Description
Fedders Corporation: SELL/SHORT
Overview
Fedders Corporation, a manufacturer of window unit air conditioners and other air treatment products, is a struggling operator in a struggling industry. The Company has seen its gross margin squeezed by rising material costs and a lack of pricing power that arises when unforgiving customers such as WalMart and Home Depot make up nearly 50% of Fedders’ sales and purchase decisions for window unit air conditioners are made mostly on the basis of price.
To make things worse, the environment is not improving. Raw material prices have increased dramatically since the 2004 season for selling air conditioners, and the Company now faces the prospect of building inventory for 2005 when raw material prices are near record highs. Combined with low profitability, this inventory build will lead to major liquidity problems in 2005.
We would summarize Fedders’ weaknesses as follows:
1. Liquidity – The Company does not appear to have enough cash to build its 2005 inventory or make March 1, 2005 interest and dividend payments.
2. Gross Margin – The Company mostly builds its inventory from October to March. Commodity prices during that period this year will be significantly higher than last year. The Company has little power to push through price increases to retailers as is evidenced by the 15% annual drop in unit prices in recent years. Therefore, the Company’s gross margin, which decreased from 21% to 15% from 2003 to 2004, will decrease further in 2005.
3. Valuation – The Company currently trades at 0.8x LTM sales and 20x LTM EBITDA with EBITDA likely to shrink further in 2005. It has over 10x net leverage alone. The comparable companies trade under 0.5x LTM sales and 9x LTM EBITDA.
4. Operations Problems – The Company’s efforts (1) to move manufacturing to China, (2) to diversify into non-commodity products, and (3) to increase its Engineered Products business have all had significant issues.
5. Management and Accounting – The Company has had to restate Q2 2004 earnings. In addition, management is failing to acknowledge any sort of liquidity problems over coming months by continuing to pay dividends (including to themselves as stockholders) given clear operating and cash flow challenges.
Liquidity
The rise in raw materials might be a temporary problem for Fedders if it were not for the Company’s high leverage and low liquidity. The Company’s cash has declined to approximately $23 million, and, according to the Company, it has only $50 million of availability on its revolver for liquidity of $73 million, assuming all of the cash is readily accessible, which it is probably not given that some of it may be “trapped” in various legal entities. We have detailed the liquidity over the next two quarters below excluding any payment for the Addison Product Company acquisition that was recently announced:
Q4 Q1 Q4 Q1 Q4 Q1
2003 2004 2004 2005 % Change % Change
Revenues(1) $39.2 $123.2 $40.0 $140.5 2.1% 14.1%
Adjusted EBITDA(2) (4.5) 9.1 (12.5) 5.6 N/A -38.1%
Adj. EBITDA Margin(2) -11.6% 7.4% -31.4% 4.0% N/A -45.7%
Copper($/tonne)(3) $2,075.0 $2,725.0 $2,800.0 $2,800.0 34.9% 2.8%
Steel ($/tonne)(3) 300.0 425.0 600.0 600.0 100.0% 41.2%
Crude ($/barrel)(3) 29.3 32.0 50.0 50.0 70.9% 56.3%
Capital Expenditures(4) 1.6 1.6 1.6 1.6 0.0% 0.0%
Change in A/R(5) (16.1) 49.5 (16.4) 56.4 2.1% 14.1%
Change in Inventory(6) 49.9 14.1 69.9 16.9 40.0% 20.0%
Change in A/P(6) 22.8 1.8 31.9 2.2 40.0% 20.0%
Change in Acc. Exp.(7)(18.3) 1.7 - - -100.0% -100.0%
Q4 Q1
2004 2005
Beginning Liquidity $73 $33
EBITDA (13) 6
A/R Change 16 (56)
A/P Change 32 2
Accrued Exp. Change - -
Inventory (70) (17)
CapEx (2) (2)
Dividend(8) (2) (2)
Interest(9) (2) (12)
Ending Liquidity $33 $(48)
Notes:
(1) Q4 2004 revenues based on approximately flat sales to last year. Q1 2005 revenues based on 10% year-over-year increase in existing business from Q1 2004 and a $5 million increase due to the recent acquisition of Addison Product Company with $21 million in annual revenue. The Company has stated it can implement a 10% price increase in 2005. We think this is optimistic given Fedders’ customer base and track record of growing revenues in the past. 10% revenue growth would be pretty close to a record.
(2) Q4 2004 EBITDA margin derived from the 5% year-over-year decrease in gross margin experienced in Q1 and Q2 from 2003 to 2004 and SG&A expense remaining the same as in Q4 2003. Q1 2005 EBITDA assumes gross margin deterioration of 1% (see gross margin section note 2 below) and increased SG&A expense from the acquisition of $0.75 million. Q4 2003 EBITDA adjusted $6 million for closing of a plant in Georgia, start-up and transition costs of moving production to China, increased stock option compensation expense due to run-up in stock price, tax gross-up on expiration of restricted stock, and a gain on the sale of an interest in a JV. Q1 2004 EBITDA adjusted $1.5 million for start-up and transition costs of moving production to China.
(3) Q4 2004 and Q1 2005 commodity prices based on current levels. Crude is used as a benchmark for resin prices.
(4) Capital expenditures kept constant.
(5) Change in A/R increased by same percentage as sales.
(6) Inventory and accounts payable increased 40% from Q4 2003 to Q4 2004 and 20% from Q1 2004 to Q1 2005 to reflect changes in raw materials costs. We think actual increases may be higher.
(7) Accrued expenses including warranties, salaries, marketing, insurance, taxes, professional fees, etc. assumed neither to use nor provide cash.
(8) Includes preferred dividends of $1 million and common dividends of $1 million per quarter.
(9) Interest includes payments on short-term notes and revolver assuming 6% average rate. Interest also includes Q1 2005 payment on $155 million 9 7/8% notes.
As the numbers above demonstrate, the Company will very likely run out of cash in the first quarter of 2005 barring any major sale of assets. Even if the Company can somehow squeeze by on the cost of its inventory, there are another $2 million of dividend payments looming on March 1, 2005 on top of an approximately $8 million interest payment on the Company’s outstanding notes. Stopping payment on its dividends would certainly have a negative effect on the Company’s stock price but would likely not salvage the liquidity situation.
Gross Margin
Fedders has little power with both suppliers and customers. Its main customers are multi-billion dollar retail chains known for their ability to buy at the lowest price. These prices have declined as much 15% year-over-year recently. These retailers do not really care about Fedders brand name. The Company’s suppliers sell at the market price for commodities. Because of increased economic activity in China, the price of these commodities has sky-rocketed. From Q1 2003, copper prices are up nearly 70%, steel prices are up nearly 100%, and aluminum prices are up over 30%. Resin costs too were up as a result of nearly a 60% increase in crude oil prices. Below is a summary of historical and projected margins and commodity prices as compared to the Company’s revenues and gross profit:
Q1 Q2 Q3 Q4 CY 2003 2004 2003 2004 2003 2004 2003 2004 2003 2004 2005
Rev(1) 123.4 123.2 186.7 196.0 78.7 69.2 39.2 40.0 428.0 428.4 491.2
COGS 95.3 101.4 142.7 161.6 63.3 61.6 35.5 37.8 336.8 362.5 420.9
GM(2) 28.0 21.8 44.0 34.4 15.5 7.6 3.7 2.2 91.2 65.9 70.2
GM(2) 22.7% 17.7% 23.6% 17.6% 19.6% 10.9% 9.4% 5.4% 21.3% 15.4%14.3%
Index 100.0 162.7 98.5 165.7 104.5 170.1 123.9 167.2 106.7 166.4 N/A
Copper(3)
Index 100.0 141.7 96.7 166.7 96.7 191.7 100.0 200.0 98.3 175.0 N/A
Steel(3)
Index 100.0 103.2 84.7 114.5 90.3 129.0 94.4 161.3 92.3 127.0 N/A
Crude(3)
Index 300.0 407.6 279.9 446.9 291.5 490.8 318.2 528.5 297.4 468.4 500.0
Total(4)
Notes:
(1) Q4 2004 revenues based on approximately flat sales to last year. 2005 revenues based on 10% year-over-year increase from 2004 and a $20 million increase due to the recent acquisition.
(2) Gross profit margin for Q4 2004 based on the 5% year-over-year margin decline experienced in Q1 and Q2 2004. Using this assumption, we think gross margin deterioration from 2003 to all of 2004 from raw material price increases will be 4% plus 2% from a reduction of the Chinese VAT tax refund. For 2005, we think gross margin is also likely to deteriorate 4% due to raw material price increases. However, management believes that the Company may be able to pass through a 10% unit price increase to suppliers that would cut this deterioration in half. Lastly, in order to be extra generous, we give the Company credit for a 1% better gross margin as a result of finishing transfer of production to China. See the reconciliation below:
2003 Gross Margin 21%
Less: VAT Tax Refund Reduction -2%
Less: Raw Material Cost Increase -4%
2004 Gross Margin 15%
Less: Raw Material Cost Increase -4%
Plus: 10% Unit Pricing Increase 2%
Plus: Cheaper Chinese Labor 1%
2005 Gross Margin 14%
(3) Q4 2004 commodity prices based on current levels.
(4) 2005 commodity index total assumed to subside slightly from current level but remain higher than 2004 levels. We think more severe drops are possible although unlikely given expected high prices as announced by many raw material providers (i.e. almost all the steel and chemical companies).
The bottom line on gross margins: we are forecasting a slight dollar increase in gross margin for 2005, which we think is generous given the short-term outlook for steel, copper and chemical prices as indicated by recent forecasts given by suppliers of these materials. Given that Fedders is making raw materials purchases for 2005 at the current time, we think it is unlikely that our forecast will change significantly on the cost side. As a result, Fedders is totally dependent on having a blowout increase in sales in order to make numbers.
Based on our assumptions for gross margins, we have developed the following 2004 and 2005 EBITDA projections for Fedders:
CY CY
2004 2005
Revenues $428.4 $491.2
COGS 362.5 420.9
Gross Profit 65.9 70.2
SG&A(1) 72.0 75.0
EBIT (6.1) (4.7)
Adjustments(2) 6.5 -
D&A 9.3 9.0
EBITDA 3.2 4.3
Adjusted EBITDA 9.7 4.3
Gross Margin 15.4% 14.3%
EBITDA Margin 0.7% 0.9%
Adj. EBITDA Marg.2.3% 0.9%
Notes:
(1) 2005 SG&A assumed to stay flat aside from $3 million in additional expenses from the Addison Products acquisition.
(2) Adjustments for inefficiencies related to moving production to China.
Valuation
Fedders not only is likely to run out of cash in the next six months, but also it has limited ability to raise cash. Its debt covenants prevent it from adding any more secured debt beyond what its revolver provides, and we think it would have trouble raising equity given the Company’s valuation and prospects. We have calculated the Company’s current enterprise value below:
$132.2 Equity Value (36.5 million fully diluted shares at $3.50)
(23.9)Cash
4.8 Minority Interest (Book)
46.8 Preferred Stock (Liquidation Value)
191.9 Long-Term and Short-Term Debt
$351.7 Total Enterprise Value
With projected 2004 sales of $430 million and adjusted EBITDA below $10 million, the Company would need to have a sales multiple of over 0.5x and an EBITDA multiple of over 22x to have any equity value. Fedders does not have the growth potential to justify this multiple even with raw materials at peak levels. More importantly, all of the comps trade at or below 0.5x trailing sales and 9x trailing EBITDA in the same high commodity price environment.
TEV / LTM Sales TEV / LTM EBITDA
Maytag 0.5x 8.7x
Whirlpool 0.4x 4.2x
Electrolux 0.4x 5.3x
Average 0.4x 6.1x
Operations Problems
The Company has made several efforts to turn its business around.
1. Fedders has moved its operations to China in order to reduce its manufacturing costs.
2. Fedders is attempting to diversify its product offering beyond window unit air conditioners, a commodity product, into central air conditioning units, dehumidifiers, humidifiers, etc.
3. Fedders has focused on the growth of its Engineered Products segment, which makes air filters and thermal technology products for industrial use.
However, the Company’s efforts have met many challenges.
1. Because of the swiftness of moving operations to China, the Company has had product quality problems. Fedders failed to work out the kinks in its overseas production before devoting all of its resources there. Furthermore, the Chinese government recently changed its policy regarding rebate of VAT taxes. It used to refund all of the 17% tax in order to encourage exports. Recently, in an effort to slow down its economy, China has reduced this rebate to 13% hurting exporters' bottom lines. This may be a one-time action, but could suggest further reductions of the rebate. Other factors that have negated the benefits of producing in China include a weakening dollar and a rising wage for Chinese labor. Management recently announced a new venture that would offer use of its Chinese manufacturing facilities for contract manufacturing for third parties, which suggests that Fedders has too much capacity.
2. The Company’s attempts to move into new products have also been under pressure. The Company is reportedly skilled at producing commodity products at low cost. Being the low cost producer does not necessarily breed success in the market for central air conditioning units, an area into which Fedders is expanding. Brand name plays a much bigger part in this segment as customers are familiar with brands such as Carrier and Trane. Customers are also much less price sensitive as the installation of a central unit air conditioner is often part of building a new home or making a major home modification. In summary, Fedders’ efforts to diversify away from commodity products will not be easy.
3. Finally, Fedders’ efforts to grow its Engineered Products business have shown promise but have not led to significantly better results. Sales for the first nine months of 2004 have grown over 25% but still represent less than 10% of Fedders’ sales and income. Margins in this segment have also proven difficult.
Management and Accounting
Fedders recently announced an accounting restatement to adjust Q2 2004 sales for sales returns. A cyncical viewpoint might be that the Company was attempting to show strong sales following its bond financing completed in March 2004. If nothing else, the event highlights poor internal controls. Also, management is acting as if they are oblivious to the Company’s potential liquidity problems by declaring the December common stock dividend. However, since management owns some 10% of the common stock, these dividends are a meaningful source of income. A cynic might say: “Why wouldn’t they pay the dividend if the equity if it is worthless? They might as well get something for their equity before it craters.”
Conclusion
Fedders is very likely to run into liquidity problems later this year or early next year. Its raw materials situation is unlikely to improve soon. Even if it can dodge these problems, the Company is still overvalued. It is trading at over 20x trailing EBITDA and 7.5x its all-time high adjusted EBITDA of $47 million in 2003, a multiple still well above the industry average of 6x EBITDA. It is also trading at 0.8x LTM sales, twice its industry’s average.
Catalysts
1. Cash shortage during inventory build out resulting in a Chapter 11 filing/restructuring.
2. Missing payment of March 1, 2005 dividends and interest resulting in a Chapter 11 filing/restructuring.
3. Report of weak 4Q 2004 earnings.
4. Announcement of another reduction in the Chinese VAT tax rebate.
5. Announcement of a dividend cut.
Catalyst
1. Cash shortage during inventory build out resulting in a Chapter 11 filing/restructuring.
2. Missing payment of March 1, 2005 dividends and interest resulting in a Chapter 11 filing/restructuring.
3. Report of weak 4Q 2004 earnings.
4. Announcement of another reduction in the Chinese VAT tax rebate.
5. Announcement of a dividend cut.