Stanley Black & Decker, Inc. (SWK) Q3 2022 Earnings Call Transcript

Welcome to the Third Quarter 2022 Stanley Black & Decker Earnings Conference Call. My name is Shannon, and I will be your operator for today's call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. Please note that this conference is being recorded. I will now turn the call over to the Vice President of Investor Relations, Dennis Lange. Mr. Lange, you may begin.

Thank you, Shannon. Good morning, everyone, and thanks for joining us for Stanley Black & Decker's 2022 third quarter webcast. On the webcast, in addition to myself, Don Allan, President and CEO; and Corbin Walburger, Vice President and Interim CFO. On our earnings release, which was issued earlier this morning and a supplemental presentation, which we will refer to, are available on the IR section of our website. A replay of this morning's webcast will also be available beginning at 11 a.m. today. This morning, Don and Corbin will review our 2022 third quarter results and various other matters followed by a Q&A session. Consistent with prior webcast, we are going to be sticking with just one question per caller. And as we normally do, we will be making some forward-looking statements during the call on our current views. Such statements are based on assumptions of future events that may not prove to be accurate, and as such, they involve risk and uncertainty. It's therefore possible that the actual results may materially differ from any forward-looking statements that we might make today. We direct you to the cautionary statements in the 8-K that we filed with our press release and in our most recent '34 Act filing. I'll now turn the call over to our President and CEO, Don Allan.

Thank you, Dennis, and good morning, everyone. As you saw from today's release, we made tangible progress during the third quarter towards our strategy around focusing our business and transforming our supply chain. We are building positive momentum as we deliver improved customer fill rates, deployed a new organizational structure, implemented cost controls and actively reduced our inventories. In addition, we made significant progress reducing debt, utilizing $3.3 billion in proceeds from our strategic divestitures. All key priorities we set out heading into the third quarter. All of this is not yet apparent in the financials, but we are encouraged by a few items. One, our headcount reductions are largely complete. Two, inventory is coming down. Three, cash generation was positive in September, and we believe this can continue in the fourth quarter and next year. And four, gross margin will be the last to turn as we face the high cost of destocking, but we expect to be through that and pivot to better performance by the middle of next year. While the macroeconomic environment remains challenging, notably softer North America consumer and European markets, combined with stubborn cost inflation, there were relative bright spots with continued strength in Professional Construction and Industrial customer demand, as well as incremental progress unlocking global supply chain constraints. Our actions to alleviate semiconductor constraints are progressing as expected and are contributing to results through our improved fill rates as well as slightly better organic revenue performance in Q3. Third quarter revenue was $4.1 billion, up 9%, driven by our Outdoor Equipment acquisitions. Organic revenue declined 2%, which was an improvement over what we delivered in the first half, due to increased professional power tool supply and a solid performance by the Industrial business as organic growth was up 14%. Price realization sequentially improved 8% versus the prior year. U.S. retail point of sale was relatively consistent with the levels we saw exiting Q2, supported by price and professional demand, even as softer DIY consumer demand persisted. Europe continues to operate in a challenging environment as a result of the broader macro, the war in Ukraine as well as the continued impacts from customer destocking due to elevated channel inventories. Our improved supply position has set us up for strong merchandising support for the holidays across all major brands and categories, with much of the product already shipped to our customers in September and October. We have gained back some key aisle end caps and off-shelf promotion areas after 12 months of limited promotional activity. During the third quarter, we successfully delivered $65 million in pretax savings from our global cost initiatives and reduced our inventory by approximately $300 million. In a few moments, I will dive deeper into our progress related to the Company's transformation plan announced in Q2. Operating margin was 6.2% in the third quarter, pressured by input cost inflation, which was partially offset by customer price increases. Additionally, our margins were impacted by our inventory destock as we began the process of significantly reducing manufacturing production levels in June and during the third quarter. This resulted in third quarter adjusted EPS of $0.76. The divestitures of Electronic Security, Access Technologies and Oil & Gas businesses were successfully completed in the third quarter, which further focuses Stanley Black & Decker's portfolio on our leading Tools & Outdoor and Industrial businesses. Proceeds from the transaction supported $3.3 billion of sequential debt reduction. These deals also conclude the strategic portfolio moves we've been executing over the last 12 months and further intensifies the operational execution focus of our company as we move forward. In terms of financial guidance, because of the ongoing changes to the demand environment, the impact related to foreign exchange and incremental costs due to our more aggressive pullback on production to accelerate inventory destocking in the first half of 2023, we are revising our 2022 adjusted diluted EPS range down to $4.15 to $4.65, and updating our free cash flow estimate to approximate $0.3 billion to $0.6 billion for the fourth quarter, which includes a substantial tax payment related to the gains on the business sales I previously mentioned. Our near-term priority is cash generation, and September marked a turning point with planned production curtailments beginning to meaningfully contribute to inventory reductions, supporting positive cash generation in the month. The decision to escalate and continue production curtailments in Q4 will clearly carry a negative P&L implication as we incur the impact of our under-absorption of fixed plant costs, while concurrently liquidating higher cost inventory from the balance sheet. Although the immediate P&L impacts are significant, and will be incurred in Q4 and likely in the early stages of 2023, we believe proactively reducing inventory in a disciplined yet swift manner is the right strategy and will put our business in a position to optimize growth and margin expansion going forward. Now, I'd like to review how we are moving forward to accelerate organic growth. We have optimized the corporate structure, focused our operating model and are transforming our supply chain to drive efficiency and fuel reinvestment. As we deploy our new organizational structure and operating model, we are elevating three key priorities to sharpen our focus: one, end user obsession and innovation; two, customer focus; and three, delivering operational and functional excellence. These are built upon the non-negotiable priorities and values that make up our culture, such as people focus and talent management, health and safety, integrity, compliance, DE&I, and ESG. In the next three years, we expect to redeploy $300 million to $500 million to advance innovation across our iconic brands, accelerate electrification in our Outdoor and Engineered Fastening businesses, rapidly accelerate our end-user market activation and create the supply chain of the future. These investments will position the Company for strong, sustainable, long-term growth, profitability, consistent free cash flow generation, and shareholder return. We have a strong track record as the industry leader in breakthrough, world's first innovations in our businesses. From FLEXVOLT to ATOMIC and XTREME to POWERSTACK, we will build upon this strength to deliver an even higher quality of core and breakthrough innovations with shorter development cycles and new technologies. Electrification is a key growth driver across our Tools & Outdoor and Engineered Fastening businesses. We plan to make incremental investments to accelerate our efforts, capitalize on share gain opportunities and fortify our market leadership position as the technology continues to shift and adoption accelerates. Market leadership includes more user activation at the front end of our businesses. As we introduce our new products and innovation, we will bring more digital tools and capabilities as well as additional commercial resources to engage directly with our customers, enhance interactions with our end users and drive market share gains. Lastly, to fully leverage these investments, we need to have a world-class and more agile supply chain that brings us closer to our customers, increases our flexibility in response to demand, and enhances our customer service levels, all to drive greater growth for us and for our customers. Aligned with these growth investments and as we execute this strategy, we will be focused on a few key success criteria. One, our powerful innovation engine will position us to grow organic revenue 2x to 3x the market over the long term. Two, our supply chain transformation is a key enabler to improve our customer service levels and operational efficiency to return gross margins back to the 35% plus level, with customer fill rates greater than 95%. Three, we have a long track record of generating strong free cash flow, and we'll continue to target 100% free cash flow conversion to net income over the long term while ensuring consistent annual performance. We are now a more focused company, executing a clear strategy with both immediate and near-term tactical actions to deliver strong value for our shareholders over the long term. Key to our success is and will continue to be market-leading innovation, and I will now highlight a few exciting new launches on the next slide. As the world's largest tool and outdoor company, we are continuing to push the bounds of our category offerings to serve the full spectrum of our makers and creators, from the DIY consumer to trade users and up to the most demanding pros. We are expanding DEWALT POWERSTACK with the launch of a new 5-amp hour battery. This is the most powerful, longest-lasting 20-volt MAX battery in its class, and is compatible with our 300-tool strong DEWALT 20-volt system. POWERSTACK is the first pouch cell technology, battery of its kind, designed to deliver unparalleled power density to best serve our most demanding professional customers and is expected to deliver over $100 million of revenue in its first 12 months since launch. Today, the 5-amp hour product is already in the European market and has received great reviews from our customers. We are also continuing to advance our high-power DEWALT FLEXVOLT line. By the end of this year, the portfolio will reach 60 products across power tools and outdoor power equipment, generating approximately $500 million of annual revenue and continuing to grow, approaching nearly 70 products by the end of 2023. The DEWALT FLEXVOLT 15 Amp-hour battery was introduced last year as a world's first innovation. DEWALT FLEXVOLT converts users who are using corded, small-gas engine, or pneumatic tools due to a high power need, and they convert them over to battery power. And it is one reason why three-quarters of the DEWALT power tool revenue is cordless today. Our FLEXVOLT technology is also advancing innovation and sustainability across our industrial business, where customers desire to replace existing hydraulic tools with cordless solutions to increase portability and efficiency. To that end, the Stanley infrastructure team recently launched the first cordless automatic rail maintenance tool, the RD60 rail drill, which is powered by DEWALT FLEXVOLT. These are just a few examples where we are continuing to deliver industry-leading innovations to push the bounds of our categories and accelerate our success. Another key enabler to our strategy is generating cost savings by taking the complexity out of our businesses while investing to accelerate our organic growth, recovering gross margins and generating consistent strong free cash flow. From an SG&A perspective, we are executing on our plan to rapidly optimize our organizational structure to become flatter and more agile. The new structure is largely complete, including a leaner corporate team. These actions will generate the $300 million of annualized cost savings as targeted. Rigor around indirect spend is in place. Initial savings of $40 million were realized in Q3, and we are on pace to deliver approximately $200 million by the end of next year. As we shared with many of you, we moved quickly to deploy this new structure so the organization can focus on its priorities and execution. We remain on track to deliver the cumulative savings of $500 million we set out to achieve last quarter, covering the simplification of the corporate structure, the reduction of indirect spend and the streamlining of spans and layers, all by the end of 2023. Pivoting to supply chain, we also activated this transformation with a sense of urgency. Detailed planning and, in some cases, project execution is underway across all four pillars of the strategy. I will now cover some noteworthy progress in the quarter. Regarding the SKU rationalization, we have approved and initiated action on approximately 50,000 SKUs, which represents roughly half of the targeted reduction. We expect the remaining SKU reductions to occur from now through the end of 2023. Second, within the strategic sourcing initiatives, we are activating quick wins that are already generating savings. In tandem, we are defining the wave one implementation plan for 2023, which covers about one-third of the addressable spend. Lastly, we are being thoughtful as we progress the facility consolidation and distribution optimization to ensure we plan effectively for successful execution with our teams and for our customers even as we work with speed. We have gained some significant early traction and are on pace to deliver the savings targeted for 2022, and we'll continue to build momentum as we enter 2023. I will now pass it to Corbin, who will take you through more detailed commentary on the third quarter performance, including gross margin and inventory levels, as well as the latest guidance on how we expect to close out 2022.

Thank you, Don, and good morning, everyone. Let me walk through the details of our third quarter business segment performance. Beginning with Tools & Outdoor, revenue grew 10% to $3.5 billion as the MTD and Excel outdoor acquisitions contributed nearly $600 million of revenue or approximately 18% growth, and price realization contributed 7%. These factors were partially offset by a 12% decline in volume and a negative 3% impact from currency. On an organic basis, we were down low single digits in emerging markets in North America and down 12% in Europe. U.S. retail point-of-sale was supported by professional demand and remained consistent with levels exiting the second quarter of 2022. Aggregate weeks of inventory in these channels remain below 2019 levels. The European results were impacted by retail market pressure due to high levels of customer inventory and inflation as recessionary concerns and the war in Ukraine continue to weigh on consumer spending, particularly in the Northern region. Adjusted operating margin for the segment was 6.8%. Excluding charges and acquisitions, margin was 140 basis points better at 8.2%, however, still below the 15.5% level from the same period last year as the benefit from price realization was more than offset by commodity inflation, higher supply chain costs, production curtailment costs and lower volume. Consistent with normal seasonality, the MTD and Excel outdoor businesses deliver only about 40% of full year volume in the back half at operating margin substantially below the annual average as margins in the first half of the year are typically bolstered by peak outdoor seasonal volume leverage. Across the North American channels, organic sales in retail and e-commerce were down versus 2021 levels, with moderate strength in Commercial and Industrial. However, as compared to a pre-pandemic 2019 baseline, organic sales performance was up double digits across these channels. Turning to the strategic business units within our Tools & Outdoor segment. Power Tools declined organically by 2%. This modest decline reflects an improvement versus the front half performance as we're seeing better semiconductor supply, which helped to raise customer fill rates and contributed to positive organic growth in North America. Looking ahead, we expect further progress in the fourth quarter and are serving a normalized merchandising and promotional schedule for our professional products with our customers. Hand tools declined organically by 7%, driven by retail consumer demand softness in European customer destock. These factors were partially offset by strength among professional-oriented customers in the U.S. commercial and industrial channels as well as successful new product launches in our CRAFTSMAN plastic storage. The Outdoor business declined 12% on a pro forma organic basis. Total revenue was impacted by moderated consumer demand like many other discretionary retail categories and lower orders, as our retailers are also working down inventory. The outdoor team is progressing on our platform integration initiatives, and we have a host of new outdoor innovations across our brands and categories in the pipeline to be launched for the 2023 season. Now shifting to Industrial, which had a great quarter, leveraging the cyclical recovery, with 14% organic growth and margin expansion back to the double digits. Segment revenue increased 5% versus last year as nine points of price realization, coupled with five points of volume, were partially offset by six points from currency headwinds and three points from the Oil & Gas divestiture, which closed in August. The team leveraged this growth and our price increases to overcome commodity inflation and deliver adjusted operating margin of 11.1%, up sequentially 180 basis points and up 340 basis points versus last year. Looking within the segment, Engineered Fastening organic revenues were up 15%, led by aerospace growth of 28%, auto growth of 22% and 4% growth in general industrial fasteners. The auto fasteners business continues to navigate a dynamic supply environment for our customers and is also leveraging tailwinds related to the recovery in auto manufacturing. Our industrial fastener business is continuing to outperform the Industrial Production Index and is maintaining a healthy backlog, which is up 7% versus last year. Aerospace fasteners delivered its fifth consecutive quarter of sequential revenue improvement. This business continues to focus on capturing the emerging recoveries in both narrow-body and wide-body OEM production. I'll now spend a few moments covering our gross margin and inventory performance and expectations. Third quarter gross margins continued to be pressured by several points as we navigated the impacts from inflation and temporary impacts from under-absorption of fixed costs related to our planned production curtailments. This is a strategic choice as we prioritize cash flow generation through inventory reductions. We're making progress with our inventory reductions, which totaled nearly $300 million in the third quarter. We expect to make further progress in the fourth quarter, which will translate into positive cash flow. While these curtailments put temporary pressure on our margins that are necessary as we get our days of inventory back closer to historical levels. With this goal in mind, we made the strategic choice to extend our planned production curtailments versus our original plan to ensure we make continued progress through the middle of next year. Back in July, we assumed our production levels would begin to normalize at year-end. However, we're now planning to maintain low production levels through the first quarter of 2023. This puts additional pressure on our gross margins and depresses payables for the near term, with the trade-off of capturing a cash generation opportunity as inventory continues to decline. These items also impact our total cash generation forecast for 2022 as we incorporate assumptions for lower working capital reductions, including the previously mentioned impact of payables and a lower earnings base. However, the cash flow generation for the Company is gaining momentum. We generated positive free cash flow in the month of September, and we believe this will continue for the fourth quarter. Our capital deployment priority is debt reduction as we look to get to our targeted 2x debt-to-EBITDA level. In the third quarter, we reduced debt by approximately $3.3 billion, utilizing the cash from our divestitures. We expect to achieve further reductions to our debt levels as we generate cash flow in the fourth quarter and in 2023. Turning to gross margins. We believe that this quarter and the first quarter of 2023 should represent the trough as production curtailments and higher cost inventory liquidations are most impactful over the next six months, pressuring margins to the low 20s. The destock impact is expected to alleviate beginning in the second quarter of 2023, with gross margins recovering into the high 20s before any of the benefits from our supply chain transformation. As you heard from Don, we expect that the supply chain transformation savings will start to accrue as we move through the year and build to approximately $500 million by the end of 2023, which will provide further support for the improved gross margins into the 30s on the journey towards 35% plus gross margins in 2025. We believe our focus on inventory reduction, cash generation, and balance sheet health are prudent as we work in parallel on structural supply chain savings to improve our gross margins in 2023 and beyond. I'll now walk through what this means for our 2022 guidance. For full year 2022, we expect low double-digit total revenue growth for the Company. We're updating our adjusted earnings per share full-year guidance to a range of $4.15 to $4.65. On a GAAP basis, we expect the earnings per share range to be $0.10 to $0.80, inclusive of one-time charges. The current estimate for pretax charges in 2022 is approximately $755 million to $795 million. On the right side of the slide, we've outlined the key assumption changes to our adjusted EPS versus our prior estimate. Lower fourth quarter revenue, primarily driven by European retail market pressure due to high levels of customer inventory and inflation, reduces EPS by $0.30. Foreign currency translation pressure further reduces EPS by $0.23. Our strategic choice to prioritize inventory reduction and free cash flow generation is accompanied by higher production curtailment costs and inventory destocking costs, which are estimated to be $0.82 of a reduction. Then the 2022 tax impact from lower earnings is expected to increase EPS by $0.25, bringing the revised midpoint to $4.40. We're continuing to expect $150 million to $200 million of gross savings to be achieved in 2022 from our transformation programs, of which $65 million was realized in the third quarter. We have also disclosed other below-the-line planning items for modeling purposes on the slide. Turning to the segments. Tools & Outdoor is expected to realize a mid- to high single-digit organic revenue decline. Margins continue to be down versus the prior year as a result of inflation, acquisition mix, and volume deleverage. We are continuing to focus on the outdoor acquisition synergy realization as a lever to improve margins within this business unit over the coming years. The Industrial segment organic revenue growth expectation remains unchanged at high single to low double digits. The industrial margin rate is expected to continue to improve sequentially. However, it will be pressured year-over-year largely due to inflation and mix. Turning to cash flow. The fourth quarter free cash flow is expected to approximate $300 million to $600 million, which will support our strong commitment and track record for returning value to our shareholders via cash dividends as well as further debt reduction. As we look into 2023, we've positioned the Company with $1 billion of annualized cost savings, which Don covered earlier. We're also aggressively working to capture the opportunities of recent spot market pullbacks on many of our commodities, such as metals, resins, transportation, as well as others. These input savings could benefit us next year after our planned destocking. We believe we are taking the appropriate actions which are in our control to position the Company to navigate a variety of demand environments and contribute to gross margin accretion. Once our visibility improves, we will also invest for share gain by advancing our innovation, electrification, and end-user activation. With that, I will now turn the call back over to Don to conclude with a summary of our prepared remarks.

Thank you, Corbin. So in summary, a lot of progress was made in our first 90 days and these benefits will become even more apparent within the financials in the coming quarters. Our headcount reductions are largely complete. Inventory is now coming down. Cash generation was positive in September, and we believe this will continue in the fourth quarter and next year. Gross margin will be the last to turn as we face the high cost of destocking, but we expect to be through that and pivot to better performance by the middle of next year. And we will continue to focus on debt reduction, further strengthening the balance sheet. All as we continue our commitment to return value to our shareholders through cash dividends. As we move forward, we have a clear strategy, vision, and execution plan. And we are laser-focused on optimizing what is within our control. The macroeconomic environment will definitely continue to be choppy, and 2023 will clearly bring new challenges. However, we believe our actions to reshape, focus, and streamline our organization, as well as reinvest in our core businesses, will enable us to deliver strong shareholder value over the long term via robust organic growth and enhanced profitability. With that, we are now ready for Q&A. Dennis?

Okay. Thanks. Shannon, we can now open the call to Q&A, please.

Our first question comes from Julian Mitchell with Barclays. Your line is open.

For my question, I'd just like to circle back to Slide 9, which was very helpful, and completely agree with the effort to get cash flow up even if it means near-term earnings are down. But I guess two related questions on that. One is the free cash flow was still negative $500 million in Q3. You've got the plus $400 million to $500 million in Q4. So really just trying to test the conviction in that tailwind on free cash given that it was, I think, worse than expected in the third quarter. And then secondly, when you look at that gross margin chart sort of bottoming in Q1 next year, just wondered what you're assuming for the macro on that point. Because I guess the risk would be that as you keep trying to lower inventories, the macro rolls and they stay kind of stubbornly high, so extra on the production is needed. So just trying to test sort of what are you assuming on the macro, on the pro channel for early next year when looking at that gross margin recovery slope?

Thank you, Julian, for your question. I want to provide more clarity on that. You're correct in saying that we are heavily focused on cash flow right now, and I was very pleased to see solid cash flow generated in September. We have strong conviction about the upcoming fourth quarter, as we've taken the right steps to reduce our inventory. In the third quarter, we made further cuts to production, which will significantly impact Q4 more than Q3. This decision was informed by our insights into what production is necessary for the first half of next year and projected inventory levels. We examined various scenarios—growth, flat, and decline—to guide what we believe is the best production decision at this time. The chart illustrates our expectations for gross margin rates by blending different centers and scenarios. While it is possible that revenue could decline more substantially and necessitate further production cuts, we will monitor the situation as we approach the end of the year and into early next year. Our top priority remains cash flow, as we believe there is $1.5 billion in inventory still to be liquidated, potentially up to $2 billion. We are committed to aggressively pursuing this, knowing it may impact our margins in the short term, especially if there are further declines in revenue in 2023. Nonetheless, we agree it's the right course of action. Additionally, we are actively addressing commodity and freight cost reductions, seeing them as significant opportunities to mitigate revenue pressures. We've observed commodity prices decreasing by 30% to 50% since April and will continue to pursue these opportunities. While the impact on our profit and loss won't be seen until later in 2023 after much of this inventory is liquidated, it remains a key area of focus. Lastly, we have a strong supply chain transformation plan that aims to create $1.5 billion in value over the next three years through product platforming, strategic sourcing, facility consolidation, and operational excellence, with benefits beginning to materialize in 2023 and expanding in 2024. We have numerous strategies in place to ensure healthy cash flow in 2023 while improving our gross margin.

Maybe if you could just talk a little bit, Don, about some of the improvements in some of the market-facing metrics that you kind of talked about on the call in terms of where are fill rates today versus where they might have been kind of early part of this year and what the progress on that looks like. And then just as you're talking with your customers, how are they kind of thinking about promotional activity and pricing as you move into '23?

Yes, thank you for the question. I'm really pleased with the team's progress in fill rates over the last 90 days. While we haven't yet reached 95% or above, we have made improvements ranging from 300 to 600 basis points depending on the product category. This is a significant achievement in a short timeframe. A lot of this progress is due to overcoming the supply constraints we faced with semiconductors, which are now mostly resolved. This allows us to focus on meeting our customers' demands effectively. Another positive metric is that over 95% of our products are available on the shelves of our major customers, indicating minimal out-of-stock situations currently. Additionally, we executed a substantial promotion of shipments to many customers in September and October, a level of promotional activity we haven't seen in over a year. This allows us to enhance our presence and generate share gain with our major customers. These factors combined demonstrate our progress as we strive to balance our core business with promotional activities, which are crucial for the success of the Tools and Outdoor business in the mid to long term. Looking ahead to 2023, our customers are feeling optimistic about the upcoming year and the opportunities ahead. They expect the professional sector to remain strong. We are preparing for various scenarios, whether it be a robust environment or one of significant decline. Given our current inventory levels, we feel equipped to address our customers' needs across both core and promotional activities, which is why we are reducing production to manage our inventory levels over the next 12 months.

Don, I have a question about inventory. I was wondering if you could quantify the $0.82 of incremental production penalty you've mentioned in the guidance. How does that translate for the full year? Specifically, how much are you absorbing on an annual basis so we can understand the opportunity when inventory normalizes? Also, regarding your promotional activity, which is a crucial part of the business, will you need to promote and discount to move that inventory in the next couple of quarters?

Yes, thank you, Nigel. I would say we've experienced a significant impact on our margins this year primarily due to a substantial reduction in production. We have made several adjustments throughout the year. In late May and June, we had to adjust based on the slower consumer demand we were observing. We made another adjustment in early July to prepare for the latter half of the year. Now, we're making further adjustments as we approach the end of the third quarter and look ahead to the start of next year. The effect on our profit and loss statement is estimated to be around $400 million, which is quite a considerable amount for us in 2022. This could translate to over $2 in earnings per share, likely more due to our low tax rate. It's a significant situation, but I view it as temporary, and we need to navigate through it to understand the impact as conditions improve. What was the second question again, Nigel? I seem to have forgotten.

Discounting.

Yes, on the inventory. So right now, I think we're being very balanced in our approach on how we liquidate inventory. We're looking at promotional activities. We're looking at alternative channels. The interesting part of the situation is that this is not old inventory. This is inventory that's been created in the last 15 to 18 months, that is very healthy inventory that we should be able to sell at reasonable price points. The question is time, how long do we want to take for the liquidation to occur. So I think we're going to strike the right balance between pursuing promotional discount activities and really just pursuing it more through normal core activity at normal price points.

Just maybe we could talk a little bit about pricing. I think that's also an important variable as we all kind of think through the puts and takes for 2023. So with demand now moving into negative territory and now that we're seeing some refreshing declines in commodity prices. What's the conviction that you guys can stick the price increases that you've taken so far? And maybe what is your view of what's going on from a competitive perspective as well?

Yes. I think when I look at this situation, it obviously is something that's very unusual. We can't go back in time and look at anything in Stanley Black & Decker and say we had a period of time where we had 10% to 12% price increases. That just hasn't been part of any history here within the Company, at least recent history. And so therefore, you have to look at it a little bit differently. That being said, we all have to remember there's been a period of time leading up to this where we had no price increase of any substance, and we were incurring substantial impact in our P&L from the inflation back in 2021. And so we can't forget that. We have to recognize that that's a dynamic that we went through. And then when the tail end of this happens and we're recovering the commodity deflation that we're now experiencing, which actually won't hit our P&L until the later stages of 2023, we have to be vigilant with the price increases and recognize that just because the commodity indices have changed, it does not mean we can lower our prices, because we have the high-cost inventory in our system that has to flow through and be sold to our customers and eventually the end users over some period of time, which is probably at least nine to 12 months at a minimum. And therefore, I think the tail, we will continue to be disciplined about this. We always are looking at what's happening with our competitors in the market. At this stage, we feel like our price points are very consistent with their price points across virtually every category. So, we don't see anything unusual happening there. And we do know there are some competitors that are still putting some price increases into the market even today. So there's going to be a tail here that we're going to have to navigate through. I believe the impact of deflation and what happens with price over the next two years will still be a substantial positive for Stanley Black & Decker's P&L.

So I just wanted to ask more about the decision to have higher production curtailments versus what the Company expected three months ago. Because back half demand is trending as expected versus the July update, so does this reflect a softer outlook on demand into 2023? Or just more urgency around bringing working capital down and generating cash, maybe after that working capital winds down that the Company expected in the September quarter?

Thank you. Corbin, could you provide some insight into that question?

No, I don't think our view in North America is changing much as we're seeing demand levels consistent with how we finished the second quarter. Obviously, demand is weaker in Europe. However, the production cuts are primarily about generating cash, which has been the main driver. As Don mentioned, we've been through several of these situations. To manage inventory, there are various approaches, but the fastest way for us was to cut our production, which we have been doing over the past three to four months.

I want to add that in response to the first question, we have considered various scenarios. One scenario involves ongoing demand decline as the housing market slows down, which may lead to a slowdown in construction for a period. We are taking this into account in our decision-making process. This is a combination of what Corbin mentioned and our outlook for potential scenarios next year, guiding us to make thoughtful decisions about our current production. We need to remember that our supply chain is quite lengthy. Thus, items produced today may not be sold until March or April of next year. This is the basis of our decision-making. We are aiming to find the right balance in reducing inventory as Corbin highlighted, while also being proactive in maintaining healthy cash flow. Additionally, we want to ensure we meet our customers' needs and avoid a decline in our fill rates. Based on our production decisions, we believe we are achieving the right balance in this area.

I want to understand the current situation, especially with the anticipated short-term disruption. Specifically, looking at the next couple of quarters, for instance, in the fourth quarter, we're expecting low single-digit margins in Tools & Storage. How much of that margin level do you see as temporary, mainly due to inventory reductions? And how much is more of a reset compared to what expectations were 90 days ago? Ultimately, I'm referencing Slide 9, which mentions a gross margin in the high 20s by year-end, with a potential for low 30s. It appears that there is a bit of a reset from expectations 90 days ago. Additionally, what challenges are you currently facing in achieving, as you mentioned, a $7 per share run rate by the end of 2023? It seems there are a few more variables or challenges that might decrease that figure by $1 or $2.

I'll start with the first question you had about fourth quarter margins and how they might be affected by the production pullbacks. The impact in the fourth quarter is about 5 points or 500 basis points, which is substantial. We're also navigating the final or middle stages of high-cost inventory due to the significant inflation in wages that we currently have in our stock and are beginning to sell through. This is another factor that is pressuring margins, and it will take time to address. Even with a 90% or 100% price recovery from this situation, there will still be a considerable effect on our margin rate. The difference in our margin rate right now is approximately 300 basis points, which is due to the disparity between inflation costs and pricing, as they do not offset each other one-for-one. To completely counterbalance this in our margin rate, we would need a price recovery of about 120% or 130% in relation to inflation. There's a dual impact on margins in Q4 that we need to be mindful of as we evaluate the quarter. While we're not going to provide an in-depth outlook for 2023, our aim is to clarify that there is a pathway to restore our gross margins to the high 20s and eventually exceed 35%. This involves addressing temporary factors, as the reduction in production will lead us back to normal production levels once we navigate this recession and its duration. If we look beyond this period, we are confident in returning to standard levels of production. We will have transformed our supply chain and addressed commodity deflation. While there may be some partial price offsets, various factors will help us drive our margins back to where they need to be. Regarding what we communicated in July, our current approach is not related to that previous guidance. We now have a revised perspective on 2023, which necessitates adjustments in our manufacturing strategies. As we approach 2023, we have the opportunity to make these necessary changes. We also aim to be more proactive in generating cash flow and reducing inventory in the short and medium term, which is what is currently impacting our gross margins. I realize no one is satisfied with our gross margins at this level, and neither am I. However, I believe we are taking all the appropriate steps within our control to improve our gross margins, even though it will take several years for that to occur.

I'm just wondering if you could run through some of the point-of-sale trends that you saw in U.S. retail throughout the quarter and maybe into October, if you saw any deceleration. It sounded like it was relatively stable, but any nuance would be helpful as we enter the fourth quarter.

Sure. Do you want to take that, Corbin?

Yes. As we mentioned earlier, there wasn't a significant difference in the third quarter compared to the exit of the second quarter. In some respects, especially in power tools, sales remained fairly strong. Hand tools did see a slight decline, but overall, point-of-sale sales in the U.S. performed surprisingly well in the third quarter. It's challenging to predict what will happen in the fourth quarter and next year, as Don noted. However, for the third quarter, we were relatively pleased with the results we observed.

Yes, I think we got a pretty good handle on inventory and gross margins at this point. Let me just ask about the outdoor acquisitions and you talked about slower consumer demand and the seasonal patterns, which I guess we understand is probably comes as a surprise to anyone. The seasonal pattern, was it consistent or was there something changing there? And just talk about margin contribution expectations and the progress on integration. And how do you avoid not being distracted by everything you're focusing on with inventory and gross margins and keep an appropriate level of focus on the integration and the achievement of value for the steel?

That's a great question. We've incorporated the integration of MTD and Excel into our transformation plan, which is part of our ongoing focus on various initiatives. We dedicate significant time daily and weekly to address these topics. This structured approach helps us refine our strategies, make informed decisions, and ensures we prioritize the importance of those acquisitions while integrating them into the Stanley Black & Decker operating system. Regarding the outdoor business, this year's outdoor season was challenging due to weather and some consumer spending shifts. However, our customers remain optimistic about the upcoming season. We're preparing for various potential outcomes, whether flat, up, or down, as we produce products in the fourth quarter for the next season. Predicting the season's trajectory is tough, but our customers are eager about it. We aim to balance our approach to meet customer needs while avoiding excess inventory if unexpected situations arise. Corbin, you may want to elaborate on our margin profile, the integration process, and provide further insights.

Yes. The integration, I think, has gone very well. And the colleagues that joined from MTD and Excel have been fantastic, and it's great to have them as target team, and they're very innovative right now. Given the seasonal weakness that we saw in the spring and summer, obviously, margin rates were hit probably more than we expected because of the weaker season. However, as we go forward, our view hasn't changed in where we think the business can get to over time. And we're generally very strong on hitting our synergy targets and getting the margins of our acquisitions to where we want, and we feel the same for both MTD and Excel on this one.

Okay. Thanks. We'd like to thank everyone again for calling in this morning and for your participation on the call. Thank you.

This concludes today's conference call. Thank you for your participation. You may now disconnect.