Description

Helen of Troy designs, develops, and markets hair care products including hair dryers, brushes, curling irons, and consumable hair and skin care products. HELE also has a housewares segment that the company acquired in March, 2004. While the housewares segment has performed well since acquisition, the core personal care business which represents approximately 75% of revenue is showing signs of stress.

HELE missed their earnings estimate last quarter reporting $.30 in EPS vs an estimate of $.50. They also reduced their revenue and EPS guidance for the current fiscal year ending 2/06. We believe that HELE is likely to disappoint again for the following reasons:

1) Inventory out of line: Inventory has grown faster than revenue for the past 3 quarters including 41% inventory growth last quarter vs revenue growth of (8%). The prior quarter was just as bad with 64% inventory growth on 19% sales growth. Days of inventory have ballooned to 270 from 180 a year ago.

2) Bad excuses for inventory out of line: In their most recent 10Q, HELE claims that they intentionally built inventory due to a desire to lock in prices ahead of potential raw material cost increases and to have holiday supply in case ports in California are crowded. (Note that HELE sources product from China and does not do its own manufacturing). While we applaud companies that try to anticipate problems, we are skeptical of HELE’s stated reasons. On the conference call, HELE management admitted that an unspecified amount of their inventory build was due to disappointing sales in the second quarter. In addition, HELE is building inventory into weakness in its core business.

3) Weakness in the core business: In the segment sales discussion of the 10Q, HELE notes weak sales due to more competition, higher raw material costs, loss of product placement at retail, and high customer returns. This does not seem like a favorable environment to be holding 270 days of inventory.

4) More weakness in the core business: In addition to shrinking sales, gross margins are down 120bp vs last year, and SG&A as a % of sales is up due to higher marketing expense. This means that HELE is spending more on marketing and inventory and selling less at lower prices.

5) Receivable growth: Accounts receivable have grown significantly faster than sales in each of the last 4 quarters. DSOs are up to 78 from 68 a year ago. This appears to add weight to management’s admission that sales are weak due to high customer returns.

6) No free cash flow: HELE had negative FCF in FY 2003 and FY 2005, and only marginally positive FCF in FY 2004. Even if we assume that cap-x is $0 (a far too conservative assumption given that the Co. has no growth without acquisitions/cap-x), L12M CFFO is $18MM. This implies that HELE is trading at 32x L12M cash flow in a no-growth or negative-growth environment in conjunction with an inventory problem.

Here are the most likely risks to the short story:
- The CEO owns 20% of the company. While this is not a guarantee of anything, significant investment by senior executives is often a positive for a company.
- The Co. has discussed making acquisitions or buying back stock. We believe that acquisitions are the more likely of the two.
- Based on an EPS calculation, HELE is trading at a discount to other comparable companies (10x vs 17x for some comps.). We don’t think that a relative EPS multiple is the correct method to view the stock, but it could be part of a possible bull story.
- HELE is launching new product in Feb. ’06.

Catalyst

As increased marketing expenses seem to be unhelpful, we expect that HELE will have to mark down inventory to sell it and will continue to miss sales, margin, and earnings estimates.