Wednesday, September 23, 2009

Black & Decker (NYSE:BDK): Downgraded to Sell at Longbow

Longbow Research is downgrading Black & Decker (NYSE:BDK) to Sell with $35 price target:

We are downgrading BDK to SELL this morning on concerns over the divergence between recent share price valuations and what we perceive to be continuing weakness in underlying NA and European power tool fundamentals. We are reducing our earnings estimates to 4Q09E: $0.37 (-$0.06), FY09E: $1.66 (-$0.06) and FY10E: $1.90 (-$0.25). Our target price is $35 based on 18.5x FY10E EPS. The shares last traded at $35 on July 24, 2009.

Weak Power Tool Fundamentals in NA – As our survey research this month indicates, we do not believe the NA category is undergoing a significant recovery. Promotional activity remains high and appears necessary to induce sales volumes. While August volumes were up sequentially, we attribute this to (a) a cold, wet July throughout large portions of the U.S., and (b) pent-up demand from deferred purchases all summer. We are not seeing any convincing evidence of a recovery in construction activity sufficient to provoke tool purchases. In fact, STAFDA pro category tool dealers are telling us they are continuing to see yr/yr sales comparisons of negative 20%. While we expect a better 2010, we think the recovery will track a very gradual slope and fall below current Wall Street expectations.

Weak European Tool Fundamentals – The European market represents 25-30% of BDK revenues. From our survey research this month we know that the market looks slightly better than NA, but not by a meaningful amount. Mix remains weak and by our tally, could represent a couple of percentage points of revenue decline in 2H09. Retailers are being extremely cautious with their inventory investments and are gravitating towards stocking opening/value (read low margin) products. As we begin in September to compare with more ugly 2008 numbers in both Europe and NA, we will undoubtedly see the negative comp numbers reflect smaller magnitudes, but we do not believe we will see a significant upturn in tool demand until 2H10.

Raw Materials Cost Inflation – With various raw materials seeing price rallies since earlier this year, we expect BDK to feel increasing pressure on variable cost margins in 2010. This extends beyond the Power Tool business as both the locksets and the faucets businesses have large exposures to base metals such as copper ($2.85/lb, up 28% past 90 days), zinc ($0.87/lb, up 27% past 90 days) and nickel ($7.92/lb, up 18% past 90 days).

Low Probability Surrounding Fall 2009 Channel Fill – As evidenced by comments from a large home center at their analyst meeting held yesterday, retailers are still very cautious on their outlook for 2010. This will invariably be reflected in how they manage their inventory investments around key power tool sales events like Fathers Day and Christmas. In speaking with retailers, we continue to hear about how this year’s channel fill will be light, even by last year’s standards. We expect this will have an adverse impact on 4Q09 earnings performance and are reducing our 4Q earnings forecast accordingly.

Low Degree of Operating Leverage is a Negative in Recovery Phase of the Cycle – As the economy slowed, we saw the benefit of having sold off or closed manufacturing assets and out-sourced a big part of the company’s production. The company’s high variable cost model did not experience as rapid an EPS decline as its more capital intensive peers. But now we are looking forward to the recovery phase of the cycle and with variable costs proportionately higher (fixed costs proportionately lower), we expect to see less operating leverage, and therefore less EPS growth as industry volumes recover. Furthermore, if raw materials prices continue to rise and BDK is not successful in fully passing through increases, contribution margins will be even further reduced and the EPS recovery will be even further muted.

Valuation – As the accompanying chart illustrates, BDK is trading at a valuation well above the typical level seen at this point in the business cycle. At 25.5x FY10E EPS (a 55% premium to the S&P500 multiple), we must go back 16 years (1993) to find so rich a valuation. In the table below, we consider what BDK might earn over the next four years. If we take the 2013 forecast of $4.33 per share and apply a 14x P/E multiple, the implied January 1, 2013 share price should be $60.67. If we NPV this at 20% (our guess at what an investor would need as a minimum target return to invest over that period of time), we get $35 per share as a January 1, 2010 fair value. For those with lower hurdle rates, we present a 15% and a 10% discount scenario, none of which gets to the price of the shares on last night’s close.

Action: Just take a look at the chart of BDK. It has nearly doubled since the beginning of July. Now Longbow is saying that things are WORSE than expected. Not what you usually hear after such rally. I would expect these comments to pressure the shares today and possibly longer. I expect BDK to be a 5% decliner today so early shorts should be rewarded.

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