic environment pressures we're seeing in those geographies around the world will contribute to this. And then two, we really believe the U.S. government sequestration and shutdown has had a modest impact in Q3 on us and will have a slightly more significant impact in us in Q4. The good news is we believe these issues are temporary, that they're not issues that will carry over into 2014. But we cannot guarantee that at this point, so our view is to be prudent about where we are today and focus on what we can achieve through our growth initiatives and other organic initiatives across the company.

The last thing I'd say is that partially offsetting this pressure is an improved tax rate. As you saw in the third quarter, we did have some accelerated tax credits, as well as a shift in the distribution of our earnings across the world that allowed a lower tax rate. We expect that to carry through for the year. And now our tax rate will be 20% versus the 23% expectation in July.

The last thing I'd say associated with guidance is that, when you think through where we were in July, we were at a situation where we felt we were beginning to accelerate organic growth. As we close Q2, we saw accelerating organic growth in many areas, emerging markets, the U.S. and even Europe continuing to slightly improve. Our second quarter organic growth was 5%. Our second half view was organic growth slightly above 6%. Now, we see some deceleration in the -- with the second half being closer to 3% to 4% organic growth versus that 6% number.

The second area, which is a change is really our slower recovery in Security. We believe we're doing all the right things in Security to get this business back to historical levels. But in the case of Europe, it's going to take a little longer than our original expectation, but we're hitting all the right areas to make sure we achieve that in 2014 and beyond.

There's a little bit of segment detail associated with our guidance to the right. I'll touch on a few things very briefly, and then you can have follow-up questions as you see appropriate. CDIY will still be a mid-single-digit organic revenue performance for 2013, although slightly lower than original expectations due to the emerging market growth expectation being slightly muted. The modest OM rate increase is still expected to occur for the segment versus 2012. Security's organic revenue is expected to be a modest decline versus 2012. And we'll continue to see modest growth in North America, which will be offset by the continued mid-single-digit decline that we've been seeing in Europe. The operating margin rate will decrease year-over-year based on the information that Jim provided a few minutes ago.

And then Industrial will continue to be a low- to mid-single-digit organic revenue growth expectation for 2013, slightly lower than our expectation in July due to the emerging market situation, as well as the uncertain government situation here in the United States. And then the OM rate is expected to decrease slightly, mainly due to the initial Infastech margins being slightly below line average, as well as the impact of some of the growth investments.

The last thing I'd say on this page is that our view for 2014 is still being developed. But we still believe that many of the things that we're seeing here are temporary around the pressures in organic growth and that our long-term objective of 4% to 6% organic growth is achievable in 2014. Along with that, we believe that we can grow our EPS year-over-year 7% to 9% associated with that. Obviously, those numbers are excluding charges.

So to summarize the presentation portion of the call this morning, we believe 2013 is continuing to demonstrate traction in organic growth, even though we are seeing some pressures in certain areas that I just touched on. We continue to focus on the organic growth initiatives. They drove half of our 4% organic growth in the third quarter, and we're definitely seeing the benefit of them. CDIY and Industrial had a solid performance in the third quarter, and we continue to see positive momentum in those businesses. We've recalibrated our Security margin performance. The expectation is below -- or is below expectations but it's progressing. And we really believe that we will regain position in this business as being a revenue and earnings grower and a driver for our performance in 2014 and beyond.

The emerging market macro environment is difficult, and the U.S. government situation is creating some uncertainty for us, but we're still demonstrating solid organic growth even with that. Our 2013 outlook has been revised for the items that I mentioned, and we remain focused on driving organic growth in our company, the efficiencies across the company, trying to maximize synergies and then allocating our capital in a way that provides excellent returns for our shareholders.

So that concludes the presentation portion of the call, and we'll move to Q&A.

Gregory Waybright

Yes, great. Thanks, Don. Dawn, we can now open the call to Q&A, please.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Jason Feldman from UBS.

Jason Feldman - UBS Investment Bank, Research Division

Last couple of years, I know have certainly been challenging from a macro perspective, in currency and a lot of acquisitions and divestitures. But when I look at your revised guidance for this year, it's actually very similar to the initial guidance you gave for 2011, 2 years ago. When you look back kind of over the last 3 years, what do you think, over that period, kind of drove the shortfall versus your expectations? Do you see any kind of structural issue with the 3 segments that you have? Was it execution? Was it M&A? Or was it really just end markets and macro?

Donald Allan

Jason, it's Don. When I look back at the last 3 years, there's things that have happened in that time frame, and obviously, we've had shifts in the portfolio. We've sold businesses such as HHI. We've had acquisitions that have kind of shape-shift the structure of the company in that time frame. In 2011, the performance, in my view, was pretty solid and achieved our objectives for that year. In 2012, we had some dynamics in Europe that were difficult that hit every company, not just ours, in the second quarter and the third quarter of that year, and we think we responded accordingly with appropriate actions. And then the acquisition of Niscayah certainly had an impact on us here in 2013, and Jim walked through that in a lot of detail, and we're responding accordingly to it. We feel like we've taken the actions to get the business back on track here in '13, so it can be -- get itself closer to historical levels as we enter '14 and move further into 2014. But my view is there's not something structurally wrong with the portfolio of the company or structurally wrong with other aspects of the company. I think it's more due to the continued portfolio transformation of our company and driving performance and trying to maximize shareholder value along the way.

Operator

Our next question comes from Nigel Coe from Morgan Stanley.

Nigel Coe - Morgan Stanley, Research Division

So just 1 question. So you're guiding for 2, 3 points of sequential margin improvements at Security in 3Q, and you've got within that range. And it sounds like your implied guidance suggests there's no further improvement in 4Q. So can you just maybe just confirm that and just give us some color in terms of what's changed in the last 3 months?

John F. Lundgren

Yes. Nigel, it's John. I'll confirm there is no implied guidance despite your calculations for the fourth quarter. That being said, nothing has changed other than, I think Jim did as detailed a job as could possibly be done on this call, that we're pleased with the direction of Security. We are not pleased with the pace. I think the other very important point is the situations in the U.S. and Europe are dramatically different. Europe, we are in the midst of meaningful organizational changes, and those take time. That does take time to, I'll say, put points on the board and have you realize the results. And as I think Jim pointed out pretty clearly, we've got a lot of things going on in the U.S. on the Mechanical side. We've talked about our business model change which -- to a distribution versus direct, which is going to help with volume but, short term, have an impact on margins. I think that's quite clear. And on the Convergent side -- access is making great progress. And on the Convergent side, we've also -- we've talked about the need to focus or refocus on more recurring revenue and less systems integration and installation, which was, I don't want to say a trap but which was a tack we found ourselves going down that's not consistent with our long-term strategy. So a lot of things going on, but there was no implied guidance for the fourth quarter as it relates to margins. My expectation is we'll continue to improve globally, the question is at what pace.

Donald Allan

Yes. The only thing I would do to clarify what Nigel said is that we certainly gave an indication of the sequential improvement back in July, with the expectation in Q3 being a much higher number than what you said, Nigel, which was we expected it to improve about 300 to 350 basis points, and it improved 170 so about halfway there, and then by the fourth quarter, get to historic -- closer to historical level. So if there was a "implied guidance" that was really what it was.

Operator

Our next question comes from Rich Kwas from Wells Fargo.

Richard Michael Kwas - Wells Fargo Securities, LLC, Research Division

Just a question -- I know 2014 is in flux a bit, but when you look at that 7% to 9% EPS growth and you're saying 4% to 6% organic revenue growth, it seems like you should be able to get much better leverage on that organic revenue growth than what you're implying in that EPS growth for '14. What are kind of the drivers of the deleveraging or the reduced leverage on the volume growth that could potentially occur next year? I'm just trying to square that.

James M. Loree

Yes. I would say that -- this is Jim. I would say that the single biggest aspect of that is a hedge because the government is shut down, business confidence is shaky right now in the U.S. We don't know what the consumer is going to do. So we're putting 4% to 6% out there because the assumption is if the economy kind of stays at the current level, then we should be able to generate 4% to 6%. If that 4% to 6% does not materialize, we still think that we're in a situation where we'll be able to generate some meaningful earnings growth in the range that Don mentioned. However, it will require some more cost cutting and perhaps, some deferral of investments and that type of thing. And we're just at an early stage here, and we can't really determine what the external environment is going to bring with it. So hold on for a couple of months and come January, we'll be talking about that in more detail. Hopefully, the U.S. government will be back in business and business confidence and consumer confidence will be moving in the right direction again.

Donald Allan

Yes. And I would add that we're really just looking to give folks an indication that we saw the potential for growth next year, both top line and EPS growth. So it wasn't necessarily to say that this is a locked-in number and the view of exactly what it's going to be, but I think the way that Jim articulated is an excellent summary.

Operator

Our next question comes from Sam Darkatsh from Raymond James.

Sam Darkatsh - Raymond James & Associates, Inc., Research Division

I've covered Stanley for a long time, and historically, at least, there's been a clear pattern of anytime there's been weakening business conditions and/or executional issues, you've also announced further restructuring actions in order to rightsize the organizational cost structure and offset the earnings shortfall in short order. And notably, I'm not seeing that sort of new restructuring announcement today, which seems really curious given the scale of the current shortfall. So how should we read that as it really -- it seems like it's a significant departure from historical management actions at Stanley, not to announce a restructuring at the same time when there's a material miss?

Donald Allan

Sam, it's Don. The way I would respond to that is I certainly understand that perspective, and I think we are very -- as you know, very active in managing our company and responding quickly to situations. The current situation, though, our view is that it is temporary and to some extent, we believe, unorganic growth. Now we do have some situations related to Security that it's taking a little longer for us to recover, but frankly, we're taking all the restructuring actions we can take in our Security business to make sure that, that gets back on track. And it would be difficult to do a lot more beyond what we've already done, especially given that we're talking about a European business, where it takes time to do these types of restructurings and they can't be done overnight. But going back to the organic growth point of view is that we believe that we're seeing a bit of a deceleration, as I mentioned, here, and it's not the right time to react by a dramatic cost takeout. But to what Jim was saying earlier, if we get into 2014 and we start to see this trend continue, because it's more issues related to the U.S. government or there's some other type of economic impact either associated with that or independent of that, then we will have to take those types of actions. And I am convinced that we'll do that because this leadership team knows how to respond to those types of difficult situations.

James M. Loree

And if you look at where we are in the cycle, to kind of reiterate Don's point about this, we think this is temporary. If you look at where we are in the cycle, you have a construction market in resi which is pretty hot here in the U.S. You have a non-resi market that looks like it's going to be pretty hot in '14. You have Europe, which is stabilizing, not out of the woods, but certainly not a big negative like it has been for -- from an economic point of view. And you have the emerging markets, which are slower, but still 2 to 3x times the growth of the developed markets. So when you look at the macro backdrop, you say, "Well, this is not a permanent problem." It's a bit of a deceleration right now, and in particular, our emerging market activities performing in the low teens pretty impressive, I think, performance under the circumstances. Our issue is that to sustain a mid- to high-teens performance in markets that are decelerating would only put us in a position where we'd be getting into a trap or the channels would get too full. So we're throttling back temporarily. And next year, we have a significant MPP, mid-priced-point, growth program that John referenced. That's going to help us in the emerging markets. So we look around and we say, "The environment is not terribly negative right now. In fact, there's more positives than negatives." Therefore, we're cautiously optimistic that '14 will be a good growth year. There's no point in going and taking a business that has great organic growth momentum, in general, and going to take a hatchet out and take a big chunk of costs out because we're trying to make up for a couple of -- $0.50 of EPS this year. So that is the backdrop. And as I said, we'll have another look in early '14, and we'll share with you our view. And we haven't lost our ability or our inclination to cut costs when the revenue isn't going to be there. But we think, based on everything we see at this point, that the environment could be relatively favorable in '14.

Operator

Our next question comes from Mike Wood from Macquarie.

Mike Wood - Macquarie Research

It looks like in terms of the Security margins, without knowing how much you're spending in terms of the growth investments and the restructuring that you're doing with Niscayah, it's hard for us to model that out. But in a similar fashion, in terms of getting to your growth investment targets of the 35% gross margins and somewhat robust operating profits by 2015, can you provide us some more clarity in terms of what gets the gross margins up from where they are currently and what sort of leads to that margin ramp over the next 2 years?

Donald Allan

Yes, Mike. I would say -- well, first of all, the gross margins are not a major drag related to these initiatives here in 2013, and they won't be in 2014. The drag tends to be more at the operating margin rate level, which is where we're making the SG&A investments and the feet on the street in, streets in the emerging markets. Some of the enhanced resources and investments we've made around vertical solutions in the Security business here in North America, those are all SG&A-related costs, so the drag is more at the operating margin rate level. Now as we get into 2014, we'll be embarking on our mid-price-point product launch in the emerging markets, which our expectation is that will be reasonably close to line average gross margin and should not be a drag in that area in 2014. So our view is that we continue to make these SG&A investments. It's more about a volume leverage, getting the volume up to the right level. So the SG&A is giving -- the investments we're making is giving us a return that's in excess of 15% OM.

Operator

Our next question comes from David MacGregor from Longbow Research.

David S. MacGregor - Longbow Research LLC

Jim, you talked about throttling back a little bit on the emerging markets business. You're at low teens now. Can you just talk about the profitability as it stands today on the emerging markets business? You've talked in the past of it being 20% or better margins. I'm just wondering how it should go in the quarter and your thoughts for the next couple of quarters.

James M. Loree

Well, there hasn't been any significant change in the profitability levels of emerging markets, with the exception of the fact that the SG&A investments are a bit higher. So that's probably costing us 200 basis points of operating margin or something in that order. So instead of 20%, we're probably closer to 17%, 18%, but it's still above line average profitability.

Operator

We have Stephen Kim from Barclays on the line.

Stephen S. Kim - Barclays Capital, Research Division

I just wanted to ask you a question, I guess, about the Security business, in particular any lessons you think that are applicable as you sort of look into future opportunities. You cited the fact that there were some sales relationships and then maybe a sales force there that wasn't exactly up to your expectations, relationships with the parent company that were, I guess, losing some of the reported results beyond your expectations. As you look in the rearview mirror and you're trying to assess the lessons you learned from this and you apply that forward, what would you think you might do differently as you assess future M&A opportunities?

John F. Lundgren

Steve, great, great, great question. And maybe there's a spot for you on our Board of Directors because we've had the same conversation with them, and I mean that very, very seriously. I'll give you the short answer, and then I'll add some color because I think it's a really, really important thing to understand. The answer is nothing. And the different -- I would argue that Stanley Black & Decker has a core competency rapidly developing, if not already recognized, for acquiring, integrating, improving the performance of the business. And even in the past, when it's been suggested we've acquired at a very high price relative to our trading multiples, within a year or 2, it looked brilliant. In the case of Niscayah, there was one really, really important distinction. It was a contested publicly-traded company, where the former parent tried to buy it. We had the opportunity to intervene as a white knight, for lack of better terminology. It was a business we knew strategically was a very important fit. We had tried to buy that business when it was part of Securitas. That being said, Jim, myself, the Security team did a lot of due diligence to the extent we could 3 or 4 years prior. We had the opportunity -- we did not have the opportunity to do the kind of due diligence that we do, so we hit the ground running Day 1, where we know what the organization looks like, we know what the projections are, we're really comfortable with the synergies. We used our best estimates. That being said, what did we get right and what did we miss? And I think you asked that. We knew that the senior management was not there for the long haul because it was a newly upgraded -- newly created public company. They had no desire to carry on and weren't a good fit with our organization and they left. We underestimated the degree to which the field sales organization and the field tech organization in both countries needed to be upgraded. That took some time. I think it's well in process. But as we've suggested earlier, we depleted some of our existing Security business' bench, and we've put some very capable resources, including Massimo Grassi, one of our most tested and proven European leaders, added him to our Security business team in an effort to drive the changes that needed to be made. And I think the other thing Jim mentioned that we missed and I don't think without proper full due diligence in hindsight -- with the guide of 20/20 hindsight, it's easy. But we underestimated the degree to which the Niscayah business allowed on referrals from Securitas to maintain their installed base and as a consequence, turn that into recurring revenue. So all those things that Jim touched on are real. We've sat back and asked ourselves the hard question. Would we -- could we have anticipated that ahead of time? And the honest answer is, we think, no. To answer the last part of your question, were it to be a publicly-traded company and we were having -- we had the opportunity to intervene because we've never made a hostile acquisition in our career. It's not our style, and that tends to not work out very well. We might try to ask more questions, do more research. But understand, we had 2 weeks to mobilize to do this deal or not. I think 2 years from now, because we're asking ourselves the question now, "Would we have made the acquisition if we had to do it over again?" The answer is absolutely yes. Are we enduring some short-term pain for long-term gain? The answer is yes. And it's a long answer to a simple question, but it's appropriate that -- we've had this question internally, and we've had the discussion with our board. And I think that's exactly where we come out.

James M. Loree

Yes. And I'll just add to it that when we did this deal, we knew there were a lot of unknowns, and we knew the environment in Europe was uncertain, although we were not in the midst of a euro crisis. And so we've put pretty significant hedges in the plan. There was a $100 million revenue hedge as an example. We assumed we would lose $100 million of revenue. That would have been sufficient to cover the Securitas issues and some of the other things John was talking about, but it wasn't sufficient to cover the euro crisis and that at the same time, so not a big enough hedge, a very large hedge. We outperformed the cost synergies, and we continue to outperform the cost synergies on this deal, as well. And we knew that was a conservative estimate of the cost synergies that we undertook when we announced the deal. And the hedges just weren't big enough based on a combined euro crisis and some of the internal structural issues at the same time.

John F. Lundgren

And last point, Steve, it kind of relates to Sam Darkatsh's question on restructuring, which I think Don answered quite well. We haven't forgotten how to do it. We do it when we need to. We've made over 50 acquisitions in the last 10 years. We haven't gotten them all perfect on Day 1. There are very few that after we've owned them for a reasonable period of time, we haven't fixed them or figured out what's wrong with them and dramatically restructured them or changed them. And I personally am confident that we'll get there with Niscayah. It's going to take longer for all the reasons you've identified. They're all completely accurate. There all with the benefit of 20/20 hindsight, and that's where we stand on it. And then I'm hoping within -- a year or so from now, we'll be able to say we told you so. You asked the right questions, and we had the right programs in place, but spot on for now.

Operator

Our next question comes from Peter Lisnic from Robert Baird.

Joshua K. Chan - Robert W. Baird & Co. Incorporated, Research Division

This is Josh Chan filling in for Pete. Just on the idea of possible deceleration, I know, Jim, you've talked a little bit about some slowing in September in CDIY. I was just wondering if September was just a slow month in general across your different kind of businesses. I was wondering if you have any color on that.

James M. Loree

Well, September was a slow month in Industrial & Automotive Repair for sure, with the government basically shut down. And there's usually a surge in September related to the government spending and so forth that just didn't occur, so that was clear. We think that there were some inventory corrections, as I mentioned, at retail, which was definitely a factor in CDIY. And then we also had the systems implementation in IAR, as well as the Kip [ph] Auto Show, which is the trade show which would occur in the fourth quarter and not September as in previous -- as in the previous years. So these factors all contributed to a slow September. It was a very slow September in relation to what we expected and what we've been experiencing on a run rate basis. And that's why a fair amount of the deceleration is attributable to both the emerging market slowdown and the U.S. government issues that we have right now with respect to the budget funding levels.

Operator

Our next question is from Michael Rehaut from JPMorgan.

Michael Jason Rehaut - JP Morgan Chase & Co, Research Division

Yes. Just wanted to focus on North America also for a bit. If you could go into more detail with regards to, I guess, what you would call some of the areas that you are happy with and that you still expect some additional improvement in, particularly in Security. You had mentioned on the -- where you felt room to go is on the field efficiency side, for example. And also in the CDIY, where you'd mentioned the inventory reductions, if it's possible, can you give any additional clarity there, if you think that will continue into the fourth quarter, for example?

John F. Lundgren

Yes. I can't give too much more clarity on the inventory reductions other than to say that what we're -- I said there was some disparity across the population or the universe of these customers, and we would never call out any one in -- specifically. But what I will say is that there is a pattern where the retailers that are performing well are not necessarily adjusting inventories. Their inventories are in pretty good shape. And the retailers that are struggling a bit are in a different place, so their inventories are getting a little bit out of line. On the average, the inventories are in good shape. So -- but you do have a little bit of a dispersion across the universe. And on Security, their -- the fourth -- the third quarter performance in terms of margin probably fell about 200 basis points or so short of where we had hoped it would be, and a good half of that is related to the field efficiency. So we did make improvements, but there definitely are some areas in the area of efficiency that are improving even as we speak on a month-to-month basis, but just not improving on a fast-enough rate. And we have good visibility into that, and we should see some improvements continue into the fourth quarter on that front. And then, in general, what I'm very happy about in North America is the organic growth. We really haven't -- we've made a lot -- talked a lot about it, but I defy anybody to go back and find out when the last time CSS organic growth was at that level in North America. So we've been talking for a long, long time about Security ultimately becoming a growth engine -- organic growth engine for the company. The vertical market solutions is the way to do that. It's a terrific, terrific business because it has a defensible value proposition. It has above line average margins, and you can grow it. It's not like the basic monitoring business, which is the more you install, the lower your margins go until you get the recurring revenue built up. It doesn't have that dynamic, so it helps us deal with that. Very excited about the growth in North America Security.

Operator

Our next question comes from Liam Burke from Janney Capital Markets.

Liam D. Burke - Janney Montgomery Scott LLC, Research Division

You'd had -- Engineered Fastening, you had a tough comp in terms of the systems orders year-over-year. It did affect your operating margins for the quarter. Looking at current order rates, how do you see that business trending for the balance of the year and into '14, both on the systems side and on the margins?

Donald Allan

Well, this is Don. The portion of the business that we're referring to is the legacy Engineered Fastening business, which is tied more to light vehicle production globally. And as Jim mentioned, the fastener piece of the business outperformed light vehicle production growth in the third quarter and has done that over ...

James M. Loree

2:1.

Donald Allan

2:1 and has done that for quite some time. But we did, in the third quarter of last year, have a significant equipment -- set of equipment sales that occurred in our European business. That was a difficult comp for them in the third quarter. But our view going forward is that we believe that, that performance versus light vehicle production will continue to be strong and healthy. And they have been very focused on gaining market share over -- well, that's certainly part of their differentiation model over the long term. But in the last 2 years, they've really been able to demonstrate that in the financials, and we believe they will be able to continue to do that at a significant pace. And when you look at the Infastech business, which is more significantly tied to the electronics industry, we believe that we're doing similar things there around differentiation that allow this business to continue to demonstrate mid-single-digit growth going forward over the long term.

Operator

We have Dennis McGill from Zelman & Associates.

Dennis McGill - Zelman & Associates, LLC

Just quickly, Jim, on the '14 numbers and the puts and takes. I can appreciate risks from the government side and kind of the uncertainty, but I would think that would flow through the revenue outlook as well. But for a given 4% to 6% increase and realizing you'll be anniversary-ing some of the brand investment or the strategic growth investments, you'll have lapped a lot of the problems in Security, it would seem like the incremental growth should be a lot stronger for that given level of 4% to 6%. So is there something else within the margin structure that would be offsets to that?

James M. Loree

There's nothing structural at all. I mean I think Don, as he said earlier, put that numbers -- those numbers out there because he wanted people to understand that we expect positive growth in 2014 no matter what the environment looks like, based on the government shutdown, et cetera. The -- so for you to conclude that if anything beyond that would be wrong -- and the 4% to 6% growth is a number that, as I said earlier, I think we can make if the economy is kind of more the same that we've had this year, for the most part, and the organic growth initiatives will buttress that number up against kind of a normalized economy that we're having this -- that we have in the first half this year and, hopefully, we'll have in '14. So it's just as I said earlier, there is a pretty substantial hedge in that number, and if the volume doesn't come through, we still expect to be able to deliver growth of that magnitude at the earnings line.

John F. Lundgren

Dennis, it's John. Let me just add a little perspective that I think will help you, but I think Jim and Don described it perfectly accurately. This is -- it's available on the public domain. It's in our proxy. And a lot of it reflects on how we compensate in an effort to motivate our organization, and the overwhelming majority of the organization is compensated based on 3 metrics: organic growth, earnings and cash flow and/or working capital turns, if you're in a business. And we want the organic growth number to be more of a stretch than the earnings number for all the reasons Jim and Don talked about. But all 3 of those metrics are important. That's how we measure our people, that's how we measure ourselves, that's how we pay our people. But I think it's important to note that earnings per share or operating margin depend on where you sit in the company. Cash flow and working capital turns are weighted slightly higher than the organic growth. We've had a lot of conversations about that internally with our comp committee, with our folks, and we think it's the right weighting. So yes, don't jump to any conclusions based on that. But I've -- hopefully, what I just walked you through will help you understand it.

Operator

We have Andy Noorigian from Vertical Research.

Andrew Noorigian - Vertical Research Partners, LLC

And just really quick, I think on the CDIY, you've mentioned emerging market channel congestion. I was just wondering if you could elaborate on what exactly that was. And as you look to '14, with the medium price point rollout, are the channels all in place for that as you look out? Or is there more investments to be made there?

James M. Loree

The channel congestion that I referred to simply relates to the fact that almost all business in the emerging markets is done through distribution, independent distribution. We have done a lot of developing distribution this year, and in doing so, we have sold a lot of tools to these distributors, who are now in the process of marketing these tools to end users. And we are in the process of creating end-user poll and end-user demand, and it's a natural process that you go through when you develop distributors. When you look at the markets, just to be clear, these markets are not growing at the pace that we're growing in the emerging markets. So our growth is coming from the development of distribution, as well as share gains that are with the existing distributors. And so part of the deceleration is driving a slower growth outlook because we certainly are not going to fill the channels to the point where it becomes an issue for the end distributors from a liquidity perspective or just it doesn't make business sense. So we're being prudent in not pushing too hard until the pool is sufficient at the end-user level, so the channels are operating smoothly.

Operator

That was our last question. I will now turn the call back to Greg Waybright for closing comments.

Gregory Waybright

Dawn, thanks. And we'd like to thank everyone again for calling in this morning. Please contact me if you have any further questions. And again, thanks for your participation.

Operator

Ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect.

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