Don Allan - Executive Vice President and Chief Financial Officer
"Thank you, Jim and good morning everyone. I will now take a deeper dive into our business segment results in the second quarter. Tools & Storage delivered 11% revenue growth, with an impressive 10% organic growth and 1 point of currency. And as Jim highlighted earlier, the initial effects of our price increases contributed 1 point of organic growth. The operating margin rate was 16.2% versus 17.6% in the second quarter of 2017 as benefits of volume leverage pricing, productivity and cost control were more than offset by commodity inflation and currency. The vast majority of the $50 million of commodity inflation and $20 million of currency that the company experienced in the second quarter was absorbed by the Tools & Storage business.
The strong organic growth and related share gains were experienced across each Tools & Storage region and SBU. On a geographic basis, North America was up 10% organically with growth across all channels. The U.S. retail channel has generated low double-digit growth, U.S. commercial markets posted high single-digit growth and our industrial and auto repair markets generated mid single-digit growth. Additionally, Canada contributed exceptional organic growth of 13%. North America’s growth continued to be fueled by new product innovations, the initial Craftsman rollout supporting the Father’s Day promotion at Lowe’s and Ace, a recovery in the outdoor products segment, and of course, our pricing efforts in response to commodity inflation and currency. This growth was achieved while maintaining normal inventory levels within our major customers in North America, the U.S. tool market continues to be supportive providing a sound backdrop for organic growth initiatives that Jim just mentioned.
Europe delivered another solid performance with 5% organic growth. All 10 markets grew organically, with above average contributions from Central Europe, the UK, Greece, France and Iberia. The team continues to deliver market share gains as they leverage our portfolio brands, deliver new product innovations and expand retail relationships to produce the strong organic growth.
Finally, emerging markets continued their trend of outstanding organic growth, up 17% with all regions contributing. Diligent pricing actions to offset currency headwinds which weekly arose in Q2 as well as a continued focus on e-commerce and the ongoing MPP launch continued to support growth in this part of Tools & Storage. Geographically, Latin America was headlined by double-digit growth in Argentina, Chile, Colombia, Mexico and Peru. Our change to a direct selling model within Turkey and Russia continued to fuel exceptional growth for those countries. And in addition, India, Korea and Japan also posted notable double-digit growth.
Both Tools & Storage SBUs showed 10% growth in the quarter. The Power Tools & Equipment Group was led by Professional Power Tools, which was up low double-digits. The consumer power tool group rebounded nicely from the first quarter impacts of the outdoor and Craftsman transition posting mid single-digit growth. Power Tools & Equipment benefited from new product introductions, leveraging our core innovation efforts, continued expansion of the DEWALT FLEXVOLT system and of course, sharp commercial execution. FLEXVOLT continues to be a differentiated growth driver for Tools & Storage. Shipments were on plan and we again saw double-digit organic growth within the North America retail channel and Europe. The 10% organic growth within hand tools, accessories and storage was due to new product introductions, strong performances within the construction and industrial-focused product lines and the contribution from Lenox and Irwin revenue synergies. Hand Tools and Storage business delivered an outstanding 11% organic growth, while accessories, was up 6%, another solid performance from this team. So in summary a great quarter for the Tools & Storage organization, where they delivered organic growth in nearly every market, initiated price increases to counter the impacts from commodity inflation currency and tariffs, all while keeping the acquisition integration and execution of the strong portfolio of growth catalysts on track. Now that is agility.
Turning to Industrial, this segment delivered flat organic growth, albeit better than internal expectations. Similar to the theme from Tools and Storage, operating margin rate declined year-over-year to 16.8% as productivity and cost control were more than offset by commodity inflation, growth investments and the modestly dilutive impact from the acquisition of Nelson Fasteners. Engineered Fastening posted total growth of 20%, with the acquisition of Nelson Fasteners. Organic growth was 3% during the quarter as strong automotive and industrial fastener growth more than offset the expected declines in automotive systems due to lower model rollover activity from our customers. This team has successfully leveraged their base business model to deliver technology, engineering and productivity solutions to increase fastener sales 800 basis points over light vehicle production across the first half of 2018 after growing over 500 basis points over light vehicle production in the second half of 2017. Specifically, we have developed a host of joining and fastening solutions that are positioned for the key trends within the automotive space, namely electrification and light-weighting. Additionally, the team has focused on the high growth local and regional Asian OEMs that are now demanding the higher technology and quality solutions we provide, another great example of commercial excellence at Stanley, Black & Decker.
And then finally, the early days of the Nelson integration remain on track to plan and the business is demonstrating pro forma organic growth with strength in the shipbuilding and construction verticals, all-in-all a very solid quarter for Engineered Fastenings. The infrastructure business has posted organic decline of 10% for the quarter. Hydraulic Tools grew organically for the seventh consecutive quarter posting mid single-digit growth as they continue to see the benefits from successful commercial launches. Meanwhile, oil and gas posted a high-teen organic decline in the quarter as expected given the lower pipeline project activity versus the prior year.
And then finally, the Security segment demonstrated total growth of 6%, which included the benefits of small bolt-on acquisitions, currency and price partially offset by a 1.5% volume decline in the second quarter. North America growth was down 2% organically as higher automatic door and healthcare volumes were more than offset by lower volume in commercial electronic security, which did have a difficult comparable due to the large installation project activity that occurred in the second quarter of 2017. Europe organic growth was flat as strength in the Nordics was offset by anticipated ongoing weakness in France.
In terms of profitability, the segment operating margin was 10%. The rate was down 100 basis points versus the prior year as it was impacted by targeted investments to support the ongoing transformation of the business partially offset by continued cost containment. The security team remains focused on the business transformation, which is targeting three key areas within commercial electronic security: one, applying digital technologies to improve the effectiveness of our service and monitoring organization, while significantly lowering the cost to serve; two, delivering simpler and more flexible solutions for our small to medium-sized customers; and three, leveraging business analytics to provide key business insights to our large national account customers. These initiatives, along with focus on commercial and operational excellence, will position the business for sustained revenue growth and margin expansion over the next 2 years.
Now, let’s take a quick look at the quarter’s free cash flow performance on the next page. I would like to highlight that the 2017 cash flow amounts presented reflect the results as previously reported and exclude the impacts of the new accounting standards adopted in January of this year. These accounting standards change the classification of an AR sales program that has since been terminated and has no impact in 2018. We believe that presenting the cash flow results in this manner for 2017 provides a more meaningful view of the company’s historical operating cash flow performance.
So, to the actual results for cash flow. For the second quarter, free cash flow was $86 million, which provides our year-to-date performance, but brings our year-to-date performance to a use of cash of $369 million. The quarterly and year-to-date declines versus the prior year are predominantly explained by carrying higher amounts of working capital to support the outsized level of organic growth and upcoming Tools & Storage product launches as well as higher tax payments related to the newly enacted U.S. total charge. From a working capital term perspective, we delivered 6.6 turns in the second quarter, which is a decrease of 0.7 turns versus the prior year. This decline is primarily due to requirements needed to support growth and new product launches, including the pending Craftsman rollout. We are confident that we will deliver strong cash flow generation in the second half of the year given our core SFS processes and principles combined with reducing working capital levels in line with normal seasonal activity. In addition, we will continue to maintain adequate amount of working capital to support our new increased growth expectations. Therefore, we are reiterating our commitment to deliver our free cash flow conversion rate of approximately 100% supported by this expected strong second half cash generation.
I would now like to take a minute to provide an update on the external headwinds we are facing this year. And just as importantly, the recovery actions we are executing. We continue to see elevated commodity prices and as a result now expect inflation headwinds to approximate $205 million in 2018, with about $100 million already realized year-to-date. This is up $25 million from our previous expectation of $180 million. Steel, batteries and base metals remain the most significant commodities generating this headwind. Additionally during the last 8 weeks of the quarter, we saw significant currency impacts emerge as the U.S. dollar strengthened. At this time, we estimate this headwind to approximate $80 million in 2018, the pressures being driven primarily by the currencies of Argentina, Brazil, Turkey and Russia. In response, we already implemented an initial set of price increases in June, with an additional set of actions planned for the third quarter.
Now, shipping to tariffs, we currently estimate the impact of tariffs to be a 2018 headwind of approximately $35 million. This reflects the impact of Section 232 tariffs on steel and aluminum as well as the initial $34 billion of Section 301 tariffs on componentry and some finished goods. We have initiated price increases for these implemented tariffs and look to further mitigate the remaining impact via the exclusion, the formal exclusion process, where applicable. In response to these $320 million of total external pressures on this page, we have taken a series of recovery actions. First, we have implemented or are in the process of implementing price increases that should yield $190 million during 2018. This is an increase of $70 million from the $120 million in actions discussed in April. Approximately $40 million of that change is related to foreign currency in emerging markets with the $30 million balance in response to higher commodity inflation and implemented tariffs. We expect the remaining price increases to be implemented during the August-September time period. In addition, $36 million in other cost and productivity actions will be executed to help these external pressures to help offset these external pressures. These represent discretionary cost reductions pacing of some investments that have longer term paybacks and incremental productivity opportunities. These are not investments that will jeopardize key programs that support organic growth in the short to medium-term.
Now, turning to the right side of the chart to address the additional $200 billion in tariffs under Section 301 that were announced on July 10, we have not included the impact of these tariffs in our guidance due to the uncertainty around implementation timing and the product categories that will ultimately be included. Prior to mitigating actions, we estimate the annual impact to be approximately $70 million to $80 million. Therefore, if you assume and it is an assumption at September 1 implementation, the 2018 impact could be approximately $25 million. However, we believe this is the potential headwind that we can manage within our current guidance through additional price actions as well as our remaining contingency. These tariffs are focused primarily on finished goods such as vacuums and tools and power tool accessories. If these are implemented, we will look to initiate price actions on affected categories to protect our profitability.
Now that these tariffs are beginning to hit finished products, it’s important to note that approximately 50% of our North American tools revenue is supported by our North American manufacturing facilities. This undoubtedly puts us in a favorable position versus competition to navigate these tariffs and may create opportunities for increased demand at our local facilities. So, a lot of moving pieces, but we are acting with agility to implement price and cost actions to offset these transitory headwinds and once they have abate we will have the business positioned for a favorable setup.
Moving to our 2018 guidance, we are reiterating our 2018 adjusted earnings per share guidance of $8.30 to $8.50, up approximately 13% versus the prior year at the midpoint. On a GAAP basis, we now expect earnings per share range of $7 to $7.20 inclusive of M&A and other charges. This is a reduction of $0.40 versus our prior outlook. The change in the GAAP guidance is related to the recently announced CPA settlement.
Now diving into a little more detail in our 2018 adjusted EPS outlook. You can see on the left hand side of the chart, we expect the previously mentioned benefits from incremental price, cost and productivity actions to generate approximately $0.48 of EPS accretion versus our April guidance assumption. We have also increased our organic volume growth expectations by 1 point contributing an additional $0.12 of EPS accretion. Including the benefits from price, we now expect organic growth to approximate 7% for the company. Finally in April, we also executed a share repurchase of $200 million contributing approximately $0.10 of EPS accretion. This cumulative $0.70 of EPS accretion will be offset in its entirety by higher expectations for commodity inflation, tariffs and currency I just discussed.
A few brief model-related planning items. We are revising our average shares outstanding to approximately $153 million, which reflects the April purchase. Second item, we expect lower other net expenses due to the favorable to 2Q resolution of a prior claim. However, this will be offset by increased interest expense expectations reflective of higher interest rates and debt levels due to working capital needs. Third item, we continue to anticipate approximately $50 million of core restructuring charges in 2018. However, the second half charges will be weighted more to the third quarter. Finally, we expect third quarter EPS to approximate 24% of the full year 2018 guide as our third quarter will see the largest impact from commodity inflation and currency, while price increases continue to be implemented throughout the quarter.
And finally, turning to the segment outlook on the right side of the page, organic growth within Tools & Storage is now expected to be high single-digits in 2018 reflective of strong volume trends in our incremental pricing actions. We believe that market conditions remain supportive and provide a favorable backdrop for our pipeline of organic growth catalysts. This team is focused on key initiatives, FLEXVOLT, Lenox and Irwin revenue synergies, e-commerce, emerging markets and the continued rollout of the Craftsman brand. We are now expecting the segment margin performance to be slightly down year-over-year given the elevated currency and commodity headwinds.
In the Industrial segment, we now expect relatively flat performance year-over-year in organic growth versus our prior expectation of low single-digit decline. With the business performing above expectations in the first half of the year, the automotive and industrial fastener growth as well as Hydraulic Tools volume should offset the market-related pressures from automotive systems and lower levels of project activity within oil and gas. We continue to expect our segment margins within industrial to be down year-over-year primarily due to the Nelson Fastener acquisition, but also slightly due to the incremental pressure from inflation and tariffs in these businesses. Nelson currently carried below segment average margins, but with cost synergies, we will get these margins up to the line average in a relatively short timeframe.
Finally, in the Security segment, we now expect the organic growth to be relatively flat year-over-year, implying low single-digit organic growth in the second half of the year. We are also revising our margin outlook to down year-over-year as we continue to focus on the business transformation I previously discussed. So in summary, we believe we are taking the appropriate actions to position the company to deliver a robust 7% organic growth, with 13% adjusted EPS expansion. This is overcoming approximately $320 million in commodity inflation, tariffs and currency pressure. In addition, we remain focused on free cash flow generation, price realization, productivity and cost management, acquisition integrations and the rollout of the Craftsman brand."
Stanley Black & Decker, Inc (SWK) CEO Jim Loree on Q2 2018 Results - Earnings Call Transcript | Seeking Alpha
