Forecast and Valuations of Black and Decker

Black & Decker

Forecasts

Since the merger with Stanley, Black and Decker has seen a steady increase in its revenues, gross profit and net income. The different elements of the new company are still being integrated, underperforming divisions are being shed, and synergies between the different components are still being developed. As the company continues to make internal improvements, it can expect that it will continue to grow both its top and bottom lines. It is reasonable to expect that over the next 2-3 years, ongoing internal improvements will help to improve margins, all other factors being equal. The post-merger improvements in the percentage of SGA expenses to revenue should continue in the short-run, albeit at a slower pace. Likewise, internal factors are likely to be responsible for at least a modest growth in income, as marketing synergies in particular emerge.

External factors are also critical to the forecast. The company expects to continue its strong growth overseas, in particular the double-digit growth in Asia, Europe and Latin America. In addition, the forecast for the U.S. housing market and economy overall is moderately positive going forward. The Congressional Budget Office was predicting a recession given the "fiscal cliff," but averting that change in fiscal policy to some extent preserves an earlier forecast of slow GDP gains in the 2-3% range for the coming years. It is important to remember, however, that much of Black & Decker's product line is sold for the construction of new homes or the renovation of old ones. The state of the housing market, therefore, is critical to the forecasting process. In 2012, the U.S. housing market had its best year since 2006 and the expectation is that this trend will continue. As a result, Black & Decker's revenue gains may well be better than the gains in the general economy. Such a prediction also fits well with the volatility implied in the company's beta of 1.48. With this information, an assumption of revenue increases of 3.5% growth over the next five years is not unreasonable. The company is assumed to have the capability to continue to lower its expenses as a percentage of revenue, but the assumption will be that current rates will hold. It is also assumed that the post-merger tax rates will hold, as will the post-merger capital structure.

The following performance measures outline the forecast for Black & Decker over the coming five years (and including the 2011 fiscal year as a reference point):

PERFORMANCE MEASURES

2011

2012

2013

2014

2015

2016

RETURN ON ASSETS

6.00%

5.27%

5.66%

6.02%

6.35%

6.65%

RETURN ON EQUITY

10.00%

12.40%

13.33%

14.18%

14.95%

15.66%

NET MARGIN

7.45%

8.27%

9.07%

9.84%

10.59%

11.31%

TIMES INTEREST EARNED

6.0

6.8

7.7

8.6

9.5

10.4

CURRENT RATIO

1.32

1.32

1.32

1.32

1.32

1.32

AVERAGE COLLECTION

55 days

55 days

55 days

55 days

55 days

55 days

The forecasted income statement is also included, based on the growth assumption noted above of 3.5% revenue growth with stable cost growth.

2011

2012

2013

2014

2015

2016

Revenue

10190

10547

10916

11298

11693

12103

COGS

SGA Exp

Other Operating Exp

Operating Income

Tax

79

82

85

87

91

94

Net Income

The capital structure is assumed to be the same for the next five years, with current items growing in line with revenues and adjustments made to the long-term debt in order to account for the difference. At present, there are no major expected projects that would result in the need to take on new significant debt.

The above figures show that the company is on the right track with respect to growing revenues faster than growing costs. These results will allow it to boost its operating and net incomes, and therefore should also result in dollar value increases in equities, even with slight increases in debt to maintain the current capital structure. There are no major changes expected with respect to the company's solvency or liquidity ratios. The figures show that the performance of the company is expected to improve over the next five years. If strong growth overseas continues, and the long-term growth in the U.S. housing market materializes as expected, both the return on assets and the return on equity should improve steadily over this time period, making the gains resulting from the merger more apparent on the company's financial statements.

Valuation

The current market cap for the company is $12.97 billion, based on a share price of $76.86. This price is near the top of the company's 52-week range. The first step in determining the appropriate valuation for the company is to determine a discount rate for the cash flows associated with the company. The cost of equity is determined using the capital asset pricing model (CAPM). The risk-free rate is 0.27%, equivalent to the 2-year Treasury rate. The market risk premium is assumed to be 7%. The beta for Black & Decker is 1.48. Thus, the cost of equity is:

(0.27)+ (1.48)(7) = 10.63%

The cost of debt is equivalent to the interest paid divided by the level of debt, so 3.9% (140 / 3526). The after-tax cost of debt is 3.53%, based on the tax rate of 9.42%. The weight of debt is 57.5% and the weight of equity is 42.5%. The weighted-average cost of capital therefore is as follows:

(.575)(3.53) + (.425)(10.63) = 2.03 + 4.51 = 6.54%

This is then used to discount back the dividends in the dividend discount model to derive an appropriate price for the company's stock. The current dividend is $1.96 per share. The dividend growth rate over the past two years has been a steady 9%. This is going to be the estimate of the dividend growth rate going forward, given that the company is expected to see its profitability, and in particular its return on equity, improve over that period. Using the dividend growth rate, the valuation for Black & Decker is:

P = 1.96 / (-.1063-.09) = $120.02

This analysis shows that the stock is undervalued on the market today. There are a number of possible explanations for this. The expected growth rate in the dividend might be lower than 9%. While this rate has held for two years, the expectation might be that the combination entity will begin to retain more income in order to fuel growth if there is a rebound in the U.S. housing market. There could also be higher expectations for capital growth, implying that the cost of equity is lower than the market expectation for growth in the coming years. This would be particularly true of the trend in the company's volatility was increasing, something that would imply a higher cost of equity. In either case, the present analysis indicates that Black & Decker might be undervalued even at its present high levels.