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Snap-on Inc (NYSE:SNA)

Q2 2010 Earnings Call

July 23, 2010 11:00 am ET

Executives

Leslie Kratcoski - VP, IR

Nick Pinchuk - Chairman, President and CEO

Aldo Pagliari - CFO

Analysts

David Leiker - Robert W. Baird

Jim Lucas - Janney Montgomery Scott

Gary Prestopino - Barrington Research

Operator

Welcome to the Snap-on Incorporated 2010 Second Quarter Results Conference Call. At this time, all participants are in a listen-only mode. At the conclusion of our remarks, we will conduct a question and answer session. (Operator Instructions) As a reminder, today's call is being recorded.

I would now like to introduce your host for today's conference, Leslie Kratcoski, Vice President of Investor Relations. You may begin your conference.

Leslie Kratcoski

Thanks Holly and good morning everyone. Thank you for joining us today to review Snap-on's second quarter 2010 results, which are detailed in our press release issued earlier this morning.

We have on the call today Nick Pinchuk, Snap-on's Chief Executive Officer and Aldo Pagliari, Snap-on's Chief Financial Officer. Nick will lead off our call this morning with his perspective on our performance. Aldo will then provide a more detailed review of our financial results. After Nick provides some closing thoughts, we'll take your questions.

As usual, we have provided slides to supplement our discussion. You can find a copy of these slides on the Investor Relations portion of our website, next to the audio icon for this call. These slides will be archived on our website along with the transcript of today's call.

As noted in today's earnings release and as previously communicated, we recently realigned our management organization in an effort to better support the products and service needs of our primary customer segment. As a result of this realignment our reportable business segment now include the Commercial & Industrial or C&I Group, Snap-on Tools Group, Repair Systems & Information or RS&I and Financial Services.

Any statements made during this call relative to management's expectations, estimates or beliefs or otherwise state management's or the company's outlook plans or projections are forward-looking statements and actual results may differ materially from those made in such statements. Additional information and the factors that could cause our results to differ materially from those in the forward-looking statements are contained in our SEC filings.

With that said, I'd now turn the call over to Nick Pinchuk, Nick?

Nick Pinchuk

Thanks Leslie. Good morning everyone. I think it's fair to say that the second quarter results provide some significant evidence that our strategies are working. We continue to make tangible gains in markets that are mixed, still tough, but improving.

In this environment we remain committed to the Snap-on value creation process. They form a powerful framework for both capturing those opportunities and for achieving cost and flexibility improvement and we continued to make progress in the four and key strategic initiatives that we believe would be decisive for us going forward; enhancing the franchise network, expanding our presence in vehicle repair facilities, extending out of the garage and into critical industries, and building and emerging markets.

In each of those areas we are encouraged by the progress that's evident in our second quarter. The organic sales in the quarter were up nearly 10%, about $57 million from last year and operating earnings before financial services were up more than $25 million or 47% over last year's level. The resulting operating margin was 12.2%, that's up 310 basis points from 2009.

Encouraging progress was the Snap-on value creation processes, processes like safety, quality, customer connection, innovation and rapid continuous improvement have driven to reality. As usual, Aldo will take you through the financials in detail but first I will give you our perspective on the markets and cover some of the operating highlights.

Last quarter, I characterized the markets as, I think I said stabilized, favorably inclined but not rebounding. Since then, we haven't seen any exceptional economic acceleration. However, I will say that overall nothing has led us to be less positive.

So certainly, we now have one more quarter of stability and we actually see some pockets are further strengthening. So we are a bit more encouraged, but we remain cautious. It's clear that the recovery is fragile.

Let me provide you a little bit more color on the sales front. In addition to the 9.6% of year-over-year organic sales increase, volume was also up about 6% sequentially from the first quarter. For us overall, there is not much seasonality except in the third quarter when summer vacations and shutdowns primarily in Europe can make volume hard to predict.

So the 6% sequential increase in the second quarter was fairly strong compared to what normally is relatively flat for a second quarter progression. In fact, it was the strongest second quarter uptick we've seen in at least seven years. This strength was reasonably widespread with all the operating group, Commercial and Industrial tools and RS&I were up all stronger than the normal increase.

In addition to those overall volumes, we've also been watching the trends and what we've been calling big ticket items, large dollar products like diagnostics and under-car equipment that have longer payback, and tool storage units, which are more discretionary purchases.

Given the capital nature, we believe activities in those products are a window on our customer's financial position and the overall confidence and we are encouraged by what we saw.

Under-car equipment sales showed favorable trends in the quarter and that was true in both North America and Europe. Diagnostics and Tool storage units, which are generally sold through the van channel also showed positive sign. So, now we recorded two quarters of big ticket progress and that is a fairly strong positive because we seen quite a bit variation in these products during the downturn over the last 18 months.

If we dissect the sales by geography, we see an uneven landscape. In Europe sales are up from last year about in line with what see for the overall company increase. Remember however, though that Europe was hard hit, very hard hit last year. So I think we need to see a bit stronger gain in order to start feeling clearly positive about that situation.

Within Europe the regional variances of the last quarter continued modest recovery in the north and central areas, weakness in the south. Spain in particular where we have fairly large position is not recovering. I think everybody is aware that Spain been among the hardest hit in the downturn, and we seen this reflected in our Spanish business. A couple of bright spots though, I'll say even better elsewhere have been under-car in Europe, under-car equipment in Europe and a even bit more rapid recovery in the East and places like Russia and Turkey, all of those were up strongly.

Also in U.K., we are seeing some strength, especially in the Tools group where actually we are coming of a fairly solid 2009. That is the comparisons aren't that easy. So the gains in the U.K. are significant, a real positive. So, I'd say then that Europe is mixed. We are seeing some positive signs, but we are still some distance from a clear trend.

Asia, no surprise it's outpacing the rest of the world. We are seeing solid increases there, both in emerging markets like India and even in the more established markets like Korea, building our presence in the region with both physicals and product is paying off.

So, with another quarter of favorability behind us we are optimistic. However, we also still believe the recovery is gradual. It seems everyday we see and we hear mixed signals and for us, for our customers it does impact their confidence. I said frequently last year that people were eating bad news for breakfast, everybody from the paper and from the TV and I think we still have a bit of the same thing going on now only with mixed signals.

So, the uncertainty remains but we would say we are moving in a positive direction. So, we will stay focused on the approach that's been successful for us; vigilance on cost, flexibility and reaching for opportunities, Snap-on value creation driving improvement, and investment in the size of initiatives for growth.

Now for some highlights on each of the operating groups, Commercial and Industrial or C&I. Sales were up 22% from last year with double digit increases in all of the units. The operating margin was 9.9% also up substantially. Volume and ongoing operational improvement did the trick in that area.

The industrial division especially in the US showed the strongest gain, making advances in critical industries, taking the Snap-on brand out of the garage like we said before. For example, our position in the Aerospace segment, it continues to strengthen. We are partnering with OEM aircraft manufacturers as well as Tech schools to develop and support Snap-on specific aviation certification programs. It's a great way to establish an early relationship with students who are future technicians. For us, it's an effective path in creating a lifelong professional customer and we continue to move forward with that type of partnership approach in a number of industries like wind, oil and gas, and in fact auto repair.

Let's go back to the Aerospace segment. This is an area where Snap-on is uniquely positioned. The mission critical nature of the work is obvious. The quality of the Snap-on brand is required and valued and the potential for growth is abundant for us.

While the industry has been depressed, there are some signs of recovery. At the Farmborough International Air Show, there has been a lot of confidence in aircraft orders were surprisingly strong. Snap-on's at that show displaying a revolutionary tool control innovations and they've been a big hit. So we like our position as the aerospace sector recovers.

We are also reaching new critical industries and tailoring our lineup to support that effort. I spoke to you last quarter of the broadened product line we've been introducing for large tool application in areas and segments like mining and natural resources. In the second quarter, we saw more progress with those customers due to that expanded offering and a significant industrial sales growth is evidence of that success.

We talk about innovation often at Snap-on. Our leadership in innovation and design, our focus on safety is also evident with the BAHCO brand. Last year, the BAHCO Handsaw System won the prestigious Red Dot award for European design excellence and this year the recognition continued with the product being named the winner of the Design IF award for ergonomics.

That system provides ergonomically superior handles, in different sizes for left and handed users with 10 different interchangeable blades for cutting a variety of materials and it offers a patented locking system. Innovation driven by customer connection is helping SNA Europe sell even in the downturn, helping BAHCO maintain a world class brand.

Asia-Pacific, as I said is continuing its upward trend. Sales were again up strongly with gains in India, China, Philippines and Korea leading the way. We've been working hard over several years in that region to establish our physical capability, more salesmen, more factory capability and capacity, more Asianized product and its being paying off. You can see it in our numbers. You can see it in the success of our new products.

A great example is the new BAHCO Asianized bandsaw, a runaway seller. So much so, that we outstripped our recently established capacity and we are acting right now to double down on Kenosha's saw capacity. So Asia is a success.

Moving to the Tools group, volumes increased to 7.8% in the quarter, about $19 million from last year. With the US posting a 9% gain, operating income was up $7.5 million to $33 million or 12.5% of sales. For sometime, one of our key initiatives has been to strengthen the franchisee network. I think we have clear evidence that those efforts continue to pay off.

In the second quarter, our sales in the US returned to 2008 pre-recession level. Now I think it's widely agreed that the overall economy hasn't returned to same levels two years ago. So reaching that benchmark is encouraging for us.

I spoken in the past about our franchisee stimulus program, aimed at supporting the network. It's been a key to our sales return and we believe that right now our franchisees are in better shape, sales strong, profits robust, cash improved. So the stimulus is working and the network is stronger.

I already mentioned big ticket items and the favorable results. Those are the products that are often require finance and in that space Snap-on credit is a huge advantage. It's core contributor to the power of our franchise network. The credit company's transition into a wholly owned subsidiary of Snap-on started about a year ago and it's progressing well.

In the second quarter it's now turned profitable as we said it would in several prior calls. At the end of the day though, in our business, you have to have great products to sell and we use our frequent touches with the end customer to create just that.

Innovation and new products are born out of technology advantages, or often born out of technology advances, but some times it's less complicated. It comes from just knowing your customers' problems.

For example, in using the 3600 franchisees and talking and visiting with customers, with automotive technicians, we found that all-in-one wire stripper, crimper and cutter pliers were designed primarily for electricians. They tend to spend more time stripping wires and you can imagine, they don't have the same space challenges as an autotech. So with that insight our engineers went to work and developed a new compact cutter and stripper tool, designed specifically for tight auto applications,

It has been huge hit, not a big ticket breakthrough product that transforms a company but thousands were sold and it's great example of using customer connection to our advantage, extending Snap-on's traditional innovation. That tradition echoes favorably up and down the product line and in and out of garages all over this country and all over the world.

Now, to Repair Systems and Information or the RS&I group. This was the group that was formed out of our recent reorganization, lining each new segment up with a primary customer base. The Tools group focused on auto technicians. C&I focused on professionals in critical industries and emerging markets, and RS&I, serving vehicle repair shop owners and managers. We've now organized a capture growth in each of these broad and important customer segments.

Back to RS&I. Overall volumes increased 4.7% driven by the equipment division activity, driven by the equipment division's increases that I'd mentioned before. It also had some solid improvements at EQS, our facilitation and essential tools business. Those gains in those areas helped to offset Snap-on business solutions or SBS where activity continues to be down, related to consolidation in the overall OEM dealer space.

Now, SBS is working to help itself. It's working to create some offsets of it's own by expanding with existing customers including internationally and with [batches] that haven't been impacted by the dealership disruption. They are also working hard to grow near adjacent market such as power sports, agricultural and construction.

Speaking of OEMs and the dealers, we are seeing some improvement in that area and the OEM manufacturers' willingness to commit to essential tools and the dealers themselves are starting to make purchases. So all of this certainly drove some of RS&I's improvement and the RS&I group is growing elsewhere.

We saw some solid sales increases related to our expansion in the heavy truck and fleet market. To think about it, that's a natural fit for us and we've been making investments in product both diagnostics and repair information and we are starting to get traction.

So that summarizes the market and I think it provides you some perspective on our advances in the quarter. So now I'll turn from an operating perspective. So now I'll turn the call over to Aldo for a review of the financial results in detail. Aldo?

Aldo Pagliari - Chief Financial Officer

Thanks Nick. Our consolidated operating results are summarized on slide 6. Sales in the second quarter of $648 million increased 9.8% from second quarter 2009 levels. The primary drivers behind are the $8 million year-over-year sales increase, include tire sales in critical industries, increased sales in emerging markets, higher equipment sales and increased sales by franchisees in the US and U.K.

The company also saw many improvement in its European based businesses. Consolidated gross profit of $303.8 million in the quarter increased $49.8 million year-over-year, while the gross margin improved by 380 basis points.

These increases were largely due to the higher sales volumes and favorable manufacturing utilization as a result of the increasing levels of production. Savings from rapid continuous, RCI initiatives and benefits from previous restructuring actions contributed about $7 million of gross profit improvement.

Foreign currency primarily transaction FX, contributed $5 million and lower year-over-year restructuring cost contributed an additional $3 million of gross profit improvement. As a result of these factors consolidated gross margin improved to 46.9% in the quarter as compared to 43.1% last year.

Operating expenses in the quarter increased to $25 million from 2009 level. This was primarily due to higher volume related expenses and $14.9 million of increased performance based incentive compensation expense as a result of improved year-over-year operating performance and increased participation in the company's stock purchase programs.

In addition, we incurred $3.1 million of higher pension expense, largely due to lower than projected asset return in previous years, related to the US Pension Plan. These increases in operating expenses were partially offset by $2.5 million of benefits from ongoing RCI and other cost reduction initiatives and $2.5 million of lower restructuring cost.

As a percent of sales, operating expenses were 34.7% in the second quarter of 2010 as compared to 34% last year. Restructuring cost in the second quarter totaled $3.1 million as compared to $8.6 million last year.

Operating earnings of $79 million before financial services improved 47% over prior year and 9.8% sales increase. Financial services' operating earnings of $1.7 million in the quarter improved sequentially from a $1.7 million loss of the first quarter of 2010 and also compares favorably with a $3.8 million loss in the fourth quarter of 2009 and $5.3 million loss in the third quarter of 2009.

As previously discussed and as expected operating income from financial services, which is before interest expense is consistently improving as the on-book finance portfolio grows. Since the termination of the financial services joint venture with CIT in July of last year, our gross on-book finance portfolio has grown over $450 million to $577 million. Year-to-date this portfolio has grown about a $180 million.

Turning to interest expense, higher average debt levels primarily related to the growth in our on-book finance portfolio, increased interest expense by $1.6 million year-over-year.

The second quarter effective income tax rates for 31.2% in 2010 and 31.9% in 2009. The improved and lower than previously communicated effective tax rate for the second quarter of 2010 primarily benefitted from the favorable settlement of a tax audit. The second quarter 2009 rates benefitted primarily from the realization of a tax benefit in a foreign jurisdiction.

Finally, net earnings of $45.3 million or $0.78 per diluted share increased from $37.4 million or $0.65 per share last year, despite $11 million or $0.19 per share of lower year-over-year net earnings from financial services.

Lets now turn to our segment results, beginning with the C&I group on slide 7, segment sales of $259 million improved 22% from prior year levels. The year-over-year sales increased was driven by a higher sales across all operating units with particularly strong increases in those businesses serving customers in critical industries and emerging markets.

Again this quarter, sales increases were realized in our European base tools businesses. While we still face headwinds in this region, we are encouraged that the higher year-over-year sales in the first half of the year may be evidence of some continuing stabilization in the European markets, despite the headlines of late, regarding financial market volatility in that region.

Gross profit in the C&I segments of $93 million increased $27 million or $41.6%, from 2009 levels, reflecting the 22% sales increase and $5.2 million of savings from RCI, restructuring and other cost reduction initiatives.

The year-over-gross profit comparison also benefitted from favorable manufacturing utilization, as a result in increasing production levels. You may recall that last year we incurred substantial cost to carry excess manufacturing capacity primarily in Europe, as a result of lower production levels and inventory reduction efforts.

For the current quarter, gross margin of 35.8%, improved 500 basis points from 30.8% last year. Operating expenses in the quarter of $67 million were up slightly year-over-year as higher volume related and other expenses were partially offset [Author ID1: at Fri Jul 23 21:45:00 2010

]by $1.4 million of more restructuring costs. As a percentage of sales, operating margin in the C&I segment improved from 1.1% in the second quarter of last year to 9.9% this year.

Turning now to slide 8; on a worldwide basis, second quarter sales in the Snap-on tools group increased 9% from 2009 levels. Excluding currency translation, organic sales increased 7.8% including a 9.3% increase in the United States. Man-count in the U.S. at the end of the second quarter increased slightly compared to prior year levels. Gross profit in the Snap-on tools group of $116 million increased $14.4 million over the prior year.

This increase primarily reflects contributions from higher sales and benefits from favorable manufacturing utilization as a result of increasing US production levels and $4.9 million of favorable currency effects.

In the quarter, gross margin improved to 43.7%, an increase of 200 basis points over 41.7% last year. Operating expenses of $83 million in the quarter increased $6.9 million from 2009 levels primarily due to higher volume related and other expenses. As a percentage of sales, operating earnings of 12.5% in the quarter for the Snap-on tools group improved 200 basis points from 10.5% last year.

Let's now turn slide 9, and the segment we now refer to as Repair Systems and Information or RS&I. As previously communicated the RS&I segment and its operations are aligned and focused on better serving customers in the worldwide vehicle service and repair marketplace, including all orders of managers of independent and OEM dealership service and repair shops. In addition to equipment products and equipment repair services, the RS&I segment included the business operations of the former Diagnostic and Information group.

Second quarter sales of $206 million in the RS&I segment were up 4% from prior year levels. Excluding currency, organic sales were up 4.7%, primarily due to higher sales of equipment and increased essential tool and facilitation program sales, partially offset by anticipated lower electronic parts catalogues sales in North America, the latter a result of OEM dealership consolidations.

Gross profit of $96 million in the quarter increased $8.2 million from 2009 level, primarily due to contributions from the higher sales $1.6 million of savings from ongoing RCI and restructuring initiatives and $1.1 million of lower restructuring cost. Gross margin in the quarter improved to 46.5%, an increase of 230 basis points over 44.2% last year.

Operating expenses of $56 million were up 1.1 million from 2009 level, improved 50 basis point as a percent of sales. Higher compensation, volume related and product development expenses were partially offset by $1.7 million of savings from ongoing RCI and restructuring initiatives, as well as $1 million of lower bad debt expense.

Operating earnings of $40 million in the RS&I group for the quarter increased $7.1 million or 21.6% on a $7.9 million or 4% sales increase. The favorable incremental operating margin is primarily due to $3.3 million of savings from ongoing RCI and restructuring initiatives and $1.8 million of lower year-over-year restructuring cost. As a percentage of sales, operating margins in the RS&I group of 19.4% improved 280 basis points from 16.6% last year.

Turning to slide ten. The $1.7 million of Financial Services earnings in the second quarter compares favorably to a loss of $1.7 million in the first quarter of 2010 and loss of $3.8 million in the fourth quarter of 2009. Financial Services earnings in the second quarter of 2009 prior to the determination of the joint venture with CIT were $16.6 million. As you know since July 16 of last year we are no longer selling loan contracts to CIT and recording gains on sales. Rather we are building overtime an on-balance sheet interest yielding portfolio. As this portfolio grows so will our Financial Services operating earnings.

Moving to slide eleven. As of the second quarter end, our balance sheet includes $451 million in gross financing receivables from our US Snap-on Credit operations and $126 million in gross financing receivables from our international finance subsidiaries for a total financing portfolio of $577 million.

In the United States, $384 million of the portfolio relates to extended credit loans to technicians. Since the termination of the joint venture, Snap-on Credit continues to manage the run-off portfolio of contracts owned by CIT, which totaled $384 million at quarter end, which is down approximately $100 million from first quarter end.

For the full year 2010, we continue to expect that the on-booked financing portfolio will grow by approximately $300 million. This suggests that additional growth in the Snap-on Credit US portfolio of about a $110 to $120 million over the remaining six months of this year.

The net cash requirements of our international finance portfolios are substantially self funding. Portfolio loss and delinquency trends continue to be in line with our expectations, and have improved sequentially compared to Q1.

Turning to slide 12, consolidated operating cash flow for the quarter was $55.5 million. At the end of the quarter our cash position of $431 million was down from approximately $472 million at first quarter end. This is driven by the net increase in finance receivables of $73 million primarily due to the funding of new loans originated by Snap-on Credit.

In the quarter capital spending of $6.6 million was down from $19.5 since last year, primarily due to last year's construction of a new R&D facility and headquarters for our automotive parts and service information business in Richfield, Ohio. For the full year 2010, we expect capital expenditures will be approximately $50 million.

As seen on slide 13, trade and other receivables, increased $6.9 million from 2009 year end, excluding $18.6 million of currency translation impacts, trade and other receivables increased to $11.7 million, primarily due to higher sales. Days sales outstanding for trade and other receivables of 59 days, improved from 63 days at 2009 year end.

Inventories at the end of the quarter increased $21.8 million from 2009 year-end. Excluding $14.4 million of currency translation impacts, inventories increased $36.2 million primarily due to higher production levels as a result of increased customer demand. On a trailing 12-month basis, inventory turns increased to 4.4 turns as compared to 4.1 turns in 2009 year-end.

Net debt at the end of the quarter was $493 million. Our net debt to capital ratio of 28.3% compares to 22.2% in 2009 year-end. If we exclude approximately $108 million of cash, currently withheld related to the previously disclosed dispute with CIT, our net debt to capital ratio as of the end of the second quarter would have been 32.5%.

In addition to $431 million of cash, we continue to maintain a $500 million revolving credit facility that does not expire until August 2012. We also have another $20 million of committed bank lines. At quarter-end, the full $520 million of borrowing capacity was available.

In addition to these facilities, our current A2/P2 short-term credit rating allows us to access the commercial paper market should we choose to do so. At quarter-end, no commercial paper was outstanding. Our liquidity position and access to credit continues to remain strong.

This concludes my remarks on our second quarter performance, but before turning the call back to Nick, I'd like to review our outlook for the balance of 2010. For the full year, we presently expect to incur approximately $15 million of restructuring cost, somewhat less than the previously communicated $18 million to $22 million. This reflects the more likely calendarization of program actions to improve the company's fixed cost structure.

We also anticipate continuing our planned strategic investments, including expansion in emerging markets and as I mentioned earlier, for the full year 2010 we presently expect that capital expenditures will be approximately $50 million.

With respect to pension, our current expectation is that 2010 full year pension expense will be $16 million higher than last year. This is down from the previously communicated estimate of $20 million due to changes in actuarial assumptions.

Finally, as a result of the favorable settlement of certain tax audit in the quarter, the anticipated effective income tax rate for full year 2010 is now expected to approximate 33.7%.

Before opening the call for questions, Nick will like provide some final thoughts. Nick?

Nick Pinchuk

Thanks, Aldo. So, wrap up. We are encouraged by the quarter's results, the second straight upward movement and perhaps the beginning of another trend. Sales up almost 10%; profits up 47% versus last year; good sequential progression versus the first quarter. The OI margin at 12. 2% is fairly robust. Our Snap-on value creation process just keep generating gains. In the quarter we saw all the elements of that play book work; safety, quality, customer connection, innovation and RCI, and you can see it in the numbers.

We've said consistently that throughout the downturn we would keep investing in the key areas, which we believed will be decisive in capturing growth going forward and we said as a result we would take advantage of the recovery as it occurs. The second quarter is testimony to the success of that approach,

The van network is robust and back to 2008 levels. Share is growing is the garage. Our presence in critical industries is expanding and we are building a significant position in emerging markets.

So looking forward we are optimistic, although cautiously so. We see the world leaning favorably in North America, mixed but positive in Europe and clearly growing in Asia. To be sure, the recovery is fragile and we are going into the third quarter, which is always difficult to predict because of the vacation period, but now we have two positive periods, so we are optimistic.

We are not certain what the immediate macroeconomics will hold but we believe in the special strength of our markets. Making work easier for serious professionals performing critical tasks is valued in any situation and with Snap-on value creation and our strategic investments we continue to believe that we are very well positioned, well positioned to take advantage of any recovery, in whatever shape, over what ever timetable it occurs.

I want to finish just by recognizing our franchisees and our associates. I know many of you are on the call. The successes in the quarter were only possible because of your efforts, your capability and your commitment. You have my congratulations and you have my thanks.

Now we will open the call to questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) We will take our first question from David Leiker with Robert W. Baird.

David Leiker - Robert W. Baird

If I think I heard you correctly you made a comment that your US tool business is back at pre-recession levels, is that correct?

Nick Pinchuk

Correct.

David Leiker - Robert W. Baird

I know you got a lot of different business, but is there any way you can give some us some characterization of any other pieces of your business that might be back there close to getting back to those levels?

Nick Pinchuk

The industrial business is starting to get back towards that level. Industrial business had a pretty strong quarter, and showing some pretty good growth, and so we are starting to approach back to 2008, however we weren't really satisfied with the 2008 levels, we thought we had a lot of opportunity beyond that, so that's the business.

The equipment business, even though we have been showing some upward growth in it, upward trends in the equipment business, we are still somewhat below the 2008 levels and of course Europe is quiet a bit below still. The European, the SNA Europe businesses are quiet a bit below that level.

David Leiker - Robert W. Baird

Okay, great. Then, as you look across your businesses, where do you think, what are the biggest laggards, where is the weakest parts of your business right now and it sounds like most likelihood it would be auto Europe at the moment?

Nick Pinchuk

Well, I might not use the word laggard but see the business that's the furthest behind in 2008, is of course our SNA Europe business. They took quite a beating over last year. They were down substantially and they are coming back. We believed in the future of that business and we still believe, we believe we were maintaining or gaining shares, we said through the years but the volume is just still quite a bit below 2008. So I'd say that has to be the place which is the weakest position.

The other play, I did mention RS&I before, there are some elements of RS&I, the new Repair Systems and Information group, Mitchell1 and Diagnostics are at 2008 levels, but SBS is down because of the consolidation of the dealers, the OEM dealers in the United States and that business is working feverishly to find offsets in adjacent markets as I said in my remarks. So if I were going to take two places which are behind, I would say Snap-on business solutions in the OEM dealership business and SNA Europe.

David Leiker - Robert W. Baird

SNA Europe is predominantly driven by Spain, right?

Nick Pinchuk

Well, the North is strong and Spain and Portugal was down. I think even the North is still below 2008 levels though, David. We are definitely seeing signs of recovery in the North but Spain and Portugal are pretty flattish. If you took Spain and Portugal out of the numbers, you'd see some pretty strong growth year-over-year but we have to remember that it's off a pretty weak base there.

David Leiker - Robert W. Baird

Then just one last item here. With the reorganization and kind of realigning the business model here, what has been the reaction from your workforce and your franchisees, distributors? What kind of response have you gotten from those folks?

Nick Pinchuk

Well, I think the franchisees, there's no reaction, and it pretty much didn't change their situation very much. I just pretty much said, we are focused on technicians. We have favorable responses from our customers particularly around the RS&I because in grouping equipment with that and now we've got a number of operations, which are truly focused on that particular customer vehicle shop owners and managers.

It's a terrific customer base for us and the fact that we declared that you are a specific customer for us and we don't want to provide you products, we want to provide, we want to solve your problems. That has been received very well.

Operator

Next we'll take a question from Jim Lucas with Janney Montgomery Scott

Jim Lucas - Janney Montgomery Scott

First question, Nick, in your prepared remarks you were talking about seeing some pockets of recovery as well as improvement on the big ticket side, which obviously is encouraging, but could you give us a little bit of more color, maybe put some numbers behind what you are seeing first on the big ticket side, but when you refer to those pockets of recovery, is any particular geography or end market standing out more than others?

Nick Pinchuk

Well, I think the US is a great, the US dealer, the van channel, the mobile van channel is I think a shinning example of, maybe pocket is a little bit of a dismissive way to look at that, but the mobile van channel is a good place to talk about that. That business, like I said is up to 2008 levels and people talk about the restocking.

We haven't seen any restocking there at all. So, in fact we like the cash position of our vans in that business. So I think we are very encouraged by the 9% to 10% growth in that channel itself.

Now, the equipment, the big ticket items in there, it's kind of bifurcated. The smaller big ticket items, that is diagnostics and tool storage are starting to get back to 2008 levels, which we like. This is was we said all along and if you look at, I think we had the best quarters since 2008 in that business this quarter.

If you look at the equipment, the other piece of the big ticket items, we are encouraged because that was in North America but we are still below 2008 levels, in low double-digits. Europe, though in equipments was a big strength for us. Europe has gotten back close to 2008 levels in the big ticket items and that was driven, I didn't talk about this in my remarks but by an extraordinary new product, which we launched in Europe the Prism aligner, this is an aligner, which allows you to package alignment into a smaller base, and as you probably can figure that the base, the garages in Europe are somewhat more compact, so the value of that aligner breaking on that market has given us some pretty good tractions., So we feel pretty good about that situations.

So, I think those are couple of places, the other place in the industrial group, the businesses in critical industries like natural resources and aerospace are up in some pretty, I don't want to give you any numbers in this because we don't give numbers out, but they are up very strong and much, much higher than our average. We feel pretty good about that and as you know industrial is not a restocking situation. That's a direct sales model so restocking doesn't have much to do with that.

Now we do have in our industrial business a smaller group, a smaller piece of the business, which we sell through distributors. You may remember this in United States it's a very small piece of the business and there could be restocking there, but that business was up over 50% in the quarter. So, we feel pretty robust about that situation, the whole idea of recognizing that when we roll the Snap-on brand out of the garage, the customers are open to that idea, they are open to that idea. So it seems to be working.

Jim Lucas - Janney Montgomery Scott

All right that is very helpful. Can you spent a minute on the Tools group because that clearly is a shinning example here, a good turn but if we go back over the last decade, the revenue for that business has fairly consistently been between a $1 billion and a $1.1 billion.

So we are seeing it back to the '08 levels as you said, but as you look at that business going forward, how do you get consistent growth out of that Tools group?

Nick Pinchuk

Certainly, its one of our strategic challenges that we said always but we believe that we have runways for growth in that group, one is the fact that we know that they are a number of customers who buy Snap-on tools for their workplace and then at home they use another brand, lets say a mid-tier brand, so we can sell Blue-Point.

We launched the mid-tier brand to sell to them also, as much as we work to make customers for life, with educational institutions and we sell Snap-on brand to them. Some new technicians simply don't think they can afford Snap-on, they buy an alternate brand. So they can afford Snap-on, we sell a Blue-Point to them. So there is opportunity to grow in that mid-tier here.

Secondly we go on about 800,000 technicians. In the United States there are 1.3 million. Fully enabled our vans call on about a 850,000 technicians. There are 1.3 million. The reason why we don't call on those others, 400,000 to 500,000 is because they are lower volume and our technicians drive by them because they don't want to spend time with them and that is a productivity issue, none of the technicians are vans driven, but that's a productivity issue.

So productivity on the van will allow us to take our existing framework, our existing network and reach out to a big portion of that 1.3 million. Now it's not a one for one replacement but it's a real opportunity for us. That's why we are launching rapid continuous improvement in the vans. That's what we are doing this year. It's one of our big initiatives and I see those two things as ways to grow.

Jim Lucas - Janney Montgomery Scott

Okay, that's helpful. Then finally, hopefully we are back to getting to some sense of normalcy despite the fragile nature of the recovery, which I think we all agree on. Could you just bring us up to-date with the realignment here as we look at the three segments? I don't want to pigeonhole into actual targets but conceptually, how do we think about the margin potential for these three segments longer term?

Nick Pinchuk

The thing is we've said that overall we would expect the target to grow in normal environment, not recessionary environment, not recovery environment, because that's all better off in that kind of situation.

In a recovery, we would expect to grow faster than normal, but we'd say we'd grow 4%, 5%, 6% per year on an organic basis and then we'd expect our operating margins on an overall basis to be mid-teens and the way that lays out with the new segments is that the RS&I, I believe is at 18, 19 now, it would be over the 20 mark some place, and the Tools group and the Commercial and Industrial would start to approach the mid-teens, be slightly below the average. So that's where we see it. We feel pretty confident we can do that.

Jim Lucas - Janney Montgomery Scott

Okay. Final question, just in terms of longer term capital allocation strategies, the Financial Services is kind of playing out as expected. Could you just bring us up to-date about how you think about an acquisition strategy longer term?

Nick Pinchuk

Our view is that we are always available. We are not a serial acquirer, but we could see ourselves acquiring properties that seem to make sense in our orb.

Lots of people used to think about Snap-on and I think we thought about this as ourselves as a company that makes wrenches, sells through vans to auto mechanics and we now think of ourselves as something broader that is, a company that provides, makes work easier, productivity solutions for serious professionals, who are performing critical tasks in critical industries like aerospace and oil and gas.

That's a much wider space, and any acquisition, an acquisition that would give us further presence in that broader space with customers we would be interested in doing.

Jim Lucas - Janney Montgomery Scott

Okay.

Nick Pinchuk

So that's where we would invest our cash because we believe that concept is a valuable concept and we believe with Snap-on value creation we can drive profitability through that and the Snap-on brand on top of it gives us legitimacy in that space. So that would be cash well spent.

Operator

(Operator Instruction) Next we'll hear from Gary Prestopino with Barrington Research.

Gary Prestopino - Barrington Research

Nick, in your comments you mentioned that the big ticket items, you were encouraged by what trends were there. Could you possibly, I don't know if you want to put a number on it but Q2 is significantly better than Q1 or just really seeing a stabilization and no more deterioration?

Nick Pinchuk

No, Q2 is better than Q1. In all of those categories, I think just let me, the stage is to be clear is that for diagnostics and tool storage, primarily sold through the van channel, Q2 was the best quarter we have seen since Q2 2008.

Gary Prestopino - Barrington Research

Okay.

Nick Pinchuk

That was the best quarter in 2008. So we had a gangbuster this quarter in terms of big ticket items and actually if you remember we said this is exactly how we understood the business. We said that people who were in garages, they were buying wrenches and they kept buying wrenches through the downturn and that was it. It was big ticket that was off, because people thought that they charged, the uncertainty, the idea of not wanting to invest in those big ticket item took them away.

Well, we are back to 2008, and lo and behold the vehicle of restoration has been the rise in the big ticket items. That's exactly what we been I think thinking about and trying to conjure in these calls for a long time and so that's really what happened. So we did have a good quarter in the first quarter, it was a good quarter, but this quarter was up double digits.

Then in terms of equipment we are still not as I said we are still not back to 2008, we are still coming off the floor and that makes sense. So Gary as you think about it, diagnostics is the best. So the most expensive its like an [$8000] purchase, tool storage can be $5,000 to $10,000 but when you are talking about some of that equipment that under-car equipment it can be up $20,000, and it's much more of a capital type equipment.

So therefore the whole idea of the uncertainty around the recession becomes more dampening in that area and that's what we are seeing.

So we are seeing progress, but it just isn't as fast and it hasn't snapped back to before 2008 levels. In fact it went deeper than diagnostics and tool storage. The one thing I did say though was that, what we are really pleased with is the effect of that new Prism product in Europe, which really gave us some boost in equipment.

Gary Prestopino - Barrington Research

Then do you feel that, you mentioned and also in your prepared comments a lot of the gross margin improvement was due to higher sales volume. I mean if the sales volumes kind of stay the same in terms of the growth here, do you feel like you will be able to maintain that gross margin somewhere in the high 46% in the back half of the year?

Nick Pinchuk

Yeah, I think that is right, I think you know, we obviously, like any company you can have a mix issue and if we have higher sales in Asia and so on, if we higher sales in Asia and so on, we can, that's is a little less profitable and the drop through is somewhat, but we still are pretty good about maintaining the number, that gross margin number, I mean we had some absorption in this period and we had some cost savings but still I feel pretty good about maintaining the gross margin.

So you got to kind of remember though is that, I think everybody should remember is, you have a couple of good quarters, we are going into the third quarter. I think that the third quarter for us is highly unpredictable, more difficult to predict because we have European vacations, the franchisees tend to relax a little bit, they go to the Merlin show or something like that, whatever they do.

Historically our third quarter has had more variance than other quarters. So we think of our year as 1, 2, 3 and 4 in terms of trying to model it out. I think the third quarter; it's hard to make a lot of judgments on.

Operator

(Operator Instructions) We will take a follow-up from David Leiker.

David Leiker - Robert. W. Baird

Just a couple of other items here to follow-up. You called up a couple of things here that were, higher costs here year-over-year, and the current expense you mentioned particular about $16 million. What is that number running year-to-date, do you think?

Aldo Pagliari

This is Aldo, David. It's about $20 million, I would say as an absolute number. Also I want to call attention to it, it did include higher, particularly higher year-over-year expenses related to greater participation to the various company stock purchase programs, which also allows franchisees to invest in the company stock as well.

So we saw some higher year-over-year participation and with the growth of the stock price, it fueled a higher year-over-year cost per share for those who participated as well.

David Leiker - Robert. W. Baird

Okay. So, 4 in Q1, 16 in Q2, what should we kind of look out for that number here, sequentially going forward in the back end of the year, do you think?

Aldo Pagliari

In Q4, it will be approximately $5 million, 4 to 5.

David Leiker - Robert. W. Baird

Then Q3?

Aldo Pagliari

It will be similar. Similar amount, maybe a little bit less.

David Leiker - Robert. W. Baird

Okay. So we really did have a pump up here that's beyond what normal is?

Nick Pinchuk

We did.

Aldo Pagliari

Sure.

David Leiker - Robert. W. Baird

Okay, great. Then, yes, I know this is the tough thing. We've talked about this before, but in the industrial market is there any way you can give us some sense of what your penetration, is there market share and…?

Nick Pinchuk

I don't know. I can't. I think I can only tell you that we are growing faster than anybody else is saying, pretty much. We're growing pretty fast and that's been for some time. It is very difficult to do that and that's bad news I think from a modeling point of view and I suppose from an investment point of view, but its good news from an operating point of view because what it means is that market is unbounded in terms of customers and in terms of products.

One of the reasons why its so difficult to say what the market share is, because how do you calculate it, because we go into a customer like a military, a tank command and we say, what you need and we're not sure. Sometimes we provide them things we never thought was part of our orb, because we put it in a kit.

David Leiker - Robert. W. Baird

Right.

Nick Pinchuk

Like a flash light or some thing or generators and things like that. We sell it, we provide it in package with Snap-on tool. So that's an example of us struggling, we try to identify that. Equally, we find customers that are added, I would say three years ago I wouldn't have said wind would have been a customer for us and now there is some customer there.

So it's very difficult to define that. I can just say that, it seems to us based on the growth, we were getting good growth if you remember all the way through the first quarter of 2009 in this business.

We were expanding and we took a downtick, growth faster than anybody else was talking about and we should because we are rolling a Snap-on brand out of the garage, it was a new thing. We are providing something new, capturer, share takers. Now this quarter it has started back up again. So, I believe we are taking share, I can't define it though, sorry.

David Leiker - Robert. W. Baird

So, as you go into these customers and these markets, I mean obviously they are getting the product from somewhere right now. Do you have sense of who you are displacing in those products or they are just new market opportunities that didn't exist?

Nick Pinchuk

Well, it depends on the location, I mean in Europe we are displacing people like…As I said if you are talking about tool competitors, you are talking about displacing people like in Europe, let's say you stop [Willie] or a [Good Door].

In the United States the usual suspects that come out of our major competitors would be those who would be displaced and also some specialist people who are small. There are people in United States who only make pliers or screwdrivers and so on. We would displace them and then also we wouldn't displace people, we would be sort of like the distributor for some other people that might have been selling direct before but the customers feels pretty good about a packaging with our tools. So all those phenomena is occurring.

David Leiker - Robert. W. Baird

Okay. Then if we look at China, the economy is hot there, the government there is trying to slow things down, we're definitely seeing on the automotive side of thing and I know your business is more industrial there, but are you seeing that slow down and what your thoughts about going forward?

Nick Pinchuk

I was just there. I have been back from China less than only a week. I was just there with our salesmen and meeting with some customers and we don't see a slow down now. Having said that though, Asia is 5% to 10%, of our business, and we are just bulking up there, we are adding factories and products and so on. So I would charge out, I in fact I do charge our people to grow regardless of whether the economy moves from 12% growth, to 7% growth, because we are just taking share in general. So we wouldn't necessarily see it so easily but having said that, I didn't see any evidence of slow down, to tell you the truth. Now I read the papers like everybody else and the government saying slowdown, but I didn't see it.

David Leiker - Robert. W. Baird

I am with you on that, and then lastly here Aldo as you look at the Financial Services business, where do you think you are on track now to rebuild that asset bases that's kind of the second quarter 2011, as you get back there?

Aldo Pagliari

I think I will take a little [mirror] targets though, David, as an end stage. If you look at the former portfolio that we had with CIT as partner was about $800 million range. We anticipate that our future statement that would be about $750 million because we are probably going to do little bit less badly seeing that things of that nature that might be better suited for Banks than do directly with franchisees.

It will take a little bit of time for some of the tail of the old CIT portfolio when it comes across. So I have been saying as I meet with people, that I think we will see our future staying at about like a $750 million US portfolio in and around somewhere around 2012. Ramps somewhere in that time frame, but you know our future state that we envisioned for this, is tending to follow the model, we have a portfolio that is yielding at expected rates, we are fortunate in that the bad debt performance and delinquencies are still on plan and on target and actually have slightly improved. We are very pleased with that.

The originations which underlie the volume tend to track more or less with the Tools group. I think it the reflects the actions in the Tools group. That's what it's there for. So pretty much as the Tools group volume rose, we expect that this renewal of contracts and add-ons as we call them will continue to prosper.

So at the endgame, we expect that this has the capability even after interest expense is allocated to create a portfolio that will generate about a 25% return on financial income and that financial income would be, the portfolio yield times the overall finance receivables, that are there within it.

Operator

At this time we have no further questions in the queue. I will turn the call back over to Mr. Kratcoski for any additional or closing remarks.

Leslie Kratcoski

Well everyone, thanks again for joining us today and for your interest in Snap-on. A replay of this call is going to be available shortly this afternoon and we look forward to speaking with you again next quarter. Thanks. Bye.

Operator

Thank you. This does conclude our conference. We thank you all for your participation.

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Source: Snap-on Inc Q2 2010 Earnings Call Transcript
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