Black & Decker: Tooled for Growth
By Amrit Tewary
With its well-known brands, strong competitive position, disciplined cost-cutting strategy, and attractive valuation, Black & Decker (BDK ) is among Standard & Poor's top picks in our household durables group. The stock carries S&P's highest investment recommendation of 5 STARS, or buy.
Incorporated in 1910, Black & Decker is a global manufacturer of power tools and accessories, hardware, home-improvement products, and technology-based fastening systems. Its well-recognized brand-name products, sold in over 100 countries, include Black & Decker consumer products, DeWalt high-performance industrial equipment, Kwikset security hardware, Price Pfister plumbing products, and Emhart fastening systems.
Two major home-improvement retailers accounted for nearly one-third of Black & Decker's 2002 sales: Home Depot (HD ), with 20%, and Lowe's (LOW ), with 11%. At the end of 2002, Black & Decker had 39 manufacturing facilities, including 20 located outside of the U.S.
In our view at S&P, Black & Decker's key competitive strengths include its portfolio of well-recognized brands and leading positions in its markets. It continues to allocate significant resources for marketing and advertising in order to maintain and strengthen its brand image.
In addition, we believe Black & Decker's Six Sigma quality-control initiatives have resulted in lower defects and customer returns of certain products, as evidenced by lower warranty costs in recent quarters. We expect this trend to continue and to enhance the luster of Black & Decker's already strong brands.
We believe this strength has helped Black & Decker withstand pricing pressures better than most of its peers in the household-appliances industry. While significant price erosion is almost a given in an industry hit by weak demand and heightened competitive pressures in recent years, we note that it has had only a 2% impact on Black & Decker's sales in each of the last three years, which was more than offset by volume increases in two of those years.
S&P expects Black & Decker to keep leveraging its brands through new product introductions and line extensions to further penetrate existing markets and enter new ones.
Another differentiating factor for Black & Decker, in our opinion, is its supply-chain-management strategy. The use of Six Sigma initiatives has reduced costs in recent years and should continue to generate productivity savings. By working closely with a few select suppliers of raw materials and with key retail customers such as Home Depot and Lowe's, Black & Decker has been able to reduce manufacturing lead times and order-to-delivery cycle times.
In addition, we think the relatively large size of Black & Decker's purchase orders often enables it to negotiate favorable terms with suppliers, thus generating additional savings.
We expect a significant near-term earnings catalyst from its disciplined restructuring program, launched in 2001 and set to be completed by 2004. The plan is estimated to cost a total of $170 million (of which $150 million has already been spent) and should generate $100 million of annualized cost savings by 2004. We have been impressed by the results to date.
Despite weak end-market demand and inventory reductions at key retailers, Black & Decker has been able to expand operating margins by closing inefficient plants and moving more of its production to countries with lower labor costs.
We expect it to keep lowering its fixed-cost base through these restructuring initiatives, thus making its future earnings more resistant to cyclical economic downturns than those of its peers. In addition, moving much of its production to low-wage countries will likely free capital and resources for investing in new product development and productivity initiatives, in our view.
S&P considers Black & Decker's financial position as strong due to its proven ability to consistently generate significant amounts of free cash flow over the years. And we believe that should continue to help it obtain favorable terms for debt financing.
With its ratio of long-term debt to total capital near the middle of the company's historical range, we think Black & Decker will balance debt repayment with share repurchases. It paid off approximately $310 million of debt in April, 2003. That -- along with a low interest rate environment -- should lower interest expenses in the near term, in our opinion.
Black & Decker's second-quarter 2003 operating earnings per share of 97 cents, vs. 81 cents in the year-ago period, was 3 cents ahead of our estimate. Sales were about flat and down 5% excluding favorable currency effects. However, we note that Black & Decker's restructuring actions and productivity initiatives resulted in an operating margin improvement of 44 basis points despite weak economic growth, inventory reductions by key retailers, and difficult year-ago sales comparisons.
We project 2003 sales to be up slightly on favorable foreign currency effects. We forecast sales from existing operations, before foreign-currency translation, to be down modestly, due to our projection of continued weak retail demand and inventory reductions.
However, we think Black & Decker should maintain or gain market share in the various segments in which it competes through the introduction of new products and acquisitions that add to earnings. We see operating margins widening to 10.1%, from 9.6%.
We see one other potential benefit to EPS comparisons: Black & Decker's share-buyback program. We expect operating EPS of $3.77 in 2003, vs. $3.23 in 2002 (before about 39 cents of nonrecurring items). In 2004, we forecast operating EPS of $4.12 on 2.0% sales growth and further operating margin expansion of 51 basis points.
STRONG FREE CASH FLOW.
On a per-share basis, we project Standard & Poor's Core Earnings of $3.46 in 2003, after adjustments of 27 cents for stock-option costs and 5 cents for pension costs. This represents an 8.3% divergence from our operating EPS estimate for the year, which is about on par with Black & Decker's peers.
Black & Decker is focusing on free-cash-flow generation, and it has targeted free cash flow at 80% of net income for 2003. We believe this is an achievable target as free cash flow has exceeded net income over the past four years, on average. Management has said it plans to use free cash flow to fuel internal growth and finance acquisitions, repurchase shares, and pay down debt.
Our discounted cash-flow (DCF) model assumes base-year free cash flow of about $235 million in 2003, down significantly from actual 2002 levels. We think the year-ago free-cash-flow number was unusually high as it was aided by a sharp decline in capital spending. We believe Black & Decker will revert to more normal spending levels in 2003, thus resulting in lower free cash flow.
Looking past 2003, we think Black & Decker can continue to increase free cash flow for several years at a rate on par with its historical five-year cumulative average free-cash-flow growth rate (CAGR) of 9.6%. Subsequently, we see free-cash-flow growth moderating gradually until it reaches stable growth of about 4%. Our DCF model, which also assumes a weighted average cost of capital of 10.5%, suggests that Black & Decker shares trade at a 19% discount to their intrinsic value of roughly $51.
At 11 times our 2003 EPS estimate, the shares are trading at a sharp discount to those of industry peers and the S&P 500-stock index, and near the lower end of the stock's 10-year historical p-e multiple range of 8 to 35. We arrive at our 12-month target price of $55 by placing a peer-average p-e multiple of 13 on our 2004 EPS estimate of $4.12.
Some potential risks may prevent Black & Decker from achieving our earnings estimates and price target. These include deterioration of the overall economy and the global markets it competes in, the loss of business from key customers, the inability to penetrate new distribution channels, and insufficient market acceptance of new products.
Other risks include adverse changes in currency exchange rates, raw material prices, or interest rates; increased competition; and the inability to generate sufficient cash flow to fund internal growth, acquisitions, ongoing operations, share repurchases, pension contributions, and debt payments.
Analyst Tewary follows household durables and consumer electronics stocks for Standard & Poor's