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.
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.
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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.
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.