Monday, October 10, 2011

HELE Earnings FY2012 Q2

Helen of Troy delivered an underwhelming quarter, to say the least.  Revenue was well below analysts forecast of $288mn, and net income for the quarter was essentially flat, and due to higher shares outstanding, EPS actually fell.  This was also below analyst estimates, which had expected a rather substantial increase in EPS.  Worse, the company had the worst conference call I have ever heard; after a delay (for "technical reasons"), it seemed as if management was completely unprepared or distracted - they could not even read their prepared remarks correctly, indicating that they had not prepared adequately.  All of this was a reason why the stock tanked when earnings were released last Thursday.  Since hitting a peak of $36 in June after the Q1 earnings report, the stock is down about $11, or nearly 30%.

The poor earnings were due to weakness in the traditional Helen of Troy businesses.  The personal care segment, which includes most of the styling products for which HELE is known, actually experienced sales declines, in part because in-store promotions, which were used to increase (uh, maintain) volume, were taken as a reduction in sales.  According to the company, the increased marketing expense was $4.1mn (although an unspecified portion of this was also credited as SG&A and not as a reduction in net sales).

Management has suggested that consumers are really curtailing their consumption of these products, and that any improvement will be "heavily dependent on improvements in employment, housing markets and consumers' personal finances" (10-Q, pg30).  Let us hope they are wrong, since we are likely a good 3-5 years away from any meaningful improvement in any of the three macro factors the company has cited.

It should also be noted that the company sources many of these products from China, and, low and behold, the costs of manufacturing in China and importing to the US are rising.  Wage inflation, which has been running around double digit levels is piled on top of a rising currency, leading to margin contraction on top of sales declines.  The rising cost of labor and the currency are both secular trends that are set to continue for the foreseeable furture.

Operating income in the segment declined by $3.59mn in the quarter, primarily due to the increased advertising expense noted above.  While the company attempted to argue that this was mostly a timing issue (advertising programs occuring in the 2nd quarter of FY2012 occurred instead in the 3rd and 4th Quarter of FY2011), this only reinforces the difficulty of the operating environment, since sales declined even though significant incremental promotional expense was incurred.  The $4.1mn, incidentally, is about 13cents on EPS, which would have been enough to lift EPS from $0.74 to $0.87, about what analysts were looking for.

Six month results were better, with an increase in operating profit of $2.68mn.  There is a catch, however.  The company has started to allocate some corporate overheads to the new operating segment (Healthcare/Home Environment)  These costs were previously borne by the Personal Care and Housewares segment.   For the six months, the reallocation was $3.01mn.  The company does not clarify how these costs had prevoiusly been allocated to the PC and HW segments, but it seems likely that they were shared 2/3 to PC and 1/3 to Housewares.  If I am correct, then Personal Care received a $2mn operating income boost, which basically leaves operating income flat for the first half of the year.  Note that in Q2, operating results declined, even after receiving a $1mn benefit from reallocation of SG&A.

Taken as a whole, we have a segment that looks set for quite a bit of future weakness.  On the conference call, the CEO remarked that "most people have a hair dryer, we need to convince them to purchase a new one even though their existing one still works" a sure sign that saturation is occurring.  One wonders if the company does not have rethink its product and category managment and consider offering more discount items to compete effectively in the discount segment.  The company notes that people are trading down.  The company may be in a tough position, strategically, in that it licenses brand names and produces merchandise for which it believes it can charge a brand premium greater than the cost of the license.  In many cases, this license fee is likely to be a fixed cost (at least in part), meaning that increasing sales of unbranded or value branded products may compete with the branded products for which the company already has a fixed expense. 

It is difficult to determine the extent to which competitors are experiencing the same challenges in the segment, as most competitors are either private companies or are simply to large to break out sales in this area.  The closest analog, Spectrum Brands, had strong sales growth in the category, but that was for the period ended in July, a selling period most closely aligned with the HELE's first quarter, in which sales growth was solid.

As this segment has traditionally represented 2/3 of the company's sales, and after the Kaz acquisition still accounts for 40%, it has the potential to be a drag on earnings for some time.

The story is somewhat happier with the OXO brand (Housewares segment), with strong sales growth in both the quarter and the first half of FY2012.  Managmeent was quick to caution that double digit sales growth is likely to moderate such that for the full FY2012 revenue growth is likely to be in the high single digits.  Based on FY2011 sales of $216mn, this would imply a full year revenue increase of $11mn - $20mn.  Since revenue growth in the first six months of FY2012 is already $13mn, we have to expect relatively flat sales in the back half of the year.  Sales this year have been helped by strong volume growth from OXO Tot (baby goods), but also happily, expanded shelf space and small growth in geograpic distribution.  It is not clear to what extent this is due to increased leverage as a result of the Kaz acquisition, it may be entirely due to the expansion of the product range.  The company's ability to continue to growth this segment will be based on the ability to continue to deliver new product introductions and to increase the geographic reach of distribution.  The company has a good track record here, and Kaz ought to help with finding new channel partners and geographies.

One cautionary trend to monitor is the fact that the OXO brand is coming under some price pressure.  OXO has generally been able to position itself as a premium product and maintain strong pricing, but the second quarter saw significant promotional efforts around stock-outs.  Coupled with higher costs (the China effect, again), the higher discounting led to a decline in operating income in the 2nd quarter, which pretty much cancelled out the gains in the first quarter.  Again, this margin contraction occurred despite allocating (my estimates) $500k and $1mn from Housewares to Healthcare.  Had these allocations not been made, the declines would have been much lareger.

Nevertheless, there are some signs of optimism.  First, the Kaz acquisition is performing better than I had expected.  Sales increased for the first half, though sales were lower in Q2, apparently due to supply shortages, which may lead to higher sales in Q3 adn Q4.  Operating income was $7mn in Q2 (up from a small loss in Q1).  The six month result of $7mn is after taking on $3mn in SG&A from the other two segments.  According to the company, this is due to sourcing and synergy savings, as well as improved category managment.  Better yet, management has indicated that due to strong seasonality at Kaz, the Q2 and the first half are not indicative of full year results, and it expects to outperform the $7mn operating in each of the last two quarters of the year.  This should lift operating profit above $20mn for the year, which is what I estimate is the segment's actual capital cost.  After interest charges of about $8mn for the acquisition, Kaz may add $16-$18mn operating, or $0.50 EPS after tax.

Moreover, the company claims to have identified an additional $10mn in synergy costs, which, if it is all incremental, would represent another 30cents (before tax).

The company has also improved working capital ratios, reducing the number of days receivable and increasing inventory turnover, which should help to free up some more cash to reduce borrowings.  The company was also able to sell its entire stock of Auction Rate Securities, which converts $20mn in nearly non-interest bearing "investments" into $19mn in cash, which is availáble to reduce borrwings.  And speaking of reduced borrowings, the company paid a $50mn note with cash on hand and increased borrowing under its revolving credit facility.  Strong cashflows in 2H resulting from an inventory sell down and strong oeprating results should enable the company to make a major reduction in the $105mn in revolving debt.

I am still annoyed that management used its view of Q2 to sell options dear.  I am also concerned about the planned compensation for Gerald Rubin, as adjusted EBITDA excuses bad behavior in the form of overly generous Goodwill.  However, I can easily see the company earning $3.40 in FY2012 and $3.70 in FY2013, and my own estimates of value based on DCF peg the value of the stock between $35, assuming very negative assumptions (no gross margin expansion and very slow revenue growth) or as high as $54, if growth is a bit stronger and margins can be returned over time to the 45% enjoyed by the legacy HELE.

All of which is to say that the stock still looks cheap.  A buyback would be in order.

Monday, October 03, 2011

HELE Earnings Preview, Part II

In part one of the analysis, we reviewed the Kaz acquisition and set some targets for the financial performance of that business unit.

HELE has also been in the news for some other recent decisions by management - insider stock option conversion and a new proposed compensation plan for the founder and CEO, Gerald Rubin.

Mr Rubin, it may surpise, does not have a very large stake in the company.  According to the most recent filings, he owned about 2.4mn shares, less than 10% of the total.  At current market prices, his stake is worth about $60mn. This is not a bad thing, except that it means his annual compensation, which can run to above $10mn matters a great deal in comparison to changes in the market capitalization of the firm.

What is particularly interesting is that he, and a few other senior executives, chose to exercise their options back in early July, when the stock was trading at an all-time high of near $36.  The stock has subsequently declined by over $10 per share, partly on market fears, but also perhaps because there is a perception that insiders, six months into their largest acquisition, believe the company may struggle going forward.  This is particularly true when one considers the fact that Mr Rubin cashed in all of his outstanding options, 1.325mn shares worth - two years before expiration!

How do I arrive at this conclusion?  By checking the latest 10-Q which notes on page 22 that there were 2mn options outstanding and exercisable as of May 31, 2011, with an average life of 2.11 years.  Mr Rubin's 1.375mn represent over 65% of the 2mn total shares, enough that his expiration cannot diverge significantly from the overall average.

Given the opportunities the Kaz acquisition presents, not to mention the ongoing and rising cash flows from the legacy business, one would assume that Mr Rubin would want to hold out for future appreciation with at least some of his options.  Why not leave some skin in the game, unless you believed the stock price had peaked?

Incidentally, Mr Rubin submitted most of these shares in settlement for taxes and the purchase price of the stock.  The company retired the tendered shares, so net share issuance only rose by about 300k - or 1%.

In fairness to Mr Rubin, the exercise may have been related to the intent to change the management contract.  Mr Rubin had been barred from participating in options under the existing stock programs, becuase of his high number of outstanding options.  Cashing them in may have been part of an arrangement between himself and the board to obtain a new incentive agreement.  I say this, because in early September, the Board announced a new agreement with Mr Rubin, one which has not been ratified by shareholders.  In this agreement, Mr Rubin will no longer participate with a share of Net Income, but rather based on "Adjusted EBITDA".  What this does is separate Mr Rubin's pay from the effects of asset impairments, such as writedowns in estimates of the value of intangible assets and goodwill.  (It applies to writedowns of other physical assets as well, but over 50% of HELE assets are of the intangible variety).

From my perspective, what this does is insulate management from the impacts of it's own decisions.  Mr Rubin has led the company for four decades.  He has made the decisions to purchase these assets - subtantially all of the intangible assets are the result of a strategy Mr Rubin has pursued.  It makes no sense to release him from the consquences should history show him to have overpaid.

These two decisions, more than anything else, indicate that Mr Rubin believes the company's prospects are less rosy than they appeared in the months after the acquisition.

Incidentally, I encourage you to vote AGAINST this proposal, as I shall.

In purchasing Kaz, HELE decided to grow the top line fast, and enter new categories.  The company has incredible cost management and has consistently managed to grow the business.  Indeed, the OXO brand alone might be worth more than the market cap of HELE.  But the acquisition is risky and it looks as though management is looking for ways to insulate itself from the consequences of those decisions.

Thursday will be most interesting.

Sunday, October 02, 2011

HELE Earnings Preview, Part 1 - the Kaz Impact

HELE will be releasing its earnings report for the fiscal 2nd quarter this Thursday.

This quarter is particularly important, because of the unfolding informatin about the Kaz acquisition, and investors will want to know how well the economics of the deal are working out.  If recent moves in the stock price reflect sentiment about the business and not just reaction to market gyration, then investors are concerned about the performance of this deal.

There are several other factors that could be weighing on the share price.  Earnings per share will likely be under pressure because of significant (and early) options excercise (at what turned out to be the recent top around $35 per share).  Management also has renegotiated a new contract, and it appears very lucrative.  More on this later

I am among those who are curious to see how managment is handling the sudden and massive growth of the business.  My own view is that the company will likely earn a fair return on the investment, but that it will be less successful than some of the smaller, more bolt-on, acquisitions (such as Pert and Infusium23) that the company has done in the more recent past.  More deals are likely to be avaible in the not-to-distant future as macroeconomic fears weigh on business valuations.  The jury is still out on whether this deal was wise - HELE may have overpaid.

The Kaz acquisition was designed to be transformative, with $270mn flowing to Kaz shareholders in an all-cash deal. (The combined company has a market cap of $775mn). This was a high sum to pay for a firm that was not making money prior to the acquisition, so we have to believe that HELE management will be better able to sweat the assets, to break up the assets and sell the pieces at higher prices than they paid, or that other synergies such as increased pricing power with suppliers and consumers will contribute to greater earnings across the company.

The deal recorded $154mn of Goodwill, indicating that HELE mangement believes there is much value to be unlocked beyond the value of the brands themselves.  Investors have to be wary, since management has a history of having to take write-offs against intangible asset values acquired at optimistic valuations. 

Nevertheless, the Kaz acquisition offers HELE many opporunities: first and foremost significantly increasing revenue - while organic growth of 5.9% was strong for a firm that makes consumer staples, the acqusition increased revenue by an additional 63.9% over the prior year quarter - if Kaz can be made anything like as profitable as the traditional HELE, earnings per share (which remain undiluted in the deal) will soar, and the stock price with it.

Moreover, Kaz helps the company to expand it's geographic footprint and it's overseas sales - so Kaz can also help to grow sales of HELE products and enhance the value of the traditional business.

Unfortunately, Kaz is a much less profitable company.  Management has not clarified the extent to which this reflects weakness of its brands compared to competitors, or whether it competes in lower-margin categories.  That HELE management has stated its aim to increase profitability in Kaz to levels consistent with the legacy business suggests that it is the former.  In the meantime, Kaz weighs on the gross margins at HELE.

In my mind, to be considered successful, the deal must achieve all of the following:
  • Produce operating cashflows in excess of both the direct financing costs
  • Demonstrate an ability to delever the firm on its own (i.e. to generate enough cash to repay the debt assumed to acquire it without resorting to cashflows from HELE)
  • Produce a satisfactory return on company cash employed in the deal - $77.5mn.  This is money that had been avaible to invest in other HELE product lines, make smaller acquisitions (with less imapact on the balance sheet)
If the company achieves all three of these objectives, it will have been a good deal in which HELE shareholders will have acquired a substantial business with little investment.  This would make Kaz essentially a good "financial" deal - in which affordable financing allowed a new revenue stream to be purchased for less than its financing costs in return for the company having to sit on the deal-making sidelines for 12-24 months while the core business piles up more free cash for the next round of acquisitions. 
To be a truly fantastic deal -
  • Kaz should begin generating substantial operating earnings within the next 12 months
  • Kaz should show ongoing incremental margin expansion as a result of the increased market power of the combined entity
  • Kaz should be able to do so while shouldering costs formerly assumed by the legacy busienss (i.e. improving profitability in the legacy business through efficiencies
  • Grow it's own revenue at a faster pace than the legacy business
  • Support improved margins in the legacy business.
How is it doing against these objectives?

According to the filing, revenue of $95mn represented an increase of 7.2% compared with the (pro forma) prior year period, so we are seeing nice revenue growth.

In the 53 weeks ended April 30, 2010 (the last full year of operations prior to the acquisition), Kaz earned an operating profit of $4.4mn on revenue of $440mn, so a 1% return on sales.  This return was consumed by $5mn in interest payments, so that Kaz made a loss.  Gross margins were 32% in contrast to HELE's 45%.  In the six months prior to acquisition, margins were even lower, (though they were improved over the comparable period in the prior year).  Opearting income was essentially zero, as increased gross profit was consumed by much higher SG&A expense.

In the latest HELE report, gross margins have appeared to increase to around 32.2%.  While revenue is broken out by segment, cost of sales and gross margins are not.  I have calculated this number by taking sales in the legacy businesses and applying the historical 45% gross margin to derive a cost of sales for the legacy business.  The remainder must apply to Kaz, and the difference must be the amount of gross profit earned by Kaz.  This number is similar to the previous year, and is in any case, imprecise, due to the method I had to use to determine it.  I would like to see an increase above 33% in the current quarter, indicating manaagement is getting better control of product lines.

Operating income was a slight loss, however, management is careful to note that the quarter is a seasonally weak one for Kaz, which averages $110mn in revenue per quarter.  Moreover, management noted that some overhead costs have been allocated to Kaz, such that Kaz is now covering $1.5mn of costs from the legacy HELE business, implying that operating income could have been as high as $1.4mn were Kaz a stand alone business - well more than 1% of sales.  We can only hope this trend will continue and that operating margins in this quarter will be above 2%.

Unfortunately, this is still not enough to cover the interest costs associated with the acquisition, so that it cannot be said to be self-financing, at least not yet.  The company needs to earn about $7mn operating just to cover the interest costs.  Based on the metrics above, it must earn another $8mn to cover the cost of equity capital injected by HELE, and finally, we would like to watch this thing delever, so let's say we need a $20mn operating profit - which means that the unit has to earn 5% on sales

Finally, management may come to regret the amount of commitment they have to Kaz because nine months into this exercise, the markets seem shaky, and it appears there may be some real opportunity to pick up quality assets on the cheap.  On a positive note, the core business seems to be generating cash quite rapidly, which means that in six more months, the company's coffers should have it in position to do another modest deal.

Part II - Management concerns next.

Buffett rationalizes repurchases

In this interview with Andrew Ross Sorkin, Warren Buffett explains his logic for repurchases.  His logic supports my thesis from an earlier post that Buffett is really making a statement about how to do buybacks - not as an annual and ongoing "return of cash" (as another Strategic Investor favorite, CL, does) but rather as a choice among investment alternatives.  Buffett wants to buy large companies with good prospects at low prices: BRK qualifies and so long as the price remains attractive relative to intrinsic value, he is a buyer.

A similar approach was explained by Lee Raymond, the man who made ExxonMobil.  Having done many deals building the world's largest non-goverment run energy company, people asked him why he suddenly stopped doing deals.  Mostly, the critics argued that the acquisition of Mobil had been too difficult for XOM.  Raymond countered that there were no deals worth doing: he noted that "we looked around and the cheapest oil we could find was our own, so we bought back stock".  You can read more of the interview here.

Buffett, I think is saying the same.  Sure there are opportunities, and from time to time a business that meets his criteria will become avaiable.  In the meantime, there is a business that meets his criteria which he can purchase as common stock - and unlike other stocks he buys, he has an opportunity to use the treasury shares in private market transactions when the stock more closely reflects intrinsic value, to acquire firms.