I am advocating a long investment in Griffon Corporation (“Griffon” or the “Company”).  The Company is organized around three unrelated business segments, two of which are currently under-earning their margin potential.  I anticipate that Griffon is at an inflection point for achieving better operational and financial performance that will lead to either the market closing the discount to the Company’s intrinsic value, and if not, then improved operational performance will further elevate the visibility of such discount, thereby calling for potential value to be unlocked by shareholder activism. 

Based on my premise that Griffon’s performance metrics will be much improved in a couple of years, I envision that upside of 40% or more can be realized in two years or less.  Griffon’s three business segments are Home & Building Products, Telephonics, and Plastics.  On a revenue mix basis, they comprise 48%, 21%, and 31%, respectively.  On an EBITDA mix basis (before unallocated G&A), they comprise 37%, 32%, and 31%, respectively.  As a “mini-conglomerate”, I have evaluated Griffon on a sum-of-the-parts (“SOP”) basis; my base case approach generates a value of ~$17 (my high case is over $20 and my low case is over $13).  GFF is currently trading at ~7.5x NTM EBITDA and ~13x EPS for the fiscal year ending September 2015.  The current conglomerate discount to my low case is almost 25% and I am not suggesting it will close very soon but I do think that as management demonstrates ongoing improvements in financial performance, the market will ascribe a smaller discount and begin to discount my base case. 

I envision the Board will be active towards trying to enhance shareholder value.  I don’t envision that management will remain idle with the current assets.  The Company has repurchased $115M of stock at $10.60 since 2011.  The CEO will likely be opportunistic in regards to tuck-ins (just announced a $36M acquisition two months ago), share repurchases (750,000 shares were repurchased in the past quarter at $11.71 per share), and might engage in a meaningful transaction that either bolsters the Home and Buildings Product or expands the Company into a fourth business segment.  I believe that management and the Board are cognizant of the discount that the current stock price represents when framed on a SOP basis and there is likely a willingness to divest at least one of the business segments (most likely the Plastics segment) pursuant to a sustainable margin profile being secured there coupled with an attractive use of proceeds.  The Chairman and CEO collectively own almost 10% of the stock. 

Griffon Corporation was founded in 1959 and initially made electronic products for the military and commercial markets.  The Company was an active acquirer; at one point, there were eighteen different divisions.  Although most of those divisions were sold, the Company remains a mini-conglomerate.  Given the holding company structure of three unrelated business segments, it would not be a surprise if shareholder activism developed towards unlocking the value at Griffon.  In fact, both Clinton Group and Barington Capital agitated for change in 2006-2008.  Although not typically an activist, note that Gabelli owns almost 16% of GFF and Mario Gabelli is not shy about vocalizing his perspective.  Also, the Gabelli funds coincidentally own a large percentage of a couple of publicly-traded peers where some strategic “fit” might exist to drive value across both companies.

As for the activism from several years ago, the Clinton Group (then an 8.5% shareholder of GFF) sought to lead a proposed levered recapitalization, per their letter dated May 27, 2007, for up to 50% of shares outstanding at $25 per share.  Although their proposal for the recapitalization did not materialize, Clinton’s activism did influence several changes including:  i. the separation of the Chairman and CEO roles; ii. an improved Board profile (Barington’s Jim Mitarotonda was appointed and served from November 2007-April 2011);  iii. and Director Ron Kramer was appointed as the new CEO. 

The Company had been undermanaged.  The previous CEO wasn’t fully-engaged and although Kramer was a Director of Griffon since 1993, his willingness to depart his role as President of Wynn Resorts (2002-2008) for the CEO post at Griffon, then less than $250M equity cap, caused many friends to question his decision.  With more than twenty years of investment banking experience, Kramer decided there was substantial value creation potential at Griffon and as the son-in-law to Chairman (and then CEO) Harvey Blau, he might have felt a family commitment to restore Griffon’s value in the marketplace and with the investment community. 

CEO Ron Kramer’s confidence regarding Griffon’s value is evidenced by his purchase of more than $8M of GFF in the past decade, at an average price of ~$9, and at prices ranging from $8.50-20.  The Chief Operating Officer has purchased ~$0.6M of GFF stock in the past two years, at an average price of $11.45, and since 2010, six other insiders have purchased over $1.5M of GFF stock.  Although stock ownership by some members of management might solely be influenced by the Company’s stock ownership guidelines, it’s nonetheless strong alignment.  The CEO is required to own stock amounting to 5x salary; for the COO, it’s 4x, for the CFO, it’s 3x, and for other executive officers and segment/business unit Presidents, it’s 2x.  

Since assuming the CEO post in April of 2008, Griffon’s stock price has appreciated less than half the increase in the S&P 500.  Although I think part of such underperformance can be ascribed to the Company’s housing-related mix when he assumed the leadership role near the peak of the housing bubble, there have been changes in operational management that Kramer recently implemented which I think is beginning to exhibit the positive impact he envisioned.  

In September 2008, during the turbulent financial crisis and in an effort to strengthen its equity base, the Company raised ~$250M in equity from both a rights offering and a Goldman Sachs private equity affiliate GS Direct at $8.50.  CEO Kramer purchased $7M of stock and two Board members were added from Goldman Sachs.  Late last year, the Company repurchased almost half of the Goldman Sachs stake at $11.25.  Although I prefer not to be the increment buyer when a “smart money insider” is selling, I think one can infer the sale by Goldman Sachs is more technical-related than fundamental since the investment has been held for six years (a typical private equity investment horizon) and the Volcker Rule necessitates that Goldman Sachs unwind its legacy private equity investments.  Under the Volcker Rule, Goldman Sachs is not allowed to have more than 3% of its capital invested in private equity or hedge funds.  Although the Rule doesn’t go into effect for another year, it doesn’t surprise me that Goldman Sachs might exit this investment in its entirety, especially since it was through Goldman Sachs Direct (i.e., capital that was directly from Goldman Sachs and not their fund managing outside capital) so the Volcker Rule is more applicable.  Given this context, the Goldman Sachs shares are probably an overhang but it might be possible for the Company to repurchase such overhang at a discount similar to when Griffon repurchased 4.44M shares from Goldman for $11.25 per share in November 2013 at a 9% discount to the stock’s previous closing price.  In the press release pertaining to the previous repurchase of Goldman’s shares, it was noted that if Goldman Sachs intends to sell its remaining shares of Griffon common stock at any time prior to December 31, 2014, it will first negotiate with the Company to sell the shares directly to Griffon.  At June 30, 2014, there was ~$46M remaining under the Board’s authorization for share repurchase.

At 4.6x, one might perceive leverage (defined as Net Debt/EBITDA) to be high.  I think improving FCF coupled with improving EBITDA will drive leverage lower by fiscal year ending September 2015 at ~3.8x.  This assumes no additional repurchase activity nor additional acquisitions and is based on better performance at the operational level in Home & Building Products and Plastics.  Most of the Company’s debt matures in 2022.  During February, management seized the opportunity to refinance its 2018 Senior Notes at 7.125% with 2022 Senior Notes at 5.25%. 

Shown below is the Company’s financial summary on a consolidated basis; note that adjustments have been made for non-recurring transaction and restructuring costs.

In the past, senior management incentives were equally-weighted to EBITDA and working capital but the Board recently modified such to be 75% weighted to EBITDA.  Furthermore, in regards to recent stock grants derived 100% on a performance basis, the Board added certain vesting provisions.  For the CEO, 200,000 shares granted in January 2013 will vest at the end of November 2013 if (and only if) each of two performance criteria are achieved:  first, the Company must achieve at least $170M of consolidated EBITDA in either fiscal year 2014, 2015, or 2016, and second, the Company must achieve aggregate EBITDA over those three fiscal years of at least $475M.  With regards to the COO and to the CFO, the vesting is driven by at least a 3% increase in sales or operating income at the business segment level coupled with selected working capital metrics.  The Board’s framing of performance criteria is admirable relative to many companies I evaluate each year. 

Described below is a summary of each business segment:

Home & Building Products (LTM June:  Revenue $923M, EBITDA $70M, EBIT $37M)

Griffon’s largest business segment, on both a revenue and EBITDA basis, is Home & Building Products.  This segment is primarily comprised by two leading brands—Ames True Temper (“ATT”) and Clopay Doors.

Ames True Temper generated ~55% of the business segment revenue YTD.  The Company announced its acquisition of ATT in July 2010 for $542M from Castle Harlan.  Ames True Temper is comprised by numerous durable brands including Ames, True Temper, Razor-Back, Jackson, UnionTtools, Southern Patio, Garant, Hound Dog, and Westmix.  The Ames business had its start back in 1774 when blacksmith and pioneer Captain John Ames began making metal shovels.   Today Ames True Temper is the largest manufacturer of snow shovels in the world.  In addition to snow shovels, the Company maintains a leading industry position in several product areas including wheel barrows, garden hose/storage, and planters.  As the leading manufacturer and marketer (in North America) of non-powered lawn and garden tools and accessories for homeowners and professionals, channel customers include Home Depot, Lowe’s, Wal-Mart, ACE Hardware, and Grainger.  The business can be sensitive to weather as snowfall is a benefit to products like snow shovels, and favorable spring weather provides a benefit to the Company’s lawn and garden products.  Most competitors consist of small, privately-held companies focusing on a single product category.  Some competitors, such as Fiskars and Truper Herramientas S.A. compete in various tool categories.  Suncast competes in the hose reel and accessory market, and Colorite Waterworks and Swan compete in the garden hose market.

To improve the margin at Ames True Temper, the Company is consolidating its facilities and has changed senior leadership.  In 2013, ATT announced it would be closing certain manufacturing facilities to consolidate operations in an effort to improve efficiency and margin.  These actions are expected to be completed by the end of this calendar year.  Management estimates that these actions, while improving both manufacturing and distribution efficiencies, will enable the in-sourcing of certain production currently performed by third party suppliers as well as improve material flow and absorption of fixed costs.  Management estimates $10M of annual cash savings from these actions which will cost the Company $28M in total, including $20M of capital spending and $4M of cash-related charges pertaining to personnel and facility exit costs.  Earlier this year, a new President was named to lead ATT; Michael Sarrica was previously the President of DRS Network and Imaging Systems, a multi-site organization serving military, industrial, and commercial markets.  Sarrica worked with Griffon’s President/COO Robert Mehmel who previously served as President/COO of DRS Technologies. 

Management envisions that there are numerous tuck-ins which can be attractively acquired to expand the ATT platform.  In 2011, Griffon acquired Southern Patio, a leading manufacturer of landscape accessories, for $23M.  During 2014, two tuck-ins were completed in Australia:  in January, ATT acquired Northcote Pottery, a leading brand in the Australian outdoor planter and décor market, and in May, ATT acquired the Australia Garden and Tools division of Illinois Tool Works.  In total, these two acquisitions amounted to $60M for over $90M of revenue.

The other part of Griffon’s Home & Building Products segment is Clopay Doors.  Founded fifty years ago, Clopay is North America’s leading residential garage door manufacturer and a preferred supplier of commercial overhead sectional garage doors and coiling steel doors.  Griffon’s market share is ~25%.  Clopay is the only residential garage door brand backed by the Good Housekeeping Seal.    

Clopay distributes products through installing dealers, retailers and wholesalers.  They are the principal supplier of residential garage doors for Home Depot and Menard’s.  Last fiscal year, Home Depot represented 11% of consolidated revenue and 25% of Home & Building Products revenue.  As one would expect, Clopay Doors is influenced by new home starts and remodeling activity.  The majority of this segment’s revenue is driven by home remodeling and renovation.  Sales into the home remodeling market are driven by the continued aging of the housing stock, existing home sales activity and the trend of improving home appearance, as well as improved energy efficiency.  In the past decade, the peak was fiscal year ending September 2006 at ~$550M in revenue and the trough was fiscal year ending September 2010 at ~$389M in revenue, a decline of ~30%.  In total for fiscal years 2005-2006, Clopay Doors generated almost $94M of EBITDA but during fiscal years 2007-2010, total EBITDA was less than $51M.  In the most recent quarter, Clopay’s revenue grew by 8%, primarily ascribed to increased volume and favorable product mix.  In the past few years, management has sought to address the cost structure and efficiency of its garage door business.  Based on changes, including facility consolidation, at both ATT and Clopay Doors, management believes it’s on the cusp of improving EBITDA margin to at least 10%. 

A financial summary of Griffon’s Home & Building Products is shown below:

Telephonics (LTM June:  Revenue $408M, EBITDA $58M, EBIT $51M)

Griffon’s Telephonics, founded over eighty years ago and acquired by Griffon in 1961, specializes in advanced electronic information and communication systems for military, aerospace, civil and commercial applications.  Telephonics is a first-tier supplier to prime OEM contractors in the defense industry (including Lockheed Martin, Boeing, Northrop Grunman, General Dynamics, MacDonald Dettwiler, and Sikorsky Aircraft) and to the U.S. Department of Defense and international Ministries.  Over 75% of this segment’s revenue mix is generated from the U.S. government.  The U.S. government, at 19% of the Company’s consolidated revenue last year, is Griffon’s largest customer.  Although Telephonics has shown a notable resilience to the effects of Sequestration and budgetary cuts, the issues for being a vendor, particularly in defense, to the U.S. government are well-documented but nonetheless a meaningful risk (I am short a defense-related peer to hedge part of such risk). 

Telephonics is a leading supplier of airborne maritime surveillance radar and aircraft intercommunication management systems, the segment’s two largest product lines.  Telephonics’ advanced systems and sub-systems are well-positioned to address the needs of an integrated battlefield with emphasis on providing situational awareness to the warfighters through the retrieval and dissemination of timely data for use by highly mobile ground, air and sea-going forces.  Management believes the need for such systems should increase because of the active role the military is playing in the war on terrorism, both at home and abroad. 

Telephonics is organized into three operating divisions: Communication and Integrated Systems, specializing in aircraft intercommunications, wireless and audio products, air traffic management systems, homeland security, and custom application specific integrated circuits for military and commercial applications; Radar Systems, specializing in maritime surveillance radar and identification friend or foe interrogators; and the Systems Engineering Group, provider of air and missile defense threat analysis, combat systems engineering and analysis, and radar systems engineering and software development.

As a result of the inherent complexity of electronic systems, the management at Telephonics believes its incumbent status on major platforms provides a competitive advantage in the selection process for platform upgrades and enhancements.  The Company maintains a technological advantage, driven by numerous years of R&D, over its competition in the mission critical products and services it provides.  Management believes that its ability to leverage and apply advanced technology to new platforms provides a competitive advantage when bidding for new business.  In the Identification Friend or Foe area, Telephonics is the sole provider of an All-Mode IFF Interrogator that is fully certified by the U.S. government.  Contract backlog totaled $457M at June 30, 2014 compared to $440M in the prior year quarter.  Approximately 67% of this backlog is expected to be fulfilled within the next twelve months. 

A financial summary of Griffon’s Telephonics is shown below:

Clopay Plastics (LTM June:  Revenue $584M, EBITDA $58M, EBIT $31M)

Griffon’s third business segment is Clopay Plastics Products.  The business was founded over eighty years ago as the first company to manufacture low-cost paper window shades.  Today its products are mostly used as moisture/protective barriers in disposable diapers and feminine hygiene products.  It is also used in single-use surgical and industrial gowns, drapes, equipment covers, and as housing wrap.  Key customers include Procter & Gamble, Kimberly Clark, Johnson & Johnson, SCA, First Quality, and the Hayat Group.  Last fiscal year P&G represented 14% of consolidated revenue and 47% of Plastics revenue.  P&G accounted for approximately half of Clopay Plastics’ revenue over the last five years.  Although this customer concentration is a significant risk consideration, the magnitude of such is mitigated by the fact that Clopay’s physical plants are in proximity to P&G’s to facilitate their supply chain efficiency.  Clopay’s approach to expanding this business is not speculative; capacity growth is typically driven by customer needs.  It’s a symbiotic relationship but definitely one in which the customer (i.e., P&G) has the balance of power.

Clopay Plastics is among the largest global suppliers of aperture, breathable, elastic and embossed films and film laminate materials for personal care markets.  The business segment is well-positioned to capitalize on the growth of personal care products occurring in emerging markets as the middle class expands and consequently new users enter those markets.   According to industry research from Price Hanna Consultants described in their Global Outlook Report for Hygiene Absorbent Products, the dynamics for global market growth are positive at ~4% per year.  On a per annum average basis through 2017, baby diapers are expected to grow ~5%, feminine hygiene is expected to grow ~4%, and adult incontinence products are expected to grow ~8%.  The substantial growth in the latter is off a lower base and driven by demographic changes in the aging baby-boomer segment, particularly in developed markets.  According to Price Hanna, volume growth of feminine pads is expected to be ~67B units from 2014-1019.  Almost 70% of such growth is estimated to be generated from less developed markets including Central & Eastern Europe, Africa, China, and India.  The mature markets are estimated to comprise less than 2% of future volume growth.  In an effort to capitalize upon the growth potential across the less developed markets, the Company has a manufacturing plant in Brazil, China, and Turkey.  Those plants comprise over 10% of Clopay Plastic’s current manufacturing square footage.  Another 30% is located across two plants in Germany.

Recent capacity expansion led to some margin challenges which has begun to abate as utilization ramps towards expected volume growth and efficiency measures materialize.  In fiscal years 2011 and 2012, Clopay Plastics margin was only ~7% but improvements are being generated as exhibited by the ~10% LTM EBITDA margin.  During fiscal year 2013, EBITDA increased by 20% on flat revenue as management restructured its European operations and rationalized marginal business.  Furthermore, management improved the cost structure at Clopay Plastics through supply chain initiatives, working capital reductions and improved operating efficiencies.  Management expects that at least a 10% margin can be sustained; for context, note that competitor Tredegar generates a more than 16% EBITDA margin in its film division which competes with Griffon’s Clopay Plastics. 

A financial summary of Griffon’s Clopay Plastics is shown below:

As described, I advocate a long investment that is predicated on improving financial performance that should garner the market’s attention of the significant conglomerate discount to the base case target.  To the extent the improved performance materializes as I envision and the market doesn’t close such discount, I think the Board will engage in value-creating alternatives to close such discount or else shareholder activism will agitate for such.  The key thesis is predicated on improving results.  The last two quarters have reinforced the notion of Griffon being at a key inflection point of improved operational and financial performance.  The earnings call from last week provided additional confidence that the trajectory is positive.  As noted, I would not be surprised if additional tuck-ins and share repurchases were to materialize before fiscal year 2016, thereby changing the sum-of-parts analysis I highlight below.  That said, I ascribe a higher probability that any strategic or financial activity will be accretive to this analysis than dilutive.