Description

Short PBH – Recommend a short PBH trade at the current price of $38 – price target of $20 represents ~45% downside.  PBH is a rollup of orphaned OTC brands (Monistat yeast infection treatment, Summer’s Eve feminine hygiene, Luden’s cough drops, Dramamine nausea relief) levered at 5.4x net and trading at 11x EBITDA.  We believe the story will unravel as competition from private label increases, brick & mortar retailers (to which PBH has significant exposure) continue destocking PBH’s mediocre and underinvested brands and interest rates rise.  Importantly, we also believe PBH’s accounting raises red flags, as management changed their definition of organic growth away from industry-standard and exaggerated synergy realization for acquisitions.

The current price presents an attractive entry point for a short as the stock has squeezed up after an unsustainable beat to fiscal Q4 ’18 expectations and a recent macro rally in the heavily shorted consumer staples space, while the business remains under secular pressure.

Valuation and PT

In my bear case, I assume PBH’s FY ‘19E EBITDA is roughly $330mm – at 9x, this represents fair value of $21 / share.  Other broken staples names trade at roughly 10x, and PBH merits a discount as these businesses aren’t structural growers, the capital structure is highly levered and negative price-cost spread presents a risk to out-year numbers.  PBH did $350mm in adj. EBITDA in FY ‘18A, but only $335mm adjusted for the divestiture of the Household Cleaning segment. I assume minimal organic revenue growth and modest cost inflation – higher cost inflation (logistics, packaging, labor, G&A) would present additional downside to my estimate.  Street models MSD EBITDA growth for the next several years, ignoring the structural pressure on PBH’s brands and utter lack of pricing power.

Bulls argue that PBH is “cheap” on FCF yield – we believe that EV / EBITDA is more appropriate because shareholders will not benefit from the cash in the medium term.  For the next several years, 100% of FCF has to be used to pay down debt in order to offset EBITDA deterioration and higher interest rates. Organic EBITDA has been in decline the last several years, and this dynamic will continue, because PBH’s brands don’t grow and costs are inflationary.  Further, any hope for EPS accretion from debt paydown is offset by rate hikes; on my math, a 100 bps rate hike will essentially eliminate any interest savings from paying down debt (debt is roughly 53/47 fixed to floating).

The Street is misunderstanding fundamental weaknesses in PBH’s model and increasing industry pressure driven by retail destocking and private label:

• PBH is a broken rollup.  PBH was established in the late 1990s to acquire orphan brands using cheap debt.  These brands historically faced limited competition because of the incidence-based nature of its offerings (colds, yeast infections, nausea) and lack of private label offerings due to small end markets.  This debt-fueled acquisition story is no longer feasible

• Rates are rising.  PBH flourished behind cheap debt and this facilitated rising purchase price multiples and ever-larger deals (see table below).  Moreover, PBH reports post-synergy multiples and not pre-synergy multiples, distorting the purchase price actually paid for deals.  Using their methodology, multiples have increased from 6-7x when the initially started on their post-crisis strategy to double-digits more recently.  Using the most recent and largest acquisition of Fleet, we can see capital misallocation at work:

• Fleet’s organic growth fell from HSD upon the time of the acquisition to negative by fiscal 3Q ’18 – recall, this is their largest deal, and they bought a deteriorating asset

• From FY ‘14A to FY ‘18A, organic EBITDA (excluding acquired, post-synergy EBITDA) has declined – suggesting a deteriorating core

• From the 2014A base of $204mm, adding $191mm M&A (Hydralyte, Insight, DenTek, Fleet), and adjusting for divestitures, organic EBITDA has declined at least 5% from the pro forma base

• Importantly, the Fleet acquisition when adjusted for divestitures was actually done at a whopping 20x EBITDA before synergies, which is an outrageous capital allocation decision and distorts investor perception of management’s decision making

• Per management, after Fleet, they chose to divest some non-core brands within the Fleet portfolio for proceeds of $110mm or 5-6x EBITDA.  Therefore, what they actually chose to own was done at a multiple of 20x pre and 13x post synergy multiples – materially higher than their disclosures

• Management also highlighted dis-synergies as an “explanation” for part of the EBITDA decline from the below bridge.  If there will be dis-synergies, that needs to be reflected in the post-synergy purchase price multiple. Conveniently, management neglects to quantify reinvestment or dis-synergies

• PBH has under-invested in their brands, suggesting that its brands don’t require as much marketing support as they are needs-based in nature.  In reality, only 1/3 of the products (female hygiene, eye care, and a couple of others) are in fact immediate use. Importantly, the entire portfolio is at risk of intensifying competition from cheaper private label

• PBH has significant exposure to customers vulnerable to declining brick & mortar foot traffic - WMT is 24% of revenue and WBA / CVS are nearly 20% of revenue (2018 10-K).  The entire FDM industry is adapting to declining brick & mortar traffic through inventory management and shelf space rationalization. WBA has spoken to SKU rationalization on recent earnings calls and KR’s new “Restock Kroger” initiative is focused on SKU rationalization and private label development

• As a result, PBH has experienced serial destocking for the last several years.  FY ‘19E guidance reflects a 100 bps headwind from destocking. Importantly, contrary to management’s long-term view, we believe destocking is a permanent feature of PBH’s model.  Because PBH has serially underinvested in brand support (evidenced by their margin profile), retailers will either a) pull shelf space because their volumes are too small or b) push private label to capture a greater share of the profit pool

• Therefore, PBH will never grow organic revenue in-line with their 2-3% target over the longer term.  If population growth is only 2%, destocking, PL competition and a lack of pricing power implies PBH’s actual organic growth is, at best, flat

• If organic growth is flat and costs are inflationary (as we have seen for the entire CPG space), organic earnings will be in terminal decline

• Private label is gaining market share across brick & mortar.  WMT and KR, per recent earnings calls, are very focused on broadening their private label assortment.  We believe PBH’s 55% gross margins are a ripe opportunity for retail to extract value from the supply chain, similar to what is happening in the packaged food industry

• Amazon OTC private label is a rising and underappreciated threat

• Amazon recently launched its private label OTC brand late summer 2017 with 30 products.  Over the last six months, AMZN has doubled its SKU count to 65 products with the inclusion of OTC products that target digestive issues, topical creams and allergy sprays.  AMZN is underpricing its OTC brands versus similar private label products, which are cheaper than PBH’s branded products

• Amazon launched a private label version of Monistat (essentially the rationale behind PBH buying Fleet) priced at a sizeable discount to offerings from CVS and PBH’s branded version – AMZN at $9.97 for a tube vs. $16.49 at CVS and $18.49 for branded

PBH has a series of accounting and disclosure red flags

• In May 2017, after the Fleet acquisition, PBH redefined organic growth to INCLUDE financial performance of the acquired company.  Recall, Fleet was growing in the 7% range at the time of the acquisition, so like all serial acquirers looking to cover up a deteriorating core, PBH tried to get credit for acquired growth from the outset

• The cash conversion cycle has deteriorated over time, suggesting quality of earnings is worsening

• In May 2018, PBH changed its capital allocation policy.  Rather than using excess free cash to pursue acquisitions or pay down debt, PBH initiated a $50mm repurchase.  It is quite odd that the company announced a repurchase while still levered at >5x

Risks and mitigants to short thesis

• PBH believes its “orphan brands” are less vulnerable to competition and online disruption

• Either brands are too small to matter and don’t drive traffic and can be de-stocked

• Or, retailer can use private label to capture more of the profit pool

• Amazon is already rolling out OTC healthcare products that are incidence-based, and drugstore foot traffic is declining due to online competition

• PBH is an M&A target

• OTC attractiveness is based on RX to generic switches – this isn’t the case with PBH’s portfolio

• Short interest is high

• SI hit all-time highs as the recent rally has presumably attracted like-minded investors – there is similar risk of a short squeeze like last quarter

Management history and incentive compensation

• Ron Lombardi has been CEO last 3 years, was CFO previously for 6 years.  Previous CEO, Matt Mannelly left in 2015 after 6 years as CEO.

• Incentive comp isn’t a big red flag either.  The two minor negatives:

• NEOs and directors own ~600k of stock (~1%) per the latest proxy – not that material

• The PSUs for the CEO / NEOs are based on adj. cumulative EBITDA and adj. cumulative sales, which spurs incentive to do bad M&A as it’s not based on organic performance

• For the CEO, 75% of LT incentive plan is PSU and 25% is service-based RSUs

• LT incentives for NEOs

• PSUs are based on adj. cumulative EBITDA and cumulative sales weighted 50/50 (33% of comp)

• SUs that vest ratably (33% of comp)

• Options that vest over 3 years (33% of comp)

Exhibits

Catalyst

Earnings reflecting weak organic growth and EBITDA declines