Snap-on (SNA) is a tool supplier with several secular trends improving its business. First, Snap-on has exposure to end-market strength in autos, aerospace and construction. Second, Snap-on benefits from commodity price weakness in steel & natural gas. Finally, China is not currently a large portion of sales, so the risk to the Chinese slowdown is limited.
The auto industry is Snap-on's largest end market. Snap-on pioneered mobile tool distribution in the automotive repair market. Two of Snap-on's business segments focus on the automotive market: Snap-on Tools Group and Repair Systems & Information Group. These two segments represent 41% and 29% of sales. So 70% of Snap-on's sales are related to auto repair and manufacturing, putting Snap-on in a great position to benefit from the strength in auto industry. Vehicle sales are strong, and trending higher. July seasonally adjusted vehicle sales of 17.6M units was higher than consensus of 17.2M.
The auto repair industry is benefiting from the secular trend of people keeping their car longer. The average vehicle in U.S. is now a record 11.5 years old, according to IHS Automotive. In addition, this trend is not expected to reverse. IHS thinks the average vehicle age will hit 11.6 years in 2016 and then 11.7 years in 2018. So the auto repair business and Snap-on should continue to benefit from this secular trend.
Snap-on has successfully diversified into markets adjacent the autos. The Commercial & Industrial Group contributes 30% of Snap-on's revenue. Included in this segment are two industrial markets also benefiting from positive secular tailwinds: aerospace and construction. Aerospace is strong as a result of the shift toward airplanes with higher fuel efficiency. Construction is gradually strengthening after years of low investment following the financial crisis. I believe these industries will maintain relative strength due to positive secular trends.
Snap-on's manufacturing costs decrease with lower commodity prices, particularly steel and natural gas. The principle raw material used to manufacture Snap-on's products is steel. Assuming steel is 10% of COGS, then a 10% drop in the price would increase net margin by 69 bps (tax rate 31.5%).
Snap-on holds 3-4 months of inventory and buys steel ahead for work in progress, so this dramatic move down steel prices should be a nice benefit to margins in the second half. In addition, iron ore has dropped back down close to it's March low, which I think indicates further weakness in steel prices is probable. I believe steel & iron ore prices will continue to be heavy, because China is exporting higher and higher volumes after the collapse in their internal demand for steel used in construction.
Geographically, Snap-on's sales are 66% in the U.S. and 20% are in Europe. Both of these geographies are currently strong relative to China. Although China is an area of growth for Snap-on, business there is relatively small. Snap-on has less than 10% of sales in emerging markets. China is Snap-on's 11 largest geographical market. There are 7 European markets larger than China as well as Canada and Japan, so I assume China exposure is less than 2% of sales. Snap-on does has four manufacturing facilities in China, but I view Snap-on's China exposure is relatively small.
Snap-on has a financing division, Snap-on Credit, which makes loans to franchisee-distributors. When I value Snap-on, I eliminate the results of the Snap-on Credit segment. I view Snap-on's credit business as a subsidy to its manufacturing business. I am not buying Snap-on for credit exposure. I don't think the credit segment has delinquency problems, so I am not assigning it a negative value.
I see Snap-on as fairly valued at 18.3x FCF and 22.5x earnings. Snap-on trades at a higher multiple than its competitors, but I am willing to pay up for the execution, strategic business plan, and secular tailwinds outlined above.
In Summary, Snap-on has exposure to the strong end-markets of autos, aerospace & construction. Snap-on is a beneficiary of lower commodity prices, particularly steel, and has low exposure to a weakening China. On the negative side, Snap-on does have some negative exposure to the stronger USD. I am avoiding investments with high foreign exchange exposure. Although I am not happy with the USD exposure, all considered, Snap-on is still an attractive industrial stock.
Michael Grove, CFA