- Snap-on's first quarter saw the first earnings decline since the Great Financial Crisis as COVID-19 crushed organic growth.
- Nonetheless, the company has strong financials and is currently benefiting from a weaker dollar.
- I am aiming to buy the stock during the next dip as expectations are getting a bit stretched given the state of the economy.
In February of this year, I wrote that Snap-on (NYSE:SNA) was likely to see a fundamentally backed breakout. Unfortunately, this Wisconsin based tool producer got destroyed as soon as COVID-19 caused a global economic shutdown. The stock dropped to $90, which is down roughly 50% from the 2019 highs. Interestingly enough, the stock is almost back to where it was when I wrote my previous article with rather unfortunate timing. Anyhow, in this article, I will tell you why the stock could further benefit from a sector rotation to industrial and basic material stocks and a weaker dollar. So, bear with me.
Here's What Happened In Q1
Let's start by mentioning that Snap-on reported its first adjusted EPS contraction since the Great Financial Crisis. In its second quarter, the company saw an EPS decline of 14% to $2.60. This is slightly below expectations of $2.70. You probably already guessed it, but the economic shutdown really hurt top-line growth. In the first quarter, net sales fell by 7.5% to $852.2 million. Organic sales were down 6.9%, or $62.7 million. Currency translations were a 1.0% headwind. The only positive factor was further acquisitions, which added $3.5 million to the net sales result.
Unfortunately, in times of steep sales declines, it is hard to adjust operating expenses right away, meaning that margins tend to suffer as well. In this case, operating expenses were 33.2% of net sales. This is an increase of 230 basis points compared to the prior-year quarter. Not only lower sales volume, but also higher restructuring costs and unfavorable foresight currency effects pressured margins and more than offset an $11.6 million benefit from a 2019 legal settlement.
As you can see below, the company's operating performance has reached its lowest level since 2015. It is very likely that this result is going to drop further as the lockdown lasted well into the second quarter, with leading indicators like the ISM index taking a huge hit.
Fortunately, financial instability is not something investors need to worry about as the company's liquidity is as solid as it gets. The company's current assets cover 250% of current liabilities. Even adjusted for inventories (quick ratio), the number is 155%. EBIT is covering interest expenses 18.3x with total liabilities valued at less than 40% of total assets. Net debt is valued at just slightly more than 1.0x.
In other words, as I have said before, this stock is a great macro trading vehicle as the company is financially stable, has the right products to deliver strong sales growth, and was able to improve margins until COVID-19 became an issue.
With that being said, and with regard to the macroeconomy, as you can see below, the leading ISM manufacturing index has taken a hit and has fallen to levels not seen since 2009. Meanwhile, the S&P 500 has recovered and is just 6% below its all-time high. Sure, the ISM index will likely recover from these recession lows, but I doubt that we will see a steep recovery. This means that stocks will likely have a limited upside or start to take a second hit in the second half of this year. Both scenarios would make sense given the state of the economy.
The good thing is that the current dollar weakness (graph below) is giving cyclical stocks a break. Generally speaking, a weaker dollar indicates a lower debt load for international dollar-denominated loans, and tends to support global growth. As you can see, this has led to outperformance in basis materials compared to safer utilities (lower part of growth below). So far, it looks like we are entering a reflation trade, which will cause outperformance in cyclical commodity stocks, rate trades like banks and industrials.
That said, Snap-on's stock, currently valued 14.1x NTM earnings, has likely room to run to $170. At that point, I think the stock will struggle to break out of the 2016-current sideways trend if economic growth is unable to significantly recover over the next 3 months (ISM index).
I will not be buying the company as I invested in a number of cyclical plays over the past number of weeks. However, I will buy Snap-on as soon as the stock offers another dip to buy. I expect that the stock will emerge stronger from this crisis than the company did after the 2015 manufacturing recession.
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