The Case for Stanley – Why Reversion To The Mean Often Works

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

October 6th, 2013

The Case for Stanley – Why Reversion To The Mean Often Works

  • Stanley’s return on capital appears to be reverting to normal following the large Black and Decker acquisition and the economic issues of the last 5 years. The return on capital has risen close to the historic trend line which has been in place for more than 30 years. Although the stock has performed better than the market – it is still in our view undervalued.
  • Valuation has not returned to trend versus the overall market from a relative PE perspective. As shown in Exhibit 1, SWK is currently about 1.4 standard deviations (or 37%) below our normal value. This is despite strong performance year to date. The issue is the much expanded capital base at SWK that is now delivering a substantial step change in earnings.
  • SWK ‘s valuation is also lagging both the Capital Goods sector and its closest peers with discrepancies at extremes in many cases. Earnings revisions for SWK although downward, have not been worse than the peer group over the last year and the expected forward earnings growth is consistent with historical trends.
  • In a piece published on the broader Capital Good space late last week, we suggested an overweight position in the group, but pointed to the construction focused stocks as a specific preferred overweight.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview – Returning To Normal

Following on from our recent more comprehensive piece on Capital Goods, we wanted to highlight why we have been positively disposed to SWK for the last year and why we remain positive.

A stock chart – Exhibit 2 – is misleading as it shows Stanley doing well, beating the market over the last 5 years and appreciating meaningfully from the trough. However, despite this performance we see more to come.

Exhibit 2

Source: Capital IQ and SSR Analysis

Stanley is a classic case of mean reversion and investor sentiment being overly biased by short term data points. There are plenty of similar examples, but we feel that SWK is almost a textbook example.

While the company has a negative slope to its longer term trend in return on capital, the trend is not severe but there has been significant volatility around the trend – Exhibit 3.

Exhibit 3

Source: Capital IQ and SSR Analysis

Some of this volatility has been caused in the past by the number of small and medium sized acquisitions that the old Stanley Works made, occasionally resulting in subsequent write downs, but the depressed returns on capital have always recovered. Given the nature of the business and the benefit of the continuous consolidation moves, as well as Stanley’s reasonable track record of new business integration, our view was always that the dilution associated with the Black and Decker acquisition would be overcome and that returns would likely improve to normal. As shown in Exhibit 3, this has happened, or at least is expected to happen; given that out current return on capital number is based on 12 month forward estimates.

What has failed to keep up so far is valuation, as it is not factoring in the significant change in the capital base and the impact that has on absolute earnings and earnings growth if SWK can replicate returns on capital seen in the past. Returns are improving quickly and we could make a case that the past trend could be improved upon given consolidation in the space and the strong brand leadership that SWK enjoys. The chart in Exhibit 4 shows SWK EPS and the recent acceleration is very evident. The chart shows forward earnings and picks up consensus estimates to drive the averages from Q3 2013.

Exhibit 4

Source: Capital IQ and SSR Analysis

Still Lagging The Market

While SWK’s earnings are recovering to what we would consider normal – Exhibit 5 – valuation has not yet moved to reflect that, as was shown clearly in Exhibit 1. What is lagging is the relative earnings multiple the stock is seeing today – Exhibit 6. Like return on capital, there has been a slow declining trend to the relative multiple that SWK has seen over the last 40 years, but today the multiple sits well below normal.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

And Also Lagging Its Peers

The multiple discount highlighted in Exhibit 6 would be less interesting if it was widespread across the Capital Goods space, but it is not. If we look at the difference between the valuation of the sector in aggregate and SWK specifically we get the chart shown in Exhibit 7 – not quite an all time extreme but close.

Exhibit 7

Source: Capital IQ and SSR Analysis

If we pick a couple of loose peers, IR and SNA, we get the pictures in Exhibits 8 and 9.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

In our Skepticism framework SWK is a standout on the high SI side, with valuation discounting a major decline in profitability – here we repeat the chart we showed in the broader Capital Goods piece that we published late last week – Exhibit 10.

Exhibit 10

Source: Capital IQ and SSR Analysis

What are we missing? Is it about earnings and revisions?

In the broader piece on Capital Goods we showed a table of expected earnings growth for the group and compared this with historical trend rates by company and what EPS growth looked like from 2010 to 2012. In the table below (Exhibit 11), we have taken the average of that table – an aggregate for Capital Goods and we compare that with SWK. Growth expectations for SWK are in line with historic norms, while in aggregate for the group they are ahead of historic norms.

Exhibit 11

Source: Capital IQ and SSR Analysis

Revisions have been negative for both 2013 and for 2014, but they have been negative generally, and if we rank the Capital Goods sector from best to worst in terms of 2013 revisions year to date, SWK does not stand out as a company that deserves to be discounted as steeply to the group as it is today – Exhibit 12.

Exhibit 12

Source: Capital IQ and SSR Analysis

©2013, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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