史丹利百得 (SWK) 2004 Q2 法說會逐字稿

Good morning. My name is Citina [ph] and I will be your conference facilitator. At this time, I would like to welcome everyone to the Stanley Works second quarter results conference call.

All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer period. If you'd like to ask a question during this time, please press star, 1 on your telephone keypad. If you would like to withdraw your question, press star, 2 on your telephone keypad. Thank you.

I would now like to turn the conference over to Gerry Gould, VP - Investor Relations. Please go ahead, sir.

Okay, thank you. Good morning, everybody, and welcome to our second quarter conference call. On the call with me are John Lundgren, Chairman and CEO, and Jim Loree, Executive VP and CFO. When we get to the Q&A period, Don McIlnay, the President of our Tools Group, and Jack Garlock, President of Fastenings, will also be available at that time for questioning.

We put two press releases out -- I'm sure you're aware of our second quarter earnings release last night with guidance, and on July 22nd, our dividend release. They're both on our website. John and Jim will review those releases and then we'll proceed to the Q&A period.

Meeting with [inaudible] we'll give earnings guidance only at the outset of the quarter as it did last night. Jim will discuss it today and then we won't comment on it further. We will [inaudible] if business conditions change materially.

We expect this call to last an hour and to end at Noon. There'll be a replay available 2 hours after the call ends through the end of the day Friday at 800-642-1687. The code for that is 8428206. After that and until then, it will be on our website and you can call me with any questions.

The usual two announcements in this discussion as well as in our press release, prior year, quarterly, and year-to-date reported earnings are supplemented with related amounts and percentages, excluding restructuring costs, impairment charges, certain other costs that's only in the prior-year period. We believe these supplemental measures provide useful information and that they remove the effect of variances in that prior year results that are not indicative of fundamental changes in our earnings capacity. Full reconciliations with reported amounts have been provided both within the press release and on our web site and for the current year. We are reporting GAAP results only.

Secondly, certain statements contained in this discussion by the various Stanley participants are forward-looking statements. As such, they involve risks. Actual results may differ materially from those expected or implied, so we direct you to the cautionary statements included in form 8K which we filed last night with the press release.

With that, John Lundgren will start the business portion of the call.

Thanks, Gerry, and good morning everybody.

Last night, we released second quarter earnings of $0.73 per share, up 51% over last year. This exceeded our previous guidance of $0.63 to $0.67 per share. As sales volumes were strong across all segments, results in momentum both remain strong throughout the quarter and they remain strong currently. The $0.73 compares with $0.11 last year from continuing operations, including pre-tax restructuring, asset impairment, and other charges of $48 million, or $0.38 per share, in the second quarter 2003. As Gerry suggested, the rest of our comments will exclude these 2003 charges, and all 2004 numbers are GAAP. So, EPS of $0.73 was above the range we estimated of $0.63 to $0.67, and up 51% over $0.48 from continuing operations, exclusive of charges last year. This was the highest quarterly EPS ever, a record for the company.

Second quarter sales growth also exceeded our earlier expectations. Sales grew 22% in total and 13% excluding the effects of acquisitions. The 22% was comprised of 9% from acquisitions, 8% from volume, 2% from currency, and 3% from price. The [inaudible] of material cost increases has been successful thus far, to an extent, but cost inflation has increased further during the last three months.

We also delivered very strong cash flows, surpassing both the second quarter and first half of 2003. In the second quarter, we generated $91 million operating cash flow versus $64 million in 2Q '03, $78 million of free cash flow versus $56 million in the second quarter of 2003. For the six months of January through June, we had $143 million of operating cash flow versus $116 million for the same six months last year, and $122 million of free cash flow versus $101 million for the same six months in 2003. The $78 million quarterly and $122 million first half free cash flow also represented all-time record levels for Stanley.

A number of factors contributed to the strong cash flow, including diligent second quarter working capital management -- specifically, $3 million of cash generated versus $26 million consumed last year. with sales up $142 million. Working capital returns improved 25% in the sales growth environment, and our team worked very hard to deliver that improvement. In fact, every Stanley business improved working capital return versus the prior year. Excluding the effect of acquisitions, working capital is down $103 million year-over-year. That's a really significant accomplishment, given organic sales growth of 13% combined with the materials inflation.

Growth has arrived at Stanley, and this quarter we certainly sustained it. The Stanley teams across all businesses executed well, delivering high fill rates, great marketing programs, and innovative new products to our customers. This execution has been enabling us to capitalize on recent customer wins. as well as the economic upturn.

Looking at the segments in our consumer products segment, sales were up 15%. Excluding positive price and currency impact, sales volume was up 10%. For the third consecutive quarter, there was double-digit percentage total sales growth in hand tools, 14% in this recent second quarter 2004, 20% in the first quarter, and over 20% in the fourth quarter of 2003. Strength was again broadbased across all U.S. channels.

Sales and acquisition in Europe were up a double-digit percentage of constant exchange rate, which was further increased by currency translation. A third consecutive strong volume quarter was delivered by Zag, our consumer storage business, with high double-digit percentage sales growth in the quarter, as in the first quarter, following over 10% growth in the fourth quarter last year.

In our Industrial tools segment, we had the most significant year-on-year improvement. Stronger markets contributed to higher volume levels while we leveraged the lower-cost based at our two largest Industrial businesses progressed with turnarounds. Sales increased 16% in total and 11%, excluding acquisitions, both for the second consecutive quarter. Organic sales growth, ex price and ex currency, was up a very solid 5% in the second quarter following 7% in the first quarter.

Proto industrial mechanics tools, which we described as the business in a turnaround in our May analysts conference, had its best performance in 12 quarters, both in terms of sales and operating margins. This business, which was essentially break-even just a few quarters ago, posted a double-digit operating margin during the second quarter.

This was another solid growth quarter for our largest Industrial business, fastening business. For the second consecutive quarter, that business grew sales over 10%, excluding the positive impact of currency. Strength was in the construction supply and Industrial channels and in the U.S., as well as in Europe.

Our Mac tools business also performed well. Although total sales declined 3% in the quarter, it's important to understand the prior year's second quarters sales included over $7 million of sales associated with the now-terminated MacDirect program. In this regard, traditional distributor sales increased 7% over 2003, and that's very encouraging.

This business continues to experience a very positive turnaround. The existing base of traditional distributors -- not new starts -- delivered a high single-digit sales growth. We've now had four consecutive quarters with growth in year-on-year root sales averaging.

We also recruited another 70 distributors in the second quarter, bringing us to an increase of over 25% in first-half distributor ads versus last year. Of equal -- or perhaps even greater -- importance, these new distributors are averaging over 40% higher sales than the new distributors we hired in the first half of 2003. So, our program to add, train, and retain capable and productive new distributors is working.

At the same time, we also conducted a program that terminated 80 of our lowest performing distributors during the quarter. This was a necessary step for our long-erm success, and we ended the quarter with just over 1,500 distributors in the field.

And, worthy of note with regard to the Mac business, our recently launched line of Jesse James toolboxes represented over 5% of Mac tool sales for the second consecutive quarter.

Assembly technology grew its sales a double-digit percentage over the same prior year quarter for the third consecutive quarter. This business is gaining share in a recovering auto assembly market, and its return on capital has surged to 18% over the past two years, up significantly from about 1% in October 2002.

And our hydraulic tools business, benefiting from a strong steel recovery market in a successful mobile share new product launch, had strong double-digit percentage sales growth as well.

Finally, [inaudible], our newest commercial industrial business, delivered over $15 million in sales in the quarter, and with accretive earnings per share for both the quarter and the five months since we've owned the company.

Turning to Stanley security solutions, total revenues increased 50% due primarily to the inclusion of acquisition. Organic sales increased 15%, following a similar 15% increase in the first quarter. Operating margin was 16% and an average of 17% over the first half of 2004. We had over 25% revenue growth for the third consecutive quarter in the access technology automatic door business, largely due to our national accounts strength. [inaudible] access system sales were up 5% after being flat with prior year levels in the first quarter. The second half 2003 and first half 2004 order trend verified this is a growth business and a building backlog [inaudible] cycle of electronic access control portion of the business.

Blick and Frisco Bay [ph] contributed $41 million of revenue at 15% operating margin in the quarter. [inaudible] earnings per share in the first and second quarters. Operating margin of 16% in this segment is excellent. While it didn't match the 18%t we delivered in the first quarter, this is largely due to acquisition mix.

Our security business generated sales in excess of $330 million so far this year and operating margins of over 17%. We're encouraged that all recent acquisitions of Stanley -- Best Access, Blick, TLC, and Frisco Bay industries -- are delivering the levels of cost, energy, and returns on capital at or near those we indicated when we made those acquisitions.

Opportunities for synergistic revenue growth will be the next focus prior to entertaining further security solutions acquisition opportunities toward the end of this year or early in 2005.

So we achieved solid growth across the board again in the second quarter accompanied by great execution. We are cautiously optimistic with respect to sales growth for the rest of the year. There's very good momentum right now with order strength across all three segments and July sales keeping pace with our expectations. Steps are being taken to sustain momentum and ensure that growth is delivered, including the key expansion of the Conapolis [ph] North Carolina Distribution Center that we finished in the second quarter; two plant facility expansions in Asia; and additional fastening capacity in collated plastic, paper tape, and galvanized nails.

Last Thursday, I recommended, and the Board of Directors approved, the largest increase in our cash dividends since 1997. The dividend was increased by 8% from $1.04 to $1.12 per year or a quarterly increase of $0.2 per share. As the company's new Chairman and CEO, it was important for me to reconfirm my support of the long and proud history of increasing our dividend payout. We consider the dividend an important part of the total return that we provide to our shareholders. Our cash flows are strong, and we think with both our confidence in the current and ongoing strength of the company and our feelings about the importance of the dividend by means of this increase.

With that, I'd like to ask Jim Loree to review our earnings guidance for the remainder of the year and beyond, as well as the status of our equity length security.

Thanks, John.

I'll start with third quarter guidance calls for 8% to 10% organic sales over third quarter '03. That would include approximately three to five points for volume, two points for currency, and about three points for price. The earnings expectation is about $0.70 per share. That's up versus 60% last year from continuing operations. For the total year,an organic sales increase of about 10% and earnings of about $2.75 to $2.85 per share are expected from continuing operations.

Our revenue comps are getting tougher, particularly in the fourth grade where it's important to note that we have one less week this year than in prior years, so if you do all the math for the revenue guidance, you'll see that the fourth quarter guidance is expected to be organically right in the 2% to 3% range.

A significant factor in our guidance is recent inflation in raw material costs -- steel in all businesses, but especially in the fastening business which buys rod steel which has been particularly plagued by the inflationary trends, plastic and [inaudible] in hand tools, aluminum and access doors, freight pretty much across the board. The impact of all that is about $70 to $80 million annually versus the mid-$60s estimate that we had back in April. We expect to be able to pass on to customers about 2/3rds or just under $50 million of that amount. We're obviously working actively to pass along more, but we do need to be realistic when it comes to the guidance about our ability to do that. So, that's a major consideration in the third quarter and full year guidance.

The negative impact is now about $10 million higher than it was a quarter ago. This prevents us from raising the guidance, although we'd like to -- although, and frankly the performance on most other fronts has been very good in the businesses and the execution has been strong. And that's notable as John talked about the working capital, and with respect to free cash flow, certainly the free cash flow generating capacity of the company is high and strong. And, now, we believe it's more likely to be in the upper end of our $250 and $300 million range that we talked about last call.

Our cash balance of $236 million reflects higher foreign earnings and we'd like to be able to repatriate some of that as we get toward the end of the year. We're certainly hoping that Congress will pass the legislation allowing the one-time repatriation of this type of cash -- this foreign cash -- at a nominal tax rate. Obviously, we're not counting on it.

As far as the equity length securities go, good news here. We indicated previously that up to $175 million would be considered to finance the acquisitions we did earlier this year. Given the cash flow strength, as we talked about, and some opportunities we had to monotize some smaller assets, including some non-core product lines -- and those activities continue -- as well as the opportunity to outsource our Mac advantage financing program. You'll recall that in previous times, we outsourced our distributor financing program and now we're turning to our Mac advantage financing program which is between $50 and $60 million of cash. So, all of that will help -- we may be able to take some of the $236 million back as well. Given the above, we do not believe at this time, notwithstanding any potential future acquisitions, that a security issuance is required. Or, to put it more clearly, a security issuance is not needed currently.

And, then just one final point regarding the financing. Last Friday, we issued an amendment to our F3 registration statement. That was administrative in nature, not signaling any intent of the company other than to keep our [inaudible] filing current.

And, in summary, we had a very solid first half of 2004. The growth was strong beyond our expectations. The strong portfolio and strengthening portfolio is definitely one of the factors. There's more strategic work ahead. The cash flow was strong, and John talked about the excellent performance and working capital was over $100 million -- takeout of working capital -- with all the organiic growth that we've been experiencing, and all that, enabling us to forgo the mandatory. And, now, the short-term focus remains on deleveraging the balance sheet to meet our rating agency desired levels in order to retain our single A credit rating. We also note that during the quarter, we were taken off a credit watch by one of the agencies and we do that as a positive development.

And now I'll turn it back over to John.

Thanks, Jim.

I'd just like to take a minute and mention a few second quarter business developments, as well as the key milestones in the marketplace for Stanley. First, we acquired CST Berger in January of this year. Less than 60 days later, the team introduced Stanley brand professional laser tools in Europe. That business has recently won significant local share at the two largest U.S. home center customers and it continues to grow elsewhere.

These wins include 100% of the pro laser business at the Home Depot with the Stanley CST and FatMax brands. With $15 million in sales in the second quarter and these wins, we expect 2004 sales to exceed $60 million and we expect to exit 2004 at $100 million annualized run rate. Laser is increasingly becoming a profitable growth engine for industrial tools, and we're very pleased with our progress in this area.

Our attempt at garage storage products at retail is expanding to 8 times the number of stores where originally tested. The results are encouraging and, as a consequence, we hope to look forward to an early 2005 rollout of this new line for Stanley.

As we indicated last quarter, we're proceeding with a retail test for Stanley paint sundries -- this would be brushes, rollers, and selected tools -- at 50 retail stores in the U.S. This is a category from which we hope to generate some additional domestic growth.

We also have a number of encouraging wins in the marketplace. Among them, [inaudible] our industrial storage business that want to bid to supply Northrup Gruman with industrial cabinets. Our consumer hardware business, which was just named exclusive category supplier for Builders Hardware at [inaudible] -- meaning added business at 800 new independent hardware stores. A line of family demolition tools being launched at the Home Depot this week, and a new innovative husky tool storage offering scheduled to launch during the third quarter. And, last, but not least, our security business won a contract for 70 all-glass, custom, sliding doors and 12 months related service at O'Hare International Airport in Chicago.

So, we're innovating, we're working with our large retail customers to enhance their offerings [inaudible], and we're bringing exciting real value propositions to the market.

We noted in our last call and at our May 7th analysts conference that we needed a commitment to [inaudible] brand support. That began this quarter with over $4 million incremental spent over the second quarter 2003, and we expect to continue to invest in our brands. The company and its performance are strong and well positioned for the near future. Serving customers well while executing strategic moves are our day-to-day objectives. Momentum is strong, and establishing a winning culture continues to accelerate. The management team and all 15,800 associates are to be complimented for pulling together and continuing to deliver such strong results.

And, now, I'd like to turn it back to our operator, Citina [ph], and take your questions.

Thank you. At this time, I would like to remind everyone, if you'd like to ask a question, press star, 1 on your telephone keypad. Initially, please limit yourself to two questions and one follow-up question. Thank you. We will pause for just a moment to compile the Q&A roster. Our first question comes Sam Dartac of branch in.

Good morning, John. Good morning, Jim. A couple of quick questions if I could. First off, you mentioned the best improved this quarter up 5% and building backlog and mentioning that you feel it very well may be a bit of a growth platform. Talk about the market share situation. Did the market at best participate in have similar growth rates or what are you seeing best from a competitive standpoint would be my first question?

We have seen nothing unusual in the quarter relative to competitive conditions. They're pretty much stable. We have said all along that we thought the EAC market -- the electronic access controL -- was growing 5% to10% and the mechanical was growing 3% to 5%. That's where our growth ended up in the quarter. You could say, well, the electronic was a little bit at the low end of that range, but the orders were higher -- the orders were roughly 8% in the fourth quarter. So, we feel pretty good about our relative growth position and share in that marketplace. I know there may have been some confusion, because I think it was Ingersoll-Rand announced some very strong numbers in their security business, and I believe they were something like total growth up 27% in the EAC segment and their segment growth was up something like 16% for security. Those numbers do include acquisitions, so I think that may have caused some confusion about the market may be taking off or whatever. They did two small EAC acquisitions and also their biometrics products are doing well in the marketplace. Our particular business on the mechanical side is strong and steady, and on the electronics side, the momentum is growing.

Thanks for the complete answer. John, a question for you, you mentioned back at the analysts meeting that you would like to augment advertising spend to bolster the brand. Can you talk about what those trends look like, discretionary spending? In this quarter and beyond?

Yeah, in terms of discretionary spending in the past quarter, I guess we take -- we feel good about the fact that a higher percentage of our SG&A we can provide at a later point precise with what is needed. But a higher percentage of our SG&A, I would classify as business building SG&A, specifically brand building, sales commission. Sales commission related, we fill good about that. But the $4 million I mentioned was pure brand building and that was incremental over prior period. Looking forward, I don't want to be too far ahead of ourselves, but we have committed to a major media thrust in October. I don' want to say more than that other than that we will be on television. It will be in support of our extremely successful FatMax products line, and we've got a lot of recent history and test data that says the brand is going to respond to it. It's a national media program airing in October which is a very important time of year. If you think about it, it's four to six weeks into the football season and begins the run up to Christmas and Thanksgiving and that would be significant. Let me know by specific numbers because we're finalizing our media [inaudible].

Okay, last question before I'll defer to others. Your guaging of retail inventories at this point? Channel inventories?

I'll talk to it briefly and then I might ask Don McIlnay who's on the call. We think they're -- my general overview and I'll ask Don -- we won't talk customer specific, because that would be inappropriate. In general, we see them at 1-1/2 to 2 weeks higher than normal. Nothing out of the ordinary. I'd say across the board, there at 12 to 13 weeks and we think 10 to 11 is more normal. Don, do you want any more perspective to that because you're the key [inaudible] for most of the large customers at retail?

Yeah, I think John's statement is pretty accurate. The inventories are maybe a touch higher than normal, and I think that goes back to what a lot of retailers reported as a less than spectacular father's day. But, we see continued strong POS, so I think we'll be out of that situation and back to normal levels at the end of July. And we're in a position -- most encouraging versus previous years as our fill rates have stayed in the higher levels -- 98+ -- so the confidence is high, our supply capabilities are high, and I see a fairly normal ramp-up period in the third quarter in anticipation of the Christmas holiday.

Our next question comes from Jim lucas with Janney Montgomery Scott.

Thanks. Good morning, guys. Can we switch gears a minute to the Industrial side of the business? Want to look at two of the businesses in particular. Personal [inaudible]. Can you expand a little bit on the strength of [inaudible] a great turnaround but more of the razor or razor blade, what end markets? Speak of the sustainability. That's question 1.

Jim, this isJohn. I love your analogy having worked at Gillette early in my career. It's more the razor blade is the simple answer. Business is good at [inaudible], but we have the guy is responsible for the turnaround on the line, and, Jack, let me turn it to you to address it specifically.

Jim, this is Jack. Things are very good, and I would attribute it to a couple of things. We've got, if you will, our profits in order in [inaudible], as Don mentioned, fill rates. We have improved those dramatically in servicing our customer. More importantly, as I kind of pointed out at the analysts meeting in May, we have a whole breadth of new product lines that we are bringing to market, not only in tools but also in fasteners that are generating a lot of interest. And a lot of people that may have tried some alternate brands over the past four or five years are back to [inaudible]. So, I guess, simply put, we kind of have our act together and we have the new products to generate the enthusiasm in the market,and it is broadbased in industrial, construction, and home center.

Okay. And, then, switching gears to Mac which has been another good turnaround. If you look at -- now that we're back to that 1500 [inaudible] level, recruiting getting better, could you talk a little bit about what you're seeing from profit outlook in the second half fare, as well as can you expand a little bit on the Mac advantage program? Is there anything new happening there that is helping you move this from your balance sheet?

Yeah, I going to direct that one to Jim. But, simply said, this is a business that's dramatically improving. It's been a huge contributor to EPS growth for Stanley. That being said, it's a business that's still performing slightly below our Stanley corporate average and where we want it to perform. But, we just had a good quarterly review with Mac yesterday, so I'd say we're more current than ever; but I'll ask Jim to specifically address your two questions.

Sure.

Well, first of all, the profitability is very much on track to where we're hoping it would be back when we did operation 15. And we did not have grand expectations. We were trying to get to a 10% operating margin in that business, and it still looks like by the end of this year that was part of the overall operation 15 plan. It looks like we have a shot at doing that if all goes well in the back half and, certainly, the trends support that. But, it's tough to tell whether it will be 8%, 9% or bit 10%. It's a bit of a crapshoot. Nonetheless, it's a dramatic turnaround -- business that I think we now consider a welcome part of our portfolio and an opportunity to provide additional earnings growth as we grow the top line and get some operating leverage out of it.

As far as Mac advantage, we are very, very excited and enthusiastic about the change that we're making here in the third quarter. And that will enable us to generate about $50 million to $60 million of cash, of which about $15 million or so will be operating cash and the rest will be financing cash flow.

So that's the CFO's part of it, which I like, but the business folks, what they like about it is this new program takes all the credit risk and puts it on a third party. The third party that knows what they're doing in financing and has a different underwriting criteria than we do and, therefore, is able to price the product differently to the customers. And we think over the medium term, that should allow us to be able to sell more cabinets, and cabinets is where we make a lot of money in Mac. So, the business team is enthusiastic about that and so am I.

If I could just also make one clarification from my remarks, I got corrected by my treasurer who deals with the rating agencies that S&Tdid not take us off credit watch, as I said, but, rather, practically they changed our outlook from negative to stable. So just for clarification, so there's no confusion about that.

One other program on Mac and the program, it will have more competitively priced products, but our distributors spend a significant amount of their time collecting receivables; and, in addition to having a competitively priced product, this is simply going to allow them to spend 100% of their time on seeking new business and servicing their customers. So, asJim said, from the balance sheet, working capital management perspective, competitively priced financing, and how our distributors spend their time, we think this all going to be terrific advantage to the Mac business going forward.

Our next question comes from Margaret Whelan with UBS.

Hello.

Hi, Margaret.

Hi, sorry about that. Good morning. Nice quarter. Jim, first question for you, would you be able to give us -- I know you don't like to give specific guidance to a business group -- but can you give us an idea of the trend that we should expect in the back of the year versus the current, in particular for security solutions?

Yeah, I think what we'll have is growth continuing pretty much -- maybe a bit slower than it has been in the access business, because what's happening in access business is there was a major Wal-Mart upgrade program that was implemented and is being implemented as we speak. But it's sort of winding down. So they'll go, you know, from significantly high double-digit growth down to more normal levels of growth for them, which will probably be in the 5% to 10% range in access. That, I think, will pick up a little bit because the order rates sort of portend that; that'll partially offset that. And the segment growth for access will probably be -- for security solutions -- will probably organically be in the 5% to 10% range in the back half. So, I guess you would say that's a little bit of a slowdown from where it has been, since it's been in double digits for a couple quarters, but nonetheless, we think that's a more normal growth rate for them on an ongoing basis.

And, in terms of the profit margin, around the 15%, 16% or possibly 18%?

Yeah. Let me expand on the profit margin a little bit, because it took us a little while to kind of unweave the story here ourselves. But, we did about an hour ago, and basically what happens sequentially we went roughly from 18 to 16, so about a 220 basis point decline. What happens versus the first quarter is there were about 100 basis points of a negative swing that was driven by a LIFO [ph] adjustment that had to be made because of the higher inflation, and there was an additional 60 basis points of costs that were related to severance in connection with the acquisitions that we just finished.

So, there's an additional 160 basis points of negative effect which should be nonrecurring in nature. And, then, there was also a mix effect of about 50 basis points due to the acquisitions and business mix. And, in addition to that, there were some field productivity issues which cost us about 50 basis points. This is all sequentially. And, about half of the field productivity issues were related to the access business where when they finished that upgrade program I was telling you about, they were doing more rural activities which they were relying on outside distributors to do which had lower margins. That will wind down.

And, then, the other half was what I'll call field execution in the best business, which is a little blip on the radar screen which has caught our attention, and that was the other half of the field productivity. So, net to net, that accounted for about 260 basis points of the deterioration, and then there was about 40 basis points of positive effect where the negative inflation was more than offset by price and productivity.

Okay. So 16% to 17% is the base level? Should be a couple hundred basis points but not so much higher?

If I were predicting next quarter, and I won't do it, but if I were, my guess would be 100 to 150 basis points higher operating margin in that segment.

Our next question comes from [inaudible] from [inaudible] Capital.

I have a question. In general, it's good to get your working capital down, but in a period where your raw materials are rising a lot, and interest rates are really low, why would you take your inventories down as hard as you did?

Simply said, we can't buy the raw materials that we'd like to buy. Virtually, every producer, including us, is on allocation from every major steel producer. We think the fact that we've been a reliable customer over time, we pay our bills on time, etc., works a lot up [ph] to be among the first in the queue; so we don't have to shut down lines as a consequence, Even more important, if our [inaudible] fastening business were to short a customer, their factory would shut down. So we're buying about all that's available for us. It's not really conscious on our part to really cut inventory levels, particularly of raw materials, and certainly finished goods and sale-related products as much as we have, where part of that is simply the market in which we're dealing and we've done a good job in managing an extremely low inventory level to keep our fill rates where they are and not create problems for our major customers.

So, if the availability of raw materials loosens and are more available, is there going be a working capital built?

No. No, we think we've demonstrated that sometimes, I'll call it a crisis, is good We clearly, with the possible exception of [inaudible] where we're working very hard to keep fill rates at the highest level, we've demonstrated across the rest of the businesses with proper procedures. We can, in fact, manage with lower inventory levels. It's been a good learning experience and that is where we'll keep it.

On the financing stuff that you're going to outsource, or you're thinking about outsourcing, do you make money on that currently and will ther be lesser income when all is said and done?

No. It'll be quite the opposite. We've lost money for years on this activity, so we're looking forward to outboarding [ph] it for that purpose as well.

Our next question comes from Eric Bosshard with Midwest Research.

A couple questions. First of all, in terms of pricing, it sounds like in the first half you were able to get through some price to deal with higher material costs and now we've got the second leg on steel prices. Will you put in place incremental pricing in the second half and how much of that is assumed successful in the guidance you're giving?

The vast majority of our price that we talked about has been agreed to by customers. There has been some delay in realizing that because of the dates of the implementation. The new inflation that has spiked in the last few weeks, which is the different -- frankly, the April inflation that we were looking at would have been -- if we had done this call three weeks ago, we would have stuck with our number. But it's only been in the last three weeks or so that we've seen another kind of inflation around the edges. You know, the steel scrap prices have gone up, and so forth. So, you know, we have some concerns, but the price recovery is in pretty good shape on the first wave, if you will, and then we haven't really begun to pursue the second wave. What it really is doing is cementing in the price increases and solidifying them so that the customers are not really in a position at this point to come back and say, "Well, the prices are going down, so you need to give it back." And I think it kind of cements that aspect of it. But, we'll have to see where this trend goes from an inflationary point of view. If it gets much worse, we will definitely be back in the marketplace with another round.

Simply said, you know, our previous guidance on all our forecasts -- Jim talked about 70 to 80 annual inflation, 50 to 60 covered. Our assumption on what's uncovered in the second half of the year is still in the $10 million to $15 million range, because some of the pricing that we announced in the second quarter we're only now realizing. That's good. It'll be hard to go back and get more, but our unrecovered second half -- maybe it's gone from 10 to 15 without any further pricing action.

At this point in time, you're not planning a second wave of price increases until you see what happens with steel over the next month or?

That's true. Plans change every day, and we won't talk about where Mssrs. McIlnay and Garlock have been spending the last week or two of their time, but quite frankly, we're working real hard to cement the price increases that we announced two and three months ago. We need to get those 100% on board before we start thinking about or talking about the next one. If this material inflation stays where it is, we have every right to go back to the customers and look and ask for more. But it's not imbedded in our guidance, which I think is your question.

Yes . That answers it.

Our next question comes from Ivy Zelman with CSFB.

Good morning, guys.

Good morning, Ivy.

With respect to your comments opening up, John, you mention that the quarter's been good and continues to be good, can you help us a little bit with respect to progression of the quarter by segment? I know that we had heard in some of the other companies that June was a little bit weaker in the consumer area with respect to orders and how it compared to March for you and how July is -- in consumer and then maybe in industrial?

Generally, I'll just say June for us finished very strongly in terms of shipments.

How about orders, John? Can we stick to orders?

Orders finished very strongly as well, if you want to stick to orders. IB [ph] is as good as we've seen in a long time. We're only three weeks into July and we're very encouraged with IB [ph] across both consumer and Industrial.

Okay, and that would be no change sequentially then from March, April, May?

I would say minimal to no change from March, April, May for IB [ph] on both consumer and Industrial.

Okay . And, to reiterate, that goes into July as well?

Within three weeks in July.

Next question comes from Steve Hawkins with Lehman Brothers.

Hi. Two quick questions; one is a clarification. Jim, did you say the security solutions improvement margins of 150 basis points, is that sequential or year-over-year?

Sequential.

Okay. Thanks. And then, secondly, back at the analysts meeting in May when you guys talked about rolling out new compensation programs for senior management, I think you had talked about maybe from thinking about a longer term perspective, including some metrics or returns on capital or equity. Have you thought any more about that?

Yeah, we've thought a lot about it, and it will take place. First of all, Gerry spent a lot of time correcting a kind of a general misunderstanding that management had the license or the ability to make value-destroying acquisitions that would increase EPS. First of all, our Board would not let us to it. Secondly, no current year acquisitions that contribute to current year short-term management incentive compensation. That being said, the longer-term compensation plans are still under evaluation by our Board, but it would be consistent with past practices, recognizing what you said places a tremendous emphasis -- in fact, the overwhelming majority of the emphasis -- on return on capital employed. If nothing else, the other element of shareholder return. But, if nothing else, it would guarantee that the short- and long-term impact for future acquisitions balance one another. But, in either case, short of that program, there is still no opportunity for management to be incented by any acquisition that would destroy shareholder value.

Well, that's certainly good to hear, although it is fair to say that the if the acquisition you did this year is not included for how you're compensated this year, it certainly will flow through for next year. And, if you are making acquisitions of higher margin businesses, that should issued inherently bring up the EPS structure over time. Does the Boards set in higher hurdle levels over time based on the change in mix of the portfolio at all?

Of course, it does . And we, twice a year at a very formal level, we review what that should be in absolute terms and relative to our peer group.

Your next question comes from Michael [inaudible] with J.P. Morgan.

Hi. Good morning . Just a couple of questions if I may on what you guys are looking at in terms of sustainable margins in a couple of your businesses. You talked about some of the changes in security solutions and what we could expect in the third quarter. Are you still looking at roughly an 18%, 8/20% operating margin from that business in 2005? Or how are we to think about that?

You're talking about security?

Yes.

That's how you would think about it. I would say between a 15% and 20% operating margin is the goal for that business and then a 5% to 10% revenue growth rate. Mechanically, and then whatever we acquire on top of that.

In the 15% to 20%, in terms of that range, would it be more than mix that would drive that or what would be the, you know -- since right now, you're still kind of in the middle of that range. Do you expect to still stay in the middle or what would help you move towards the higher end?

The only reason we have -- it's not that wide a range from what we're talking about here -- the only reason have a range is -- this quarter's a great example. We had 100 basis points of fluctuation due to items that were just sort of one time in nature -- unusual, if you will. Who can predict that in any one quarter? On an ongoing basis, we look at the market and we look at the industry, the competitive dynamics, the amount of value created, the value proposition to the customer, etc., and we conclude that this is a 15% to 20% operating margin business and we've proven -- thus far, anyways -- for the past years, we've been able to run it as such. We don't see anything dramatically changing in the near to intermediate term relative to the competitive dynames. So, I think that's the basis for our view there.

Okay. And, secondly, on the Industrial tools side -- you obviously had a very nice year-over-year improvement and it looks like profitability in that area is starting to improve sustainably. Where do see that going next year in terms of a achievable margin?

I think it was the last call when I was asked that question, and I said I would be happy if it got to 12%. I would still be happy if it got to, let's say, around 12%, 13% on a sustainable basis. We're in a very nice area right now for industrial companies, and that industrial segment operates like an Industrial company. I said, you know, the security business, when we look at the attributes of that business, we conclude it's a 15% to 20% business. When we look at the industrial business, we kind of conclude it's a 12% to 13% business -- should be, given the competitive dynamics, the growth in the industry, all of the different factors that ultimately determine what the economics are for a segment. And I think that's probably more realistic that we'd be in the 12% to 30% range on an ongoing basis.

I think it's important on the industrial side to take note of the fact that the overwhelming, or a large piece of our year-on-year improvement is taking break-even businesses, specifically Proto and Mac, and returning them to high single- or low double-digit kinds of returns. We absolutely think we can maintain them at that level, but going forward, we're not going to get the double-digit lift on businesses. Those two businesses together account for 30+% of our Industrial segment. So we won't have that in terms of year-over-year comps when we're having this conversation one year from now.

Once again, in order to ask a question, please press star, 1 on your telephone keypad. Please limit yourself to two questions. Next question comes from Eric Bosshard with Midwest Research.

My second question now, in terms of free cash flow and inventories, the two pieces of the question -- first of all, can you give us some more color on where inventory improvement is coming from and if you had slowed plans down to accomplish that? Secondly, with the amount of free cash flow that you're going to be generating, talk about the use of that and when you think the organization will be on its feet again to bring on board another acquisition?

Well, the inventory improvement which is about $70 million year-over-year is pretty much across the board. You know, it's not isolated in any one area, which is good news. There's a number of good reasons behind that. One of them is certainly the availability of raw materials. But, there's also the Stanley fulfillment system which which Paul Isabella talked about at length at the analysts conference. And that has a lot of substance to it and it's taking root. That's a big factor in the inventory reduction. Another factor is that the compensation plan actually rewards folks for improvements in working capital terms. And, so, management is incentivized to be more efficient with working capital, and I think that may be one factor why the working factor has improved across the board. And, certainly, inventory has been the biggest driver of the improvement.

Should we see inventory levels flat down at the end of the year? Do you have a sense of what we should expect for inventories in the second half?

In the guidance or in the outlook for cash flow, we pretty much assume flat to maybe $10 million to $20 million improvement, but nothing more.

Okay. And, then, in terms of the use of free cash flow from this point, especially as it relates to acquisitions?

I think, first and foremost, is getting the securities issued, or lack thereof, behind us, Eric. It's something that is pretty important to all of us. We absolutely feel that we'lll be in a position to make some acquisitions. You know where they'll be. I would say early in the first quarter of next year. I think I said in my comments, and I meant it, we've got a good pipeline and we think we'll be organizationally in a position to on-board some new acquisitions about a year from the last one -- specifically, be active in the fourth quarter with the objective of on-boarding them early in the new year.

And, also, just for expectation setting, I would not be surprised if some of those acquisitions were more oriented towards the tool business, not to say we've departed from security because we are clearly on a track to grow the security business. But, as we look around, in the tool industry the consolidation forces seem to be picking up, the power tool activity in particular, and I'm not saying we're out looking at power tools in a serious way; but we are definitely looking at additional acquisitions like our CST Berger or perhaps more in the core of our hand tools business and mechanics tools businesses. So, we recently saw what Black and Decker did with the Pent-Air tools group and that made perfect sense for them; it made no sense for us. And it's quite possible we may find something, maybe not as big, but certainly of a similar ilk in the sense that it's in the core and provides a lot of good strategic benefits.

Your next question comes from the [inaudible] with Smith Barney.

Actually it's Steve Kemp from Smith Barney. Following up on that if I could, Jim, with respect to evaluating potential acquisition candidates in the tool categories versus the security business, how you the dynamics of that would be, you know, quite different between the two categories and the candidates you might be looking at. Can you give us a sense for what kind of things or different hurdle rates you might be setting in different metrics that would sort of tilt you toward an acquisition in one category or the other? For example, would you be, perhaps, having a higher threshold on, first, one- to two-year returns in a tools acquisition versus security or something of that nature?

I guess the answer is of course, because we know the tool business so well, we'd absolutely have it tested and [inaudible] an on-boarding model in the tool business. I think you're right on to say that. It also gives us a far higher degree of confidence -- and don't think exclusively North America. But our ability to get the synergies quickly, both primarily on the SG&A and operating cost side in the tools business, and as a consequence, our hurdle rates would reflect that because the businesses would probably be -- most likely be -- lower growth going forward. So, I think that's a very fair assumption.

You clearly see the differences in prices, say, between tool assets and security assets. And that, to some extent. is one of reasons we would look at the tools more seriously is because the price is right in tools. And, in security, while we haven't had any difficulty finding assets at appropriate prices given the growth profile and economics, if the market goes in the direction of even loftier prices for security companies -- and we've seen a few transactions recently that have opened our eyes a little bit in terms of what prices could rise to -- that would make the tool acquisition on a relative basis even that much more attractive to us.

Great. And, as a followup, with respect to your security business, you've demonstrated that you have enough momentum in the current portfolio with what businesses you have in that segment to grow at a pretty healthy rate with good return, but I guess there is always going to be the expectation, at least in the last year or so, that you're going aggressively grow that business, and it sort of seemed like the Blick and Frisco Bay acquisitions specifically seem to be sort of a first step on the long path in that business. If we saw that business see its acquisition trajectory slow relative to maybe what we saw six months ago, would there be any changes necessary in the way you manage your current portfolio of businesses? I guess what I'm asking is would Frisco Bay and Blick be able to continue to grow organically without sort of a new company coming in that could help them leverage and find new synergy?

That's a simple answer -- Absolutely! Blick is doing well as a stand-alone business and we're delighted with the growth of Frisco Bay and the opportunity that we see to get both geographic and technological synergies at Frisco Bay. Within our $650 to $750 million annualized securities solution businesses, it is not a small business now. The opportunity for -- I'll call it -- if intra-business synergies exist, we're realizing them, and so I guess the simple answer to your question is we do not need a new acquisition to continue to grow the recent -- I'll call them bolt-ons, or add-ons -- at or above the planned rate.

Your final question comes from Ivy Zelman with CSFB.

Guys, I got cut off. Can give us an update on SEC investigation or formal investigation, please?

There's really nothing new to report, Ivy.

No news is good news, Ivy. But, as you know probably better than we, we're not expecting a call from them to say everything is fine. But there has been absolutely no more contact or dialogue since we spoke three months ago. And when I say absolutely none, I mean 0.

When they came to you three months ago, were they requesting documentation?

They've been given what they asked for. The answer is no.

Okay. Thank you.

At this time, there are no further questions. Will there be any closing remarks?

I think not. I thank everyone for their participation on the call and their interest. We are delighted with the quarter behind us. We are cautiously optimistic about the quarter facing us and we encourage you to watch this space.

Thank you. This now concludes today's Stanley Works second quarter earnings conference call.