CSCO: Ralph Nader and I agree

Hard for me as it is to believe, Ralph Nader, "Consumer Advocate" sometime presidential candidate and general left-loony gadfly and I agree about Cisco Systems (CSCO): John Chambers is bad for shareholders.

In an editorial for Reuters, Nader - apparently a CSCO shareholder with 18,000 shares - complains of the poor use of company cash, which has primarily gone to counteract dilution from the excessive equity compensation the CSCO management team, led by Chambers, has handed itself over the years.

Nader is arguing that with massive cash balances and $3bn a quarter in operating cashflow, the dividend at 6 cents is really insulting and represents hostility towards shareholders.

I myself have written an article detailing my own view that CSCO as a business is cheap, worth probably $30 a share, or even a bit more, but that the business carries a risk that merits the discount - "John Chambers risk" which is the risk that all of the shareholders money will be used for management compensation

While I agree with Nader that management could and should take some near term steps to enhance shareholder value, the fact is, as long as Chambers is there, the stock will price the risk of his management into the stock price

2012 Theme: Inflation vs. Deflation

In the embedded video, "Bond King" Bill Gross discusses the outlook for inflation and deflation and shows why getting the right answer to this question is a major factor for investors: asset classes perform quite differently under "reflation" (increasing inflation), disinflation (lowering inflation) and deflation.



Mind you, most financial assets, both nominal and real, perform best under periods of falling inflation, the "30 fat years" described by Gross.  Under reflation, both nominal and real assets perform badly, but real assets perform much less badly, as they can "keep up" with rising prices, albeit slowly.  Finally, nominal assets do well in deflation and real assets do very poorly in deflation.  The problem for nominal assets (e.g. bonds) is default, which rises sharply and can lead to a permanent impairment of capital.

The real question is: which are we likely to have.  While Gross doesn't say - he makes it clear that the jury is still out - he does help to deconstruct the problem and lay out some of hte markers.

Thinking about M&A Strategy

The McKinsey Global Institute has just published a study that looks at different M&A patterns or strategies that large (non-bank) firms employ to grow the business.  The blow matrix shows how McKinsey thinks about what firms are actually doing.  Not all strategies are created equal, and McKinsey is quick to note that different industry segments have tended to different strategies. 

It is perhaps not a big surprise that the largest companies are the most likely to use acquisitions to grow, as organic growth in mature markets (which large firms dominate) have difficulty growing at faster than the rate of inflation.

Smaller companies are relatively more likely to focus on organic growth or on "selective" deal making, where usually few deals are done, which deals may be transformative (target represents a significant share of acquirerr market cap).  McKinsey has found that companies that employ a programmatic approach to acquisitions do best.  This may be due to the expertise gained in evaluating and integrating such deals, or it may reflect good discipline in purchaing without overpaaying.

HELE is a bit too small to qualify here, but it too could be said to be selective or perhaps "programmatic".  It has looked diligently for additional reveneu and has only really been able to generate organic growth with the OXO brand (thought OXO itself was one of a series acquisitions.

Helen of Troy (HELE) successfully integrating Kaz

In TSI’s most recent post about HELE, we noted that the big question mark for the company was the effectiveness of the Kaz, Inc. integration.  This was a big transformative deal, on par with the OXO acquisition, as Kaz would account for about 40% of the revenue of the combined company.  Based on the most recent earnings release, HELE has done a magnificent job of turning that business into a success, and if the stated goals of increasing gross margins to reflect those of the historic HELE are achieved, the acquisition will be a dirt cheap out-of-the-park home run.

Until this latest earnings release, it was hard to get a flavor for the success of management in reducing costs and improving operating performance in the Kaz business.  Clearly, the company was having some success.  The pro-forma for Kaz, (which was privately held) had a full year operating profit of about $4m, or a measly 1% of sales.  Some of this may have been a function of Kaz’s prior status as a private company, in which several benefits for senior manager/owners may have been borne by the company, it is hard to tell from the financials.

HELE demonstrated already in the first quarter that they intended to improve operating performance.  The Kaz business (which is conveniently listed as separate own segment) had no reported operating income – HOWEVER – that was after a $1.5m allocation of operating expense from traditional HELE segments.  On a stand-alone basis, Kaz had earned $1.5m in the first quarter.  Ignoring seasonal effects, this implied a $6m operating profit, or a 50% improvement.  This level of enhanced earnings would be just enough to pay the interest on the additional financing, but not to also count for the equity, but was encouraging enough that the market bid up the stock to all-time highs (at which point, management decided to unload its options, and the stock tanked).

The second quarter earnings report brought additional good news on the Kaz front.  Thru the second quarter, Kaz managed to earn $7m operating, again, after a $3m allocation of overhead from traditional HELE.  Thus, after two quarters, HELE management had succeeded in increasing operating earnings by 2.5 times – with two quarters to go.  Better yet, management indicated that operating profit at Kaz was highly seasonal, that the first two quarters were not representative and that the third and fourth quarters would produce far more operating income than the first two quarters.  They delivered.

Kaz earned $13.5m operating in Q3, again, before $1.5m in reallocated expense – or $15m as a stand-alone entity.  The 9 months figures are $20m and $26m, 5 and 6.5 times full year operating as a private company.  While I expect the fourth quarter to be somewhat weaker than the third, an additional $7-$10m operating is not out of the question, for full year operating of $27-$30m ($33-$36m before allocation of $6m in corporate overhead).   This is a stunning improvement.  In 14 months of ownership, management will have increased operating income of the Kaz business by a factor of somewhere between 8 and 10!  With $194m price tag, the company will be earning (pre-allocation) something on the scale of 18% on investment, against a WACC of 12-15%.  Note that much of the purchase was financed with debt issuance of $100m, at 3.9%, and expansion of the company’s credit line.  Cash on hand was also used, and as the credit line has been paid down, a greater portion of the financing is now coming from equity, but this is certainly a terrific start.  Were management able to increase margins even five or six percentage points, they could add another $20m in gross, which should, all else equal, flow directly to operating profit.  (Management has stated repeatedly its intent to lift Kaz margins from the mid thirties to the traditional HELE margins of the mid forties, but this seems unlikely, and in any event a long term goal at best.   Were they successful, there would be yet another $20m in operating, even before any volume growth from market growth or new product introduction).

Either of these events would increase operating earnings per share by 60 cents.  Kaz, as a US entity, has a higher tax rate than traditional HELE, which is a Bermuda company, but based on my expectation of Operating profit for FY2012, NOPAT should be a healthy $20-$22m or about 60 cents above FY2011.

Figures for the fourth quarter in the Kaz segment will be distorted by the acquisition of PUR Water.  This will raise gross margins, as the business had high gross, but operating is less clear at this stage.  Advertising revenues around PUR will increase SG&A.  However, management has identified several opportunities to grow the business, and given the incredible cost control HELE has been able to exercise, this looks like another good opportunity to reinvest the company’s growing cash flows in high return activities.  Indeed, operating earnings are now rising so rapidly that the company can now purchase a $100m business every year simply from internally generated funds.

PRICE TARGETS

Analysts have begun to argue that the stock could be worth as much as $50 per share, as EPS will likely top $4 in FY2013.  This is based on continued strong performance from Kaz, continued high single digit growth in the OXO brand and modest growth in sales of the personal care segment.  I think a price of $45 is quite reasonable, as I believe HELE is entitled to a 11x multiple.  This is low for a consumer staples company, in part because there are several risks. 

RISKS

The first risk is that management is becoming overly focused on growth through acquisition and takes its eye off the traditional HELE business segments.  This would be a problem because the traditional business is both strong and profitable, and at 60% of revenue, and an even greater share of operating profit, these segments are crucial to the performance of the company.  Thus far in FY2012 they have disappointed some, as revenue has grown but only as a result of heavy promotional activity.  This could mean that management has been somewhat distracted and is not executing as sharply, and is thus relying more heavily on promotion to move product.

The second major risk is that management makes a poor acquisition, either by purchasing a product or business unit whose competitive position is too weak, or by simply overpaying.  Fortunately, HELE tends to acquire mature products, within establish markets and along with a license for or outright ownership of brand names.  Often these have been built by major firms (e.g. P&G) but are either too mature or too small to get the attention they need.   HELE then focuses relentlessly on cost and on using the HELE sales force to increment sales.  Still, the company’s record is not without some black eyes.  Some years back they purchased an infomercial business (with a goal of promoting HELE product, I think) and were forced to close down the business within two fiscal years.  More recently, the company massively overpaid for its acquisition of Belson, and had to take a huge impairment on Goodwill and intangible assets.  TSI hopes that the increased earnings and cash flow of the business enable the company to look at a greater range of deals and to be able to be even more successful buying “gems”.  (Of course, as a company grows, scale can also reduce the range of opportunities one can look at, by making many deals “too small” to have material impact on earnings, but HELE is probably a few years away from this point).

Third, one has to be concerned about input costs.  As a products maker, HELE is subject to significant commodity cost exposure.  Moreover, many of HELE products are made in China, where labor costs are experiencing significant inflation.  This matters, because with a managed-fixed exchange rate, labor costs in USD, GBP and EUR are rising, which could constrain margins.  Furthermore, over time, the yuan is rising against other currencies, compounding the effect.  There are ways of combating this, including increasing scale as the business grows, and moving production to yet lower cost markets, or even sourcing in the local market.  Again, as the business grows, it has more options.

The fourth major risk is heavy dilution.  In FY2012, HELE revised the compensation for executives, and expanded the number of options available by 3 million, to about 10% of shares outstanding.  Not all available options need be distributed, of course, but TSI assumes that substantially all will be.  The question is, over what time period – if this is done over 10 years, such that management only receives about 1% of outstanding equity each year, things will be fine.  If it is more aggressive, current shareholders should assume dilution and slower growth in EPS.

OUTLOOK

Even with these risks, TSI expects that HELE will continue to grow revenue and profit at strong rates.  Organic growth will never be super fast, as the company competes in mature product categories, but the company executes well and, if it remains selective, it should be able to grow the bottom line even faster than the top line.

While the company has never paid one before, I look forward within the next five years to seeing the company begin to pay a small dividend to attract the value-growth retail investors it needs to expand its multiple.  Most of these will be retail investors looking for a means to have a decent yield with growth potential.

Finally, if the company can continue to grow revenue and market cap as it has, it is not unreasonable to believe that it can join the midcap S&P400 within the next five years, which would certainly give it a boost, as would an inclusion in the Russell 1000.  But one step at a time.

At this point, I am looking forward to seeing the full year results for the quarter ending the end of Feburary, at which time I fully expect the company to exceed $100m in net income for the first time, to see how Kaz and the PUR acquisitions are faring and to hear about management’s next plans.