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Morningstar | Snap-on Reports Solid 2Q 2018 but Hand Tools Still Sluggish; Maintaining $132 FVE

Narrow-moat-rated Snap-on, the hand tool, repair systems, and diagnostic equipment provider to critical task repair and maintenance professionals, reported solid second-quarter 2018 earnings per share before special items of $3.11, handily surpassing the consensus of $2.92 by $0.19 and $0.52 higher than the $2.59 reported in the prior year. Commercial and industrial, or C&I, and repair services and information, or RS&I, group revenue increased 9% and 2%, respectively, which more than offset 1% lower revenue in the hand tools group. Consolidated revenue grew 4% to $1.037 billion, but excluding currency and acquisitions, organic growth was somewhat subdued at 1%. Unfortunately, this 2-star-rated stock currently trades at roughly a 20% premium above our $132 fair value estimate.

Second-quarter 2018 revenue excluding financial services was $955 million versus $921 million in the prior year, representing a 4% year-over-year increase. Financial services revenue rose 6% to $82 million on stronger contract originations with franchisees. Operating margin excluding special items and with financial services on an equity basis was an impressive 20.2%, expanding slightly by 30 basis points compared with the second quarter of 2017, primarily owing to a 90-basis-point decrease in cost of goods sold, partially offset by a 40 basis points increase in corporate spending. We think Snap-on's narrow moat, derived 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, EPS increased 20% from 2017 to $3.11. During the quarter, Snap-on repurchased 371,000 shares of common stock worth approximately $55 million. Consequently, the diluted share count contracted to 57.3 million, down 3% year over year. Owing to headwinds from still weak but improving U.S. sales in the hand tools group, we still expect margin contraction this year (70 basis points) as Snap-on partially offsets the group’s weaker performance 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. Even so, while the hand tools group's EBIT margin declined 30 basis points year over year to 19.2%, we were encouraged that C&I and RS&I expanded 70 and 170 basis points to 14.5% and 25.9%, respectively.

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 interestingly for dividend investors, the 30-year annualized dividend-growth rate slightly exceeds 6%.

However, with a consensus price target of $181, we would note that 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 $181, investors would have to believe that Snap-on can generate a midcycle normalized sustainable EBIT margin of 22.2%. 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.