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 avail√°ble 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.

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