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  • Stanley Black & Decker (SWK) Deworseifies 1 comment
    Jun 18, 2012 3:32 PM | about stocks: SWK

    Stanley Black & Decker (NYSE:SWK) is a firm with a big presence in security hardware and a lot to boast about besides. For example, management emphasizes "The Stanley Fulfillment System", continuous improvement techniques that have increased working capital turns 23% last year. The company's aggressive diversification strategy has brought down sales to U.S. and international home merchants from 31% in 2010 to 23% in 2011 (16% sold to Home Depot and Lowe's, with their huge pricing power and private-label brands).

    Formed from the merging of The Stanley Works and Black & Decker Corporation in March 2010, the $10.75 billion company has had a lot of spare cash to aggressively acquire huge businesses that are as dissimilar as Niscayah Group AB, an access control and surveillance solution provider in Europe (for $984.5 million in 2011) and CRC-Evans Pipeline International, an onshore and offshore pipelines manufacturing supplier, for $451.6 million in 2010. Its stated objective is to acquire higher-margin businesses. Stanley Black & Decker employs 44,700 people worldwide (16,600 in the United States) and it is headquartered in New Britain, Connecticut.

    Before assessing earnings yields, asset values, or liquidity ratios, I already don't like this investment. Here's why:

    Management writes that the Company has returned 47% of free cash flow to its shareholders since 2002. As a combined company, here are their long-term objectives:

    • 4-6% organic revenue growth; 10-12% total revenue growth;
    • Mid-teens percentage EPS growth;
    • Free cash flow greater than or equal to net income;
    • Return on capital employed (ROCE) of 15;
    • Continued dividend growth; and
    • Strong investment grade credit rating.

    Their long-term capital allocation objectives are:

    • Invest approximately 2/3 in acquisitions; and
    • Return approximately 1/3 to shareowners (dividend growth / share buybacks)

    This sounds great. Unfortunately, something's got to give. Investors ought to skeptical of acquisition sprees because they, not management, are the investors (Peter Lynch called this phenomenon deworseification). When the free cash flow that is not returned is invested in profitable business units in cases such as these, legacy brands suffer. After all, why can't management build moats rather than buy them?

    This disability feeds on itself. Since management is presumably not overpaying or underpaying for businesses but emphasizing big margins, the assimilated businesses probably do not have great growth rates. Money to feed the beast with more "inorganic revenue growth" runs out and total revenue growth falls, impacting returns on investment. (As a point of fact, organic sales volumes have been falling slightly.) The holistic picture is that management runs from fighting for its businesses in favor of pipeline manufacturers (?!), infecting the organization with an attitude of submissiveness in the marketplace.

    The best evidence of this phenomenon is precisely the rapid moving away from certain sales channels (from 31% to 23% last year; cited above). You can't sell hand tools without the big retailers in an environment with so much retailer consolidation. If Home Depot and Lowe's come out with private-label brands, the premium brands will have to fight for a smaller piece of the business, and each will have to be that much more worthwhile for consumers (read: well-funded). Instead, management pays lip service to the company's strengths and to the company's "shareowners".

    I do not even think management set out to diversify sales channels, because they are not ultimately in control of where consumers like to buy DeWalt hand drills. Rather, they acquired businesses that diluted the branded tool and storage product despite their being "important foundations of the Company that provide strong cash flow generation and growth prospects". Then, they saw a way to advertise this shift (not unlike how I blog about bad investments, but hey, I didn't read the report for nothing!).

    On the other hand, their security business benefits especially from healthcare-related services. Niscayah (electronic security) in particular sounds like a good move. I am not dogmatic; security is why I got interested in this stock in the first place. But if stock market prices go up and debt becomes more expensive, will management stand by their word and continue to plow 2/3 of free cash flow into acquisitions? If they do, I don't like them. If they don't, I don't like them. I'm not sure they are in a long-term frame-of-mind.

    Appendix

    Stanley Black & Decker defines itself in three segments (copied from its 2011 Annual Report):

    Construction and Do-It-Yourself (half of revenues, ~13% net margin)

    • The professional power tool and accessories business
    • The consumer power tool business, which includes outdoor products, plumbing (Pfister) and the hand tools, fasteners & storage business

    Security (quarter of revenues, ~15% net margin)

    • Electronic security solutions
    • Mechanical access solutions

    Industrial (quarter of revenues, ~14% net margin)

    • Industrial and automotive repair tools
    • Engineered fastening
    • Infrastructure
    Themes: industrials, acquirer Stocks: SWK
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  • Varun Munjal
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    Author’s reply » "Free cash flow greater than or equal to net income" is a vacuous long-term priority.
    14 Dec 2012, 01:07 AM Reply Like
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