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Morningstar | Snap-On Posts Mixed 3Q, With Some Bright Spots

Narrow-moat Snap-on, the hand-tool, repair systems, and diagnostic equipment provider to critical task repair and maintenance professionals, reported a mixed third quarter. Adjusted EPS of $2.88 beat consensus of $2.86 and exceeded last year’s third-quarter EPS of $2.45. Revenue excluding financial services was $898 million versus consensus of $929 million. Commercial and industrial, or C&I, revenue increased 5.0% over the prior year. In contrast, repair services and information, or RS&I, and the hand tools group, HT, revenue declined 5.7% and 0.7% respectively versus their 2017 levels. During the quarter, Snap-on’s overall revenue was negatively affected by a foreign currency translation of $12.7 million. Unfortunately, this 2-star name trades at a 17% premium to our $132 fair value estimate.

On a year-over-year basis, revenue excluding financial services was down 0.6% compared with the third quarter in the prior year, which was $904 million in third-quarter 2017. Financial services revenue rose 3.8% to $82.0 million from $79.0 million in the prior year, continuing a trend of a growing financial service portfolio, which increased $35.6 million in the quarter. Operating margin before financial services was an impressive 19.3% of sales compared with an adjusted 18.6% of sales in the third quarter of 2017 with a $15.0 million legal charge excluded. This improvement was achieved through a 2.6% reduction in costs of goods sold and a 5.2% reduction in operating expenses. We think Snap-on's narrow moat derives from its ability to consistently innovate new product and its status in the market as the premium brand to own, enables the company to consistently deliver solid profitability and returns for investors.

Combined with fewer shares outstanding on share buybacks, adjusted EPS increased 17.2% from third-quarter 2017, to $2.88 from $2.45. During the quarter, Snap-on repurchased 493,000 shares worth approximately $85.7 million. Consequently, the diluted share count contracted to 57.3 million, down 1.7% year over year. Due to recent improvements in margin performance, we are anticipating a 50-basis-point increase in operating margin this year, with progress along its defined growth runways, pricing from premium brand status with automotive repair businesses, and the benefits of management’s value-creation processes and rapid continuous improvement program. Moreover, we remain positive on Snap-on's ability to create new products, for which it has received numerous awards this year. Interestingly, part of RS&I relative weakness was due to its introduction of the new Zeus diagnostics platform in the third quarter of last year. We were encouraged that operating margins improved across all three segments. C&I expanded operating margin by 10 basis points year over year, to 16.1% from 16.0%. Hand tools group improved operating margin by 80 basis points, to 15.2% from 14.4% last year. Lastly, RS&I increased operating margin 60 basis points to 25.7% from 25.1% the previous year.

In our opinion, Snap-on stock’s rich valuation is being driven by the markets’ insatiable hunger for relatively lower-risk, good-quality dividend growth, and yield. Globally, central banks have contributed to low short-term government bond yields. Historically, Snap-on stock has traded within a range that results in dividend yields between 1% and 3%. With the interest-rate environment heating up, the stock’s current dividend yield is 2%, but more interesting for dividend investors, the 30-year annualized dividend-growth rate slightly exceeds 6%.

However, with a consensus price target of $183, the sell side continues to value Snap-on stock as though economic cycles no longer exist. Our $132 fair value estimate includes a midcycle, normalized, sustainable 15.3% EBIT margin assumption in the final year of our Stage I forecast. Over the past 10 years, Snap-on has had high and low EBIT margins of 19.3% (2017) and 9.9% (2009), respectively. Our 15.3% midcycle assumption represents 80 basis points of expansion above the 14.5% 10-year median. Our midcycle assumption reflects an improved break-even point on Snap-on’s richer profit mix as RS&I becomes a larger piece of the pie and on progress made from its RCI program that improves the company’s efficiency.

In contrast, for our DCF model to match the sell-side consensus price target of $183, investors would have to believe Snap-on can generate a midcycle normalized sustainable EBIT margin of 22.7%. In our estimation, that sanguine level of profitability will not be attainable for Snap-on, even when all product and geographic markets are running flat-out at cycle plateau. In our opinion, the sell side is valuing Snap-on stock as though the company’s business is no longer subject to any economic cyclicality.