史丹利百得 (SWK) 2006 Q3 法說會逐字稿

At this time I would like to welcome everyone to the The Stanley Works third quarter results conference call. All line have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question and answer session. [OPERATOR INSTRUCTIONS] Thank you. Mr. Gould, you may begin your conference.

Thank you, Janice. Good morning, everybody. On the call this morning as always are John Lundgren, our Chairman and CEO, and Jim Loree, our Executive VP and CFO. We have two press releases out there; our third quarter results and guidance that we issued last night, and our fourth quarter dividend that we issued yesterday morning. There is a power point presentation on our website, so we'll refer to these charts as we go through the presentation this morning. We put a PDF version up there about ten minutes ago for your ease of printing it. John and Jim will review the results and we will go to a Q&A period. The call should last about an hour. There will be a replay available beginning at approximately 3:00 PM, 2:00 PM this afternoon. It's 2:00 PM. The replay will be available through the end of the day, Saturday the 28th. The replay number is (800) 642-1687 and you will need the code 8716378. After that it will remain on our website where it currently resides. You can call me with any questions, (860) 867-3833.

Two reminders, first in accordance with Reg G we issue guidance in the press release at the beginning of the quarter and we don't comment on it thereafter unless there's a material change in which case we would issue a press release and have a conference call. And secondly, certain statements contained in this discussion by Stanley Works 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 yesterday's press release and I would like with that to turn the call over to John Lundgren.

Thanks, Gerry. As is our custom let's review third quarter results and some of the key business highlights. Then I will turn it over to Jim who is going to talk about our guidance and then as always we will open it up to questions and answers.

Revenues were up 21%. That was driven primarily by the Tacoma National acquisitions both of which were closed in the first quarter, so weren't included in our results third quarter '05. As you can see from the sources of growth organically we grew 1% primarily due to price with volume flat and a lot of movement within the various businesses that we will come on to in our segment discussion. We've got 1% from currency, 19% from the acquisitions for a total of 21%.

In looking at the segments and we will get into more detail a little bit later, consumer products was up 1% organically, the remainder of that increase due to the inclusion of national hardware in the consumer segment. Important to note hand tools and we will come on to it in a minute, is up 7% as we are quite pleased with the continued progress of our FatMax Xtreme roll-out. Industrial tools was flat organically up 30% due primarily to the inclusion of Facom and we had a great quarter in Security Solutions. 5% -- actually a little more than 5% organic growth and 9% in total including the couple of small bolts on acquisitions in the excess technology and systems integration business. Weak in the U.S. retail markets has dampened growth in some of our consumer and industrial segments. We are still cautiously optimistic as we look forward and we will get into that later in the call.

Earnings of $1.09 were up 22%. You can see the walk and some of the key contributing factors. You can will recall our guidance on the July call was $1.03 to $1.07. Assumed within the guidance was 4% to 6% organic growth at a 23% tax rate. What's contributing to the earnings, in particular in tax rate, 20% tax rate versus 25% a year ago and 23% in our guidance, were favorable audit settlements which of course render reserves obsolete and current regulations require us to take that to the P&L which is exactly what we've done. If you look at the share count it's down about 2 million. That's obviously the impact of the 200 million share buy-back earlier in this year most of which was completed in the first quarter.

Some of the highlights by business, you see more than $1 billion in revenue for the second time, up 21%. The acquisitions adding $158 million. Strong hand tools, very encouraged with Mack, Proto, and our Vidmar storage business all up double digits. Fastening was weak. It's down 7% on an apples-to-apples basis in revenues and as suggested, Security with a terrific quarter in access, strong U.S. mechanical business and good progress in Europe also posting some nice growth. Operating income up 17% in absolute terms, $146 million of operating income, margin was 14.4% in '06 from continuing operation. That's primarily the impact of adding in a significantly lower than line average national business and we will come on to that in just a second. Double-digit growth in EPS as I've already talked about and Jim is going to give you a little more detail but a terrific quarter and YTD performance in terms of cash flow which certainly increases the likelihood of meeting or exceeding our $350 million of cash flow which has been in our guidance since fourth quarter is historically a strong cash flow period for The Stanley Works.

Moving on to our results versus guidance, we try to do this to make it as clear as possible. Prior year earnings were $0.89. We guided a $0.14 to $0.18, within our guidance of $1.03 to $1.07 was a $0.14 to $0.18 improvement in base earnings growth. We were basically there, slightly above the $0.18 with all businesses with the exception of Bostitch which a revenue shortfall and costs, costs us $0.04 to $0.05 in the quarter bringing us back to the bottom end of the range, but all in we were encouraged with the base business performance getting us to a subtotal of as you see $1.03 in our results at the bottom end of our range from operations, versus the guidance. We got $0.04 versus the guidance from the tax rate which I've already discussed and another $0.02 with less restructuring charges hitting the quarter than was inherent in our guidance or implicit in our guidance. One other point as we talked about organic growth. I said earlier it was 1%. Base earnings did hold up well. Even though we only had 1% organic growth, it was actually 1.4%. We obviously round. It was clearly below where we expected it to be but we were very pleased with the business's performance and maintenance of margins particularly in the core given the lack of organic growth that we put in our guidance.

Moving on to, you know, why lower growth in terms what we're looking at going forward. This is a complicated chart, but it's one we will continue to spend time with you on. And it talks about not only Stanley's dependence on home building but on U.S. home centers, mass merchants, and other -- I'll call it other home building related accounts. If I can direct you -- and it's about 20% of our total. So the -- if I can direct you to the right-hand side of that chart you see certain businesses like Security, Proto, Vidmar, Facom, et cetera, that we firmly belief have absolutely no dependence on either home center, mass merchant sales or home building, and that is roughly 50% of our revenues, $2.1 billion on our $4.1 billion base.

Within the other slices, businesses like hardware, fastening, hand tools and laser are included in those businesses. And the small slices suggest that the weighted-average dependence on residential construction is between 5% and 10%. And the percentage of our business that would be impacted by any downturn, softness or retail inventory corrections in the home centers or mass merchants is 10% to 15%. It's quite specifically, home centers count for 17% of Stanley's revenues and it just gives you a flavor for the arithmetic impact of any softening in either home building or in large domestic retail sales. So any softening in demands of 10% to 20% in those effective markets, it's just arithmetic, it's a two to four point organic revenue decline and hopefully that will help you understand at least how we think about it. We are not overly dependent on either of those markets or channels. That being said we are also not immune to it.

Looking at the segments, another very successful quarter in consumer despite a weaker retail environment. You see revenues and operating income as I've talked about. Operating margin was very strong at 18.4%. It was down 130 basis points and as I've previously mentioned, that's purely the impact of national. It's about a $200 million business which represents about 15% of the segment with mid single digit operating margins. And I'll come on to it. Hand tools was up 7% organically, really strong FatMax Xtreme sales, great FatMax results where we are beginning to experience less cannibalization than was within our original plans. We have begun to roll out the Xtreme product which we brand XL in Europe. It's so far so good is what we can say on it. Some of the offsets that got our organic growth back to flat were weak mechanic sales, hardware and storage.

When I say week mechanics tools it's worth a minute. Margins were good, the base business was good. We did have a $10 million favorable promotional activity in the third quarter last year that didn't repeat. That being said it's in the organic -- it was in the base, it's in the organic growth. We didn't get it. Hardware, about a third of our business is in the home centers, two-thirds not. That business was softer than we expected it to be and we are in the midst of rejuvenating our line and in several line reviews on ZAG, our consumer storage business. It's been affected by resin prices. But those three businesses were soft compared to the same quarter a year ago which basically offset all the good news and positive news from the FatMax Xtreme roll-out giving us 1.4% organic in the quarter.

We are very encouraged with the way our businesses are performing outside the U.S. but PLS or retail take away is softening. Three of the last five weeks have been less than expectations and retail inventory levels, and that's our top seven domestic retailers, are at about the same levels they were a year ago. So underlying our caution is last year there were, at 11 to 12 weeks of inventory as we were early in the fourth quarter. That got cut to about eight by the end of the year. So a lot of inventory which resulted in a dramatic organic sales growth, I'll say surprise or shortfall last year. Jim is going to discuss our views on both the market and what we think will happen to inventories that's included in our, I'll say tempered guidance for -- of 2% to 3% organic in the fourth quarter despite what's going on out in the marketplace. We think that will be a good achievement if we get it and we will talk to you about what's baked into it.

The national hardware acquisitions is on track as I say. It's mid single digits. We will get it up to the line average. We have a history of doing that. It takes 18 to 24 months. We've owned this business nine months and so far we've got not all the costs that we anticipated to get out. Our history as we get the costs out first, we stabilize the business, it starts to grow, 9 to 12 months later and that's where we are in the process.

Looking at our industrial tools segment, a lot going on. Revenues up 30% primarily due to Facom. Operating income up 40% and operating margin, despite some of the issues in fastening, up 60 basis. Revenues were strong across the segment as I previously mentioned with a lot of businesses that are cited below, up 6% ex-fastening. So most of those markets holding up pretty well. Mechanics tools, that's our professional mechanics tools, our Proto business, storage which is Vidmar, hydraulics is continuing to perform quite well, all posting double-digit growth. We are really encouraged with Mac Tools revenues up 18%. The U.S. route averages were up 22%. So you can do the arithmetic. It suggests that the routes were down about 4%. We are being much more selective in bringing on our new distributors which means they are coming on at a slower rate. That being said, we are retaining them longer and they're far, far, far more effective on average and this is two quarters in a row that we;'ve had some good news from Mack. We are not declaring victory yet, but are certainly pleased with the progress and the trends and at 8% OM year-to-date, as you know that's a very high ROIC business due to the low asset base and our working capital requirements.

Fastening or Bostitch's organic sales fell 7%, combination of weakening markets and our commitment to walk away from unprofitable business. That began in the second quarter and it's had more impact on our top line than we anticipated and we are a going to talk about how we are going to address that going forward. Facom is on track to say the least. The ECP approval process is behind us. You'll recall we announced our intention to close four distribution centers and two plants. We have one plant behind us, one scheduled to close soon. The DC consolidation is on track. We are still maintaining the weekly operating and reporting rigor associated with that acquisition and we are very pleased with its status. Our comprehensive Bostitch cost reduction program and initiative is underway. Let's quickly review what we can say about that at this stage of the process.

You'll recall we've installed new leadership within the Bostitch business in the second quarter of '06. The leader is an engineer with outstanding analytical skills, incredible process rigor and discipline which is what the business needs. And has been well accepted by both the management and the rank and file thus far so we are three or four months into it. We are learning a lot about the business or more about the business than we knew before. We are cautiously optimistic that we are getting to the bottom of what the true issues are. We've completed the acquisition of Besco; it gives us a competitive advantage in terms of Taiwanese technology and capability, Chinese cost competitiveness and a great opportunity or the obligation to protect our intellectual property while still having a lower cost source of tool production. We are in the process of integrating Besco. We've only owned it a couple of months. The program that's being launched in the fourth quarter will transfer certain of our North American tool production to Asia. We've identified the opportunity to close two manufacturing facilities and reduce our footprint or quite specifically the square footage of manufacturing space we have producing the same amount of product by up to 25%. We've gotten a lot better on granularity and customer profitability and as I mentioned earlier we walked away from a lot of unprofitable business that's had an impact on revenues, less impact on margins, but as we bring our revenues down slightly the short term impact has been larger than we thought and thus we are in the process of right sizing the business and the manufacturing footprint as well as SG&A to serve that base.

SG&A is not out of line in total or in absolute terms but it's always on -- at Stanley and especially if about 10% of the revenues we've been generating up to now turn out to be unprofitable in the long run, we will very quickly reduce SG&A as well as the manufacturing footprint to size it correctly. Our expectation was included in our strategic plan that we reviewed with our board yesterday is to return Bostitch to acceptable levels of profitability within 24 months. It's an iconic brand. It's a strong industrial business. It's an important part of the Stanley portfolio and we are going to fix it; we are not going to give up on it.

Looking at Security, we had a very encouraging quarter. Among the highlights, operating income up 5%, revenues up 9%, more than half of which was organic, about 5.5%. Good progress in Europe, up 2% ex-currency. Our automatic doors or access technology business grew 13% organically. We are gaining big share in this space. Mechanical access was up 7%. So organic growth was strong again. Despite the growth in -- organic growth in revenues, we didn't get a lot of operating leverage in that margins were down 70 basis points. That being said they are 17.4% in absolute terms. I would like more businesses in our portfolio that could decline 70 basis points to 17.4. What's driving that is $4 million of non-ferrous metal inflation in the third quarter. $4 million on Security's revenue base is 200 basis points. And that's primarily aluminum, tremendous amount of aluminum in access doors. It's brass, obviously in mechanical locks and it's zinc which we use in our platings. So we absorb 200 basis points of materials inflation and only realized a 70 basis point reduction in margin. The team did a great job of managing their margins. Pricing is catching up in the third quarter and by the fourth quarter we actually see our ability to recover the inflation. And by the way these non-ferrous metals aren't high on everybody's radar screen. They've doubled in the last nine months, as much or more as steel at the beginning of '04. But we see pricing catching up and actually with the potential to turn favorable by the end of the year as we enter the first quarter.

So this business is performing well. The pipeline is pretty active. Fourth quarter is normally weaker on a sequential basis due to seasonality. That's reflected in our guidance. But the momentum to create some very positive favorable comps versus the fourth quarter '05 is clearly there.

Looks like the cash flow which we are encouraged about it. Jim is going to take you through that and some guidance and we will come back for Q&A.

Okay. Thanks, John.

The free cash flow is $96 million up $38 million versus last year in the quarter. In excess of net income as we like to see. And year-to-date I think it's a great story, at $260 million we are in a great position here at the end of the third quarter to meet or exceed our $350 million target there we've had out there for awhile. Recall last year we did $294 million for the total year and we were sitting at $168 at the end of the third quarter. And that was a pretty average fourth quarter for us in terms of cash flow. So I'm looking for a big fourth quarter here and an excellent finish to the year.

As you dissect the current quarter cash flow, although working capital consumed $44 million of cash; it was very similar to last year, but we had an inventory increase in the quarter which was driven in the large part by the -- virtually all by the sales mix and we will liquidate a lot of that in the fourth quarter and obviously that will put a little strain on the gross margin in the fourth quarter above and beyond what we usually experience.

Moving to the balance sheet, the balance sheet is progressing in accordance with our plans for the year. We are now approaching the pre-Facom acquisition, pre-National and pre-$200 million share repurchase that we did earlier in the year levels. So we've been able to deploy the cash flow towards some debt reduction here this year and we will see some significant debt reduction and we are certainly hoping that the -- and predicting that the debt will be right around in the $1 billion range as we close out the year which will put us below the commitments that we made to the rating agencies when we purchased Facom and National and did the stock repurchase.

Moving on to guidance, for sales growth, this somewhat tempered guidance for the fourth quarter of 2% to 3% growth in consumer, 1% to 2% -- this is organically -- 1% to 2% organic growth in industrial and 3% to 5% in Security Solutions. Let me give you a little color on that. The -- you recall last year in the fourth quarter we had a very tough performance in the home centers especially in December. And we ended up with a consumer segment down 3% organically last year. This year we are predicting 2% to 3% which would basically get us back to where we were two years ago. And that's on the strength of FatMax Xtreme as well as the FatMax XL roll-out in Europe. And Europe is developing some positive momentum. So inherent in that is a relatively pessimistic view and it may be realistic but it's pessimistic as it relates to inventory status at the -- at retail. And we've assumed in this guidance about a 50% correction vis-a-vis what we had last year and hopefully we will do better than that but we felt it was prudent to put it in the guidance that way.

Moving to industrial, we see a continuation of some issues in fastening although we see less of a downward pressure because their comp is very easy. They, too, were affected by the retail correction last fourth quarter and the strength in the other industrial businesses will continue and the combination of all that will give, us we think about a 1% to 2% organic growth performance in industrial. And in Security kind of in the range of 3% to 5%. And so in total we have about a 2% to 3% growth outlook for the fourth quarter on a relatively easy overall comp and we certainly hope that we can do better than that but right now that's what we collectively felt was an appropriate place to be which gives us some down side protection in the event that there is in fact a retail inventory correction which given the softness and the caution that we are seeing out in the U.S. retail market we really think is the right thing to be doing right now in terms of forecasting. And then you can see the acquisitions adding their part to the revenue growth and the total revenue growth expected to be in the fourth quarter about 23% and then very similar to the total year number of 22% to 23%.

Again I just would like to add at this point that we see no negative share loss issues in the Stanley's portfolio with the exception of fastening business which are really under our control more than anything where we are giving up some unprofitable business as John mentioned but inherent in the rest of the portfolio we see nothing but positive share trend and as I said the fastening issues are where we are walking away from some business ourselves, are self-inflicted.

Okay. Then we will move on to the cost inflation picture. This is very, very similar to what we looked at last quarter, no big changes, no big surprises here. Inflation has been an issue increasingly all year. As you can see, our price increases are catching up with it, but it takes time and right now we expect that in the second half we will offset about 65% of our inflation with price and for the year that would be about $50 to $55 on the $32 million.

Okay. Let's move on to guidance and for the fourth quarter I mentioned the 2% to 3% sales growth. The restructuring of $0.05 which helps us cover the closure of one large fastening facility, the beginning of the closure of one large fastening facility. And operating earnings per share of about $1.05 which when you net out the restructuring gives us about $1.00 a share, somewhat down from the previous estimates that we have which were around $1.13 to $1.17. However, all of the differences attributable to the more cautious revenue growth outlook that we now have. That $1.00 would give us 33% earnings growth in the quarter on a very -- we could argue an easy comp but there is still a lot of good performance in there as well. And then for the total year, we talked about the sales growth assumptions already, so I won't belabor those. We have the $3.81 from operating earnings per share which would exclude the step up charges of $0.17 and the restructuring charges of $0.19 which will ultimately incur and a total of GAAP earnings of $3.45 which would be 8% growth for the year. And as I mentioned the cash flow greater than or equal to $350 million on a comp of $294 the prior year.

As we look forward we have tempered our outlook for '07. As you recall in the past it was in the range of 3% to 5%. We brought it down to 2% to 3% on the basis that the U.S. retail markets are slowing and we may have an okay second half next year. We don't know. But we've predicted an ongoing slowing in the U.S. retail markets which is the single causal factor for the reduction. Even with the tempered organic growth estimate, we still expect to be delivering earnings growth in the 16% to 19% range which includes $0.12 of restructuring. The very good news there is that the Facom, excellent Facom integration performance is ahead of schedule and as a consequence, what was originally allocated to be restructuring for Facom next year of a similar magnitude will now be able to fund a good part -- a good portion of the fastening profit improvement initiative that John referred to. So in addition to that within that '07 guidance that I just mentioned of $4.00 to $4.10 is only a $10 million improvement for the fastening profit improvement initiative. And if the management team executes, I think they have a good shot at doing better than that. We are really quite confident in our cash flow outlook next year for about $380 million to $410 million, a nice increase over '06.

Then I would also mention within the $4.00 to $4.10 we've assumed a tax rate of 26% to 28% which would be in comparison to 2006 about a $0.16 to $0.24 earnings per share head wind. And so although we didn't add it back to the operating and break it out separately along with the step up charges and restructuring charges you can see that the comparison if you did add that back to the $4.12 to the $4.22 versus the $3.81 would be a really powerful earnings performance on 2% to 3% organic growth and as I said we feel very confident about that.

Now I would like to take a minute and step back and make a few observations, more for investors that are interested in the long-term. And from 2001 to 2005 this Company delivered an earnings per share compound annual growth rate of 20%. This year we will deliver about 8% earnings growth and in our '07 guidance which I told you we were very confident in, we have 16% to 19% growth assumed. That's with a circumspect view of 2007 organic growth of only 2% to 3%. And that's with acquisition integrations of Facom and National performing as billed or slightly ahead of as expected and only $10 million of Bostitch operating improvement margin built in, despite the fact that we have a two year initiative to get that business back to acceptable levels of profitability. That '07 earnings growth when we look back, when -- if we look back to '01, would be, would represent a compound annual growth rate of 17% over that six year period. And a revenue growth rate of about 11%. Which over the long-term I would say is a pretty respectable performance if we deliver it. And I will say that the underlying business performance today of the Stanley business units is very strong except for fastening, which is a $600 million business currently earning about 2% to 3% operating margin. But what you should know is that the fastening cost reduction plan is about nine months into execution. It is being executed by the new business leader and her team and it is being program managed by the same group that does our acquisition integrations, the same group that ran, that is running the Facom integration is helping the Bostitch group take their profitability up. That business, the fastening business was double digit operating margin as recently as 2002 so a return to acceptable profitability would result in meaningful earnings per share accretion for the Company. And as I said the Facom speed of execution in their integration has enabled us to fund the Bostitch restructuring without any additional restructuring charges in 2007 than we otherwise anticipated.

And finally the portfolio is stronger than ever with stronger franchises and less reliance on large customers and growing international presence. So we have a high level of confidence in 2004 [sic] and as far as we are concerned these weaker U.S. retail markets are just another speed bump. John?

Just to close on the quarter and we will take -- take -- then we'll take questions. I think we've said about everything on the summary chart. Sales in excess of $1 billion for the second quarter, record quarterly earnings of $1.09 from continuing ops. We are pleased with cash flow, optimistic about it going forward. The ECP is definitely on track. Great traction on our FatMax Xtreme roll-out. I think an important point is our portfolio diversification is paying off, organic growth is encouraging and Security Solutions and some of our industrial businesses. Jim I think said all we can say at this stage, but if nothing else, I hope you will take away the conclusion this is not something we started thinking about last week. This is something we've been working on all year and it takes time to develop and begin to execute a program of this magnitude. We are incredibly pleased with the quarter and let's take some questions.

[OPERATION INSTRUCTIONS] Your first question comes from the line of Margaret Whelan.

Good morning. It's actually Susan for Margaret.

Hi, Susan.

Your tax rate this quarter was lower than we expected and I guess you are expecting something around 20% for the fourth quarter. But going out longer term how should we be thinking about the tax rate as we are modeling?

In the guidance we said 26% to 28%. I think that's probably more of a steady state number for us. We've had a couple of good years here and some good things have happened with European restructuring and some positive developments in our U.S. Federal taxes and some other things like that but realistically with the portfolio we have, we are probably in the 26% to 28% range over the longer term.

So we can hold that out even going into '08?

Obviously, Susan, a large acquisition outside the U.S. would impact that but you are not factoring any of those into the model and neither are we. So business as it exists, same store sales if you will, we like that range.

Okay. And then you've had a lot of success with your FatMax Xtreme line, it's been very well-received out there. Can you give us any sense of maybe what's coming up next in terms of new products and development or any further expansion on that line?

Let me just say our vitality index which of course we measure as a percent of sales accounted for by new products on an annual and a three year basis is as high as it's been across our entire consumer segment. The simple answer is a polite, no, we won't. The pipeline is very full. As you may or may not have picked up, we've introduced our second wave of Xtreme products in the U.S. as we speak. That's finding its way to the stores in the month of October. In Europe we basically took two waves and did it simultaneously in the fourth quarter. What you can expect is seasonal, at least once if not twice a year going forward introductions of new SKUs under the Xtreme brand going forward. But we are just never going to be in a position where we are talking to the investment community about it before our customers. It's a little bit frustrating but what serves us well in the past as soon as you can find it on a customer shelf, we will tell you all about it but customers first and it served us well in the past and it's just something we can't deviate from.

Okay. And just building on that is there anything coming up for the holidays that you can share with us?

One thing that is public, our focus in that channel -- obviously in our industrial and securities segments have nothing to do with the holidays. In the consumer segment, remember 62% to 65% of our volume comes from the professional. That is not seasonal. That being said, the brand is ubiquitous. It's extremely well known. If you've watched the ALCS or the NLCS or the World Series you will see media support for Stanley Max life flashlight or illumination tool. It's a great product. That will have a seasonal lift. It's been extremely well received and as I say it's supported by the media now through the ends of the year. But it's one SKU. It will be tremendously successful but that's not going to move the needle on a global Stanley basis. We are not a fast moving seasonal consumer company. We sell premium quality hand tools to the professional who uses them every day, uses the tool to make a living.

Your next question comes from the line of Mike Rehaut.

Yes, good morning. I was -- first question, I was just a little confused on the tax rate, also, I don't want to beat a dead horse, but you had said in the presentation that you had an implied 23% tax rate and going back over the transcript in the Q2 presentation I wasn't able to find any guidance of that number and we were looking for a 27%. So I just wanted to understand where the source of confusion was there.

Well, Mike we thought we would mention what the tax rate was implied in the guidance which is why we used the word "implied". We did not state it in the guidance last time around. We are trying to get out of the practice of providing tax rate guidance because of the volatility. But because of the significant swing in earnings, we felt it was important to share it with you as a result of the actual performance.

Given that you don't give out margin guidance for the second quarter, I just was confused on how it was implied. You only gave a top line growth guidance number and a bottom line number. So again I guess I wasn't, I was a little confused or if you can just tell me how the 23% was implied?

Well when we put guidance together, as you can imagine, we have a number of estimating processes that we use similar to probably the models that you actually produce in your own, within your own firms. We don't just pluck things out of the air. We have forecasts and ranges for some things and point estimates for other things and when it came down to the tax rate, we are just telling you what we used. Okay? You can tell us what you used in your model and we can tell you what we used in our model and that's where we are.

Your next question comes from the line of Ivy Zelman.

No, this is Justin on for Ivy. In fastening, are your share losses in both, I know you go through a few channels, but you have industrial, you have construction supply, you also have retail lines. Are your share losses in all three lines or is it specific to maybe consumer?

I would say it's not specific to consumer. Let's start with, yes, it's across all three of the channels to which we sell. Probably the largest shares would be through staff to distribution and things of that nature where we realized that a lot of our end of quarter business is at relatively low margin. It's a different set of SKUs for the most part, flowing through the home centers. It's good business. We don't think we've lost meaningful share in the home centers or the consumer businesses as you're calling it. So most of it would be focused in the industrial channels and particularly on, not so much customers but specific large chunks of business we've done too late in the quarters in the past with not enough margin. It's distributed our supply chain and not helped the customers either and that's the business we are trying to wean ourselves off of.

So in fastening what are your current capacity utilization rates for that business? And what is an acceptable margin?

We are not going to tell you what our capacity utilization rates are because they're -- only because we can define it in four different ways. We have it for tools, we have it for fasteners, we have seven -- six plants around the world. It's simply a question, I can't precisely answer on the telephone.

But I did try, if that second part of your question was what are acceptable margins, I tried to allude to what they might be in my comments and as I said the division was in double digits operating margin territory as recently as '02. Today it's 3% to 4%, 2% to 3%, in that range. And so I don't think it's unrealistic to assume that acceptable territory would be where it once was and there's no real structural reason why it couldn't get back to where it was in '02 other than we have a cost issue and we've taken on some unprofitable business and we spent too much SG&A in that business over the last couple of years.

And the only thing I can add to that is on the capacity side while I don't think you need it and we are not going to provide it, that's not what we are here to do, what we've already said in this statement is we can reduce our manufacturing footprint by 15% to 25% and still with a high degree of confidence, fulfill existing and anticipated demand. That doesn't mean the business is going to get that much smaller. It means we can improve productivity in our good plants as I'm sure you know. We have a great plant in Poland. We have a state-of-the-art new facility in [inaudible] near Beijing and we have the opportunity to -- with the Besco acquisition to modify what we make where in North America which will basically help us to fulfill current and future demand with 15% to 25% less space. So we don't have any capacity issues. We have the opportunity to take some structural costs down and that's exactly what we are going to get on with doing.

Your next question comes from the line of Eric Bosshard.

Eric?

Your next question is from Kenneth Zener.

Hello?

Yes?

Okay, just wanted to make sure I'm on. Obviously the organic growth rate was disappointing. You addressed the factor for fastening in the industrial area as well as in the consumer. But on the positive side, I was really surprised that your margins didn't face greater pressure given how much you missed the volume expectation. Can you kind of address the specific -- you guys have obviously done a lot of restructurings over the last four to five years. Can you address some of the specifics that enabled you to put better margins on such a lower volume?

Yes, let's start with, we are very focused on gross margin improvement right now as a Company. We spend -- every business leader and CFO of a business within Stanley spends a considerable amount of time analyzing their gross margins and what's driving them from quarter to quarter to quarter, whether it's productivity, whether it's price, mix, inflation, all these things, and we are very granular about controlling our margins and that is something that we, as inflation has increased over time and the importance of price recovery has been -- become much more important, mix management, et cetera, we have made some considerable strides in improving our gross margin performance. And obviously that helps with the operation margin. The -- I think also when we look at what performed well from a revenue point of view and what didn't perform as well, even within the segments -- let's take -- we know what the profitability of fastening is from an operating margin perspective because I mentioned that. Well, you can imagine that their gross margins are not up to line average and so as we lose fastening business, it has a positive mix effect on the. industrial segment. Okay? As we have growth in hand tools which is a high margin business and as we have a lack of growth or negative organic growth in businesses like ZAG or Consumer mechanic tools, they tend to have lower margin. It was a combination of I'd say very good rhythm and operating rigor related to gross margins in general for the Company and that will continue; it's only gaining momentum as well as the fact that we benefited from where we did have sales issues. It tended to be in areas that were of lower gross margin than others that were very positive performances.

I appreciate that. I just want to follow up and I hope you continue to hit those good margin businesses. On to securities. I know you guys have slowed down what had been a more aggressive growth outlook as you were restructuring in the U.S. Two questions, are we getting to the point where we are solidified enough in the U.S. so that acquisitions in Europe are looking more attractive? A., are you facing private equity competition? And also in the automatic door business you said you gain share. Is that mostly through new maintenance accounts or is that on installation? Because I know there are different margins there. And I appreciate it. Thank you.

First of all, what we said on Security is we did some modest restructuring. We are trying to steady the ship. As you know we are in the midst of a meaningful systems upgrade which is going quite well. To solidify the base for Security so we can grow for the future. The acquisition pipeline is full. The question is, can we get at it at the right price? There's tremendous private equity as well as large strategic competition for Security, for high quality security assets. We have, as you well know, strategic hurdles as well as financial hurdles. We are not going to make an acquisition that we don't think we can, A., get the returns on and, B., integrate and run, but we are, we think, pretty quickly approaching the stage where we are ready to add to this platform from an organizational capability. Now can we get there in terms of price and returns? That remains to be seen at the negotiating table. There's a lot of activity out there.

Jim [inaudible] and I along with Justin Boswell who runs the business are right in the middle of all of it while we want to continue to show the kind of sequential organic growth and margin improvement which you've seen in Security. The access business was both, all I can say about this business is we just hope it continues and we would love to be able to expand that business model primarily to Europe, secondarily to Asia. It is more difficult to do with entrenched competition. But as you know the, it's an all B to B business. Commercial construction isn't under as much pressure of late as residential construction but we've got new installs. We've got retro fits. We've got service and the margins in that business are, in that particular business are pretty good across all fronts and our objective is to maintain our momentum with access and longer term expand our geographic footprint, take our very successful U.S. model and get it to Europe.

Your next question comes from the line of Eric Bosshard.

Hi, Eric.

Thank you. A couple things, first of all, on slide six I wasn't completely clear. If you could just review again the source of the revenue shortfall in consumer and on the slide you talk about 10% to 20% softer demand. I guess what I'm trying to figure out is where the demand was softer than expected.

It's no demand. That was just the arithmetic, Eric. This is all of Stanley, first of all, and what we were trying to point out, and apologies if it's not clear because we don't think it's material. We can even get more granular off-line if it suits you. But all we are saying is between U.S. home starts which we specifically focused on on our last call and since our last call, many of our large customers have talked about softening markets or trends in their business going forward, we said, well, let's include that, too. So we've taken what we think is the best combination of home center mass merchant dependents and U.S. home starts, not through the home centers, and what we are saying is that is 10% to 20% -- at least 10% and no more than 20% of our business. So that all we've said is if that were to soften it could be as little as 2% or as much as a 4% point organic revenue decline for the Stanley Work.

Said another way, we have people expressing shock that we could have such an organic growth miss with the outlook we had of 4% to 6% and the reality is about 20% of the company is exposed to the U.S. home center mass merchant and other residential construction activities. And when you have a 10%, 20% dislocation in that marketplace which is --

20% of 20% is 4%. This is not a really sophisticated analysis, but we think it's straight forward and we can spend more time on specific businesses.

I guess I understand what you are saying and the point was that 90 days ago on the call you said 5% to 10% of our business is new construction. It's lousy and that's what's taking place. I guess what I'm trying to understand is what was the deviation within the other 5% to --

It's our customers. That's right and that was whether that's -- very little of that's through the home centers. Some of that's direct. It's the deviation since the last call or what we've added to it is that we've seen the numbers. You've seen the numbers before. We say 15% to 20% in a given quarter, 17% on an annual basis of the Stanley business is through the large retailers and the home centers. They've expressed softness in general in their sales, whether it's they are going to reduce inventories or anticipating not as bullish a season. Those have been public announcements and all we've said is adding all that to the 5% to 10% gets you up to 20%. So we are basically just expanding the field where there could be softness and saying, if it is soft this would be the arithmetic impact on Stanley's organic growth. We added a slice to the pie, Eric, and I apologize for the confusion. That slide is exactly what we showed you the last quarter, the fatter slice is what's not in the skinny slice that's in our big customers that might also be under pressure that certainly no one had talked about in July and we certainly didn't include in our organic growth rates.

Okay. The point is that both sides of those slices are now seen as 10% to 20% softer demand.

Yes, sir.

Okay. Great. My second question, in terms of your 2007 guidance which suggests kind of 20% earnings growth I understand that you have less Facom inventory write ups but you also have this hurdle of the tax rate. What is the big area of confidence that you have that is going to allow you to generate that degree of earnings growth in '07?

I think that's fine. It's across the board. Jim? Jim can give you I think a high level walk that will add some -- hopefully add some credibility to that.

I mean, basically and there is Facom operational improvements that are very significant and as you know the Facom integration is going extremely well from what we announced and we've -- and what we've commented on today. We have improvements in national that are basically earnings accretion that we committed to. We have some smaller acquisitions that are adding some benefits and then we have about $0.28 coming from our core operations on top of that which we feel good about because we have a fairly, we think a fairly conservative organic growth forecast and we have the gross margins and the SG&A under control and really believe that we can deliver that. We have also some head winds. We have a tax rate head wind of about, depends on what turns out to be but something in the order of $0.15 to $0.18 as a head wind for us. And we also have a little bit of share count head wind and a few other things but there aren't that many head winds beyond share count and tax rate and the big one is the tax rate. So there's a lot of tail wind from the acquisitions, there's a lot of tail wind from the operational improvements and by adjusting our organic growth forecast to something that is reasonably cautious, that's what gives us the confidence.

Your next question comes from the line of Jim Lucas.

Thanks, good morning. A few questions. First, relating to security. As the mix begins to shift more to the systems in the fourth quarter, can you bring us up to date on what you are seeing in terms of some of these systemic changes? You've been working toward improving the margins for the systems side of the business? And second, unrelated, I think lost in today is the cash flow that you continue to generate and you've alluded a little bit to the acquisition pipeline at least within Security. But can you talk about potential uses of the cash flow as you are thinking about today in '07 whether it's debt reduction, acquisitions, share repurchase, how would you prioritize this?

Let's start out with the cash flow because that's sort of top of mind here as you talk about it. I love to talk about cash flow. What we are planning right now is first we have our dividend and right now our policy is to try to increase the dividend every year and work our way towards a 25% pay out ratio. That does not involve any significant increases although in terms of dollar consumption, cash consumption although it will result in some nice percentage increases for the investors. And then beyond that, the next use of cash is to pay for our acquisitions that we are doing about $100 to $300 million a year in acquisitions as a target. And the cash flow after dividends being about $300 or $250. That sort of is at the high-end of what we might spend on acquisitions and then if there's any left over, we are looking at share repurchase on an opportunistic basis just like we did in the first half of this year -- or if the acquisitions don't materialize because as John mentioned before, we have criteria that must be met both from an operational capacity point of view and a financial point of view. And we are disciplined about that.

Now having said that, as John mentioned the pipeline is relatively full. The Security team in Indianapolis is ready for, to take on some new acquisitions. They've made -- As you know they've been on a moratorium of any significant acquisitions for about a year and a half. During that time period we turned our focus over to buying companies that increased the strength of our core franchises such as industrial and automotive tools, ala Facom or hardware, ala National or Besco which is dramatically -- for a small acquisition gives us dramatic benefit in pneumatic tool costs for fastening. So during that period when the Security folks were taking their time off in order to get their processes unified and systems implemented and performance more consistent, we did acquire other companies and we are getting to the point now where we think the Security people may be able to, if we come across the right deal at the right price and so on, meeting our hurdles, we can take that on at this point in time. So at which long winded answer I forgot the first question, Jim.

First question was on the systems side of Security.

The FI profitability, is there going to be more of that in the fourth quarter and if so.

Just to be totally candid, we are not, it's not going backwards and it's going -- it's moving sequentially in the right direction, it's just a little slower than we'd like and it's still way below line average and one of the reasons you saw the mechanical growth a lot stronger than the electronic growth in the quarter was that we intentionally slowed down the electronic while we got the profit model more aligned with our objectives. So I don't think we are going to have a real strong fourth quarter in electronic. It's not going to be weak I don't think either but it's not -- we are not going to mix heavily into electronic in the fourth quarter, would be my guess.

Jim, my comment, this is John, my comment on seasonality is just what we've learned over time, sequentially. There are two things that I think everyone is learning about the Stanley Security business with assuming the same product portfolio going forward. In the fourth and first calendar quarters, you have a little seasonality in the access business because we do face site readiness issues. Whether it's rain or snow or weather and a foundation isn't poured, we still have the structural cost of the installation team and if we leave a couple of installations undone due to weather there's no way to recover it during the quarter. It's the nature of the business which is why we tend to see slightly better operating margins in the second and third calendar quarters than the first and fourth. The other reason is our strong position in educational institutions in the high margin mechanical locking business. I think everybody understands you change out locks on college campuses when the students aren't there and that tends to be late June, July and August. That tends to flow into two different quarters but it's second and third quarter where we get a nice lift in that business that normally doesn't repeat in the first and fourth quarters. So those were really the two factors underlying my comment and it may have been unconsciously misleading because we're certainly not anticipating any material mix shift up into the SI business in the fourth quarter.

Your next question comes from the line of Nigel Coe.

Good morning. Just a question on the recovery in Bostitch. What is the assumed profile of the recovery? Do we have a J curve here where maybe we go into break even or a loss before improving? Do we go along at 2%, 3%? What's baked into the 2007 numbers?

Jim has given that already. At this stage what we've said from the low to mid single digit operating margins on about a $600 million revenue base, Jim said there's $10 million of operating margin improvement, if you will, baked into our '07 guidance. That's obviously not going to get us to double digit operating margins and it's certainly not a J curve, if that to you implies a hockey stick or an L curve, so be it. Our objective is to beat it, but we have about 10 million which is a couple hundred basis points on their revenue base built into next year on top of where they finish because it does take awhile to relocate factories and over time either two to three year, the two year projections to get it back to where it's been and beyond that we are trying to move it toward line average.

So the sales decline moderating in 4Q, maybe some dispensation with prices, would it be fair to assume that maybe we would get a flat margin in 4Q?

Flat versus what? Flat versus prior year? Versus 3Q?

3Q.

Versus 3Q? It certainly would be in a reasonable zone to assume that. I would hope it could be slightly better but I think those of us who have been watching this business for a period of time would feel pretty careful about predicting any big increase. So I think you are probably in the right zone.

In our 10% to 20% range we talked about mass merchant and residential construction. Bostitch is probably at the high-end of that, 25% in that about 20% of its business is home centers, probably their third largest channel or market if you will is construction, after furniture manufacture, after pallet making, after some other thing. So they might be under a little pressure in the fourth quarter from the top line perspective, but to Jim's point, not material relative to global Stanley.

Two more questions if I may. Just to get to consumer tools, looking at the fourth quarter sales growth at 2%, 3%, obviously there's some elementary adjustments coming through that that you have seen. What is the underlying point of sales that you baked into that number?

That we've baked in? Right now we are running, whereas earlier in the year we were in a kind of a high single digits for hand tools. We are like in the low single digits for hand tools. And that's with all the momentum that comes from the introduction of these products. So it's clearly a market slow down and that's kind of where we are. Some of the other business were probably slightly negative in storage and flattish in consumer mechanics tools.

Okay. I noticed at [inaudible] they exited one line of their storage products. Is there sort of a change in the dynamics in storage right now?

Well, I think, Nigel, don't be confused. We have two dramatically different storage businesses. What's reported in the consumer segment primarily, our ZAG business is plastic to a lesser extent metal tool boxes and a very emerging trend in the category is soft storage. And we've had some fairly good reception of soft storage products that we've put before some of our large retail customers. And those are generally quite low ticket items as opposed to our industrial storage business, Vidmar, often coming out of somebody's capital budget, a lot in the government and things of that nature, dramatically different dynamic. The consumer storage business in our consumer segment is about twice the size of the industrial business, dramatically different margin perspectives, dramatically different competitive set. So we need to be very careful how we define storage. But our consumer storage business is more seasonal. It acts more like a consumer product than the professional emphasis that we talked about. Customers do like to feature that item around holiday time or Father's Day time. So it will be a little more, I'll say volatile, than our base hands tool line which as I mentioned earlier where two-thirds of that volume is going to people who by these products to make a living.

Your next question comes from the line of Stephen Kim.

Thanks. Most of my questions have been asked, but I wanted to address the question of the margin degradation in fastening that you sort of outlined. You said it was basically double digit in 2002 and it's kind of come down the 2% to 3% range. Can you give a sense for whether in between nails, fastenings and the nailers, was there a material difference in terms of the margin trajectory between those broad categories? Or was it pretty much the same?

It's been a very storied couple of years. If you go back a couple of years ago we just -- they got killed by steel inflation. On fasteners. On fasteners. And the tools -- the tools were not affected that much but over the years the competitive intensity in the tool market driven by the fact that a lot of the competitors, in fact virtually all of the competitors source their tools from Taiwan, had increased. And we had not done too much about that. Probably 20% of our tools were sourced from Taiwan and 80% were made in low cost countries before we bought Besco. So it was two different situations there and then we recovered a lot of the price in that steel inflation era but not all of it. And our competitors didn't try to recover as much because perhaps they had a little better cost advantage than we did. Perhaps we had a little better fixed cost than they did. And so the chickens came home to roost in this business over time as we slowly and for various reasons developed a cost disadvantage of some significance along with a price umbrella. So now what we are dealing with is getting the costs back in line so we can be actually world cost competitive in this business and we can have pricing flexibility.

Remember, Steve, within our fastening business, I think it's something that folks often don't focus on. It's 25% tools and 65% fasteners and then 10% peripheral items that we can call them support items or things of that nature. So think two to one fasteners to tools, at least two to one, almost three to one in terms of impact on the business. So tools can hurt, it's $150 million plus in revenues but the business is more likely going to go the way that of fasteners themselves although we are very excited about the upside potential on tools with some product development going on, with having a strategic source of both high quality and low cost production in Taiwan and in China. But as I say, we've only owned this company for about six weeks and it will be awhile before you see the impact of that in our P&L or in our tools top line.

Right. Got it. My second question relates to Facom. If you could give a sense for what the margin dispersion looks between Facom and the rest of industrial. Obviously I know that there's been a goal to sort of get the margins up, I would imagine operating margins to double digits. Do you get the sense that you're -- basically you've penetrated the double digits yet at this point in Facom?

Oh, yes. Definitely. The Facom margins -- first of all you have to sort of look at it by quarter because the Facom business in effect takes the month of August off. So they have a -- literally a month of cost with no revenue. And so their third quarter is always a lower operating margin than any other quarter. And so for instance in the second quarter we were in, what, 14% kind of range? In the third quarter we dipped down sequentially to about 10%. And we would expect to go back up in the fourth quarter, back to at least where we were in the second quarter and with some of the other benefits that are kicking in, we could get even a little better than that.

Your final question comes from the line of Sam Darkatsh.

Good morning, John. Good morning, Jim. Two questions, both of them have to do with inventories. First, with respect to the retail inventories that I think you categorized as 12 weeks, when we exited the second quarter, I know it's not apples-to-apples for seasonal reasons, but when we exited the second quarter we were at ten weeks and the suggestion was that the retailers might have wanted to get to eight weeks. And with the slowing demand trends at retail why would you think that the retailers would only do half of the inventory draw downs that they did last year instead of taking down to eight or nine weeks at the end of the quarter, particularly given the trends that they are seeing on take away?

I guess two responses to that, Sam; one, trying to predict and understand where -- obviously we talk with them ever day where our customers heads are and we understanding where our business is. They were hurt as were we by the unprecedented and abrupt level of retail inventory reduction from 11 to 12 down to eight. They suffered tremendous out of stocks in December, January and across a lot of product lines but particular Stanley's and despite some obviously difficult negotiations at times at the end of the day, what's in our mutual best interest is what's right and they don't want to be out of stock on high margin items like Stanley FatMax and FatMax Xtreme tape rules. The second point is simply this time last year we didn't have, I will call it inertia, momentum of a tremendously successful stream of new product introductions that the consumers like it a lot and the customers like it because it's higher margin. So we've got, if you will, more fuel from the Stanley side and we think the experience of "Hey, we did this for a good reason; we probably did too much too fast. " And while we cleaned up or improved our retail inventory situation, we hurt our own POS, this is from our customer's perspective. So, will they do it again? Perhaps. Do we know exactly what they are going to do? No. And they probably aren't going to call us six weeks or even six days ahead of time which is why we thought the most, I'll say prudent, neither cautious or reckless assumption, was to assume half the level of retail inventory reduction that we experienced last year in the fourth quarter.

Okay. And going along with that, your own inventories are obviously pretty high as I'm guessing that you are forecasting higher orders than what you saw and so your production levels were higher. I'm calculating maybe $70, $80 million in excess inventory which if you apply a 20% contribution margin to that would have helped this quarter by about $0.15 and would have hurt Q4 if you draw them down buy about $0.15. Is my math wrong or what do you calculate your excess inventory?

Not even close.

Your math is quite a bit off.

Let's separate the core business from Facom and National for a minute because we are still getting our arms around exactly what their inventory can do and what it will do over time. But if we just take the core business, our inventories were $441 million in September of '05 and they are $477 million at the -- in September of '06. So they are up about $36 million our days are up just nominally. So and this includes some of the smaller acquisitions as well. So you can't take it all and just assume that it's organically related inventories, but a good portion of it is. So my estimate is that we are probably about $20 million high on inventories vis-a-vis where we would like to be and that's all baked into the guidance for the fourth quarter bringing that down.

At this time I will turn the conference back over to Mr. Lundgren for any closing remarks.

Yes, we started a little late and ran a little over. So thank you for your interest and patience. I just wanted to reinforce a couple of the points that Jim made prior to the Q&A; stepping back from a quarter for a second. Stanley is a 50% larger company than it was three years ago in terms of revenues. And as Jim quite clearly pointed out, with earnings growth and earnings projections commensurate with the revenue growth. There are three viable platforms with a more diversified business as well as product and customer mix than three years ago, which would imply less volatility regardless of the market conditions that we are doing business in. We are serving a lot of different markets, a lot of customer bases, a lot of checks and balances. Two large acquisitions, in fact two of the three largest acquisitions in Stanley's history are being systematically integrated and we are particularly encouraged with both the integration status as well as the business and operating performance of Facom at this stage which gives us reason to think that's going to continue going forward as opposed to some huge bump in the road that we haven't anticipated. And even in the third quarter, the majority of our businesses performed extremely well with one exception but our consumer vitality index and our brand awareness are at record high levels, good solid organic growth in Security and virtually all of our industrial businesses. I think it's clear that we are stepping up to and addressing the cost competitiveness issues in Bostitch and as I think Jim made very clear we certainly have the cash flow and expecting the continuation of the cash flow to support the execution of our strategy. So we are encouraged by our recent performance. We are maintaining a cautiously optimistic outlook going forward as we close '06 and enter '07 and I look forward to speaking to you again in January. Thanks.

This concludes today's conference. You may now disconnect.