Description

Here are some quick stats on Enesco. Market cap $96 MM, no debt and $18 MM cash, T4Q Revenue $254 MM, T4Q EBITDA $19 MM, T4Q EPS $0.55, and tangible BV of $8.61. So current EV/Rev is .31, EV/EBITDA is 4.2, P/E is 12.4, and P/BV is .79.

I submitted this same idea almost a year ago (see ENC March 25, 2002), at a slightly lower price. However, I believe it is now a more compelling investment idea as earnings visibility has increased, the balance sheet has improved and the company’s turnaround initiatives are strengthening. My write up from March, 2002, suggested EPS could reach $1.25 within a couple of years if management’s turnaround plan succeeded. I’m now more confident in that forecast as EPS should approach $1.00 this year, and FCF/share should exceed $1.30. Similar to last year, modest cap ex requirements relative to depreciation combined with working capital reduction produces free cash flow materially in excess of EPS.

Enesco has traditionally been a designer and manufacturer of giftwear and collectibles (with associated collectors clubs) under names such as Precious Moments and Cherished Teddies (these two licensed brands still account for over 40% of revenues). Products are sold through specialty gift shops (65%), mass merchants such as WMT. TGT, KM, and SKO (20%), drug stores (5%), Avon (5%), and other miscellaneous outlets (5%). Consumer interest in these types of products has generally waned, and specialty gift shops in particular have been under pressure. This poor industry environment is reflected in Enesco’s significant revenue decline since the late 90’s. Comparable companies (see FOB, DFS) have also seen meaningful revenue declines through this period, although decent results from RUS offers evidence of opportunity for companies with good execution. Additionally, part of Enesco’s revenue decline during the past few years was due to SKU rationalization from 20,000 to 10,000 as lower margin SKU’s were eliminated. Unlike most other areas of retailing, the gift and collectibles market remains very fragmented with thousands of suppliers, and small independent specialty shops still controlling about 60% of the market, while large mass merchandisers account for less than 10%.

Enesco’s turnaround is being led by CEO Dan DalleMolle (hired March, 2001), a long-time Newell-Rubbermaid senior operating executive, along with several executives he recruited. Using a lot of moves from the old “Newellization” playbook, they have taken a number of actions to stabilize business with the core channel of specialty gift retailers. The former network of independent sales reps was converted to a captive sales force and approximately 20-25% more reps were added to improve customer service (the cost of the sales force is now 100% variable with sales). Retailers were offered better dating terms to improve their cash flow. The number of SKU’s was more than cut in half, and the SKU management process was altered to guarantee the retailers delivery of the products they ordered rather than placing orders of interest and waiting to see what they actually received. The company has also reported a meaningful increase in on-time deliveries. In general, Enesco is raising service levels, product reliability, and trade terms, enabling retailers to improve their sell-through and ROI. An article in Giftware Business magazine discussing some of these issues and improvements can be found at:

http://www.giftline.com/giftwarebusiness/search/search_display.jsp?vnu_content_id=1509768)

Finally these efforts are starting to show some signs of success. The decline in sales to the specialty gift channel is moderating, and several important buying shows were held in January where Enesco saw a 4% increase in orders over last year.

Just as important as stabilization of its traditional gift channel, Enesco is growing its position as a sourcing agent to mass retailers for a widening variety of short-run gift and home décor items. Over the past year the company has added exclusive distribution rights for a variety of products that are incremental to its traditional line of products, and the mass channel is key to the company’s future growth prospects. (CEO DalleMolle has a lot of experience servicing mass retailers from his days at Newell). Enesco products were tested in an increasing number of Wal-Mart stores in 2002, reaching approximately 270 stores by year end. Wal-Mart represented 7% of total revenue in 2002, up significantly over the past few years. Growth through Wal-Mart continues to represent a major opportunity as Enesco is already scheduled to expand to at least 400 stores in 2003, and possibly as many as 1,500. While this sounds like a lofty goal, it does seem credible considering Enesco products are very profitable to the retailer (WMT had initially budgeted $188 in ENC sales/SF but has instead been getting $300+).

Enesco is also increasing sales of seasonal holiday items (figurine scenes from “It’s a Wonderful Life”, ornaments, snow globes, mugs, picture frames, porcelain bells, etc.) to Walgreens and CVS. While the opportunity apparently exists to sell incremental every day items through these channels, Walgreens has already indicated that it will increase its 2003 holiday orders by 50%.

Enesco reached a milestone in Q4 2002 by reporting y/y revenue growth of +5%, the first real revenue growth in 4 ½ years, through a combination of strong growth with mass merchants and moderating decline in the specialty channel. These developments provide some comfort that revenue has finally stabilized and is possibly ready to show some reacceleration.

The better top line should enable cost cutting initiatives from the past two years to lead to meaningful margin leverage. Enesco renegotiated more favorable sourcing contracts (Asian suppliers) and began seeing gross margin benefit in Q3. This benefit should have an increasingly positive impact as inventory closeout sales ease in 2003. SG&A improvement has been a strong point for the company since the new management took control. The company exited 2002 with an SGA annualized run rate of $89 mil vs. $131 mil in 2000. About $12 mil of the annualized SG&A reduction came from headcount reductions within the first 6 months of the new CEO’s tenure that eliminated approximately 25% of the company’s personnel. The remainder of the cost savings came from general belt tightening across all areas of the organization including lower travel and advertising expenses. While most of the SG&A reduction has largely run its course, 2003 operating margin will benefit from the first entire year of the lower cost base. Some incremental cost savings is also expected through the current implementation of a new ERP system.

Modeling just 3% revenue growth in 2003 (slightly less than the just reported Q4), gross margin of 44% (up from 42.2% in all of 2002, but flat with Q4), flat SG&A (seems too conservative since SG&A was down 18% y/y in 2002 and 2003 gets full benefit of cost cuts), no interest expense (has no debt and enough cash on hand to fund its seasonal borrowing needs), and a 35% tax rate gets to a net margin of 5.5%, and EPS of $1.00. With cap ex of $3.5 mil, D&A of $5.5 mil and modest benefit from working capital, free cash flow for 2003 should be at least $18 mil, or $1.30 per share. I believe these are reasonable assumptions. These projections yield the following 2003 valuations: EV/Rev of .30, EV/EBITDA of 2.8, P/E of 6.8, P/FCF of 5.3, and P/BV of 0.71.

It is still debatable whether or not the market for these non-commodity, often impulse driven products (life cycle typically 6-18 months) migrates more meaningfully to the mass channel in coming years. However, Enesco is positioned to benefit from improving strength in both channels and may end up being a force that eventually drives more of this market to the mass channel by offering an organized sourcing option for these products and the logistics required to support customers of this size.

RISKS

The near-term risks to the story primarily relate to the company’s ability to drive revenue growth and its ability to offer fresh, popular merchandise in appropriate quantities. Missteps in merchandise offered or excessive levels of inventory would likely lead to higher than expected closeout sales which would have a negative impact on margins. Enesco is mitigating an increasing amount of the inventory obsolescence risk by structuring new distribution agreements with the ability to return inventory to the manufacturer.

In the specialty gift channel Enesco will have to constantly swim upstream as this channel is expected to remain under pressure for the foreseeable future.

Thinking longer-term, one must consider potential channel conflict. Does an increasing amount of distribution through the mass channel alienate the specialty channel? For now, I am satisfied that it will have limited impact for several reasons. First, there is no SKU overlap as Enesco offers separate products to each channel. Second, I believe the mass market represents much more of a market expansion for these products than a cannibalization of the traditional channel. The true collectors will still perceive their local specialty retailer as a destination location to obtain the lines of limited edition items as they hit the market, while mass market distribution will reach incremental buyers whose purchase is based largely on impulse. The multi-distribution strategy has the opportunity to potentially create incremental collectors who would not have been exposed to the products otherwise.

You will also find a sizeable offering of these products on secondary markets such as Ebay. Does the availability of product on a secondary market pressure the primary market for these products? Although the rise in popularity of Ebay has mirrored the revenue decline for collectibles manufacturers, I believe the two are largely unrelated. First, the primary market is driven by new product introductions, so the secondary market cannot create a perfect substitute purchase. Second, these are not commodity items, and each piece of inventory is fairly unique. The items available in the secondary market today are primarily products that have already made their contribution to primary market sales while current primary market sales are being driven by new products that are not available in the secondary market (Remember each product has a short life-cycle). Finally, the increased liquidity in the secondary market (thanks to Ebay) may stimulate speculative interest in the primary market as a result of competitive bidding that often drives up the value of popular editions that are no longer available (and Enesco has been shorting the production runs).

Catalyst

The catalyst will likely come from continued modest revenue growth and realization that current year earnings power approaches $1.00. Importantly, this level of earnings requires only that sales and costs follow recent trends. If earnings get to this level, I expect a stock price above $10, more than 50% above the current price. The longer-term (2-3 years) earnings power is likely to be a good bit higher than $1.00, which should drive further price appreciation beyond this year (I’m forecasting a 2003 op margin of only 8.4% and rising). If I’m wrong and sales stall and margins don’t improve, then I think the downside is pretty limited since the company is debt-free and already trades at depressed levels of 78% of tangible book, 32% of revenues and 4.2 times EBITDA.