Description

Preface: This may not be the most exciting short for hedge funds chasing near-term performance, but I think there is a reasonably good chance this business  underperforms your longs on a relative basis over time, particularly given dissapating tailwinds/increasing headwinds. Note PBH’s FY ends on March 31st.

What Do They Do? PBH acquires OTC consumer personal care brands that CPG companies no longer want (essentially ones which have gone ex-growth), cut expenses, manage for modest brand extensions/distribution gains and otherwise sweat the assets for cash flow. 

How Do They Generate Value? PBH squeezes any remaining juice out of their acquired brands, targets GDP-type organic growth, optimizes for cash flow, then uses any residual cash flows to buy more discarded brands. Rinse and repeat.

How Do They Trade? PBH is a sleepy, under-the-radar stock owned mostly by passive funds without much trading volume or price discovery. It doesn’t trade expensively for a consumer staple company (see P/E chart below), though it is trading at the high end of its own historical range. 

They do not pay a dividend. Per their own adjusted numbers, they are generating 6-7% FCF yield. FCF is used to pay down debt alongside some share repurchases. Short interest is relatively modest.

Why Has It Traded Well? I believe there are two factors at play:

First, the company benefited from the recent inflationary environment to generate growth that is extraordinary for the moribund profile of its brands: FY‘22 organic growth was 10% while FY‘23 organic growth was 3.5%, both well above PBH’s own target of 2-3% organic growth. Despite seeing mediocre gross margin benefits, the fixed cost base leverage caused earnings to stairstep in FY’22.

Second, the company has used the recent years of stable cash flows to delever from riskier debt levels in the 5x’s down the the high 2x's, which lowers their bankruptcy risk and also sets them up for future accretive M&A.

Why Consider a Short Now? Due to PBH’s business model, the company will be perpetually challenged and is likely to slide into negative growth over time. There are also fading tailwinds and emerging headwinds which have not yet shown up in results. However, given the lack of specific timing catalysts, I believe PBH could best be used as a long-term short hedge against your long portfolio. 

Inflation Tailwinds Dissipating

Pricing benefits have represented the majority of the organic revenue gains from FY‘22 - FY’24:

FY‘22 - 10% organic growth came almost entirely from taking price in a highly inflationary environment

FY‘23 - 3.5% organic growth was ⅔ price, ⅓ volume

FY‘24 - 0% organic growth (affected by supply chain issues in Q4), growth came from  ⅔ price, ⅓ volume prior to supply chain issues impacting results

The company is guiding 2025 organic growth of only 1%, of which ½ will come from price and ½ will come from volume.

Pricing gains are already increasingly harder to come by, and will be even more difficult to find in a lower inflation environment. As discussed in the next two sections, volume gains are likely to be increasingly challenged as well.

Distribution Channels Increasingly Challenged

PBH is poorly positioned in key growth channels like Club, as their product positioning is the opposite of that desired by the high-volume, high-value Club formula. Instead, PBH has high distribution concentration in the Drug channel, which we all know is in serious retrenchment as demonstrated by big pharmacy chains' mandates to pare store count. Dollar stores have also been challenged. PBH’s main growth avenue has been e-Commerce (Amazon). While their online growth efforts are commendable, this is also the channel most exposed to price comparison and substitution as customers are perpetually nudged toward better-value alternatives.

Underinvestment Is Not a Long Term Strategy

PBH’s strategy is apparent in its financials. The company has some of the highest gross margins in OTC personal care brands, while spending the least on marketing (SG&A charted below as an inexact proxy for A&D). 

PBH has 570 employees (90% of production outsourced) vs. other small cap consumer businesses: 2k at HELE, 3k at SPB, 10k in non-manufacturing/supply chain roles at NWL, 9k at PRGO (some are manufacturing/supply chain, but not clearly broken out). 

Given minimal product innovation, few distribution expansion opportunities, a skeleton crew workforce, and a cut-costs-to-the-bone mentality, PBH is likely to succumb to private label competition and competition over time. Even if there were no competition, PBH’s customers will be aging out over time given its lack of brand investment. Although there are some categories like eye-care that are expanding, there is simply no price-quality dimension in which PBH brands win in the long run and no durable advantage as a subscale cost-cutting, low-innovation business trying to hold the line on dying brands.

Other Items: PBH occasionally has earnings hiccups from supply side issues, distribution channel destocking, or weak seasonal traffic such as from a limp cold & flu season. The market is accustomed to taking these bumps in stride, as the company has always managed back to at least flat.

Periodically, PBH takes big goodwill impairments on their acquisitions. The most recent was FY’24 (Summer's Eve, DenTek and TheraTears). Previously was FY’19 (Fleet, DenTek and Efferdent brands). This is, of course, a non-cash accounting item, but highlights the declining value of PBH’s brands and that their M&A may not be value enhancing.

History Rhymes for Levered Roll-ups: While PBH’s operating performance has been relatively steady in recent years even prior to inflation (less so in prior years), it is worth considering the history of small-scale consumer staples-type rollups in aggregate. Looking at the experience of companies like NWL, HAIN, B&G, PRGO, ACCO, there are periods of renaissance when they catch a consumer wave or cost cut to excellence. However, these models have generally proven to be challenged over the long term, as CPG is an intensely competitive space with low barriers to entry and strong buyer power from merchandisers. They can appear to be humming along just fine (often with the help of M&A accounting tricks), and then suddenly encounter rapid and catastrophic degradation in key financial metrics.

To be clear, cherry-picking examples of flailing businesses isn’t a big part of the short thesis. I only highlight them to indicate that cost-cutting CPG business models are fraught with fragility risk, and underinvestment can remain hidden for long periods of time. For a business like PRGO which has built up solid internal systems, I think a successful turnaround is a very plausible outcome. For a low growth, skeleton crew, outsource-practically-everything business like PBH, there is no “anti-fragility.” When something eventually goes seriously wrong, there will be no way to fix the problem or grow out of it. 

Valuation: I don't love the idea of doing a valuation on something like PBH, given it is almost entirely dependent on what you believe the inputs are.

If you believe this model works and will generate decent returns on capital over time, then it is hard to argue with its valuation. It might even be undervalued. Analyst estimates project a substantial earnings growth stairstep in FY’26 (see below), foreshadowing a relevering, accretive acquisition. 

In any case, trading the stock around earnings or multiples has not worked well historically, I surmise because of the shareholder base composition, liquidity and buybacks. You may even be fighting the company’s $300 million buyback authorization for the next few years.

On the other hand, if you believe this is a melting ice cube business that must constantly use its FCF to replenish its eroding businesses, then a DCF might be a better way to think about the business. For simplicity’s sake, below is a valuation sensitivity table table for PBH’s share price based on a perpetuity growth model. The table uses an input of $240 mm of LFCF and sensitizes at varying discount rates and growth. 

For the sake of completeness, the midpoint of the company’s own 6-8% EPS growth is the rightmost column, even though we would be giving them double credit for both giving CF back to shareholders and simultaneously using it for M&A to generate growth. Perhaps this can be thought of as the “management really is brilliant with M&A” scenario. In general because we're implicitly giving them "double credit", unless management is indeed doing brilliant M&A or their existing assets are much better than historically the case, then the perpetuity growth model below is likely over-valuing PBH.

In any case, this is just a though exercise. I frankly don’t know what the right inputs are to the model, and I doubt the market cares. I do believe that, over time, PBH will go into negative growth and also underperform any half decent business you might own on the long side. Now might be as bad a time for PBH as any, with pricing actions getting more difficult and their channels being increasingly challenged. You may deal w/ all of the typical frustrations of shorting these days, though this stock is generally not face-rippingly volatile and is unlikely to be acquired. On the other hand, you get the option for a sudden, catastrophic collapse in the business as has been experienced by many levered consumer rollups in the past.

Risks:

Various environmental factors could help their gross margins - input cost deflation, peer price inflation, general inflation

Small cap, staples sector correlations - could get continued boost from the interest rate trade, index moves

Acquisitions to keep story going

Cash flows for existing brands have more longevity than expected

Nostalgia fads, rising baby boomer spending

Catalyst

Organic growth going negative

Operational hiccups becoming more chronic

Surprise operational collapse as per levered rollup history