Description

When a company with about $300MM in sales has a market cap of less than $10MM, one can presume big losses and a risk of bankruptcy. Home Products International Inc. (HPII - $1.25 – 7.4MM shares outstanding) did indeed have horrible results in 2000, and its substantial debt position does make it very risky.

Yet HPII is in much better shape than meets the eye, with a surprisingly strong cash flow, due to extremely high depreciation and amortization charges, that allowed it to pay down some debt in 2000 despite the huge reported loss and heavy capital spending. Conditions in its industry are starting to turn up, and HPII appears to have enough credit availability to ride out any remaining difficulties.

There is a chance of black ink as soon as this year’s Q2, and substantial reported profitability in Q3, when HPII will start to benefit from a change in FASB rules will eliminate its heavy goodwill amortization charges. Next year reported eps of over $1 seems possible, which sounds crazy for a buck stock, but isn’t really, given its tiny share base relative to sales.

HPII manufactures low priced household goods, such as plastic storage containers, hangers, servingware, kitchen and bath goods, and laundry products, all sold under the “HOMZ” label (http://www.hpii.com/home.htm). Its main competitor is privately held Sterilite, and both, along with many small competitors, offer lower priced products to compete against Newell Rubbermaid.

This is a very competitive, commodity business, but it is relatively recession proof, and from a profits point of view actually counter cyclical, in that profitability is greatly affected by polypropylene (“PP”) resin costs, which go up and down mainly with auto production. A glut of new PP resin capacity has just come on stream, so unless natural gas prices take off from here, resin prices should continue to weaken, even if auto production revives somewhat.

HPII’s three biggest customers are WMT, KM, and TGT. The biggest suppliers, such as HPII, have an edge with these large retail chains, who need vendors with a broad line capable of serving many distribution centers. These big chains continue to grow at the expense of smaller regional chains and mom and pop retailers, which can be served acceptably by smaller vendors, making those customers a lower margin market segment for HPII . So while there is little organic growth in the industry as a whole, over time a big supplier like HPII should be able to piggyback on the growth of its large customers.

Last year HPII was squeezed by a combination of intense price competition from new industry participants, and the soaring cost of PP resin due to the then strong economy. This nasty combination affected all players, many of which went under, which is starting to reduce competitive pressure. In addition, HPII opened a new factory in TX and, at the end of the year, announced the closure of its highest cost factory in MA, causing a large write down. That should help costs and cash flow starting in this June quarter, as will lower resin prices.

The key to understanding HPII as a stock play is that the market cap of under $10MM is so tiny. Bank debt is high at about $90MM, in a term note plus a revolver, at LIBOR +3%, and there are $125MM in face value of a subordinated debenture due in 2008. Toss in about $5MM in capitalized leases and you have a TEV of $230MM, which I am not claiming is a fabulous bargain for a company with $300MM in sales, even with its $34MM EBITDA from a terrible year.

But the TEV doesn’t have to go up much for you to make some money; the leverage is so high that just going from $230MM to $240MM will be a double, and $300MM will get the stock to double digits.

The risk is bankruptcy, which could happen if PP resin prices zoomed, interest rates shot up, or an intense price war broke out again. While no balloon payments are due on its debt for several years, the company after the seasonally slow March quarter could be very close to violating one or two of the covenants on its bank debt, allowing the bankers to pull the plug if they so chose. That would be stupid on their part, since HPII’s huge free cash flow (maintenance cap ex is no more than $10MM) should allow a rapid pay down of the debt in the next couple years, and its negative book equity suggests HPII is worth much more alive than dead. But one should never bet one’s life on bankers being smart.

In return for that risk, you have a stock with a plausible potential to return to double digits, where it was in early 2000 when it reached $13.50. That wasn’t a crazy, dotcom price; in 1999 HPII earned $1.45 fully taxed, even after $0.70 in goodwill amortization and heavy depreciation. The new FASB rule will eliminate the goodwill charge, and the 2000 year end write-down will reduce depreciation by about $0.25 per share and eliminate taxes for years to come.

1999 was an unusually high year for plastic housewares margins which won’t be repeated soon. But should investors see that industry conditions are improving, reducing the bankruptcy risk, and see how the reduced amortization and depreciation charges allow more of HPII’s strong cash flow to show up as reported earnings, then a stock price at least several times the current level would be surprising if it didn’t happen.

One last note: Marty Whitman’s Third Avenue Value Fund recently bought $51MM in face value of HPII’s subordinated debentures. He isn’t God, but he is a proven value investor, and he put three times more into the debentures than the entire market cap of the equity, which puts his money virtually on the front lines with any equity investor.

Catalyst

1)Improving industry conditions reduces threat of bankruptcy, and 2)Asset writedowns and a new FASB rule eliminating goodwill amortization reduce non-cash charges that have been covering up cash flow to the tune of $0.95/share/year.