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.

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