CNM3D

ENR Write Up

October 30, 2013

Recommendation: Sell short

Current Price: $98.92

Target Price: $76

Bull Price: $115

Market Cap: $6.1B

Liquidity: 590k shares or $63MM per day

Description

Energizer Holdings (ENR) is a 2000 spin out of Ralston-Purina. The company has two divisions: Household Products (primarily batteries) and Personal Care (primarily wet shave, along with feminine care, suntan lotion, wet wipes, etc.). In the fall of 2012, ENR announced a large corporate restructuring with the aim of ~$150MM a year in permanent cost savings. On July 31^st, 2013, ENR announced the acquisition of JNJ’s feminine care division for $185MM.

Thesis

ENR is a low quality business. Batteries, which are ~45% of EBIT, are in secular decline and facing an expanding promotional competitor (SPB’s Rayovac). Wet shave, which is approximately 30-40% of EBIT, is lapping a major product launch and facing a larger, promotional competitor (PG’s Gillette). In response to persistent negative sales in batteries, ENR announced a large restructuring plan with $150MM in project permanent savings. Despite the failure of ENR’s similar 2011 restructuring plan, analyst/bulls have factored a near complete success into their estimates.

Further, on ENR’s Q3 call, management announced the loss of two key battery customers which combined represent a 6% loss in sales on top of -2% industry trends, implying a tough Q4 down >10% and 2014 battery sales down 6-8%. Despite this significant headwind, ENR guided 2014 EPS up mid-single digits, which implies flat battery EBIT and makes 2014 estimates entirely dependent upon restructuring success. Given ENR’s past failed restructuring and aggressive 2014 guidance, I believe ENR is likely to miss guidance and its present valuation does not adequately discount this risk. In addition, management has recently been consistent sellers after several years of little action.

Valuation

• Target Case: If cost cuts fail to materialize, for 2014, I forecast 19% battery margins (inline with 2012) with -6% sales growth and 50 bps of personal care (wet shave) EBIT margin expansion and 3% sales growth plus 20 cents in EPS from the JNJ acquisition, which yields ~$6.35 in EPS.  Applying a 12x multiple, ENR’s average for past 5 years, yields $76 per share.
  • Note: This is better organic personal care sales and EBIT growth than JNJ has seen since 2009.
• Downside Case: If I model 2014 battery margins at 25% (500bps higher than batteries’ previous all-time high margins) and with the same assumptions for personal care and JNJ acquisition, I reach $7.65 in EPS. A 15x multiple yields $115.

Risks

• Continued Multiple Expansion – At 14x 2014 EPS estimates, ENR trades at a discount to the Consumer Staples group, which typically ranges from 16x-20x. While I believe a larger discount is warranted given ENR’s lack of topline growth, some bulls may disagree.
• Non-GAAP Earnings Beats – As ENR is the midst of a restructuring, there is a significant difference between GAAP and Non-GAAP earnings. While I am suspicious of the validity of ENR’s “restructuring” charges, in the near term, ENR has a pass from the buyside to make up earnings beats via Non-GAAP charges.
• Takeout – While I believe it is unlikely given the lack of interest at $65, ENR occasionally attracts speculation as a takeover candidate. However, assuming a 7.5x EBITDA on batteries and a 10x on the rest of the business would only yield $108 per share, ~10% upside from current levels. A 12x multiple on the rest of business, aggressive given wet shave difficulties and low quality of remaining brands, would yield $122. (Street 2014 estimates as EBITDA base.)
• Change in Strategy by SPB (Rayovac) or PG (Gillette) – If a major competitor were to change strategies and the battery/wet shave category were to become less competitive, ENR’s shares would benefit.

Catalyst

• Earnings Disappointments into 2014 – As previously stated, I believe 2014 estimates are too high for ENR. On both the Q2 and Q3 releases/calls, management has talked down 2014 numbers, including explicitly guiding below the Street for 2014. As management has already exited stock and will likely hit their 2013 bonus targets, I believe management will look to lower 2014 EPS expectations on the Q4 call.

Q4 and 2014 Estimates

• For Q4, ENR guided battery sales down greater than 10% (customer losses, product exits, industry declines) and implied slow Personal Care (wet shave, etc.) growth
  • My estimates for Q4 are roughly inline on sales and slightly below on EPS
    • As ENR’s EPS guidance is “Non-GAAP”, not tracking FCF, and I do not trust management, I put little weight on current EPS
    • During 2014, ENR’s “restructuring charges” should dissipate and ENR’s GAAP and Non-GAAP earnings will equate, hence I believe the market is focused on 2014 EPS
• For FY 2014, ENR provided initial guidance of mid-single digit (MSD) growth, or ~$7.35, which roughly corresponds with $780MM in EBIT
  • Note: Guidance does not include the JNJ acquisition, which will be discussed below
• Assuming Personal Care grows topline 3% with 50 bps margin expansion, significantly better than achieved in last few years, implies $495MM in 2014 EBIT
• Further assuming $180MM in Corporate Expense (flat y/y), implies ~$465MM in EBIT, roughly flat y/y
  • However, on the Q3 call, ENR announced the loss of two key customers (Sam’s Club and Family Dollar) which combined will negatively impact sales by 6% for the next four quarters, Q4 2013 through Q3 2014, on top of the expected 2% or more industry declines
  • Assuming a 50% incremental margin on battery sales (likely conservative, explained below), implies a $61MM-$82MM headwind to 2014 EBIT
  • Compared to 2012 battery segment EBIT of $400MM and 2013 Non-GAAP EBIT of ~$470MM, this is a very significant drag
• Even with my conservative assumptions for Personal Care and incremental margin, ENR’s 2014 guidance still implies a complete success of the $150MM restructuring program plus an additional $10-$25MM in savings

• Note: Street estimates for Battery EBIT are ~$465MM to $480MM, as most analysts are less bullish (i.e. conservative) in their Personal Care assumptions.
• Given past failed restructurings, my conservative Personal Care assumptions, and incremental battery margins likely above 50%, I believe it is highly likely ENR will miss 2014 estimates
• Note: On July 31^st, ENR announced the acquisition of JNJ’s feminine care segment for $185MM, with limited disclosure beyond the price and total sales of $250MM. I assume 8x EBITDA, D&A at 2% of sales, and a 27% tax rate to get ~$18MM in Personal Care EBIT and ~$0.20 in EPS accretion. The actual transaction price and synergies could be wildly different. This is just a simple estimate.

Batteries

• Batteries were ~45% of ENR’s 2012 EBIT
• Global alkaline battery sales are in secular decline due to the shift towards electronic devices with rechargeable batteries
  • Walkmen have been replaced by iPods, Gameboys by iPads
• In the past 12 months, global alkaline battery volumes are dropped ~5%, which is on top of HSD volume declines in the 12-24 month period
• At the same time volumes decline, ENR faces continued pressure from both SPB (Rayovac) on the low end and PG (Duracell) on the high end
  • SPB has grown market share over the past several years
    • There is virtually no difference between Rayovac and Energizer/Duracell batteries in terms of performance and/or shelf life
      • A quick Google search will return dozens of scientific articles confirming this
      • When consumers traded down in the Great Recession, many discovered that there was no difference and did not “trade up” as the economy recovered
      • SPB has offered better vendor support and gross profit dollars for Rayovac batteries, which has enabled SPB to gain shelf space at outlets such as WMT, HD, LOW, etc.

• PG has significantly outspent ENR in marketing and now has a leading market position in batteries
  • PG spends ~16% of revenues in advertising and promotion while ENR spends ~9%
    • Note: This difference in ad spend also affects ENR’s other divisions, which will be discussed below
    • This significant difference in advertising and promotional support has lead to Energizer market share losses as ENR is priced inline with Duracell despite lower support
  • Essentially, merchants need a  Good, Better, Best strategy and Duracell is providing the ad/marketing supporting for Best, Rayovac is providing the price for Good, and Energizer is hanging somewhere in between and not investing in either price or ad spend
• Energizer’s poor position in a declining category implies a significant headwind to EBIT growth
  • Assuming 50% incremental margins, every 1% decline in batteries implies ~$10MM headwind to EBIT
  • ENR’s overall gross margin is ~47%. As there are fixed costs in ENR’s COGS line, batteries are historically modestly more capital intensive than Personal Care, and batteries are seeing not just volume but price reductions, I believe 50% incremental margins is a conservative estimate.

Restructuring Plans

• In response to the challenging outlook for batteries, ENR  announced a restructuring plan in Fall 2012
  • ENR plans to reduce headcount by 10% and rationalize its battery manufacturing footprint
    • Most of the cost cuts are SG&A, though ENR does not provide the requisite detail to properly analyze how fixed vs. variable costs are accounted for in COGS and SG&A
  • While a sensible step for a declining business, ENR’s guidance is exceptionally aggressive
  • ENR expects $225MM in savings from the restructuring, with $150MM permanently falling to the bottom line
    • This is an enormous number, as 2012 battery segment sales were $2.2B and EBIT was $400MM, implying a 680bp increase in operating margins and a 38% increase to profits
    • Note: I am referring to ENR’s “Household Products” segment when I refer to the battery segment. Technically, this segment also includes portable lighting, but as these products are a minor percentage of sales and profits, I refer to the segment as “batteries” for simplicity.
• Of note, this is not the first restructuring the battery segment has seen
  • In 2010, ENR announced a less aggressive $65MM-$85MM restructuring plan with permanent savings of $35MM
  • Despite management’s belief that the full cost savings were realized, battery segment EBIT has declined from $451MM in 2010 to $411MM in 2011 and $400MM in 2012
    • Note: At the same time, revenues have fallen from $2,200MM to $2,088MM. If we are to believe that the full $35MM cost savings were realized, that implies $85MM in EBIT deterioration over the past two years despite only $112MM in revenue declines… an ominous sign and significantly above my 50% incremental margin assumption.
• Battery manufacturing is not a particularly capital intensive and does not require high effective utilization
  • Battery segment operating margins have held between 18-20% operating margin over the past several years
  • Battery plants are basically large, automated lines operating in a normal environment without need for excess heat/cooling, sterilization, etc. They are not manufacturing facilities where idle time is particularly expensive and rationalizing capacity would imply a significant margin benefit.
    • This is not a blast furnace heated to 3,000°F or a semiconductor fab that must be constantly held in a clean room environment
  • Most of ENR’s battery plants are near fully depreciated, implying little chance for margin expansion from lower capital intensity
    • Battery segment D&A has average 3.0%, 2.9%, and 2.6% in 2010, 2011, and 2012
    • Capex has been running about half of battery segment D&A (was $58.3MM in 2012 vs. D&A of $82.0MM)
  • Importantly, ENR has been operating between 50%-80% utilized for the past few years

• If this really were a segment where 10% capacity rationalization would have tremendous margin benefit, economic logic would dictate that it should struggle to achieve profitability in a sub 80% utilization scenario, yet ENR has held 18-20% operating margins with no problem in this environment
• Further, as with most manufacturing, I would expect per unit pricing to be a larger predictor of future operating margin than effective utilization
  • Here the trends are clearly negative, as continued pressure from PG and SPB keep a lid on pricing
  • ENR actually tried to take pricing in 2012 and was thoroughly rebuked by retailers, who simply awarded increased shelf space to Rayovac/Duracell
• Bottom Line: While a positive and the right step, I do not believe ENR’s restructuring will reach its targeted $150MM in permanent savings.

Personal Care/Wet Shave

• ENR’s other division is Personal Care, which accounted for  ~55% of 2012 EBIT
  • ENR’s second largest product by EBIT is Wet Shave, which accounts for 30-40% of overall EBIT and 2/3rds of Personal Care EBIT
  • The other segments, such as sun care, feminine products, and infant care, don’t really move the needle
• In Personal Care, recent trends for ENR have been weak
  • ENR originally guided Personal Care to MSD 2013 organic revenue growth
    • ENR has not had MSD personal care revenue growth since rebounding from the recession
    • ENR subsequently lowered FY guidance to LSD in Q2 and flat y/y as of Q3, with Nielsen trends running below that
    • This is not a management team with a history of conservative guidance…
  • For 2014, Street estimates imply LSD revenue and EBIT growth
    • My estimates are actually slightly ahead of the Street to be conservative
• Despite wet shave ostensibly being a good long term business (Buffett was a big Gillette holder), I believe ENR’s wet shave business is unlikely to see better than MSD EBIT growth in the foreseeable future
  • PG has a strategic plan to dominate/gain share in its key categories, such as wet shave
  • Gillette had lost share to Schick following the Hydro launch so PG is simply pushing back to regain what they lost, despite ENR’s management complaints about an “irrational competitor”
  • PG didn’t get traction pushing its higher end Fusion product, so instead is pushing its legacy Mach 3 as well as disposables
    • This is an unusual step for PG and represents a move down into categories that were typically ENR’s turf
• Simply put, I believe the present pressure in wet shave may not be as short lived as ENR management hopes and the rest of Personal Care are small, low quality brands

Management Caliber/Stock Sales

• Management has repeatedly been accused of self-enrichment and poor operational choices
  • For instance, ENR previously paid management only on EPS growth regardless of how that EPS growth was reached
    • One time benefits and tax changes would suddenly boost Q4 earnings just enough to meet required thresholds and/or numbers would be sandbagged if management was far from target
  • Operationally, management has been hit or miss
    • It took management until 2011 to admit a secular problem in batteries, despite two years of data and numerous market research indicating such
    • Management has repeatedly over promised and under delivered on guidance
      • I.E. – The “successful” 2011 cost restructuring, despite subsequent negative EBIT growth
• In the context of a tainted management reputation, I find the recent increase in insider selling troubling
  • Prior to Fiscal 2013, CEO Klein had sold only twice since 2007
    • 40,000 shares in 2009 and 50,000 shares in 2010, both related to options exercise
    • His 2009 sale was within 2% of the 6 month high and ENR subsequently missed numbers the immediately following quarter and traded down ~20% from his exit
    • His 2010 sale was 7% off the 6 month high, and the immediately following Q ENR missed sales estimates and shares traded down 15% from his sales
  • In December 2012 and February 2013, CEO Klein sold 40,000 and 60,000 and shares at ~$81 and $91, respectively, both related to options exercise
    • These sales represent about 20% of the CEO’s net value at risk in ENR’s stock and ~63% of his options at risk
      • The rest of his stock position is tied to partially/fully vested stock equivalents and other equity awards which may or may not be saleable
      • Of note, the December sale occurred exactly 4 days after the proxy was mailed
  • Other management have been sellers in the past 9 months
    • The heads of both divisions, the CFO, and several members of the board, including the largest shareholder and former CEO Mulcahy, have all been sellers after limited sales over the previous three years

Earnings Quality

• ENR’s current earnings improvement is largely non-GAAP and of low quality as it has yielded little improvement thus far in CFFO
  • Through Q3 2013, in Non-GAAP terms, ENR has generated a $74.1MM improvement in battery EBIT, $109.1MM in GAAP restructuring charges which should yield a $34.9MM tax shield vs. YTD cash restructuring payments of $29.7MM, and $12.2MM in lower corporate expenses
  • This is also in the context of management’s plan to improve working capital efficiency, so I am comparing CFFO pre-working capital changes

• While I detect no large balance sheet anomaly and there are always timing differences with cash vs. accrual accounting, ENR’s current Non-GAAP improvement has been underwhelming from a cash perspective, which calls into question the validity of ENR’s cost savings