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.
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