Snap-on Stock: Margin Ceiling May Be Near (NYSE:SNA)

Snap-on Incorporated (NYSE:SNA) sells tools in a wide range of industries. The company has had a massive amount of operating leverage in the company’s long-term history as Snap-on’s margin has over tripled in the last twenty years. Although Snap-on’s financial history is extremely good, I only have a hold-rating for the stock as my estimates for the company’s future seem to be priced in. Also, as the company’s margins have reached a very high level, there can only be so much more space for the margin to grow.

The Company

Snap-on defines its offering as productivity solutions – the company sells simple tools, such as wrenches, drills, pliers. The company does also have more sophisticated products in its range of offerings.

The company operates under numerous brands. Many of Snap-on’s brands are based on an automobile offering – Snap-on’s business as a whole has a good amount of revenues coming from the automobile industry. Snap-on’s brands include Snap-on, ATI Tools, AutoCrib, Bahco, Car-O-Liner, and Cartec, for example:

Snap-on’s stock price has appreciated at a CAGR of 8.6% in the past thirty years, and has had a modest dividend yield on top, with the yield currently standing at 2.56%.

Financials

Snap-on has achieved a moderately good amount of growth in the company’s history, as the compounded annual growth rate has been 4.2% from 2002 to 2022 with quite low variance in the growth:

The growth seems to be mostly organic, although the company has had multiple small acquisitions to grow its list of brands.

Better than Snap-on’s revenue growth, the company has significantly grown its EBIT margin from a level of 7.9% in 2002 to a current trailing level of 26.2% – the company’s margin leverage has accounted for more of Snap-on’s long-term earnings growth than revenue growth, opposite to most companies.

The question is – can Snap-on continue to have incredible operating leverage? Snap-on has already scaled its gross margin from 45.7% in 2002 to a current trailing level of 51.1%, and operating leverage in terms of OpEx should be nearing a ceiling. Currently, operating expenses including selling and general expenses represent only 24.9% of the company’s revenues – a company such as 3M, a leader in multiple verticals, has a opex-to-revenue ratio of 27.1%, above Snap-on’s.

Yet, operating leverage has continued in the first half of 2023 – the first half’s EBIT margin grew by a whole percentage point compared to the previous year’s period due to a higher gross margin. My approach to further margin expansion is to not expect it but to keep it in mind as a possibility.

Snap-on doesn’t seem to have significant interest-bearing debts on its balance sheet; almost all of the company’s debts seem to be operational in nature. On the other side of the balance sheet, Snap-on has quite a large amount of cash at $871 million – the cash balance leaves room for further small acquisitions or a good amount of share buybacks, for example.

Valuation

Currently Snap-on trades at a forward price-to-earnings ratio of 13.5, a bit below the company’s ten-year average of 15.4:

Taking the price-to-earnings ratio at face value, the ratio seems reasonable in the current climate for a company like Snap-on. As usual, I constructed a discounted cash flow model to take a deeper look into the valuation – it seems that the DCF model agrees that Snap-on is currently valued quite fairly.

In the model, I estimate a revenue growth of 5% for the current year, in line with analysts’ expectations. Going forward from 2024, I estimate a growth of 4.5% for 2024 that slows down into a perpetual growth rate of 2% in steps – the estimated rate is roughly in line with Snap-on’s organic history. As for the company’s EBIT margin, I expect only a slight further leverage. In the DCF model, the margin grows by 1.3 percentage points from 2022 to 2032 – if the company does demonstrate a margin expansion more in line with Snap-on’s history, the stock could be worth way more. I don’t think such leverage is a base scenario though, as margins are already on a very high level.

These estimates along with a weighted average cost of capital of 11.09% craft the following DCF model with a fair value estimate of $241.33, around 6% below the stock’s current price:

The used weighed average cost of capital is derived from a capital asset pricing model for Snap-on:

In the CAPM, I estimate Snap-on’s interest rate to be 5.65% – as the United States’ 10-year bond yield is 4.65%, I believe the estimate is reasonable as I added one percentage point into the yield. The company currently doesn’t hold a significant amount of interest-bearing debt – I believe that a good part of the company’s interest payments are related to leases and other mostly operational activities. For that reason, I estimate a low long-term debt-to-equity ratio of 5% for the company.

On the cost of equity side, I use the United States’ 10-year bond yield as the risk-free rate. The equity risk premium of 5.91% is Professor Aswath Damodaran’s estimate for the US made in July. Yahoo Finance estimates Snap-on’s beta to be 1.10. Finally, I add a very small liquidity premium of 0.3% into the cost of equity, crafting the figure at 11.45% and the WACC at 11.09%, used in the DCF model.

Takeaway

I believe that Snap-on is a fair investment at the current price. The company has achieved a remarkable long-term margin expansion, but the company needs to have further leverage for the stock to currently be undervalued in my opinion; as Snap-on’s margins seem to already pushed close to their limits, I wouldn’t think of significant further margin expansion as a base scenario. For the time being, I have a hold-rating for the stock.