Value Investors Club / Prestige Brands Holdings (PBH)

Description

Investor fatigue, a Q2 that wasn’t great and tax-loss selling are driving PBH – a high-quality/low-growth company and longtime fixture on the Magic Formula list – to levels where a purchase begins to make sense. The company is moderately undervalued on a no-growth basis. Except it’s growing. Just slowly and fitfully. But PBH’s organic growth (historically ~4% but more like 3% recently) is achieved with minimal capital expenditure (~1.5% of net income in 2007), making it quite valuable. I estimate the shares are worth 25% more than they trade for today, with deleveraging providing additional return to patient equity holders. Smart acquisitions could drive the shares much higher.

OVERVIEW

PBH acquires, markets and distributes branded OTC healthcare, personal care and household cleaning products. The acquisitions are structured as asset purchases, which results in amortization tax shields and free cash flows in excess of net income. The operational aspects of manufacturing, warehousing and distributing product are outsourced. PBH contents itself with marketing and managing its brands, many of which rate #1 or #2 in their respective categories. Americans scanning a list of their brands will find most immediately recognizable.

A pdf of a summer presentation is here.

Here is a summary of the acquisitions of the constituent brands, the earliest ones effected by private equity sponsor GTCR Golder Rauner:

Date	Acquired	Price (MM)
Feb-04	Medtech/Spic and Span	$ 274.00
Apr-04	Bonita Bay	$ 561.00
Oct-04	Vetco (per Barron's)	$ 50.00
Oct-05	Chore Boy	$ 22.70
Nov-05	Dental Concepts	$ 30.20
Sep-06	Wartner (plus contingent $5MM earn out)	$ 31.20
FY 2006	Impairment of Goodwill & Intangibles	$ (9.32)
		$ 959.78

This compares to a current EV of ~$836MM.

As the above table suggests, since coming public around the start of 2005, the company has made a few smaller acquisitions. It achieves organic growth around the acquisitions by extending brands (Chloroseptic sore throat strips similar to Listerine’s PocketPaks Breath Strips, for instance), rejiggering marketing strategy and by increasing ad and promotion (A&P) spend.

Judging by share price history and fragments from the conference calls, investors were more or less indifferent to this strategy, with the stock bouncing around between $10 and $15 the past two years. Recent events which I believe fixable appear to have turned investors downright punitive.

WHY I THINK IT’S SELLING FOR WHAT IT IS

First, there was a fairly benign accounting restatement at the end of 2005, which is summarized in this 8-K.

Next, the Wartner acquisition led to an arbitration claim by OraSure Technologies, which had been a supplier to the company’s existing Compound W wart removal business. Say what you will about the wisdom of trying to further consolidate the wart removal business at the risk of enraging a supplier. Anyway, the arbitration was settled in OraSure’s favor for $1 and yet to be determined legal/arbitration fees.

More recently, PBH participated in an industry-wide voluntary recall of its pediatric cough and cold medicines (representing ~1% of total sales), resulting in $1.9MM in return allowances and obsolescence reserves. It’s unclear how the FDA will ultimately come down on this, and it’s uncertain as to if/when PBH can reenter this line.

Between the arbitration and the recall was a shake-up in the management ranks. Most notably founding CEO Peter C. Mann was succeeded by Frank P. Palantoni in early 2006. Palantoni left after just three months by “mutual agreement” with the board, resulting in Mann’s return as interim CEO. The search for a permanent replacement finally ended in January2007 with the appointment of Mark Pettie, a Kraft and ConAgra veteran. There have been no acquisitions under Pettie, which I suspect put a subset of existing shareholders off. Instead, management has been directing FCF to pay down their term loan (maturing 4/2011 and with $311MM out at 7.74% interest as of 9/07, this seems a wise move).

Finally, the last few quarters saw receivables spike – typical of the September quarter but more pronounced this year due to customer orders coming in later than usual – and A&P spend rise without an immediate top line response.

WHAT I THINK IT’S WORTH

Yahoo has it trading at 10x forward earnings. Simple discount math suggests a higher multiple is warranted. Assuming the portion of FCF in excess of net income cancels out the minimal required capex, using a 10% discount rate and 3% perpetual growth, a ~14x multiple results. I get ~$10/share with some simple DCF modeling, but given that acquisitions (whose timing, size and financing are unknown) are part of the company’s strategy, the exercise is somewhat pointless.

Adjusting for the above $1.9MM allowances and reserves and adding back $2MM of the most recent quarter’s legal expense (management says ‘the vast majority’ of Q2’s $3.1MM legal expense is unusual), the company is priced at just under 8x EV/EBITA. Given the cash generating power of the business and its minimal investment requirements, I believe a 10x multiple is more appropriate. A multiple on EBITA assumes additional acquisitions are made (amortization is sustainable), so it may be more appropriate to look at EBIT. A 10x multiple on TTM EBIT (ignoring any modest growth) gets you to ~$9.50 per share.

Comps suggest higher values. None of these are particularly ‘clean’ as growth profiles vary widely and OTC brands trade at higher multiples than household cleaning brands. Note that the Dubilier-CCA deal ultimately busted:

TAKEOUTS AND BRAND ACQUISITIONS
Date	Buyer	Target	EV	EV/S	EV/EBITDA
12/10/2007	Reckitt Benckiser	Adams Respiratory	$2,300,000	6.55	30.10
10/31/2007	Clorox	Burt's Bees	$ 950,000	5.59
1/2/2007	Chattem	Portfolio of JNJ brands	$ 410,000	3.57
12/19/2006	GlaxoSmithKline	CNS Inc	$ 566,000	4.00	16.00
11/2/2006	Dubilier & Co	CCA Industries	$ 94,000	1.48	10.28
8/7/2006	Church & Dwight	Orange Glo/OXICLEAN	$ 325,400	1.63
6/12/2006	Adams Respiratory	Delsym	$ 122,000	3.19
1/27/2005	Kelso & Co	Del Laboratories	$ 480,000	1.26	11.80

As for public comps:

PUBLICLY TRADED COMPS
Company	EV	Sales (TTM)	EBITDA (TTM)	EV/S	EV/EBITDA
Chattem Inc	1880	387.8	114	4.85	16.49
Zep Inc	373	563.46	37.27	0.66	10.01
Alberto-Culver	2190	1540	173.95	1.42	12.59
WD-40 Co	673	307.82	52.67	2.19	12.78
Church & Dwight	4350	2110	339.26	2.06	12.82
CCA Industries	52	60.14	8.15	0.86	6.38

SUMMARY

The past two years have not been smooth ones, but PBH’s ability to generate cash remains intact. It seems likely that what has driven it down to current levels has passed. The shares seem moderately undervalued at present, with free cash flow accruing to equity over time through debt-paydown.

CATALYSTS AND RISKS

A none-too-exciting combination of insider buys (small in size but increasing in number), possible reinvigoration of top line growth from increased/focused A&P spend, debt reduction to levels where covenants permit the company to issue dividends and buy back stock, and increased investor interest in high ROIC consumer product names in inflationary or recessionary times could drive the price upward. The private equity put seems dead at present, but the diminished competition could allow PBH to acquire brands on better terms.

As to risks, increasing commodity costs and the ceaseless price pushback from WMT could keep things depressed.

Catalyst

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			2007	2008
Price:	8.06	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	403	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT