Description

On the surface, Central Garden & Pet (CENT) looks like a highly levered, non-differentiated producer of pet and garden products trading at over twenty times trailing earnings. However, under the surface, CENT is undergoing a major change and has virtually a whole new management team focused on streamlining operations. Earnings power will increase significantly in the next few years as management begins cutting fat and driving margin expansion. There is a significant amount of low hanging fruit to be harvested and the stock could appreciate 50 percent or so with just simple management blocking and tackling.  Should management deliver on their expectations, there is significantly higher upside potential.  

This isn’t a low risk situation as CENT carries a significant amount of debt. At 3.6x net debt/EBITDA and undergoing a major transformation, there isn’t a ton of room for error. That being said, CENT’s products are fairly recession resistant. For example CENT has performed well during recent economically stressed periods of time. From September ’01 to September ’02 sales only fell four percent and from September ‘08 to September ’09 they fell five percent. Increased commodity inflation, though, is a real risk. In FY 2011 EBIT was down 22 percent due mainly to increased input costs they were not able to pass through to customer.

CENT made 27 different acquisitions from 1997 to 2011 (and 40 since 1980) and each of those companies was left to function as effectively an independent business. Despite having similar brands and many of the same customers, these entities had very little synergistic relationships.  Facilities were being severely under-utilized and some were at less than 40% utilization rates. At the end of September 2011, there were 66 facilities supporting $1.6bln in revenue while Scotts Miracle-Gro, for example, had 35 facilities and $2.3bln in domestic revenue. In addition, buying/procurement was not centralized preventing the company from benefitting from economies of scale. One senior management team member put it bluntly saying “there was an absence of processes.” The company had 26 different ERP systems. Sales and marketing was also a disaster where an insignificant customer might get 5-6 calls. Data was being collected by each entity and not being shared with the others. Several of their products were competing with each other.  There were too many SKUs including at least one where a grand total of $500 worth of merchandise was sold in a year. What can only be described as a boondoggle of management was showing up in the numbers as five year trailing operating margins were 11.6 percent for the Pet segment and only 6.7 percent for Garden segment. This compares to the following five year averages of some comps:

Garden

Scotts Miracle-Gro  (Global Consumer segment): 16.9%
Spectrum Brands (Home and Garden segment): 13.5%

Pet

Spectrum Brands (Global Pet Supplies segment): 11.8%
PetMed: 14.6%
Uni-Charm Corp (Pet Caring segment): 14%

Enter Gus Halas who was hired as a consultant in 2009 and officially as CEO of Central Operating Companies in April of last year. While founder, Bill Brown, retains the CEO role, Halas is effectively controlling the operations of the company and attempting to transform the company from the boondoggle described above into one integrated, multi-brand company that has improved processes, reduced number of facilities, fewer SKUs, and a centralized process for all divisions. Note that Bill Brown still retains control of the company with super-voting shares and has been reluctant to give up control in the past. At present Gus seems firmly in control of the operations but there is a risk Bill Brown changes his mind.  

 Gus in his own words “was not looking for another career” and Bill Brown sought him out to help change the company. He was essentially retired after running T-3 Energy Services from March 2004 to March 2009. Gus was a consultant for a year at T-3 before becoming its CEO. T-3 stock went from $6.95 to a peak of $79 in June of 2008 before falling to $10 during the financial crisis. In his own words,Gus has been doing turnarounds for 30 years. It should be noted that Gus struck his options at $12.50 and $15 and not at the market price at the time of his hiring. He is very much aligned with shareholders on effecting this turnaround.

In just over a year, Halas has already made great strides in collapsing the silos and implementing a process. The back office teams are now all aligned by function and purchasing has been consolidated, they have closed six warehouse facilities, and SKUs have been reduced by 7 percent.  As of the beginning of 2H 2012, management believes that have already taken out $15m in permanent cost reductions. They are spending more on marketing and further building their brands. Finally, Gus has built out a talented team and has hired people with branding experience.

The plan is to reduce CENT’s SKUs by 35 percent and focus management time, advertising spend, and salespeople’s efforts on the best brands. Gus expects this (along with demographic trends that favor both pet and gardening segments) to drive 10 percent top-line growth. Their plan is to steal back share that was lost by the lack of focus and dispersion of marketing dollars and time. A byproduct of SKU reduction and supply chain optimization is that management thinks they can take $120-140 million out of inventory which will be used to reinvest in the business, debt pay-down and buybacks.

Management has gone on record saying they expect a $30 million run rate reduction in costs by the end of 2012 and by $120 million over 2-3 years.  $120 million on a $600 million equity would have a big impact.

Assuming they get to 10 percent company margins by 2015 and five percent annual top-line growth beginning in 2013 (half of management’s expectations for 10 percent top line growth), CENT could earn $1.90 a share in EPS and $225 million in EBITDA in 2015 vs $0.50 EPS and $114 million in EBITDA in 2011. On an enterprise value of $1bln, CENT would trade at 4.4x EBITDA and 5.2x P/E. There is significant upside optionality on top of these numbers if CENT grows faster and/or pays down more debt. CENT has bought back a lot of stock over the last few years and could continue to plow free cash flow into buybacks further increasing upside potential.

Catalyst