史丹利百得 (SWK) 2005 Q3 法說會逐字稿

At this time, I would like to welcome everyone to the third quarter results conference call. [OPERATOR INSTRUCTIONS] Thank you. Mr. Gould, you may begin your conference.

Thank you, good afternoon, everybody. On the call with me this afternoon are John Lundgren, our Chairman and CEO; and Jim Loree, our Executive VP and CFO. We have two press releases out there that we issued. Our earnings and guidance release and we declared a fourth quarter dividend. Those press releases are out on our website, StanleyWorks.com and they will be mentioned at various points on the call. Secondly, again this quarter, Jim and John will go over a PowerPoint presentation similar to what we did a quarter ago. It's up on our website, it's at StanleyWorks.com in the Investor Relations section so you can follow along and 10 about minutes ago, we put a PDF version up there in case you want to print it easily. So Jim and John will review the matters in the releases and then we will have a Q&A period that will follow. According to Reg FG as we usually do we will give earnings guidance today at the outset of the quarter, consistent with today's release and we won't comment on it thereafter except at tomorrow's analyst conference. And if business conditions were to change materially, we would issue a pre-release.

The call should last about an hour. There will be a replay available two hours after the call through the end of the day Saturday at midnight. The replay is 800-642-1687 and for that purpose the code is 1223471. Thereafter it will be on our website and you can call me with any questions. One reminder, then we will get started. Certain statements contained in this discussion by the various Stanley participants are forward-looking statements. As such, they involve risk. Actual results may differ materially from those expected or implied so we direct you to the cautionary statements in Form 8-K which we filed with today's press release. With that, I'd like to turn the call over to John Lundgren.

Thanks, Gerry. As you know, this morning we released our third quarter earnings, $0.90 a share, quite consistent with our pre-released October 4, guidance -- October 14, pre-release guidance and significantly above our guidance that we've given on our second quarter call. The strong performance was driven primarily by tremendous revenue growth, 12% across the Company and 7% of that of which was organic. 5% via acquisitions.

As you'll see from the chart -- the graphic aid that we have, volume was up 5%. We got a percent from price and a percent from currency, leading to the 7% organic. Business was good in all three segments, better in consumer and security than industrial and we will dive into those a little bit. Consumer with 15% growth, all organic. Industrial tools up 3%, of which two-thirds was organic. And security showed 4% organic growth, 26% total revenue growth on the strength of ISR security group and other recent acquisitions. So 12% total, 7% organic revenue growth in the first quarter, a really good performance by our historical standards.

As previously stated, earnings from continuous operations were well above our July guidance, consistent with our October 14, pre-release, which is why we pre-released, of course, at $0.90 a share an increase of 25% over the same period year-ago. Operating margins increased to 14.8%, among our better performances ever. Tax rate at 25%. You will see in a later slide that contributed $0.04 to earnings relative to our prior year tax rate of 29%. But a good performance from a margin perspective as well as EPS.

Looking at revenues and highlighting the various segments, our consumer business was driven by extremely strong performance in U.S. hand tools and storage, which were up over 10%, all organic. Our European tools business and our hardware businesses were flat. European tools really was the tale of two geographies. Our U.K. business was relatively soft, offset by reasonable gains on the continent, so, all-in, a flat performance in Europe. Hardware flat, in a difficult market, but nonetheless a good margin performer.

There were some issues in it our industrial business, I will come on to that in terms of margins, but our assembly technology business focused on the automotive industry, was weak. Mac was weak. Offset by our CST/Berger and Stanley laser measuring business, extremely strong. Professional mechanics tools, hydraulics tools, and our Vidmar storage business all had terrific quarters. And in security, we're very, very pleased, a little later on in this presentation Jim is going to take a deeper dive into security, revisit where we've been and where we're going, but the Americas were up 7% with our mechanical business and electronic access both strong. Automatic doors our access strong. And Europe relatively weak. That again, the overwhelming majority, 80%-plus of our European security business is in the U.K. and we're experiencing difficulties in softness across the board in that specific geography.

Operating margin, as I said, up 19% to $125 million or 14.8%, 90 basis points. We really saw the advantage of our leverage of the increased volume. SG&A, excluding acquisitions, was flat. So flat SG&A, which included a lot of incremental brand support within the total SG&A being flat, really, really produced some leverage at the margin level, contributing to the strong performance. The EPS, just to get a little more granular, you see it $0.72, up $0.18. Roughly operating income or pretax earnings contributed $0.16. It did include $0.02 of restructuring, which had been in our guidance and was -- did take place in the quarter.

Tax settlement and repatriatation were two large numbers, but were coincidentally almost perfect offsets, both worth about $0.15 and those are detailed in our release. They were expected, they were anticipated in our guidance. We were within $0.01 of what each of those would be. And they were offsets in the quarter. And as I said previously, tax rate did contribute $0.04 of the $0.18 improvement year-on-year. Cash flow of 58 million was a little bit less than prior year. We weren't terribly disappointed with that cash flow and as Jim will touch on, our cash flow projection for the year remains intact at about 300 million. Timing of tax payments had some influence and working capital needs, specifically receivables, due to a very strong quarter in general and a strong September in particular.

Looking by segment, there's not a lot to comment on in consumer other than it was just a record quarter from all perspectives. Revenues up 15%, as I said. Operating income up 37%. Operating margin, 19.3%, which we believe, with looking at whatever history we can find, is the best performance of that segment in Stanley's history. As I said, U.S. hand tools, mechanics tools, and ZAG, our consumer storage business, all showing volume strength across all channels. Europe, weaker than the U.S. Hardware, flat, as I previously mentioned.

In March, we talked about the fact during July that we had a lot going on in terms of summer rollout programs. They've provided a really strong start to the second half of '05. We're on the air, as some of you may have seen with brand support behind consumer fastening introduction. Great garage door offering, we're rolling out to the home centers and just a lot of tremendous momentum behind our consumer business as we enter the fourth quarter and exit the year.

I also mentioned earlier, advertising support continues to stimulate end user demand. While SG&A in total is flat, we've upgraded the mix within our SG&A more and more that's going to brand support and less and less to admin. So we're getting a nice lift from that support.

Looking at industrial tools is probably where, I think the only even remote cloud on the horizon, as it relates to our third quarter results. We had great revenue growth as industrial does enter the late part of the cycle -- or reasonable revenue growth at 3%, but operating income was down 12% versus same quarter year ago. Margins were down 150 basis points. And what was driving -- there was some tremendous strength within our industrial segments, specifically hydraulics, driven a lot by steel prices, was up significantly. Our professional mechanics tools business, Proto and, again, Vidmar, as I mentioned. Laser leveling and measuring couldn't be a better story from Stanley's perspective. That's an acquisition that we've had on board slightly more than 18 months now. It was a $50 million business when we bought it. It's at $100 million run rate with sales of 25 million in the third quarter.

Europe, in this particular case, is strong. We've leveraged the Stanley brand, we've expanded our geography while maintaining operating margins in excess of 20%. We're very excited about the future of our laser leveling and measuring business and it had another strong quarter.

Fastening, our Bostitch business, experienced unfavorable mix as well as inflation. That business, as you know, is about two-thirds to three-quarters fasteners and the remainder tools. Margin was down about $5 million versus the third quarter of '04. The mix impact of that was more kit business and less pure differentiated fasteners and professional tools. So negative mix and a tremendous amount of steel inflation led to $5 million decline in operating margins based on same period year-ago, despite a reasonable top line.

Mac tools was struggling, sales were down 10% in the quarter. Operating margin was at 4%. I'll remind you that this is a pure distribution business with not a lot of capital -- working capital or fixed assets. That being said, that's a low -- relatively low performance for Mac tools. Significantly improved versus a couple of years ago, but below where it's been the last couple of quarters. Our distributor count was down despite some good recruiting. As fuel costs have had a tremendous impact on these independent franchisees, raising the bar in terms of what they need to break even. And there were some negative impacts from the hurricane in the southeast.

Moving on to security, another good quarter for the second consecutive quarter, specifically revenues up 26%, of which 4% was organic, as previously mentioned. Operating income up 32%, margin up 80 basis points. Some of the highlights for security, again, is the sequential growth and Jim's going to spend more time in just a minute but after our disappointing 13% margin in the first quarter, we predicted and forecast and felt we had the programs in place to deliver consistent 15% or better operating margins for the rest of the year. We delivered 15.6 in the second quarter and now 17.9 in the third quarter with a lot of things going right. We felt very good about that performance, leverage in our field operations initiatives, as well as a good business mix.

Organic sales in the Americas were up 7%. High margin mechanical access and automatic doors were up single digit percentages. Electronic access, which is higher growth, but slightly lower margin was up double digits. And as I mentioned previously, Europe was down a little bit with the majority of our European business being in the U.K. We're expecting 3 to 5% organic growth in the fourth quarter going forward with margins in the 15% range. There is some seasonality in our security business in the fourth quarter. Based on historical precedent, particularly within the access business that focuses on retail, where we have less availability on the sites, to get at the installations, but we're still looking for continuation of the dramatically improved performance in security.

And finally, we've gained some great new business in access, both in control and integrations. Wins at TJX, Toyota, some government wins, particularly in prestigious accounts that we've actually press released, not the least of which was NASA, where we've gained perimeter control and access control for three of their -- for three of their major facilities. Looking at security, I'm going to turn it over to Jim, who's going to take us back to our first quarter call and and move on from there. Okay.

Thank you, John. What you have in this chart in front of you right now is a chart that Chris Epple, our CFO of the Security Solutions Business, reviewed at our May 6, analyst meeting. And at the time, you will recall we had just concluded our first quarter and announced results with a 13% operating margin in security and there was a lot of skepticism about whether the margins in security would ever get back to the 15 to 20% range and what the path to get there might be, if it was feasible. There was skepticism externally, there was not much internally because we had a very clear road map to do that and we shared, Chris shared that with the analyst community in May.

And you can see on this page what he demonstrated in terms of -- outlined in terms of the profit improvement drivers and SG&A reduction, some leverage on organic growth, which up to that point had been elusive in that segment. Improving the profit -- profitability of the electronic access business, finishing the integration of a few acquisitions that had been undertaken that had ultimately good margins, but in the beginning a bit lower margins than line average. And centralizing the field ops, all of which would yield about a 17% operating margin after a 1-point hedge, it was believed at the time. And that's what he put out there.

If you flip to the next page for me, what you see there is the actual performance that we've had since then. And in the second quarter, we had modestly better margins than we expected and then we had significantly better margins than we predicted in the third quarter, that we had predicted for the second half of the year. 18%. Obviously a very solid performance. The main cause for this outperformance of the estimate is that the profit improvement initiatives that we had discussed during that meeting and subsequently, are ahead of schedule. We have about 30 to $50 million of annual profit improvement, projects under way that business, some of which I've outlined a minute ago. And the team is doing a great job executing those. They're really working diligently on building out their customer value proposition in the field that will deliver that 24 by 7 service to our national customers and are putting in -- unifying the business processes of their various acquisitions that they've made over the past few years. So we're in really good shape in the security business and really on where we thought we would be in the beginning of '07.

Now, having said that, for the fourth quarter we would expect to see some sequential decline in the margin, not dramatic, but it could be a point or two of sequential decline because that's what normally happens in the security business in the fourth quarter, if you follow the history. So 16-ish kind of operating margins would not be a surprise to me. That's more or less what's factored into the guidance that you will get in a minute here. But in any event, security is back, organic growth and margin performance.

Moving on to cash flow for the year, the cash came in at 58 million, the free cash flow, which is down 26 million versus the same quarter a year ago. 16 of the 26 relates to a timing of tax payments and then the rest of it is predominantly associated with the working capital that John mentioned related to primarily receivables. Overall, the working capital turns improved from the third quarter a year ago from 4.2 to 4.3. Our core sales excluding acquisitions were up 53 million with that solid sales growth that we talked about and in the month of September alone they were up 12% organically. So that was what drove the higher-than-normal receivables. We're highly confident that we will get those receivables liquidated in the fourth quarter and that we will be tracking to our $300 million estimate for cash flow for the year.

Turning now to the guidance -- this was provided in the press release. Let's start with sales -- organic sales growth. We're looking for organic sales growth of 1 to 2% in the fourth quarter and some would say that, at first blush, appears to be conservative or underwhelming, but I would say that if you think about it, last year we were up 7% organically in the fourth quarter and that was against a 14-week quarter during the prior year, so the real net of that kind of a performance is -- would have been equivalent to being up like 12% versus the prior year, so, we do have a very difficult comp. We do have good momentum at the same time, but it's prudent to assume that we will be in the kind of 1 to 2% organic growth range. Acquisitions will add about 4 points and that will give us total growth of about 5 to 6%.

Operating earnings per share before any restructuring of $0.85 to $0.87, $0.01 or so before restructuring will give us a net -- or a GAAP earnings per share of $0.84 to $0.86. That would be 8 to 11% growth for the fourth quarter. Which would, in fact, end a great year for us, up 16% with $3.30 to $3.32. Kind of the range that we've narrowed into here for the -- for '05. And that would be on 4 to 6% organic growth, very consistent with our long term objectives and 8 to 10% overall growth with 300 million of cash flow.

We'll be talking a bit more tomorrow at our analyst meeting in New York City about two exciting acquisitions that we have announced in the recent months. The Facom tool company, the French acquisition, and National Hardware. Both of which we have announced accretion, which sums to $0.11 a share in '06, $0.45 a share in '07. $0.75 a share in '08. If integrated successfully, these acquisitions will drive significant earnings power for the Company over the next few years, as you can see by the numbers and so there's a lot of focus right now on integrating those acquisitions successfully. First we have to get them closed. A few regulatory hurdles to get through on both of those yet, but we're hoping for year-end-type closes in terms of timing.

So we thought it would be helpful to just spend -- as opposed to doing it at our analyst meeting tomorrow, to spend a few minutes helping with the modeling aspect of what we're -- what our year might look like because it's a little complicated next year with the two acquisitions coming on board and you have no experience or very little experience with Facom or National in terms of what their revenue splits or other performance might look like so we thought we would provide a little color in it that area based on what we know. So let's start with the organic growth. We think that will be about 4 to 6% for the year and from a quarterly perspective, a little bit front-end loaded, which is a good thing, as the comps in the back half of the year do -- are tougher in general. And then Facom with about $450 million U.S. revenue at an exchange rate of about 1.2, we -- the way their seasonality works, the first quarter would be about 27% of their total year, then second would be 25, third 22, with the August as a pretty quiet month over there for the French tool company. And then 26% in the fourth quarter.

National has a little bit more even split, $185 million in total revenue. 24% in the first. 25 -- or excuse me, 27 in the second. 25 in the third and 24% in the fourth. And then in our guidance and we do provide acquisitions in our guidance, about half of those acquisitions are just carryover from -- they're already completed acquisitions. The other 50 million or so would be new acquisitions and it's difficult to really say exactly when they will come, so, we just evenly split those across the year. But if we close all of those transactions successfully, which we believe we will, the total revenue growth for the year would be about 26 or 27%.

Now, moving on to the next page, this gives us a -- layering in these acquisitions and this growth, gives us a very attractive profile as we go forward over the next few years. The key assumptions here, again, 3 to 4% organic growth throughout the period. Facom and National closed January 1, of '06, 100 million a year of security acquisitions. No repurchase assumed in these numbers, but certainly possible when we have this kind of an earnings outlook and we don't have the kind of stock price appreciation that we would expect to go with that, it's possible that we could do a share repurchase. We have about an 8 million share authorization outstanding and we don't assume any major security acquisitions, although it is possible along the way if the right one at the right price were to appear, we could potentially pursue that.

What that gives you is revenues next year of about 4.2 billion. Significant growth from the 3.3 that we expect this year and over time, over the succeeding two years, starting to work our way up to $5 a share of earnings. A pretty exciting outlook for us and our shareholders.

So with that, I just will spend another minute or so on a little bit more detail on 2006, because, again, it is relatively -- there are some moving parts here and relatively complicated. So let's start with our earnings per share estimate. If we just assumed that our earnings per share -- our tax rate was constant in '06 and we assume that there was no stock option expense, we would be looking at EPS in the range of 3.65 to 3.70. However, this year we've enjoyed several tax benefits, which generally have been summarily dismissed by the investment community, and as we kind of look forward, the tax rate looks to be about 28 to 29%. And so we have to subtract the dilution associated with that higher tax rate in order to get to a reasonable forecast for the succeeding year. And so that will give us a -- about a $0.14 to $0.18 drag on earnings and nets us earnings per share of $3.47 to $3.56 before any acquisitions or stock option expense.

In order to account for the acquisitions, we have $0.10 from Facom, $0.01 from National and the additional 100 million, about half of which is carryovers, $0.03, so, that would be $0.14 of total accretion but all of that is after a $0.30 inventory charge and if the acquisitions are closed -- and this is a noncash inventory charge -- and if the acquisitions are closed in the -- as assumed here, on January 1, most of that inventory charge would be incurred in the first quarter, it would be realized in the first quarter. Some would spill over to the second quarter but by the middle of the second quarter, the inventory charge would be done and in the run rate of earnings, you would expect to see the gross accretion from those acquisitions, which is $0.44 before the charge. And you'd expect to see one quarter of that in the run rate -- in the third and fourth quarters. So if you kind of add the $0.14 back to the 3.47 to 3.56 you get 3.61 to 3.70, and then we expect stock option expense to be about $0.06 a share and that will begin to be recorded in the first quarter of next year and the net of all of that gives us a preliminary outlook of 3.55 to 3.64.

One other point I'll make on the Facom accretion, that $0.10 accretion derives in the first year only, derives primarily from tax-related items. So even though we have a higher core tax rate of 28 to 29%. If you're putting the Facom accretion into a model, I would suggest that you put most of it in to lower the tax rate and run that to a bit lower tax rate than 28 to 29%.

So the last point I will make about this slide is that -- and I've already made it to some extent, but I will reiterate it, that an investor who is following the Company closely should be able to see, in the run rate, partially by the second quarter and fully by the third quarter, significant accretion, more along the lines of $0.44 annualized in the third and fourth quarters. So, it should be -- should not be a long wait before you see the benefits of these acquisitions, assuming that we get them closed in the beginning of the year. So I hope that's helpful. It really was intended to be helpful for those of you that are trying to model the Company. Because as I said, several times it's a bit complicated this year. But hat should simplify it for everybody and hopefully be helpful for you. Now, I will turn it back over to John.

Thanks, Jim. Just a couple of other -- I will say third quarter highlights, some of which we've touched on, before we open it to up to the Q&A. Obviously announced in July was our offer to acquire Facom from [Fammalek] for $500 million. We will update a little bit more on that tomorrow, but that's proceeding towards closing, as Jim suggested. We're targeting -- we're targeting the first of the year and at this stage, there is no reason to change that target.

Also, the more-recently announced agreement to acquire National Hardware for 170 million, again, we have both -- the normal government hurdles, we don't anticipate any difficulties and we're targeting that towards early in the year, closing as well. Successful launch of new products and category offerings in consumer tools has just been a terrific story and hopefully the majority of folks on this call will be able to participate in some of our meeting tomorrow that we're going to feature some of those items. We closed two small security deals, ABZ, European Laser, and Pinnacle, a U.S. integrator. And finally, Tim Jones, who comes out of the -- basically the OEM business for automotive has replaced Dennis Bishop. Dennis was our long-serving President of Hydraulics Tools, retired in the second quarter and this was an opportunity to bring a bright, young talent on board to manage security and we're pleased to have Tim as a new senior member of the Stanley management team. With that, we will turn it back and we will it up for questions.

[OPERATOR INSTRUCTIONS] Your first question comes from Ivy Zelman, CSFB.

Hi, guys, you there?

Hi, Ivy.

Good afternoon. Great quarter.

Thank you.

I'm trying to understand your outlook a little bit better. Realizing that you're giving 1 to 2% organic growth, it just looks like a significant deceleration. You indicated some of it is seasonality. Your comp, you also said was a tough comp, but you actually had a pretty tough comp this quarter. Are you seeing any changes in consumer, specifically, with respect to orders that might lead you to believe that the current double-digit pace is not sustainable? And also realizing you had a big new product rollout, John, that you talked about, if you can at all help us break out what in the quarter -- in consumer, was new product versus existing product in terms of that strong 15% organic growth, that would be helpful. That's my first question and I do have others.

I think that was more than one, Ivy, but we're going to try to take it one at a -- we're going to try to take it one at a time. I'm going to let -- the issue on the outlook then I'm going to turn it over to Jim, it's in industrial as much as consumer, but Jim can talk to it.

Yes, well, I think when you look -- let's just take it segment by segment. 15%, growth is -- that's a pretty healthy quarter for consumer. I wouldn't want to forecast that kind of a quarter every quarter but -- actually, I'd love to be able to do it, but I wouldn't responsibly be able to do it. It was a great quarter for consumer. There were a series of product rollouts that will be discussed and demonstrated in more detail tomorrow and thus far, point of sale has been strong, so that is an encouraging factor, but there is some load-in in that kind of a number, as you might expect. And I would say we did have a bit more third quarter activity that the customers were looking for the product a bit early and maybe requested the product earlier than we had anticipated in our outlook and some of that came from the fourth quarter. So consumer, it would be far more prudent to assume that that might be in the more normal quarter for consumer in the fourth quarter, even though there's a tough comp.

Jim, let me just interject, and we normally don't look at our numbers this way, but it's quite clear if you add them up. This is a market growing at 3.5% and we're up about 7 year to date, which is obviously healthy. But we are looking at the tough comp and as I say, we've arguably pulled a little fourth quarter business ahead unintentionally in the third quarter. Jim's point and there is some pipeline associated with 182 new products, the majority of which rolled out this summer.

And we will probably get, a 3 to 5% organic growth out of security in the fourth quarter and then the wildcard will be industrial. We're a bit gun shy with Mac and fastening right now in particular and assembly and so we're not -- we're not -- we do believe we're kind of late cycle. We see a couple of other indicators, such as our hydraulics business, which is a very cyclical business, with a declining backlog, even though it's been incredibly strong orders -- I mean incredibly strong revenues and the orders have been strong, as well, but have weakened recently. So for industrial, we're looking more for a flattish kind of -- flat to maybe up a point type of performance as opposed to where they were this quarter. So the blend of all of that will come out to I think within the kind of guidance level I was giving you, maybe a point or two above it. There could be a point or two of conservativism on top of all of that.

Jim, with respect to consumer, obviously the margin was a phenomenal performance. When we're modeling forward I would imagine you don't think that 19% is sustainable or do you? What would you expect that we should use on a more normalized basis?

Well, 19 seems high, but it's a great business. I think it's a -- it's probably in the 17 to 19% kind of a range for the foreseeable future.

And that would include the fourth quarter?

Well, actually the fourth quarter in general, for all the segments, if you look at the history, will come down a bit. And that's because the vacations and the inefficiencies that are associated with the holidays and a manufacturing company typically bring the gross margins down a tad. So I would say if you were looking at the fourth quarter overall, which we have -- in our guidance we brought the gross margins down probably 0.5 a point from the third quarter sequentially, which is just a seasonal downtick, so you might want to factor that in, as well.

The only other point I'd add on consumer, we have got a lot of brand support driving this phenomenal growth. Accounting regulations require us to report the spending in the quarter in which it's incurred. So we've had tremendous third quarter sell-in. Those of you who have been watching television the last month or so, is in the fourth quarter, we've got tremendous brand support going on in October and for the rest of the fourth quarter. And while it will continue to drive volume that will have a margin impact because we're -- we are not allowed to spread or allocate mass media across the year. We absolutely have to take the charge in the quarter that it occurs.

Your next question comes from Margaret Whelan, UBS.

Hi, guys.

Hi, Margaret.

Good afternoon.

Good afternoon. I look forward to seeing you all tomorrow. I just want to hit on the security business. I didn't really understand, I guess, where the sales growth came from on the margin expansion. I know that it's improved sequentially, but can you tell us exactly what was driving it? Was it just the incremental sales that drove the incremental margin? Or more efficiencies? Or where was that coming from? And then the second question I have pertains to security. Again, you say you don't expect major acquisitions there in '06 I'm just trying to reconcile that with the fact that you wanted to get it to half your business.

Yes, we will talk at length about the second part of your question, both John and I will talk about that tomorrow when we see you, so I suggest we perhaps would be best to leave it -- leave that particular one until then. But let's take your -- your first one. The strength in security sales was in North America, very much broadly based. It was particularly strong in the electronics segment, which was up in double digits, via electronic access. So we feel like we are either going with the market there, possibly even gaining a little share. The automatic door business and the mechanical access were in single digit growth, in kind of the normal range you'd expect the market to be growing, 3 to 5%.

Yes..

But the offset to the electronic was the European business was quite weak. And they had about a minus 7% organic growth over in Europe.

Okay.

So--.

And Europe is about 15% of our security business.

Yes.

And we're not terribly concerned about that. We're not happy with it, but we're not terribly concerned about it because the order rates were up 4% in Europe. And what they have been going through, a part of the margin improvement came from cost reduction in SG&A and there was a big SG&A reduction in Europe in the first -- I think it was the second quarter of the year.

Was that with Blick?

With Blick, yes. And so that kind of, I think sort of distracted them from growth for a quarter or so. They seemed to get it back in the third quarter. So we're not -- we're obviously monitoring the situation but we're not terribly concerned about that. But we were very encouraged by the broad-based growth that we had in North America and our ability to generate the high margins that you see with mixing into electronic. Then the question becomes, well, why, -- where is the profit improvement coming from? It was back in May and then subsequently on the conference call in July that I discussed the profit improvement initiatives that we are undertaking in security, which are literally 30 to $50 million of margin improvement at today's sales rates, over a two-year period. And the team is actively working on these things. They range from -- well, they're really the things that I described in that one chart that Chris Epple showed and then some more things on top of that, like centralized procurement, manufacturing productivity improvements--.

Can you give us a sense of where you are with regard to those targets they sent out at the beginning of the year? Where you want to be? Or si there room for improvement from here?

In security?

Yes.

Well, I think we're ahead of schedule, Margaret, on the security profit improvement.

And it's sustainable?

Well, we certainly hope so.

I guess the question would be what kind of controls do you have in place?

We've got great controls. We have got good people out there. They are focused on profitability. They stood up in front of the analyst community in May and they put their reputations on the line and I think they're very focused people.

And I just had a second question with your '06 guidance, what's the tax rate that you're assuming?

For '06. We're back up to a 28 to 29% tax rate before any benefits from the Facom acquisition.

Okay. I'll see you tomorrow, thank you.

Okay. Thank you.

Your next question comes from Sam Darkatsh, Raymond James.

Good afternoon, John, good afternoon, Jim.

Hi, Sam.

I actually do have only two questions. First question, it looks like -- Jim, I just want to make sure I'm clear with this, fourth quarter versus third quarter, looking at it sequentially, it's roughly the same amount of revenues and EPS is going to be down a few pennies. Now, that's partially explained by the point or two degradation sequentially in security. Is there anything else that sequentially would change earnings delivery?

As I said a couple of minutes ago, the gross margins in the fourth quarter almost always go down about 50 basis points or so from the third quarter.

That's factory utilization, Sam, primarily.

I got you. Okay. I'm sorry--.

[MULTIPLE SPEAKERS]

Last thing -- the change in mix in fastening. Now, oftentimes -- you've talked before about fastening being a nice indicator that you looked at in terms of being a leading indicator because it goes into a lot of pallet manufacturing. Does the fact that you're selling more kits in less differentiated product tell you anything about the tone of business going forward? Or is it more of a promotional or end market issue? Or help us understand why that dynamic might have occurred.

Yes, that's fair. I think we do look at fastening as a tremendous indicator and our pallet business was neither up or down. I think the mix to which I referred to, Sam, is unique to Stanley. Specifically, kits are a combination of fasteners and two tools sold primarily through the home channels. And while it's good for revenue, it's not particularly good for margin. That was unique to Stanley and our business in the third quarter. So our, let me call it pure fastening business in general. And you're correct to point out pallet repair is our largest single end user market. Second is furniture construction. A lot of -- I think a lot of folks incorrectly assume it's home construction, which it's not.

Those two businesses are good indicators of the general economy going forward. Those were neither better or worse than we anticipated. It was just -- we basically gave away more tools than we usually do in the third quarter. In the home centers. That's the bad news. The good news is when we give away tools, the folks with those tools often buy fasteners to shoot with them, so, we -- we think we'll ultimately see that coming back.

When you say neither up or down that doesn't necessarily mean the growth rate itself was flat -- or I should say that the sales year-over-year were flat, it just means the growth rate hadn't changed? Is that what you mean? Or was it actually flat year-over-year?

No, it means year-over-year it was flat.

Okay. All right. Thank you.

Your next question comes from Eric Bosshard, Midwest Research.

Good afternoon.

Hi, Eric.

Jim, in your securities slide that Chris Epple gave back in May, you talked about an '06 operating margin of 17%. Based on the performance of 2Q and what happened in 3Q, you're 1.5, 2, 3 points ahead of where you thought you were going to be in 2005. As we think about the operating margin security in '06, which had this 17% margin, is there any reason at this point for us to say, gosh, that 17 is going to probably be at least 18 and start from there? In other words, is what you've accomplished in 2Q and 3Q sustainable to the point that we can start to think now about some upside to that 17 next year?

Part of it is arithmetic, Eric. Jim, will get more granular, but remember, next year's number that we're showing for security, we're assuming the carry-forward and addition of about $100 million worth of acquisitions. Let's just call it a 17% OM business for a minute. Our acquisitions are in the 6 to 9 -- 6 to 8% OM range when we buy them and it takes us anywhere from 12 to 24 months to get them up to let me call it security segment standard. Just the arithmetic impact of 100 million at 8% on top of what we've got is going to mix that down a little bit. Jim may add a little more granularity to that.

No, I would agree with that. I would also say that if we can just get to a sustainable 15 to 20% range, averaging out to about 17%, we would be pretty pleased with that and I think it might be premature to bet on too much upside, just given all the variables that we're dealing with, including a pretty uncertain economy.

Is there anything in the performance of 2Q and especially 3Q that you'd look at and say, everything went right in 3Q and that's how we got to this margin?

I think it's more everything went wrong in 2Q and -- sorry, in 1Q. 2Q was pretty -- was about what we'd expect, far better execution and 3Q, a lot of things did go right, including our -- our mix of business, despite good electronic business. We had a great quarter in access, a great quarter in mechanical and as you know well, those are our high margin businesses within the security segment.

But I do think people are going to have to -- as long as this is a business -- that's an $800 million business and 200 million a quarter, it's going to have some volatility in the margin rate. We can't escape that. It's just that $1 million here or $2 million there, which might be a cost or a benefit, that just occurs, may not repeat itself and it's kind of one of those things, you just don't know in any given quarter exactly what it's going to be, but you know it's going to be within a range.

And then my second question -- I guess I covered your company for five years and can't ever remember a quarter where you said Mac did extraordinarily well this quarter and as a result we had upside out of this segment. We only hear about Mac when it does something wrong. I know you put a lot of attention into improving the business, but I guess after four years of trying really hard to turn this business around and changing the model and changing everything you could do and changing that again, I mean at what point do you look at this business and say this effort could pay back a lot better if we took all the smart guys in Mac and had them work on consumer tools or had them work on Facom or had them work on security. What's the thought process of management or even the Board when it comes to that business?

I'll take it, Eric, it's -- we want to see the glass half full, which sometimes Jim and I have a hard time doing. This business was bleeding money less than two years ago. We're not declaring victory having it at a 5% OM business with flat to down sales, but I will come back to even at single digit operating margins and little growth, we are not destroying value with this business in that it has virtually no capital associated with it. No fixed assets, no working capital in terms of inventory or receivables. It is a distribution business that can survive on lower margins. So the OM, while it arithmetically mixes down our industrial segment and we're not happy with it, the relatively large comparable top line drop was a concern to us this quarter and we're trying to understand that relative to what's going on in the marketplace, various competitive reporting and everything else. That did surprise us.

So margins aren't good. They need to get better. We need to stop the decline and, in fact, reverse it on the top line. And at the end of the day, you're right, Jim is actually going to -- and I collectively -- are going to touch on some of our thoughts on Mac tomorrow. But it's 6% of Stanley sales and next year is going to be 5, if nothing happens. So I don't want to be cavalier about a relatively small business. It's a tough business model. We maybe are burning more management brain cells trying to figure it out than it merits. That's where you were leading. We're pretty mature about those things and if a year from now we've come to that conclusion, it may have -- we may think about it differently going forward.

A couple of years ago it was 13% of the Company. In terms of its revenue. And next year it will be 4% of the Company. So that is the good news, even if it doesn't get jump-started, it will become an increasingly smaller -- has become an increasingly smaller part of what affects us. Having said that, we don't enjoy or support spending our management time on something that doesn't pay back, but I have to be honest with you, the market -- in the marketplace, these folks, at Mat Co., are really knocking the ball out of the park and we're not. So we're not at a stage now where we're questioning the business model as much as we're questioning our execution and our performance and that's really where the jury is going to have to rule here at some point. And so the team in place has its mission and we will see how they do.

Your next question comes from Lorraine Maikis, Merrill Lynch.

Thank you, good afternoon. Can you talk a little bit about the impact of higher material costs and what you expect going forward and what you've built into your guidance for that?

Yes, I think we can, Lorraine. Obviously there's two big drivers, one that affects everybody and one that is more Stanley-centric, if you will. Our assumptions on energy aren't any different than anybody else's. They will have a ripple effect and it will effect us as it affects everybody else. As we said many times, when you think Stanley, think steel, in terms of material costs, what's built in our guidance is about $35 million of raw materials inflation, the overwhelming majority of that being steel for next year. It's been incredibly volatile, as you know, the last six or eight weeks. We meet at a senior management level with all the procurement executives, discussed regularly, have a formal monthly meeting, look at changes to the forecast and one of the reasons we're doing it every month is because if we do it every week, we'd just be changing up, changing down. But we're seeing a little bit of headwind in the fourth quarter compared to where we've been. But worked into guidance that Jim gave you next year is about 35 million of steel inflation, which we will try to mitigate through a combination of productivity and pricing.

Okay. And then in the consumer revenue outperformance, were there any particular products or customers that really drove that growth and outperformance there?

The product performance was broad based, as I think you're aware and we will discuss it a little bit tomorrow, we manage our consumer business -- we like to think of it from the market backwards as opposed to the product forward. We have five strategic business units that cover the major functions and all of them performed well. Three of them performed extremely well. The other, I think, good news is our business was strong in both the home centers -- the large customers, who we all know, as well as in what we would call the two-step channel. So it was in our -- measuring -- our measuring business, our cutting and clamping business, those SBUs together account for about 50% of consumer. They were both up mid-teens in terms of growth and nice growth in both the home center as well as the two-step channel and that was a lot of great sell-in of new products and again complemented by nice pull-through from the strong marketing programs that we have in the field.

Your next question comes from Stephen Kim, Citigroup.

Thanks. Good, strong quarter, guys. Question for -- actually, two questions, if I could, one on security and one on consumer products. In security, I was intrigued by the fact that despite electronic obviously having lower margins than your mechanical, that your strong sales growth in electronic versus mechanical, I mean mechanical is good, too, but not nearly as good as the electronic, your margins still were able to go up so much. I guess my question is of the initiatives that you guys have been pursuing this year in security, have they had the effect of, in any way closing the gap, if you will, between the various levels of profitability, within that business? Or would you say that it was pretty much just, you've had a rising tide where all of the businesses have done better proportionately similarly?

Very much the former, Steve. Specifically, if we look at the industry, mechanical margins are higher than electronic margins. We have always felt, and, the data is not perfect out there, but Jim and I are strong believers, as are Justin and his team, that our spread between mechanical and electronic has always been higher than the industry at large. Thus, the majority of our focus, I won't say overwhelming majority, has been in field execution, field operations, around the electronic business, around the integration business. That's where we're spending our time. That's where we have management focused. That's where we think we have the greatest upside and we saw that. We saw ourselves closing the gap internally and we don't think that's a function of the marketplace. We think it's a function of where Justin and his field ops team are spending their time and where they've been spending their time since the first quarter and some of the programs that Bridget Marnaca laid out for the investment community in May.

Okay. Great. And the second question relates to the consumer business. I was also intrigued by the fact that you -- I think it was Jim, said that he anticipated this might -- this is a very strong business and 17 to 19% operating margin business going forward. And I guess what I find intriguing about that was that it's been a pretty rare occurrence for you over the last few years to actually have a quarter where you have an operating margin, at even 17, I think you did it once in the last few years, besides this quarter. And obviously this quarter benefited from some tremendous sale -- a surge in sales, some of which it's kind of hard to imagine you'd get that much leverage of overhead expenses on a quarterly basis going forward. So I guess I wanted to tap into what was the -- what is it about this business which makes you feel that a 17 to 19% range is the right range? I would have expected maybe a 16 to 18 or--?

I will go with 16 to 18.

Okay. We will go with 16 to 18.

The level of accuracy, of 17 to 19 versus 16 to 18 is a little suspect, but let's just say 16 to 19 for argument sake. And what I think you will, if you're there tomorrow, anybody that's there tomorrow at the meeting will see, is this is not the consumer business of 3 years ago, 5 years ago, 10 years ago. This is a new consumer business. And there is a enormous emphasis on the end user, there's an enormous emphasis on innovation, broad commercialization, and strength behind the brand. And empowering the management team. And these folks are delivering value that customers are willing to pay for. And that has mixed up the average bill. It has -- with all the new products, it has mixed up the -- the gross margin. And it's all, I think, a correlation between the value proposition that we're offering the customer and what we're getting paid for and that's really what's driving -- that and -- and the tremendous global cost competitiveness that we've built over the past decade in terms of all the cost reductions and so forth that positioned us to be not only delivering great value to the customer, but to do it in a cost effective manner.

And to kind of reemphasize my response to Lorraine's question, it is broad-based. I'd like to say there is a laser product or a demolition product or , a homerun, it is broad-based across all five SBUs and that's the reason that Jim and I decided to take these business leaders to whom the investment community has not had a lot of exposure and give the investment community some exposure to these people who are delivering the results. They are subject matter experts, they're passionate about what they do. They've been working at this for a long time and those trees are finally starting to bear some really nice fruit.

Ladies and gentlemen, we have reached the end of the allotted time for questions and answers. Gentlemen, are there any closing remarks?

Yes, I just wanted to thank everybody on the call. We had great participation. I'm sorry, not everybody got in their questions. We are going to be in New York tomorrow and I just wanted to remind everybody, from about 11:00 onwards, a broad representation of the management will be available. At the New York Stock Exchange, the formal presentations start at 12:15 and hopefully many of you on the call can be there tomorrow and if there are folks in the queue who didn't get a question in, that we will address those for you tomorrow. Obviously, offline Gerry will manage any of those that he can. Thanks very much for your interest.

This concludes today's third quarter results conference call. You may now disconnect.