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. Cost savings are starting to positively impact margins.   While it is important to acknowledge that Q1 is the seasonally low quarter and that the next two quarters results will determine the earnings for the year, clear progress was made on margins this quarter. We believe investors need to do their own analysis on not rely on what management says in a conference call or in a presentation. Ultimately, results have to show up in the financials of the company. We think too much time and attention is spent building models using only percentages as a percent of sales or “modeling to management guidance.” If an investor is really going to understand the operations of a company, it is important to start with the absolute numbers to get a better historical context on what those percentages should be or can mean. For example, CENT reported consolidated gross margins of 27.5%, which is the highest Q1 gross margin in four years. However, it is still almost 500bps below 2009. So even though sales are $22M higher than 2009, gross profit dollars are $8M below that level and about $15M below where they would be at a similar gross margin. Looking at the company this way is important for two reasons. It helps investors judge what might be “normalized” gross margins (noting that this quarter may have been helped by the inventory charge last quarter) and to understand that net income cannot grow without further increases in gross margins and gross profit dollars. Secondly it shows that gross profit dollars have been flat for three years and any improvement in operating income has come from the previously discussed cost cutting. Looking at line items and not the “headline” numbers, like the earnings “beat” this quarter, are more useful to the investment process.

  $ Millions

2009

2010

2011

2012

2013

Sales

$269.00

$282.00

$302.00

$292.00

$291.00

Gross Profit

$88.00

$83.00

$81.00

$77.00

$80.00

Gross Margin

32.7%

29.4%

26.8%

26.4%

27.5%

 

 

 

 

While consolidated SG&A as a percentage of revenue has indeed declined from 32.3% in 2009 to only 30.2% in 2013, it should also be noted that SG&A is basically unchanged from 2009 even though shales are $21M higher. This shows that all of “cost cutting” the company has been doing for years has finally started to show up in the numbers. It also shows that, once again, the main drivers of higher net income in the future will most likely have to come from higher sales, higher gross margins and ultimately higher gross profit dollars. We are encouraged that Mr. Ranelli made it clear that this is the company’s main priority in the future. Will it happen fast enough to drive the stock price substantially higher in the typical investor holding period of weeks or months?  Probably not, it is a very stable slow moving business. But over time, we believe that CENT can certainly outperform most investments because there is the possibility of higher earnings and a higher multiple on those earnings, something most argue is not possible with most stocks after last year’s huge run up.

 $ Millions

2009

2010

2011

2012

2013

Sales

$269.00

$282.00

$302.00

$292.00

$291.00

SG&A

$87.00

$89.00

$92.00

$90.00

$88.00

SG&A % of Rev

32.3%

31.6%

30.5%

30.8%

30.2%

Segment Operating Margins Improve in Both Divisions   We do not want to place too much emphasis on such a small quarter, but the company is clearly starting to move operating margins and income in the right direction. Importantly, the Pet segment margins improved due to price increases in the dog and cat categories, which we believe are very important to the long-term growth of the company. This is encouraging. Margins in Garden were positively impacted by lower commodity costs (which will move around), lower returns and higher sales into a new channel, which is also encouraging.

Operating Income

Q1 13

Q1 12

Q1 11

Pet

 $14.40

 $10.20

 $9.70

Margin

7.8%

5.2%

4.8%

Garden

 $(6.00)

 $(8.50)

 $(11.30)

Margin

-7.8%

-5.2%

-4.8%

Inventory is still too high, but management is making progress We have been focused on elevated inventory levels for two reasons. The first is that large increase in inventory over the last year has been a huge drag on cash flows and resulted in an increase in the company’s net debt situation. For example, in FY13, higher inventory levels reduced cash from operations by $62M, which contributed to the company’s cash flow swinging from $89M in cash from operations in FY12 to a negative $28M in FY13. This short fall was funded with $33M in cash and a $23M increase in debt. If ending inventory is just held flat with last year’s level, all else being equal, cash from operations would improve from negative $30M to positive $30M. Consider the fact that just two years earlier the company generated $80M in CFO and you can see how important working capital management is.   Below is a basic table of the changes in working capital for Q1 FY 14 and Q1 FY13. Even though inventory is higher YOY, the increase relative to Q1 last year is smaller, which helped cash from operations swing from a negative $28M to a positive $30M. This allowed the company to repay the draw on the line of credit and reduce debt to just the $450M 8.25% note due 2018. This significantly improved the company’s starting liquidity and offers hope that cash from operations for the year will return to more normal levels of $50-$80M, which would create $20-50M in free cash flow for the year. Capital expenditures are returning to a more normalized $30M a year (a $10M reduction from last year) which also helps FCF. The company has $50M remaining on its stock buyback authorization and later in the year could resume buying back stock with the FCF.

Changes in Assets and Liabilities $ Mills

Q1 13

Q1 12

Change
Accounts receivable  $51.20  $51.70  $(0.50)
Inventories  $(35.00)  $(67.00)  $32.00
Prepaids  $(13.70)  $(15.20)  $1.50
Accounts Payable  $16.90  $3.30  $13.60
Accrued Expenses  $10.00  $3.40  $6.60
Other  $-  $(2.00)  $2.00
Net Change  $46.30  $(22.50)  $68.80
Cash from Operations  $30.00  $(28.00)  $58.00

We are encouraged that management has been following up its words with tangible results in the reduction in inventory growth. We are hopeful that inventory can actually decline YOY in the coming quarters. Here is a list of a few comments made by management on recent conference calls highlighting their acknowledgement that inventory levels need to come down.   Q3 Conference Call: We are broadening our focus to include reducing Central’s inventory levels over time. We are committed to doing so in a way that will meet our customer service objectives in addition to freeing up working capital.   We are focused on working down our inventory balance and expect to reduce it over time.   On that point, we are, essentially, beginning meetings every Monday to bring our inventory levels down. So we’re going to take an aggressive approach to reducing our inventories.   Q4 Conference Call:   Having successfully improved our fill rates, we are now focused on bringing our inventory down to more normalized levels. We intend to do so in a gradual manner without jeopardizing the success we’ve had in raising our fill rates with our customers. This will free up working capital to be used in other areas of the business.   As far as moving forward, we’re going to bring those inventories down, but we certainly see looking forward — our plan going forward to bring those down over time.     Q1 Conference Call:   We improved customer fill rates significantly, and we took positive steps to improve our cash flow and reduce our inventory levels.    While we are currently building for the upcoming garden season, we are focused on bringing our investment in inventory down over time when compared to comparable quarters. We’ve made progress in our inventory reduction while balancing these actions with maintaining our fill rates.   I think inventories are still high as kind of a carryover from last year because we went through the seasonally — exited the season in June with our inventories very high.   While it is true that inventories increased 7% YOY with flat sales and similar YOY sales results expected in Q2 FY14, there has been clear progress on growth rates in inventory. For example, the 7% YOY increase in inventory in Q1 was the smallest YOY increase in the last five quarters.  The 9% Q/Q increase was the smallest Q1 increase in the last three years and compares very favorably to the 21% sequential increase last year.

Q4 FY11

Q1 FY12

Q2 FY12

Q3 FY12

Q4 FY12

Inventory

$330.00

$366.00

$380.00

$334.00

$330.00

Q/Q

$36.00

$14.00

$(46.00)

$(4.00)

Q/Q %

11%

4%

-12%

-1%

Y/Y

$           –

Q1 FY13

Q2 FY13

Q3 FY13

Q4 FY13

Q1 FY14

Inventory

$398.00

$435.00

$413.00

$392.00

$427.00

Q/Q

$68.00

$37.00

$(22.00)

$(21.00)

$35.00

Q/Q

21%

9%

-5%

-5%

9%

Y/Y

$32.00

$55.00

$79.00

$62.00

$29.00

Y/Y %

9%

14%

24%

19%

7%

Summary   One quarter results are too small of a sample size to declare the company is completely back on track. Unpredictable weather and consumer behavior in the next four months can quickly derail the gains made in this quarter.  But that is out of the hands of management and what management can control (i.e. inventory levels, operating costs, customer service, and product innovation) is showing tangible signs of improvement. Liquidity has improved and the recent management announcements changes show the company is serious about growing sales and improving gross margins.   We believe that Mr. Ranelli is managing the company in a way that is appropriate and is clearly placing the interests of the company’s customers over Wall Street hopes of a quick fix and turnaround. The fact that Mr. Ranelli continues to say on conference calls that this could be a two year process is encouraging for us to hear as long term investors. If working capital usage continues to improve and cash from operations returns to historical levels of $50-$80M, the company could resume its $50M stock buyback later this year (15% of market cap). The only debt the company has is a $450M 8.25% coupon note with a maturity of 2018.   In March of 2014, the company can redeem the note at 104.125% of par. The premium falls to 102.063% in 2015 and 100% in 2016. While a reduction in the $37M a year in interest expense would be welcome, historically the company has chosen stock buybacks over bond redemption and given the 104% premium, we believe the company would delay any redemption until 2015. We still believe in our initial assessment of the long-term value of the company of $12-$15 a share.   Finally, we will leave investors with this table which we think speaks volumes about how short-term focused (on both stock momentum and company operations) investors/analysts are. We continue to urge investors “do your own work” and not focus on what analysts say or what the stock chart looks like.

Conference call

# of Analysts asking questions

Stock Price

Q2

11

 $9.00

Q3

9

 $8.00

Q4

8

 $7.50

Q1

4

 $6.50

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About Tim Heitman