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.

 

One-Hour Analysis of Northrup Grumman

From Value Line

  • Stock has consistently underperformed since 2002, stock has been flat for over 10 years
  • Stock is cheap in term of cash flow, not that cheap in terms of book value
  • Took a big charge in 2008, a pretty good size negative
  • Made several large and probably bad acquisitions in 2001-2
  • Have done a spectacular job of deleveraging ever since
  • Balance sheet is almost “too good”, they could certainly afford acquisitions, over $3 billion in cash
  • Margins are at all time highs, this is more a negative than a positive
  • Impressive size of stock buyback, these guys have really “got religion” in terms of really working for shareholder
  • VL shows small pension liability, this needs further investigation
  • Lots of mixed signals here, not quite as clean as LLL

[Read more…]

One-Hour Analysis of Aerovironment

From Value Line

  • AVAV has only been public since 2007
  • Founder a “beloved aeronautical pioneer”
  • Went public at $20, shot to $40, now back near $20
  • Not that cheap at over 15x earnings
  • In two growth-oriented areas, drones and electric cars
  • Clean book value
  • Plenty of cash
  • Has not done any buybacks
  • Insiders own 17%, unusual for this industry, but have been sellers recently
  • Is electric car business subsidized, or does it have real economics?
  • No pension issues
  • ROE still only 10%

[Read more…]

One-Hour Analysis of AAR Corp.

From Value Line

  • Stock had a big run 2002-6, miserable ever since
  • Under book and about 10x earnings
  • Added too much debt in 2012, almost enough to be totally disqualifying
  • Interest coverage of about 3x, not encouraging
  • Over 50% commercial aerospace, a positive
  • Some insider buying
  • Big capx in last few years, needs to be investigated

From Footnotes

  • Large exposure to troop transport and logistics
  • Own aircraft fleet and leases others, some in joint ventures, very complex
  • Very complex financing transactions
  • The recent acquisitions were primarily international [Read more…]

One-Hour Analysis of Kratos Defense & Security Systems

Not in Value Line, So From Various Sources

  • At half of book value this stock seems very cheap
  • But with a tremendous amount of goodwill, we would use 90% of sales as a better metric, which is not real cheap
  • This stock is essentially like a private equity deal, lots of debt and a sliver of equity
  • Would be tempted to throw the stock out, without too much more work except there are many interesting things to study here
  • Debt is trading above par, and interest is well covered
  • CEO Demarco is a great salesman, he tells a fascinating story
    [Read more…]