Stanley Black & Decker, Inc.
Q4 2012 Earnings Call Transcript
Published:
- Operator:
- Welcome to the Q4 and Full Year 2012 Stanley Black & Decker, Inc., Earnings Conference Call. My name is Lorraine, and I will be your operator for today's call. [Operator Instructions] Please note that this conference is being recorded. I will now turn the call over to Vice President of Investor and Government Relations, Kate Vanek. Ms. Vanek, you may begin.
- Kathryn H. White Vanek:
- Thanks, Lorraine. Good morning, everybody. Thank you so much for joining us for the Stanley Black & Decker Fourth Quarter and Full Year 2012 Conference Call. On the call, in addition to myself, is John Lundgren, CEO; Jim Loree, President and COO; and Don Allan, Senior Vice President and CFO. Our earnings release, which was issued this morning, and a supplemental presentation, which we will refer to during the call, are available on the IR portion of our website as well as our newly revamped iPhone and iPad app and mobile website. A replay of the call will begin today at 2
- John F. Lundgren:
- Thanks, Kate. Good morning, everybody. Listen, this morning, beyond reporting our fourth quarter '12 results and providing our 2013 guidance, which I know everyone on the call is interested in, a couple of other objectives of this morning's call are to essentially close the books on the Black & Decker merger and, of equal or even greater importance, lay the groundwork for what we believe is a series of really exciting organic growth initiatives. So thanks for joining us early this morning. Quickly, on the fourth quarter. Revenues were up 4%, to $2.7 billion. Half of that was organic growth, up 2%. And very interesting, on the organic growth, 6% in CDIY and Engineered Fastening, 2 of our strategic businesses performing really well, and those were -- that growth was offset by declines in Europe due primarily to market conditions in IAR as well as Security. A little more on that later. Diluted EPS of $1.37, combination of strong operations and a favorable tax rate. That was up 12% versus same period a year ago. GAAP earnings of 70 -- were $0.79. Full year revenues, up 8%, 2% organically. And 2012 EPS of $4.67, x charges, was flat versus prior year. But if you normalize the tax rate, i.e., equal -- 2012, make it equal to 2011, diluted EPS GAAP was $2.70 but, with a normalized tax rate, would have been a 12% increase year-on-year. And Don is going to provide a lot more granularity on tax and its progression '11, '12 to '13 when he gives you some more detail on the outlook. Strong year in cash flow, $1.1 billion, x charges, for the year. Working capital turns of 7.5, a 42% increase since the pro forma pre-merger levels. 2013 guidance for diluted earnings of $5.40 to $5.65 a share. That's a 16% to 21% increase versus 2012, driven by organic growth in the range of 2% to 3%, 100 basis points of which we believe will be driven by the early returns on some of the organic growth initiatives that Jim is going to walk you through a little later on this morning. And finally, March 2013 marks the 3-year anniversary of the merger between Stanley and Black & Decker. It's an important milestone. It came with a few notable executive management changes, and those were announced in a press release on January 14 and they're taking effect during the first quarter of this year. So let's turn to the final chapter of the merger. And I guess it's both a pleasure and my good fortune to be able to talk about it at least on this call this morning and it's probably the last time we'll talk about it in any particular detail. But let's wrap it up. We did really well on cost synergies. By the end of 2013, we will have achieved $500 million in cost synergies, significantly exceeding our target and commitment of $350 million. We've exceeded that target by 43%. As you all know, CDIY right now represents about 50% of our revenue. The $760 million in CDIY of operating margin in 2012 exceeded the entire 2009 operating margin of the entire company, legacy Stanley and legacy Black & Decker combined. That's the impact of cost and revenue synergies, a prolific new product development activity in process and exceptionally strong execution by the CDIY team led by Jeff Ansell and comprised of really the best athletes from each of the 2 legacy organizations. So it was just a terrific opportunity, and thankfully, in retrospect, we were able to take advantage of it. Revenue energy projects continue to yield strong results. We've surpassed $300 million in revenue synergies versus a goal of $300 million to $400 million. And probably the simple example, just to refresh everyone's memory, Stanley Hand Tools are up $25 million in Latin America -- or will be by the end of 2013. Business was virtually nonexistent but -- as we were able to sell premium-branded Stanley products through a well-established Black & Decker distribution network. It's just one of many, many examples of how the -- of the power of the combination of these 2 companies. The cultures, driven by world-class innovation, have resulted in more than 1,500 new products and $1 billion of organic growth over the last 3 years. And probably one of the greatest achievements in terms of results from the combination is the degree to which the Stanley Fulfillment System has been initially embraced and fully embedded across the 2 companies. Working capital turns were 7.5, up from 5.3 pro forma pre-merger levels. And within CDIY, which is where the majority of the integration activity went on, working capital is down 50% from the 2009 pre-merger levels. That is a lot of freed-up cash to reinvest in our businesses. So by all measures, we truly believe the merger to date has been a resounding success. Let's move on to the quarter. In terms of sources of growth, as you saw in our earnings release this morning, Stanley grew 4% in the fourth quarter, 8% for the year. Of the 4% in the fourth quarter, it was 2% organic, which was 2% volume and flat on price. Acquisitions added 3%. Currency was a 100-basis-point headwind, for a total of 4%. Quite similar to how it played out for the year, where volume was up 2%, price was flat, leading to 2% organic growth. Acquisitions added 8%. Currency was a 200-basis-point headwind, and that yields the 8% total growth. Looking quickly by business, to give everyone a flavor for the fourth quarter and the year. Exceptional performance of Professional Power Tools in the quarter and on the year, driven by the 18- and 20-volt lithium-ion DeWalt product introductions, just tremendously well accepted across our customer base. The Consumer Products Group also had a terrific fourth quarter and a great year. The fourth quarter 9% was driven primarily by new products, Gyro and Matrix, as well as some really good acceptance of some of the smaller products in Japan, which is a small but important market where that business continues to perform well. Engineered Fastening, another bright spot, up 6% for the quarter, 9% for the year. MAS commercial, up 3% for the quarter, reversing a trend where they were down on a year-to-date basis. Hand tools and fastening was flat for the quarter, 2% for the year. Europe actually grew but offset in -- by the U.S., where we made the conscious decision to exit some lower-margin businesses in hand tools and fasteners. Infrastructure, down 2% in the quarter, 6% for the year. The primary driver there was our oil and gas business, where the onshore business was slow across the board, offset partially by strong growth, albeit from a low base, in the offshore business, and Jim is going to talk about that a little bit in his section a little later on. Quickly, convergent security was off 3% for the quarter and for the year. U.S. Security actually grew in the fourth quarter. Most of the decline was Europe, and a lot of that was Niscayah, much of which was planned. And finally, last but certainly not least, IAR was down 5% for the quarter, 2% for the year. You will recall that IAR is one of our few businesses where we have more business in Europe than the U.S., due to the extremely important FACOM franchise, among others. That franchise is stronger than ever. I won't dwell on European market conditions, but we've -- we have, at a minimum, maintained and likely gained share in Europe by being off only 2% for the year in our Industrial & Automotive Repair business. So the key organic growth initiatives are in process, we're going to expand on this, and a couple programs in place to rev up the engine for a couple of our smaller businesses that are lagging fleet average in terms of performance. Let's look real quickly on a geographic basis. I don't want to spend too much time on this. But upper left, if we want to look at North America, very strong quarter in Canada and a very good year. More importantly, the U.S., which accounts for 48% to 49% of our business, grew 1% in the quarter, 1% for the year. CDIY and Security were up, offset by the Industrial segment, as we've talked about on an ongoing basis. Moving to the middle of the chart. Europe was off 3% in the quarter, 2% for the year. It does represent 26% of our business. Again, in the fourth quarter, CDIY grew, whilst convergent security, primarily Niscayah, as well as IAR were off in the fourth quarter. So a total of 3% organic volume decline, 2% for the year. Emerging markets remained -- go from strength to strength
- James M. Loree:
- Okay. Thanks, John. As John indicated, I'll hit the segment info fairly quickly. It is a fairly clear and relatively simple story this quarter, operationally. And the first part of the story, relating to CDIY, is just a terrific performance by that team, with a 6% organic growth and 180 basis points of profit rate accretion. The organic growth was 7% in North America. We had double-digit growth in the emerging markets and we were flat in Europe. Now of all those accomplishments, I would say the last one perhaps was the most challenging to deal with and perhaps the most impressive because they were able to take what in Southern Europe was a down 10% to 20% type of performance across those countries and translate it into an overall flat performance. Really outstanding work in the U.K. and real strong in other parts of Europe, excluding the south as well. So they've taken the new products and they've done some really creative promotions, and they've really worked hard to offset the difficult market conditions in Europe. And now moving to the global business. The Professional Power Tools, up 14%, as John mentioned; consumer, up 9%; hand tools and fastening was flat, as new storage products and Black & Decker Hand Tools strengths were offset by lower U.S. sales as we exited some dilutive-margin promotion activity that we had engaged in last year. What's really impressive to me is the profit rate, 14.5% in the fourth quarter. That's really strong for the fourth quarter for this type of business. And as you will probably recall, the margin rates have been pretty strong in CDIY all year. And we think that -- as we enter 2013 with strong organic growth momentum, that we have a new watermark for operating margin rate that represents a sustainable -- we think, sustainable level, with perhaps room for even further improvement. In the home market, that's firming up as we sit here today, and a solid new product pipeline so we're pretty bullish on this segment for the future. And then moving to Security and Industrial. The story is -- it was articulated as basically weakness in Europe in both these businesses negatively impacted the growth and profitability in the segments. Security had negative 3% organic growth and positive growth, if -- albeit 1%, but still a sea change in terms of performance in CSS North America and we're happy to see that. Minus 5% in Europe. And the Mechanical Access business, which is primarily U.S., was up 3%. The operating margin rate in Security was 15.5%, essentially flat, down 20 basis points versus the prior year; and 17.3%, excluding the Niscayah dilution that -- or rate dilution that occurs because of the lower rate. Although, the Niscayah integration is continuing to progress smoothly and they've essentially doubled their operating margin rate since the inception of that integration activity. CSS overall was down 3% organically
- Donald Allan:
- Thank you, Jim. So I'd like to start with a review of free cash flow on Page 13. As you can see, our free cash flow performance was very strong in 2012. One thing I would like to highlight, though, is this financial statement is a little different than what you've seen in the P&L, which excludes HHI. The cash flow statement actually has the impact of HHI in it for the majority of the year. However, it does not reflect the full year cash flow performance for HHI because we did close the transaction in the early to mid-December. And as a result, there's roughly $30 million of loss in cash flow associated with HHI. So when you adjust for that, our performance was about $1.1 billion, $1.1 billion, and compared to the $1.60 billion (sic) [$1.06 billion] that you see here on the page. One thing I would like to point out as well is that our working capital performance, as John mentioned, was very, very strong, up to 7.5 from 7.2 in the prior year, which generated in the fourth quarter almost $350 million of free cash flow. It was slightly short of our expectation. We expected it to be slightly above $400 million of free cash flow in the fourth quarter, as I mentioned back in October. And naturally, the gap that you see, the $1.1 billion versus our guidance of $1.2 billion. That, all set aside, is fantastic performance in free cash flow overall, 2 years in a row in excess of $1 billion, and it continues to be a strong part of the story for our company. Couple of items to note as well here on this page. There's a large gain associated with HHI that's included here, and we're actually backing that out. So it's included in that income and then it's backed out so it doesn't affect the operating cash flow. A very tax-efficient transaction selling HHI, which I think most of you are aware of. The growth -- the pretax gain was almost $390 million, and the tax effect -- or effective tax rate was $25 million. So a very nice story there, with less than 10% tax paid on the gain associated with that transaction. And then the last item to mention would be our CapEx. CapEx was relatively in-line, about 2.5% of our revenue for the year. And we would expect that, going into 2013, we'd see a similar trend in the percentage of revenue as well. So the last takeaway on free cash flow is that we feel this is definitely a differentiator for our company. We'll continue to focus on working capital improvement, going forward. As you know, we have a road to get to 10 working capital turns, and we still feel there's many areas of improvement that are available in our businesses. So with that, I'd like to move to 2013 outlook. For EPS, we expect to be between $5.40 and $5.65 for the year, which would be a 16% to 21% EPS growth versus 2012. Let me walk you through some of the assumptions associated with that. First, organic growth. Organic growth, we expect to be up 2% to 3%, which would be an accretive impact in EPS of anywhere from $0.00 to $0.15. Breaking that down into a little more detail
- Kathryn H. White Vanek:
- Lorraine, we're ready for the Q&A.
- Operator:
- [Operator Instructions] And our first question comes from Dan Oppenheim with Credit -- from Credit Suisse.
- Daniel Oppenheim:
- You talked a lot about the -- sort of the organic growth, but I was wondering about the CDIY. You talked about the operating margin to increase slightly, with the cost synergies. You're doing a great job in terms of looking at sort of pricing incentives there to help margins slightly. Is there further opportunity that you have there in '13 and beyond as we think about margins in that?
- Donald Allan:
- Yes, I -- this is Don. I think the -- 2013 for CDIY will continue to be a nice year of mid-single-digit organic growth, us focused on more margin accretion related to the cost synergies. But it's also important to recognize that we do want to make sure that these growth investments are in place and begin to get a impact in the back half of 2013. So that will mute clearly the operating margin rate expansion, to some extent. But going forward, as far as looking at this business and operating margin rate, we do see -- still see opportunity for further expansion. And I think one of the bigger areas will be our ability to focus on these organic growth programs in emerging markets. If you look at the incremental operating margin rate, it's 25 associated with these growth initiatives. A large part of that is impacting CDIY. And so even if we do see price pressure in certain areas, overall, I do believe that we'll be able to continue to expand operating margin rate.
- Operator:
- And our next question is from Stephen Kim from Barclays.
- Stephen Kim:
- You spent a lot of time talking about the emerging markets opportunity and your approach to it, but I did have one additional question. You -- we talked about opening up a few different plants. I gather these are probably going to be relatively small, mostly assembly oriented, but I wanted to confirm that. And when you talk about opening up an Indian plant and expanding Brazil and maybe China and Turkey as well, I was wondering if you could be a little more specific about which countries you were thinking about prioritizing, particularly as it relates to opening up plants, this year.
- James M. Loree:
- Sure, Steve. First of all, you're right about the plants being relatively small. There's no need to build monuments at this point in time. And the key for these plants is to keep the overhead down because the competitors don't have high overhead and some of our plants in the emerging markets that serve the Western markets have a lot more overhead than the local plants of competitors serving the local markets. So there is a very important element of that, which is keeping the overhead down. It's really a different approach. We have to have the -- kind of the Western-company mentality in terms of compliance with regulations and all those sorts of things, and environmental and so on, but we cannot have the Western mentality as it relates to the overhead in the plants. So relatively small, and typical investment for something -- for a plant of this nature would be in the neighborhood of around $10 million. And then the other question that's in terms of prioritization
- Operator:
- And our next question comes from Michael Rehaut from JPMorgan.
- Michael Jason Rehaut:
- I had a question about your outlook for Security in 2013, specifically in North America. I believe you're looking for modest growth to be offset mostly or completely by Europe. I was wondering if you could go into the growth drivers in North America for Security. And I think over time Security in general has been looked at as a higher-growth opportunity as you've pieced it together over the last 10 years through different acquisitions. And I -- maybe first talk about 2013 drivers, what's working for you, what's maybe still an opportunity and, additionally, how the growth in Security in North America has played out over the last few years relative to your expectations.
- John F. Lundgren:
- Yes, I'll take that, Mike. There's some level of granularity we're not going to provide on this call. But I think we've been fairly public. Remember, our -- you know well, our Security business in general, and North American business in particular, is overwhelmingly commercial. About 20% to 25% of that business is driven by non-residential or commercial construction. That's the biggest driver. About another 15% is retail construction. And as Jim pointed out, while commercial construction is improving from a very low base, we still don't anticipate for that to be a robust market. So what's slowed down the growth of that business the last 2 or 3 years is, quite frankly, the complete lack of any commercial construction activity or, certainly, the reduction in commercial construction activity. And we do need new commercial construction to get the new accounts, to prime the pump to generate the recurring revenue that is so important to that business. The opportunities, though, are in areas such as -- where we're less developed such as health care, which, as you know, is an important small but emerging high-growth business for us that we report within our Security business. And with the acquisition of Niscayah, particularly in North America, the Niscayah team is -- was very well positioned. It has tremendous vertical market expertise in the financial and banking sectors. That's 2 areas where, up until now, we had very, very little business. And we think that we have the opportunity to grow in those areas irrespective of market conditions. So you got a commercial construction market that is anything but robust, but we think it'll be a little better than -- it'll be no worse than prior years, with the upside opportunities in health care, financial institutions, all other things, a very little change from prior years.
- James M. Loree:
- Yes, and I'll take a stab at kind of adding something to that, which is we've done as a company, I think, 70 acquisitions over a 10-year period. And of those, the vast majority have been in Security. And they have been all-consuming into -- for the management team. When we bought into what we thought was a high-growth market and in normal -- under normal circumstances historically, it has been both from a secular point of view, given the importance of Security growing and so forth, and also just from the standpoint of being a technologically driven market that has a lot of innovation and value-creating change going on within the industry. So it is a high-growth market. It has been depressed by commercial construction over the years. But the key to growing in -- and outperforming vis-à-vis the market regardless of what size the market is at any point in time, or growth rate it has, is to have differentiated value propositions. And what I would say we did over the course of building the Security business was we assembled all the pieces that are required to provide differentiated value propositions to various industry verticals, so for instance, health care, education, financial services, government, the global customer that wants to be served in a global fashion like an industrial or that type of organization. So we have all these pieces. And one of the thoughts behind the hiatus that we went on in July was that we're not getting above-market growth in Security. And in order to do so, we have to spend the time and focus the same people that have are -- have been focused on doing over approximately 50 acquisitions and focus them on organic growth and taking with we have and maximizing it. And I just got back from a sales meeting from North America Security, where they had every commercial person in the organization gathered in one location, and they have gotten to the point now where they've been able to take these value propositions that I've discussed here and now commercializing them -- in the process of commercializing them. I've never seen, in the Security business, a more charged-up sales force than we have right now because they finally have what they need to grow and they're going to go out and do it. So I would suggest that we are totally on the right track in terms of growth in the Security business. We have -- if you look back, you can certainly argue that it hasn't been what we'd hoped for, but I'm very confident that it will be, on a prospective basis.
- Operator:
- And our next question comes from Rich Kwas from Wells Fargo Securities.
- Richard M. Kwas:
- Had a question on the Security, longer term, on the margin. So you're around 15%, 16% right now. What's the progression to get to that -- back to that high-teens rate? I think, John, you referenced you're going to need some macro strength on the commercial construction market, retail construction market. But other than that, is there anything that would prevent you from getting there over a 2- to 3-year period?
- John F. Lundgren:
- The answer is -- Don's going to give you a little more granularity, Rich. But remember, Niscayah is a big piece of that now. It's way below line average margin. That being said, we've increased the Niscayah operating margin between 500 and 800 basis points. So part of it is simply math, as the Niscayah represents almost 40% of our Security segment now and the margins continue to increase. But I'll ask Don to give you just a little more granularity than that.
- Donald Allan:
- Yes, Rich, if you look at -- obviously, Jim reviewed the Q4 performance where you had that segment, it was 15.5%, but without Niscayah, it was closer to 17.3%. So clearly, the underlying business is still kind of in that 17% to 19% range that we're striving for in this business. And in the third quarter, it was closer to the 19% number when you excluded Niscayah. So it really comes down to our continued execution on the cost synergies in Niscayah and a combination of making sure that some of these growth initiatives -- although Jim didn't go through as much detail and the ones in Security, but there are certainly some significant growth initiatives in the world of Security as well, in that $850 million, that will allow us to stimulate more volume growth, which ultimately will help us leverage the cost base and ultimately drive those percentages in that range of 17% to 19%, with an average of probably about 18%. I mean, I really believe that this business, based on its current makeup, is in that category and it's more of a timing issue over the next few years.
- John F. Lundgren:
- Rich, and I'll remind you of one more thing. I know you're aware of this, but remind you, and I think it's important for everyone else on the call, this business overall, more on the mechanical than the convergent side, does have a little bit of seasonality. And historically, if you go back in time, you're looking at a couple hundred basis points lower margins in the first and fourth calendar quarters, a lot of reasons. We've discussed them, and more -- better margins in the second and third quarter. It's purely due to seasonality. And so as you're looking at that long-term margins, take a 12-month look and project forward. And be careful projecting off a quarter because I would argue that second and third quarter flatters our margins a little bit, and first and fourth quarter depresses them somewhat artificially due to seasonality.
- Operator:
- And our next question comes from Sam Darkatsh from Raymond James.
- Joshua Wilson:
- This is Josh filling in for Sam. A quick clarification before my main question. You said Niscayah was 40% of Security segment sales in 2012?
- John F. Lundgren:
- It's -- well, remember you take out HHI and add Niscayah, it's almost 50% of what's now remaining.
- Joshua Wilson:
- 50% of the remaining. And then shifting gears to the Infastech acquisition. Could you give us some color, if possible, on what's going on to delay the timing in there and why there might be risk to the close before February?
- John F. Lundgren:
- There's -- simply said, it's factors really beyond our control. China has a very methodical antitrust, believe it or not, approval process. We've done everything we can do. We are in the queue and, simply said, any acquisition is very, very thoroughly reviewed and that we see little or no risk. As I'm sure you're aware, Chinese New Year, which starts in mid-February, things do slow down a lot, so I believe there is an incentive on the authority side to get that behind them prior to Chinese New Year. And obviously, there's an incentive for us to get it done. But what our advisers tell us is we've done everything we can do. It's in good hands. It's going through a very normal and expected, albeit a slow, approval process. But we don't see any -- there's -- there are no numerical activities or issues, it's just a question of time.
- James M. Loree:
- Yes, exactly. There's no reason...
- John F. Lundgren:
- So 100 -- 99.9% probability of closing. The question is purely on timing, if that helps.
- Operator:
- And our next question comes from Dennis McGill from Zelman & Associates.
- Dennis McGill:
- Two questions, kind of related to the longer-term targets that are intertwined. The first is, on the ROCE target of 15%, can you just tell us what that is today or what that was in '12 and how you guys calculate that? And then relative to the 4% to 6% organic growth target for the whole company, how would North America look in -- within that target range?
- Donald Allan:
- Yes, I would say the ROCE at the end of 2012 was about 10.5%. And Kate can send you the details of the calculation because it's not exactly clear cut. But it's relatively consistent with what you would expect with an ROI calculation, with some adjustments for after-tax interest and amortization, in some cases. So when we look at that and we say, "How are we going to get that to 15%?" We clearly think that we'll get a significant improvement in 2013 just from the fact that we won't be doing any significant acquisitions. And we'll continue to show significant earnings improvement, with almost 20% EPS growth in that time frame. And so we would expect probably almost a 2-point improvement in 2013 from that level. The associated CFROI, or cash flow return on investment, at the end of 2012 was about 12%. And so there's about a 2-point -- 1.5- to 2-point gap between ROCE and CFROI and that's probably due to the intangible amortization that we experienced through a lot of these noncash expenses through the acquisitions that we've done over the last 8 years. And we would expect a similar result in there, where that would improve probably 1.5 to 2 points as well in 2013. And so we feel like we're on track to really move that forward, and both those ratios, getting them in that 12% to 15% band, even ROCE, probably in 2013. In North America, it's likely going to be a little bit higher than the line average for the whole company, but we don't have -- we don't exactly do a precise calculation...
- James M. Loree:
- North America was not on revenue. It was on organic growth, not on ROCE, up to 4% to 6% organic growth.
- Donald Allan:
- Yes, I mean, the 4% to 6% organic growth in North America, I would say that that's probably -- when you look at that over the long term, I would say that you're probably still looking at a couple of points of growth, frankly, in North America. And so the bulk of the growth is going to come, I would imagine, in emerging markets over the long term.
- James M. Loree:
- Yes, if we can get the core growth rate in North America to 2% to 3%, the 4% to 6% is very achievable. And just -- because it is 50% of our volume, yes. And just one other thought on the ROCE and the cash flow return on investment. The ROCE for us over the years has become disconnected from the cash flow return on investment because of our acquisitive activity and the amortization that's associated with it. It's really -- I mean, for those of -- that are familiar and have studied it, it's really more of a book income concept than it is a cash income concept. And we're evaluating -- as a management team right now, we're evaluating moving to more of a cash flow return investment view because it actually is more relevant to our business today because our cash earnings are substantially higher than our book earnings. And we are going to discuss that at the -- at our next analyst meeting, which will occur sometime in the middle of the year, date to be announced. So we'll have more on that, but I think cash flow return on investment is increasingly more relevant to measuring the return on investment of this company.
- Operator:
- And our next question comes from Ken Zener from KeyBanc Capital.
- Kenneth R. Zener:
- Quick question. The 17% -- or just to begin to address this, the 17% EPS in 1Q compares to 22% EBIT mix last year, so if there's any outlying driver, if you could address that briefly. But with Niscayah, because it's such a large piece of the business, could you update us where we are in the transition? If I think about HSM, the reverse integration that you did, you were sloughing off low-margin install business as you transition to a more a recurring revenue mix. Can you highlight the challenges and successes you've faced in that relative to the economic stress that we've had?
- James M. Loree:
- Yes, I will address the Niscayah while Don racks his brain and tries to figure out the answer to your other question.
- Kenneth R. Zener:
- It's seems -- the EBIT mix is lower.
- James M. Loree:
- Well, we've owned Niscayah something like 16 months now. And when we bought it, it was one of those -- it was a contested situation. So we didn't have the normal opportunity to go in and vet the management team thoroughly, like we would with a uncontested transaction. And so the hope was that we were going to get some good people at the headquarters and that we were going to be able to take our basic business processes that we have in North America and implement them in Europe in fairly short order. And what we found was that we had strong country managers in -- for the most part, in Niscayah, which was good, but we also found that the centralized management team was quite weak in Europe. We...
- John F. Lundgren:
- [indiscernible] country managers in the U.S. as well.
- James M. Loree:
- Yes, yes, yes. So in any event, yes, I -- well, everything I've said thus far relates to Europe. And we'll talk about North America separately. So we put a Stanley leader in charge of the business. He replaced the entire management team within about 4 months after ownership, and they have gotten great traction. And they have outperformed their cost synergies. And now they're really focused on growing the business in a tough environment. One of the challenges with Niscayah was that, from a growth perspective, in addition to the environment, was the fact that a fairly significant percentage of their revenue came from referrals from Securitas because they were -- at one time, Securitas and Niscayah were part of the same company and then they were spun, Niscayah was spun from the parent. And they still had a symbiotic relationship because Niscayah was the electronic business and Securitas was the guarding business. And so when a customer needed electronics, they were referred over to Niscayah. So we've had to kind of fill that -- the gap there in the revenue that no longer comes from Securitas because they were the ones that we contested the acquisition with so they're not the -- they're not our friendliest allies out there in the marketplace. So I think the management team has done a fabulous job, when you think about the revenue being down about 5% on the average this last year organically, of filling the gap for the lost business from Securitas as well as dealing with a difficult market in Europe. And they're -- it's very stable. They're going to perform at or above the cost synergy targets. And the acquisition is going to drive every bit of return that we thought it would. And in addition to that, it has really enabled us to be a global security franchise. We're really one -- we're really the only commercial security company in the world that can coordinate globally now, which is a big advantage. So all that is a good story. It's a tough environment. We bought it right before the European market issues were manifested. However, we expected that, we anticipated that. And so I think in the end this is going to be a terrific acquisition. It's -- the operating margins are about double what they were when we bought it, now, and moving on up again this year as well. So it's all in pretty good place. The North American piece, I think, was, for the most part, a pleasant surprise in the sense that -- I talked earlier about these value propositions and the verticals and so forth. They brought in North America great strength in these verticals. So they had a vertical market approach in North America. They were relatively subscale but they managed to do quite well with their business despite that because they have such strong vertical value propositions. We've taken those and we've now integrated them with the commercial force in North America, which has given us an advantage, we think, in the marketplace, especially as we pursue these organic growth initiatives. So I think on balance, we're very happy with Niscayah. It would have been better if the public relations aspect of this, buying a European company, hadn't occurred 2 months before the Europe went into a deep freeze, but nonetheless, we anticipated that. We have it all built into our pro formas, and it's going to be a great acquisition. It already is.
- John F. Lundgren:
- Yes, just one final point, Ken, on Niscayah, and Jim touched on it -- 2 points, I think, just to close the loop because the last thing we'd want to leave is any impression that the integration thus far has been anything but a terrific success, that we're completely satisfied, more than satisfied with the acquisitions and what it does for us. But the first point Jim made and an important one
- Donald Allan:
- Yes. So the answer to the question, Ken, is, as I mentioned, 17.5% of our total EPS will happen in Q1, which is slightly below when you look at the historical trends. There's a couple of factors. When you look at Q1 last year, our operating margin for Q1 represented about 22% of the total year operating margin, which is close to the EBIT number or EBITDA number you were mentioning. In this year, we would expect that operating margin number to actually be closer to 20% of the total for the year, in Q1. Why is there a difference? Well, the real -- the main difference, frankly, is these investments we're making in growth. As I touched on, we do have a dilutive impact for the year. The bigger part of that dilutive impact happens in Q1, and it begins to moderate as we get into Q2 and starts to flatten out in Q3. So that's the driver associated with that. And then the other area would be in the area of interest and tax. So we will -- our interest will spike, as I mentioned, due to the Infastech transaction temporarily throughout the year. We will see that happen initially in Q1 and then begin to work its way down as the year goes on. And then in addition to that, the tax rate, we did have a modest tax benefit in Q1 of last year that's also affecting that, that we don't expect to repeat.
- Operator:
- And our next question comes from Mike Wood from Macquarie.
- Mike Wood:
- Could you elaborate on the roadmap or experience you've had in the past with the mid-price-point product that gives you visibility that you can gain share and achieve a 35% gross profit margin without bringing in more price competition from the people that you're taking the share from?
- John F. Lundgren:
- Yes, I think it's as simple as -- and I think, Jim described it pretty well. We are familiar enough with the end markets that we understand the features that people will pay for and they won't. And our history with a product that was successful at lower margins was, quite frankly, we were up. I'll use the not-so-elegant term of dummying down products produced for the West by taking cost out to get to a price point where it would sell. The new approach, and it's a pervasive effort across our company, of designing to value, what will -- what product teardowns? What will an end user pay for? What does he value, and what does he not value? So simply, it's reengineering these products from a clean sheet of paper, as opposed to trying to just take cost out of a higher-cost product produced with more features and benefits for a market that it wasn't designed for. And as Jim said, to do that, we need basically a 0-base or clean-sheet engineering approach, which we've invested in and that's part of the investment that Jim alluded to. And secondly, we need to produce it locally in plants. They're going to be -- they're certainly going to be capable -- not capable, they will adhere to Western EH&S standards. Some of them are already our plants but with a lot less overhead, a lot less infrastructure than some of the plants designed to produce premium-priced products in low-cost countries but to export to Western markets. So the combination of designed for local market needs and produced in local markets will give us a tremendous edge, and this is something we've got a lot of experience with. We know what the price points are in the market. So we're beyond cautiously optimistic. We're confident that this approach is going to yield the kind of results we're looking for.
- James M. Loree:
- And in addition to all that, we have looked at a number of companies that do this and in terms of business development activity. And I can tell you that their income statements and their cash flow statements and so forth, when you consider what -- the things that we know and the synergies that we can bring to that sort of business model, we -- there is an existence theorem. And I think it's really important because what John described was now 80% to 90% the theory of the case, but we have examples in the emerging markets of business development targets that we've looked at that can get there and so we know it can be done.
- Operator:
- And our next question comes from Jason Feldman from UBS.
- Jason Feldman:
- Thank you for the detail on the strategic growth initiatives. It was very helpful. But when we think about those organic growth initiatives as you kind of stretch to get to the 4% to 6% long-term organic growth range, do we need to start thinking about incremental margins differently as kind of an ongoing structural basis? Or do you view these kind of upfront initial investments as more kind of onetime-ish in nature and then ultimately will kind of get back to the incremental margins that you've targeted historically?
- James M. Loree:
- Yes, the organic growth has the ability to drive operating leverage in the company. So while there will be some investments, the investments, for the most part, are simply the operating expense that kind of goes with the gross margin in order to get a certain contribution margin. In some cases, if we're building a plant and so forth, there will be some additional fixed costs. But I would say that we fully expect the emerging market element of this to be, overall, rate accretive to the company, even with all of those investments, very quickly. So it'll be a net positive for operating margins over the long term for the company from the emerging markets. And then most of the other thing that we're doing are very much relying on existing plant, existing facilities. We're adding salespeople, for the most part, commercialization people. That is going to be more incremental at the contribution margin line, based on what we do today. And in most of these initiatives, we're -- as you walk through them, in many cases you'll see that every one of them has a specific value proposition associated with it. And we're big believers in that, the stronger the value proposition, the more you can get paid for something. And we're very much interested in value-pricing these as we go forward.
- Operator:
- And our next question comes from Eric Bosshard from Cleveland Research.
- Eric Bosshard:
- The -- you -- I think hand tools, you commented, were flat in the quarter, which related to you walking away from some of the lower-margin business. I'm curious, as you look at '12 and '13, how you look at the market share performance of hand tools and what you see going on inside of that business.
- Donald Allan:
- Yes, I would say that, John articulated us walking away from business, which I -- this was a very intelligent decision by our CDIY team. As you know, we look at different pieces of our business and make sure that we're achieving certain levels of profitability and pricing associated with that, but ultimately, we also are very aggressive around new product innovation and technologies that help us drive growth as much as possible. And when I look at the hand tools business
- James M. Loree:
- Which would imply modest share gain.
- Donald Allan:
- Which would imply modest share gain. And it also would imply that we continue to drive activities in emerging markets that will help that global growth number as well.
- Operator:
- And our next question comes from Peter Lisnic from Robert Baird.
- Peter Lisnic:
- The -- can you give us a little feel for the implications for the change away from the direct model in U.S. Mechanical Access? Just kind of discuss the strategic implications there and what that might mean for what I thought used to be, at least, or might still be one of the highest-return profiles business-wise in your portfolio.
- John F. Lundgren:
- Sure, Pete. That's a -- it's a great question. And I think Jim gave a great start to answering it in his prepared remarks, so I'm going to kick it to him. But importantly, it is a conversation that we've spent a lot of time internally having as a corporate management team and with Brett's team. But Jim, why don't you just elaborate a little bit on this year?
- James M. Loree:
- Yes. I think now is a great time to do it, number one. It historically has served Best quite well because, if you go back when I -- if you go back to the -- I think it was the '30s when Best kind of came into existence, they had a patented product that was the interchangeable core that played extremely well in certain segments of the market like health care, education, government and so on. And they -- and as the market evolved over the years, they had the direct model and the 2 largest competitors had a distribution-oriented model. And as the economy slowed down and construction slowed down over the last 5 years or so, the distributors, with their profit margins under pressure, began to look more and more at other ways to grow their business and to grow their profits and they started becoming more aggressive in some of the markets that were traditional home territory of Best. And today, we're not dealing with a proprietary interchangeable core anymore. The patents have all expired and so forth. So our sales force is largely accustomed to being sort of -- had a farming mentality, if you will, in serving these customers and did a lot of transactional support for the customers and so forth, things that distributors do very well. But they weren't out there with the size and scope of go-to-market resources that the distributors were. And though -- and we did have the advantage that we could cover multi-geographic locations more effectively with a direct model, but it also is more expensive. And so when we've looked at this change, we think that this is a moment in time when we have enough value to add to the distributors in the sense that we have an installed base, very valuable, and we have extremely robust new product development for the first time during our ownership of Best Access, especially in the mid-price-point product, which has become extremely important in the -- with the economic issues that are going on today. So for us, to get to the construction market, we felt we needed to make this change. And we felt that it's always somewhat risky in an entrenched distribution model, but we believe that this is a time -- a moment in time when we have enough value to add to these distributors that we can partner up with them and put away the competitive aspect that we've had that's always made it difficult to work, to coexist, with the distributors with the kind of a hybrid model that we had. And we've taken a lot of cost out of the field in order to account for the somewhat-lower gross margins that'll be associated with this. And so we think it's income neutral from the standpoint of making the change because of the cost takeouts. And we think that this will enable us to really charge up the organic growth in the MAS model. So we still believe that it will be a great return business on a go-forward basis, but we think it'll be a higher-growth business.
- Operator:
- And our last question comes from Liam Burke from Janney Capital Markets.
- Liam D. Burke:
- You've had a great deal of success on the working capital management side. It's been a focus, and obviously, the cash flow is reflected in that. With a lot of effort in the growth of emerging markets, how does that affect your working capital management forecast?
- Donald Allan:
- Yes, I would say that I wouldn't see them having a significant impact on working capital. We still feel very passionate that achieving 10 working capital turns by the middle of this decade is achievable. And all the initiatives that we're looking at in emerging markets, we don't expect to impact that objective. Now that being said, we probably will end up carrying a little more inventory in that part of the world to make sure that we meet the needs of customers, but when you assess the impact as a percentage of the whole company, it's not going to be more than a tenth or two of an impact across the whole company. And it doesn't really impact our objective of getting to 10 working capital turns.
- Operator:
- Thank you. Do you have any final remarks at this time?
- Kathryn H. White Vanek:
- No. I just want to thank everybody for logging in today and participating. Please let me know if you need anything in the way of follow-ups.
- Operator:
- Thank you. And thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.
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