The hardest thing about investing is isolating the elusive, always-different, information from the noise.

 

We love reading commentaries from a wide variety of investment firms.  We read them to find potential new ideas or just to learn something new about analysis or investing. We thought this passage from the Frank Fund’s  Q2 2013 commentary was spot on. The entire commentary is worth a few minutes of your time.

http://frankfunds.com/quarterly/2013_q2.pdf

“With every investment case there are mountains of potential information available. To paraphrase Kathryn Staley from The Art of Short Selling, where creativity and experience come into play are boiling down the mass of numbers to “the most important thing.” Every buy or sell decision, long or short, should come down to a “most important” set of data, and  the hardest thing about investing is isolating this elusive, always-different, information from the noise. As with Mr. Sabella’s problem of the day, it has nothing to do with the textbook, so you must draw on experience and creativity.” 

A $1 Billion Opportunity: NCAA Brackets Thought Out Like Stock Picks

This is a guest post from our friend Shaun Currie. Thought it was timely. And we do like sports betting!!!!!

It’s that time of the year – March Madness, the time of year in which brackets are in full bloom. But this year, there is a little more incentive to participating: Quicken Loans (with the help of Warren Buffett and Berkshire Hathaway (BRK.A) (BRK.B)) will award $1B to a participant that can get a perfect bracket. Though it’s unlikely that anyone will actually win the grand prize, top finalists will win $100,000 each (not a bad pay day for a free bet!). So the question is: How can I improve my chances of winning?

Well, since we talk about stocks and investing so much, let’s use some of this knowledge to try and give ourselves an edge in bracket-picking. I wrote this article because the skills we use to pick stocks and create portfolios are directly applicable to picking brackets. Plus, it’s just fun to talk brackets.

Where Is There Value?

We all know that there is a big difference between perception and reality. What a stock (or team) trades for (what its seeded) can vary drastically from its true value. For this portion of your analysis, I suggest that you take a look at some of the leading websites, like sagarin.com or kenpom.com, to get a ranked listing of the teams based on their statistical value (it’s the closest thing we can get to “valuation” for this practice).

If you see a 4 seed ranked 41st in the country, then maybe you shouldn’t think of them as a “4 seed” in your brackets. There’s a chance that this type of team might only be in the tournament for a “short” amount of time. Likewise, if you see Louisville as a 4 seed, yet they are ranked in the top 5 overall, it could be time to take them “long” into the final four.

What Is The Market Pricing In?

One fact to note for you brackets: In the first round, its typical for 8-12 upsets to occur. This is defined as a higher seed beating a lower seed. So how do you pick an upset? First, I suggest that you don’t take Weber State or Coastal Carolina. I know how bad you want to swing for the fences and be the person to call it, but it’s not happening – A 16 seed has never beat a 1 seed, and it won’t happen this year either.

In order to properly find upsets, I suggest that you put your “trader hats” on and ask: What is the Market pricing in?

For this, we will look at what market participants (bettors) are pricing in (through betting lines, or what investors would call “quotes”) for the individual games:

8 seed vs 9 seed
Team (SEED) Spread (Team on Left Favored) Team
Pittsburgh (9) -6.5 Colorado (8)
Oklahoma State (9) -1 Gonzaga (8)
Memphis (8) -2.5 George Washington (9)
Kentucky (8) -4 Kansas State (9)
7 seed vs 10 seed
Team Spread (Team on Left Favored) Team
Texas (7) -2.5 Arizona State (10)
UConn (7) -4 St. Joseph’s (10)
New Mexico (7) -2 Stanford (10)
Oregon (7) -2 BYU (10)

As you can see, “the market” is pricing in that two 9 seeds will win their games. Additionally, the market is also pricing in that it is less likely Kentucky loses its first round game than it is that Oregon does in a 7 vs 10 game. I like to look at this analysis to get a feel for “market participant perception” just as I would if I were trading.

Just to note, I think the best way to use this strategy is relative to others games on the same line (like comparing all 7 vs 10 games against each other, just like we do when comparing metrics on similar companies).

When In Doubt, Pick Teams That Have Done A Good Job Lowering Transportation Costs

After you have done all of your analysis, if it’s still too close to call, I suggest you take the team that is closer to home. There’s a better chance your fans show up, you don’t have to worry about time zone changes (like being an west coast team that has to play at noon on the east coast), and it just makes it easier to focus on the game, which could result in a better performance. Good luck to any team that has to play Syracuse in Buffalo, NY or Duke in Raleigh, NC.

Don’t Fall In Love With A Stock (Or A Team)

Do you have that one stock in your portfolio that has never really made you money, but you don’t want to sell it because you have convinced yourself that you’re in it for the long-haul? Chances are picking your bracket in the same manner will result in equal dissatisfaction. Maybe it’s your Alma Mater, or maybe you watched them as kid, or maybe “Pounce the Panther” out of Milwaukee is just the coolest thing you have ever seen; BUT I’M TELLING YOU NOW, DON’T PICK THEM!

Come’on, this is $1B we’re talking about here, straight from the Oracle’s pocket himself! Look at the data, form a thesis, and make the right selections. I promise that Pounce the Panther will forgive you.

It’s OK To Hold Onto One Flyer (But Only For A While)

Now I know this sounds like somewhat of a contradiction with the section above, but it is OK to hold onto one long shot into the sweet 16. Usually, at least one double digit seed makes the second weekend. Again, it’s not Pounce the Panther, but a team in the 10 to 13 seed range making the sweet sixteen is realistic. Some names I think have a higher likelihood include:

(11) Providence

(11) Iowa/Tennessee

(12) North Dakota St or (13) New Mexico State

I will note though, odds say that the second weekend is the last weekend for these teams, so let’s take our gains in the sweet sixteen and not advance them any further.

So overall, we’ll let one speculative pick slide because the odds say it makes sense. Plus, it’s fun to root for the underdog; we’ll just call it our own personal Plug Power (PLUG)!

Trust In Good Management Teams

Just like investing in companies, teams should be given a premium valuation if they have strong management teams, or in this case very successful coaches. Teams like Michigan State, Louisville, Duke, Syracuse, Florida, and Kansas should be given a little extra value when filling out your bracket because they have experienced coaches that have won championships before. When it comes down to the final minutes of the game, wouldn’t you want to make sure that your picks are in trusted hands of coaches that have a history of strong execution? I know I would.

Make Sure “Blue Chip” Teams Are Weighted More Heavily In Your Bracket

Just like when you construct a good portfolio in order to minimize risks, make sure that your final four is weighted more towards the top teams. It’s fine to have a bunch of small positions (early round wins) in some of the speculative teams, but make sure that your core portfolio (the big games) holds top 10 teams. I have provided the top 10 list from Kenpom.com, a leader in statistical analysis on college basketball, below:

1 Arizona
2 Louisville
3 Florida
4 Virginia
5 Wichita St.
6 Villanova
7 Duke
8 Creighton
9 Kansas
10 Michigan State

As tempting as it is to include the Ivy League in all the fun, I plan to have all of my final four picks come from the list above.

Risks

Risks For This Bracket Strategy Include:

  1. There are no risks its free!

OK, well if you want some risks (because we have to always ask ourselves “what’s the downside”)…

  1. You could lose your job because you spend the next 8 hours working on your bracket, and maybe your boss isn’t a basketball fan
  2. You could be reading this article, thus missing out on another article that could be making you money in the markets (but I’ll note: 1. This is a lot of fun so I don’t really think you’ll mind, and 2. I have you covered – just check out my Top Ideas for 2014 Article)
  3. I could be totally wrong and Pounce the Panther could be hoisting the trophy on April 6. That’s the fun part about March Madness: Anything can happen!

Conclusion

I hope that you enjoyed this article. I considering it a fun exercise on how to use your investing skills in other areas, and I hope that some of the information above helps you fill out your brackets better. I wish you the best of luck in March Madness! (well, best of luck to everyone except Warren Buffett.)

(My apologies to Mr. Buffet in advance – I’m a big fan)

Broyhill Investor Letter Quote.

Experience has taught us that the management of return is impossible – outcomes are extremely unpredictable in investing and timing is uncertain at best. Consequently, we focus on what we can control – process.

What are you hoping to gain by checking that stock price right now?

“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” – Paul Samuelson

 

I will be the first to admit that over my 30 years in the investment field, I have wasted a significant amount of time checking stock quotes. I am also convinced that my investment returns would have been higher if I had used that time reading SEC filings and annual reports or listening to presenations or talking to other investors about ideas. Frankly, unless an investor is looking to buy or sell a stock right then or use it to calculate an enterprise value while doing research, there is little need to look up the current stock price of a company. If you are really intending on holding an investment for years, does it really matter that the stock is up or down 1% or even 5% on any given day?

Many investors think that there is a certain amount of informational content in the daily random price movements in stock. They tend to worry about what “they” know and “why” their trading is moving a particular stock price. It is my experience that rarely do “they” really “know” more than anyone else and if they are acting on information you do not know, it is almost always very short-term in nature (whisper number on earnings) or illegal (merger news) and rarely is it something fundamentally significant in the long-term. I would argue that almost every negative “surprise” that drives a stock down is actually listed as a risk in the risk section of the 10K. Good analysts and investors attempt to weigh those risks against the financial strength of the company and current and potential future valuation under “normalized” operations before they even invest. Therefore, much of the “new news” investors are reacting to should have been incorporated in the long-term investor’s analysis (both macro and company specific, good or bad).

We have pointed out numerous times about how most successful investors think like owners of businesses rather than owners of stocks.  Business owners understand that wealth is created by the accumulation of cash flows over a long period of time. How much of a distraction would it be for a business owner for someone to call him up several times a day and offer to buy his business or sell a similar one at a price that was driven in by the price quote of a public “peer”? The business owner would find the process extremely distracting and an unproductive use of his time. Yet, isn’t that what investors are doing when they check the price of their stocks multiple times a day, or even just once a week?
Next time you feel compelled to look up a quote on a stock you own, ask yourself, “why” you are doing so?

  • How much does it matter to your investment thesis how others are reacting to news of the day in general or company specific news? Most successful investor letters we read often speak about a position that was acquired after a large drop in the share price due to bad earnings or other announcements. They are being proactive based on their own analysis and not reactive to “new news” which they have considered in that analysis.
  • If the stock is up X percent in a day, do you feel some sort of satisfaction or vindication? If the stock is down Y percent, does it make you feel uncomfortable or anxious? Does it matter that there is a news story that supposedly explains the proximate cause of that reaction?
  • Many times when a stock price has changed more than 1% or so during the trading day, there is usually a news story associated with it that is attempting to explain the proximate cause of the change. How often do you find the explanation additive to your investment thesis?

Thought Experiment

In a previous post, I talked about using the right side of your brain to improve your investment process. The post also talked about Charlie Munger’s idea of “invert, always invert” when analyzing a company. I am going to suggest another way investors can “invert” to help their investment process.   Oscar Wilde has been quoted as saying, “A cynic knows the price of everything and the value of nothing”. I think many investors fall into the same trap. Ask an investor or an analyst the price of a stock, they might be able to tell you off the top of their head what it is. But ask them what market cap that represents or what enterprise value to EBITDA ratio or free cash flow yield and you will most likely get a puzzled look. If you really do have to look at stock prices frequently, I would suggest setting up your quote page in a totally different way than the traditional, Open, High, Low Close format.

Instead of setting up your stock quote page to show stock quotes, set it up using valuation metrics. Pick a couple of metrics that you use in your investment process. A few metrics that we find useful are price to book value, EV/EBITDA, free cash flow yield, dividend yield and EV/revenue. I believe you will find that your emotional reaction to big changes in stock prices will start to change. Let’s use a very simple example of a stock trading at $10 a share and at that price the stock is also trading at 10X EV/EBITDA. If the stock were to drop 10%, on a typical quote set up the stock would show $9  -$1.00 (-10%). However, if we set up the quote page so that the number we see is the EV/EBITDA and set up the color code as lower is better, we would see that the stock is now trading for 9X EV/EBTIDA and the 1X decline is GREEN or positive. Investors have been so conditioned by looking at stock prices that green is good and red is bad, we can use this set up to trick our mind into understanding that lower stock prices (generally speaking) are GOOD for long-term investment returns. It has been said that there are no bad assets, just bad prices. Assuming no significant permanent impairment to long-term cash flows, as the valuation of an asset declines, its expected return increases.

Another thing you will start to see that a 1% or 2% or even 5% change in the price of a stock has little impact on the valuation of the company. Using the example above, a 2% change in the price of the stock would mean that the EV/EBITDA changed from 10X to 9.8X. I would hardly call that material, even though seeing a 2% decline in a stock in a day may feel bad. Need another reason to try this? Studies have shown that equity valuations change 19 times the underlying fundamentals. So even rather large relative changes in stock prices, which feel like they represent an adequate re-pricing of “new news” usually overstate the true change in the long-term fundamental valuation of the company. Yes this is overly simplistic. Stocks do not decline 10% in value in a day for “no reason”. Earnings estimates are most likely to be lower after such a decline, but the company’s book value probably won’t change much and neither will the long-term earnings power. This is not so say that our original thesis is not wrong and cannot change based on current events. But as a business owner, we are spending our time thinking about the long-term competitive strengths and weaknesses of the company and should understand when the near-term results may in fact be signaling a change in our thesis.

If you set up your quote screen in the way I suggest, I think you will find yourself looking at it less often because valuations don’t change as much day to day, reducing the “entertainment value” of looking up stock price movements. I think you will find your investment returns will improve over time and you will spend more of your investment process time reading annual reports, SEC filings, transcripts of conference calls and presentations and searching the internet for relevant information on the company or its products.

 

 

 

 

Central Garden & Pet (CENT): Another Step in the Right Direction

In our last update, we said that CENT had made one step forward and one step back. We think it is fair to say that after reviewing the company’s Q1 FY14 results, the company has finally taken one step forward. Our investment process is to look at the numbers first (SEC filings preferably) and listening to company management and analysts last when we form our opinion as to what the company is actually doing. We also place little faith in the “informational content” of short term stock price movements.  Media outlets dutifully reported that CENT “beat” earnings estimates of a loss of $0.31 by $0.05 per share on “better than expected gross and operating margins.” The fact that the earnings estimate was comprised of only two analyst estimates seems less significant to the media or the fact that FY14 and FY15 estimates have been declining all year (down 25-30%). However, we do believe that the numbers do show that management is finally making progress in its multi-year turnaround effort after many fits and starts. [Read more...]

Body Central: Thoughts After A Disappointing Quarter

Body Central: Update

Since we wrote our original article in March of this year, Body Central’s (BODY) stock price has experienced significant “volatility” (to use a popular term ) for “a big stock decline”. A 40% rise in the stock price, followed by a subsequent 50% decline in just six months is pretty surprising, even for the volatile teen retailer space. While we had no expectations of a significant improvement in BODY’s 2014 business (the new fashion merchandise is just hitting the stores now), we were surprised that the company hasn’t been able to show stabilization in its core business. After the latest quarterly report, the well documented list of excuses continued to get longer. Instead of simply repeating what was in the press release, conference call, and 10Q, and calling that analysis, we wanted to share our thoughts on the most important aspects of the company’s business.

Confluence of events conspires to negatively impact their business.

Outside of the possible destruction of the company’s new headquarters and distribution center, it is hard to believe anything could have gone wrong in the quarter. Any investor in retail stocks is well aware of the weak sales and earnings reports that a large number of retailers have reported in the last 30 days. Since BODY is in a major transition in terms of management (at least 4 major new hires), fashion (denim and shoes are completely new to their merchandise strategy), customer base (reduction in number of catalogs, focus on “social media” and new customers), store base (“stores are too black and tired”) and information/distribution systems, the company was ill-prepared to suffer a slowdown in general business conditions.

In our original article, we said we would have liked new management to have had more direct experience in teen girl retail turnarounds. The latest quarter illustrates how important that is. The company is changing its merchandise strategy and marketing plan in the middle of the back-to-school season using data it only collected in June and July. The company has also significantly reduced the number of catalogs it sends out to better align the catalog customer with this new merchandise mix and marketing message. While revenue per catalog has been declining for years, a 27% reduction in catalog distribution this quarter only exacerbated the sale decline. On the positive side, management attributed a significant portion of the margin contraction to the direct business and on a sales per catalog basis, the metric flattened after 5 years of declines.

We believe that looking at two or three year stacked same store sales figures give investors a better feel for a retailer’s sales trends than just looking at the current quarter’s numbers. While sequentially, same store sales declined 160bps to -13.2%, on a two-year basis they declined 780bps to -20.8%. This is a huge turnaround from the mid-teens positive comps of just two years ago. There is no other way to say that these numbers were terrible. However, management did attribute a significant part of the decline to fewer catalogs being distributed and on a sequential basis, the YOY change in catalogs more than doubled from -12% to -27%. So at least part of the “dog ate our homework” excuse can be validated.

SSS Mar Jun Sep Dec
2013 -11.6% -13.2%
2012 -1.4% -7.6% -11.9% -11.6%
2011 16.1% 14.7% 8.2% 7.0%
2010 17.6% 14.9%
2 Yr Stack
2013 -13.0% -20.8%
2012 14.7% 7.1% -3.7% -4.6%
2011 25.8% 21.9%

Lower than expected sales almost always lead to higher than expected inventory and this was certainly the case for BODY. While gross margins were only down 380bps, we feel that, based on historical trends, inventory is heavy by about $6-10M in terms of a normalized gross margin. Management stated that gross margin pressure would continue into the third quarter and frankly we think it could be worse than a 380bps decline if management really tries to clear the decks for 2014.

Guideposts

In or original article we said that BODY was “cheap for a reason”. Now the stock is even cheaper for similar reasons, especially on an EV/Sales basis (21% vs. about 38%). Admittedly it is more expensive on any earnings or EBITDA metric an investor would choose to use. Our basic earnings model appears to have been too optimistic on revenue growth in 2014 and SG&A costs. There is a tremendous amount of negativity towards teen retailers as illustrated by the large declines in stock prices and weak same store sales across numerous retailers. However, as is usually the case when that is the situation, valuations, especially on an EV/Sales basis, are near the low end of their historical range (while restaurants, another consumer oriented segment, are trading near the high end of their historical range). Recent 13D filings by Sycamore on Aeropostale (ARO) and Blue Harbour on Chico’s (CHS) and turnarounds at Christopher & Banks (CBK) and Cache (CACH) highlight the opportunity that longer term investors have in the space. To borrow a line from Monty Python and the Holy Grail, it appears as though specialty retailing is “not dead yet”.

With the company valued at only 21% of sales, a valuation typically reserved for low margin grocery store chains and office supply companies, we are not ready to give up quite yet on the long-term potential of BODY. The company has adequate liquidity at this point with a $20M undrawn revolver, $38M in cash (40% of its market value) and cash flow breakeven now. Once the distribution center is completed next year, $10M in cash flow will be freed up. However, we would like to see some progress on the following items as confirmation that we haven’t totally missed the boat and have found the dreaded “value trap”:

  1. Inventory has to come down $24-$26M (this would be better than $30-32M). The first step to margin recovery is always a reduction in inventories which will help reduce markdowns and restore gross margins. However, it is also true that it usually takes a rather large reduction in selling price to clear that inventory, which results in further degradation in gross margins in the short run. Management was clear on the earnings call that this is most likely going to happen in the next quarter or two.
  2. Slow/stop growth in new stores. A big pet peeve of ours is a management team that continues to rapidly grow its store base, while its core business is in disarray. The company is building a new distribution center, while growing its store base by 11% a year and needing to refresh its existing store base. Since rising inventory and lower gross margin and higher SG&A consumes precious cash, it is imperative for management to focus on liquidity and its merchandising and defer the ever popular “we are a growth company” mentality. Stopping store growth can help offset the cash burn from the new distribution center and operating losses. Inventory liquidation and lack of the necessity of purchasing inventory for new stores can also help liquidity. The company’s cash balance and $20M untouched revolver are a comfort at this point.
  3. Stabilize SG&A. SG&A as a percentage of sales has historically been in the low to mid 20s. With all the new hires and store growth, it has trended upwards of 30%. With a gross margin running 30-32%, it is difficult to make money. Management indicated that $23-$24M is a sustainable run rate. Considering it was around $80M just a few quarters ago, more clarity on this would be helpful.
  4. Better articulation of merchandise strategy. On the last conference call, management indicated that a lot of their consumer research was completed in July and that they were learning a great deal about how customers viewed their position in the market. Not only was it surprising to learn that they were that out of touch with their customer, it was also surprising that they set their new merchandise without this information.
  5. Two-year comps need to start improving from down 20%. Two years ago, BODY was showing 14% two-year comps, so the company had its merchandising strategy right in the past. If the new strategy is working, comps over the next three quarters should start coming in at less than minus 8 to 10%, which would move the two-year comp to better than -20%.

Central Garden & Pet: One Step Forward, One Step Back

As long-term investors, we normally do not pay much attention to any particular quarter’s results or investor reaction to them. However, since Central Garden & Pet’s (CENTA, CENT) stock price declined by almost 25% after investors reacted with vigor to “disappointing results”, we thought we would provide a brief overview of what we think were the important aspects of the company’s results.

We think that short term investors were hoping that CENT’s third quarter results would “beat expectations” due to the relatively good quarterly results posted by competitors Scotts Miracle-Gro (SMG) and Spectrum Brands (SPB). Alas, CENT reported results that missed on both the top and bottom lines and unlike SMG and SPB whose stocks trade near all-time highs, CENT’s stock price recently touched a five year low. Since investors have had ample time to react and overreact to the earnings release and conference call and have already decided what might happen in the next two quarters, we do not feel the need to repeat the numbers here. However, there were a couple of positive developments that we feel should be pointed out.

 

1

2

 

First of all, as we suggested in our original article, CENT has the ability to raise prices in the pet division due to the more fragmented marketplace. On the latest conference call, Mr. Ranelli reiterated that price increases were taking place in the pet division. We found it encouraging that Mr. Ranelli understands where to take price to attempt to improve margins and is implementing those price increases. We think that operating margins in the pet division can improve quicker and be more sustainable than the garden division. In fact, operating margins in the division declined only 100bps on a 13% decline in sales. It is important for investors to understand that last year the company sold $31 million in new flea and tick products at a very high 30% incremental operating margin. Those sales were $23 million lower in 2013.  We also like the fact that the company is considering a low risk strategy of brand extensions in pet products. Numerous other brands from Kong to Martha Stewart have been successful extending their brands into pet supplies. Nylabone is one brand that seems capable of branching out.

 

The company continues to struggle with weather, competition, commodities prices and slow consumer acceptance to its new products in the garden division. These are all part of the game and tough to predict, but it would be nice to have a few things break their way next selling season. For the first nine months of the year, the garden segment operating profit has declined by $9 million (all occurring in Q3) versus flat operating profit for the pet segment.

 

Inventory levels continue to be higher than we would like to see and are also consuming more cash than we would like to see at this point in the selling season. So far this year, inventory has been a $78 million drag on cash flow and other negative changes to working capital of around $40 million have resulted in a $130 million negative swing in cash from operations to a drag of $65 million. Management offered several excuses for the increase in inventory including a “planned higher level of inventory this year to support our customer needs and ensure robust service levels in light of last year’s supply chain disruptions in both Pet and Garden”. Let’s hope that is not another way of saying “channel stuffing.” Short sellers, “forensic accountants” and others will duly point out this negative swing is a “red flag” in any business. Having written short selling research for over ten years, we are well aware that negative cash flow divergence is something to seriously consider and is at the top of the list of things that concern us. In fact, the weak results caused the company to amend their credit agreement in terms of interest and asset coverage.

 

 

 

Having acknowledged the higher net working capital situation (as illustrated in table 1), it should be noted that inventory should decline in the fourth quarter for seasonal reasons. This should give the company some time to get inventory lower before the big ramp up for the spring selling season. Inventory is up around $85 million YOY, but only about $20 million on a four quarter moving average. Management has acknowledged inventory is too high, so we are hopeful progress can be made on this front. In spite of the higher inventory, the company still has ample liquidity with only $60 million outstanding on its $375 million credit line (due in June 2016) with the option to increase that by another $200 million if a lender is willing to make it available.

 

Table 1

  Jun 2012 Sept 2012 Dec 2012 Mar 2012 Jun 2013
A/R $246.00 $202.00 $151.00 $332.00 $244.00
Inventory $335.00 $330.00 $398.00 $436.00 $413.00
A/P $232.00 $206.00 $214.00 $243.00 $206.00
 
Net W/C $349.00 $326.00 $335.00 $525.00 $451.00

 

While there is no doubt that the top line and gross margins are still works in progress, it appears as though the numerous restructuring initiatives over the years are finally starting to flow through the income and cash flow statements. After increasing by almost $4 million YOY in the second quarter, total SG&A declined by $12 million as employee-related reductions and other cost cutting measures where implemented in the third quarter. This is the first tangible sign of significant cost improvements in YOY. The company also stated that these and other measures will result in $5 million in savings in the fourth quarter. As table 2 shows, costs in the third quarter were starting to approach 2011 levels, an encouraging sign. As the focus on cost cutting subsides, management can begin to refocus on the most important drivers of value creation, sales and gross margins.

 

Table 2

  2013 2012   2013 2012   2013 2012   2011
  Q1 Q1 YOY Q2 Q2 YOY Q3 Q3  YOY Q3
S&D  $47.30  $48.30  $(1.00)  $59.60  $57.50  $2.10  $75.60  $84.70  $ (9.10)  $71.00
W&A  $42.80  $43.70  $(0.90)  $46.80  $45.00  $1.80  $44.00  $47.00  $ (3.00)  $42.00
Total  $90.10  $92.00  $(1.90)  $106.40  $102.50  $3.90  $119.60  $131.70  $(12.10)  $113.00

Note: S&D= sales and distribution  W&A= warehouse and administration

 

In addition, it also appears as though the company is finally approaching the end of a long and expensive information technology platform restructuring and upgrading program. The company has spent nearly $90M since 2005 (including $11M in fiscal 2013) upgrading its enterprise-wide information platform. In the company’s 10K, the company expected to spend around $40M in total cap ex, mostly related to the upgrade. This was on top of $39M spent on cap ex in 2012. In the latest 10Q, the company stated that it expects capital expenditures not to exceed $30M. We had mentioned in our original article that the wind down of the upgrade would boost free cash flow and it appears that at $10M a year in CFO will be freed up starting in 2014. That is a significant sum considering the $360M market cap of the company.

 

The company has authorization to repurchase $100 million in stock. However, only $50 million is available in fiscal 2013 and beyond. Historically, the company has been an aggressive purchaser of its stock, but so far in 2013 it has only purchased the token amount of $2.6 million. While we have no doubt that management recognizes the value that is presented in its shares today, we also believe that until the ballooning inventory situation is resolved, the company will place maintaining a high level of liquidity over stock repurchases. It should be noted that there are no new restrictions on share repurchases in the newly amended credit agreement. The credit agreement was amended to reduce the minimum interest coverage ratio to 2.25X from 2.5X and a 1.1X minimum asset coverage ratio was added. While we never like to see credit amendments due to underperformance, we believe that CENT’s recent improvements in costs and cash flow gave the company’s bankers confidence that the turnaround is beginning and were therefore willing to amend the credit agreement with no new onerous terms.

 

We believe that management has been able to show progress on several fronts (cost cutting, cap ex and price increases) which is encouraging. However, in order for the company’s valuation to improve on a sustained basis, the company must show progress on the other things it can control like working capital management, product innovation and gross margin improvement. Weather always plays an important role in the garden division, but is totally out of control of management or investors and is a risk that will always be present. We still think the company could be acquired at a substantially higher price (assuming no liquidity event is the motivating factor), but that is really in the hands of Bill Brown and his control position in the stock.