Description

PBH shares offer a compelling leveraged play in the relatively predictable / stable consumer staples space at a very attractive valuation ~ 5x FCF to equity.  Though the company has had some substantive challenges in recent months / years and is perceived to have an over levered balance sheet, we feel Mr. Market has overreacted and believe the shares have discounted all the bad news and then some, offering an attractive risk / reward situation with limited downside.  At 7.2X EV/ EBITDA minus maintenance Capex requirements (capex are virtually zero), and with prospects for improving performance and profitability, the stock seems quite cheap to us.

Background

Prestige Brands is a relatively small consumer products company that manages a portfolio of products in the over-the-counter healthcare, household cleaning and personal care categories.  A few of their better-known products are: Clear Eyes (eye drops), Comet (cleaning product), Chloraseptic (sore throat medicine), Spic and Span (cleaning) and Compound W (wart remover), to name a few.  In total, Prestige manages a long list of products that range from nail polish remover (Cutex) to sleep aid drugs (Compoz) and other lesser-known, more obscure niche categories.  The complete list of 40+ products (and their extensions) can be seen on Prestige’s website: http://www.prestigebrands.com/index.html

In general, Prestige’s leading brands are well-known leaders in their respective categories – holding either the #1 or #2 spot in terms of share.  75% of the company’s revenues come from #1 or #2 brands in very specific niche categories that are subject to limited competition from the majors.  In fact, PBH’s broad portfolio of brands was built through a series of acquisitions from larger competitors / peers in recent years.  By buying small, niche brands that have been neglected by prior owners due to a lack of strategic fit, and investing in them, they have been able to revive products that otherwise would have slowly perished.  For example PBH might buy a product that has been ignored by JNJ or P&G due to the limited market size / opportunity in the category, and then proceed to apply some basic product management discipline to boost brand equity and sales.  This strategy / biz model is similar to that Chattem (CHTT) and Church and Dwight (CHD). 

What is unique about PBH is its extremely asset light model that outsources manufacturing, distribution and R&D.  This enables them to focus on their core competencies – sales, marketing and product / brand management & development.  In turn, this keeps capex low (0.2% of Sales versus CHTT’s 1% & CHD’s 4.1%) and FCF high, which is a key aspect of our investment thesis, and makes us feel comfortable with the higher debt load PBH carries on their balance sheet.

Market Profile / Op-Fin Trends

PBH’s principal customer relationships include Wal-Mart, which accounted for more than 10% of FY 09 gross sales, Walgreens, CVS, Target, and Dollar Tree. The company's top five and top 10 customers accounted for about 47% and 59% of gross sales, respectively, in FY 09.  This represents a pretty significant customer concentration; however one of the company’s main strategic initiatives is to switch to an in-house sales force that will help expand its channels and improve relationships with existing customers, thereby reducing customer risk.

With EBITDA margins ~ 30%, PBH has industry leading margin levels, however, analysts worry that commodity cost pressures combined with weak pricing power and sales-mix shift, margin levels might not be sustainable.  It is important to note, however, that while margins have been strong, historical ROIC have substantially lower than peers (6 to 7% range), due primarily to low capital turns.  We believe the margin pressure is real however its impact will be more than offset by the company’s increasing focus on top line boosting initiatives that will consolidate their product portfolio, resulting in a healthier mix of winning products that will increase turns.

Strategic and Restructuring Initiatives

PBH has undergone a number of organizational and strategic changes in the last year or so.  Some of the key strategic initiatives have been around its brand portfolio.  It has developed a “feed the winners” strategy.  The basis of this initiative is to redeploy resources from the weak brand to the stronger brands, and eventually shed a number of the weaker ones through “strategic alternatives”.  Though management has had limited success divesting of these, interestingly today it announced a sale of three shampoo brands (stated 2 – 3% of sales in press release) to Ultimark Products for 9 million dollars.  Assuming these are relatively low margin products, it seems they were sold at a decent price.  We view this sale in a positive light as it shows that management is executing.  By divesting these starved brands anemic sales should stabilize and a stronger, better-managed portfolio should emerge.

A second initiative that has been ongoing is a concerning its sales force.  In the past PBH has outsourced its sales to brokers.  This has created numerous problems, namely shaky account / relationship management with key customers, which is a key worry among analysts and shareholders.  However, this is a change that has been ongoing for the last year or so, so results should be seen soon.

Finally, a broad cost restructuring has been underway for the last year or so.  The board and management have been adamant about communicating their commitment towards improving the financial position of the firm and focusing generating FCF.

Recent Challenges – AKA “the hair”

As with most value opportunities, there is almost always some underlying reason(s) for the market to sell a stock to such low levels.  Here are the main areas of concern and risks:

-       Too much leverage: PBH was taken public a few years ago by private equity investors (GTCR Funds), which explains to a large extent the large debt load.  There are no maturities until 2011 & 2012 but earlier in the year there were concerns on whether the company could their covenants.  The good news is that liquidity has improved lately and FCF will continue to be used to pay down debt and improve the company’s financial position.

-       Lagging Performance: PBH’s organic sales growth in recent years has lagged that of its peers.  Chattem organic, top-line growth in the high single digits versus PBH’s ~ 2%.  This underperformance is mostly due to mismanagement of relationships with retailers (due to its use of brokers) on certain product lines (recently got into dispute with retailers on packaging of wart removal products) and an ongoing restructuring effort of its product portfolio (more detail on this initiative in below section).

-       Abnormal Seasonal Headwinds: Recent years have been characterized by abnormally poor cold / flu seasons – impacting Chloraseptic and other cold products.  This might very well turn into a tailwind this year with all the worry around the swine flu.

-       Sales Strategy Changes: Though promising, transition always poses risk and performance tends to take a dip before improving.  Overall though, this is without a doubt a positive change for the company that will solidify its key relationships.

-       Concerns on Retail destocking & decreasing # of SKU for shelf space: While this is certainly a legitimate concern, and probably the one we worry about the most, it is highly unlikely that retailers will do a broad overhaul of their shelf-space.  Mitigating this risk is a renewed focus on customer and account management to assure that products get shelf space.

-       Pantry destocking by consumers: While this is also a reality given the economic times, most of the portfolio consists of products that are essentially non-cyclical.  Moreover, as consumers trade down, certain products have actually exhibited some strength – e.g. Comet & Spic and Span cleaners.

-       CEO leaves: This probably has been the biggest drag on the stock.  While the official story is that the former CEO resigned due to “divergent views about the Company's strategic direction during the current economic climate”.  PBH concurrently announced a 10% reduction of its workforce, which would generate savings of 2MM a year.  It is worth mentioning that the new CEO, Matthew Mannelly, has an impressive background and seems well suited for the job.

-       Board Changes: Peter Mann and Vincent Hemmer step down from PBH board.  From news release “Mr. Mann, the retired chairman and CEO of Prestige Brands and a founder of the company, is stepping down to pursue a new business opportunity & Mr. Hemmer of GTCR Golder Rauner, a private equity owner of the company's stock, is stepping down following that company's significant reduction in holdings in Prestige Brands.”

While the organizational changes do make us wary, the bottom line is that this is a business that will probably do better without financial engineers and empire builders.  To succeed a company of this type needs is a good brand manager at the helm to make decisions about products to buy and sell, and a good sales force to maintain healthy channels and partners.  Mathew Mannelly has extensive experience as a brand manager and seems to be the type of CEO with the right skills.  However, it is still fair to be nervous after so many changes and be suspect of something else going on behind the scenes.  Having said that, we will maintain a close eye on any further developments on the organizational front, but we won’t let this news keep us away from owning the stock.

Balance Sheet

With a Debt/EBITDA ratio 3.5X Prestige still has substantive more debt than its peers; however, with an ongoing cost structure restructuring effort that has shown promising results in recent quarters, proven FCF generation capabilities & the healing of capital markets, we aren’t worried about the company’s ability to manage their financial leverage.  Plus, there is clearly a market for disposing of assets if management were to decide they wanted to accelerate their deleveraging or increase liquidity.  Leverage covenant concerns are slowly easing as the market witnesses the resilience of PBH’s cash flows.  The company has also stated they are monitoring the capital markets for attractive refinancing options, which given some of the outrageous junk that has been sold in recent months, makes us feel confident that attractive refinancing terms could be achieved if minimum milestones are reached.

Despite challenges PBH is still a Cash Cow & has some hidden assets

By focusing on cashflow generation (highest FCF margins ~ 22% amongst peers) the company has been able to continually delever its balance sheet reducing debt from around 500MM in FY 2006 to 361MM today with a 36MM cash cushion (325 net debt).  With around 60 – 70 steady state FCF’s and a market cap of around 350 MM you can get an approximate 20% yield on your investment.

It is worth noting that FCF per share is consistently higher than EPS, due to ongoing non-recurring D&A amortization schedules on financing fees, goodwill and intangible assets.  Prestige also has $10 MM annual cash tax savings for approximately the next 8 years as a result of $314mm deductible tax asset on its balance sheet which serves as a tax shield.

Improvements may materialize, but if they don’t stock has solid margin of safety

The stock has been a victim of plenty of headline noise.  While this may continue in the near term, it is important to recognize that in the long term this is a straightforward business that is fairly predictable.

If you add up the renewed focus on stronger products, an in-house sales force, cost restructuring, healthier balance sheet, better seasonal trends than recent years (flu / cold comparisons), and other ongoing initiatives, we could see the company results improve; however our thesis more based on achieving marginal improvements that increase stability in the business, rather than expecting any dramatic upside surprises.  Even if organic sales maintain a historically achieved CAGR of 2% and margins don’t deteriorate to much, as noise clears up surrounding the management / organizational changes and debt is paid down, the stock should trade up to a 10% FCF yield or 11x EBITDA multiple (due to lack of capital reinvestment), which translates into a 13 dollar stock.

Catalyst

- Clarity sorrounding organizational changes (future earnings calls and buiding of rapport with new CEO)

- News on ongoing sales restructuring / retail channel management

- Continuing with debt paydown and / or refinancing news

- More successful divestitures of weak performing brands

- Potential buyout, purely on valuation