Description

Rayovac Corporation (ROV) – Short Thesis

Short Thesis
I am recommending Rayovac as short for the following reasons:
• Weak #3 player in the highly competitive battery industry undergoing long-term pricing and unit volumes declines
• Slow-growing/no-growing core battery business, plus management’s stated goal to more than double revenue from $1.4B today to over $3B in 3-5 years, forces management to pursue an aggressive acquisition strategy
• Loss of acquisition synergies from Remington acquisition (anniversaries 9/30 quarter) increases pressure to execute and grow
• Microlite acquisition increases risk through exposure to volatile Brazilian market and declining zinc carbon battery business/movement towards alkaline
• No dominant market positions (outside of Brazil)
• Declining market share in core battery market: from ~9-10% 5 years to ~7% today
• Highly leveraged balance sheet combined with rising rate environment makes financial flexibility limited, especially if pursuing large acquisitions (ROV has benefited from low interest rates)
• Walmart exposure: over 17% of sales coming from WMT; constant pressure to lower prices

Fiercely Competitive Industry
The battery business itself is a very bad business – unit volumes and pricing continue to decline, and it is subject of fierce competition. In fact, average battery prices have declined in 3 of past 4 years, and ~10-15% since 2000. Given Rayovac’s market share, it has little chance of winning a protracted price war should its competitors choose to pursue one (again). Some of this comes from a secular shift away from disposable batteries and to rechargeable batteries (like those used in PDAs, Ipods, etc.). Also, the batteries of today last much longer than previous generations and come at a cheaper price – this is expected to continue. Lastly, increasing commodity costs have begun to hit battery makers – although it has not yet been reflected in their margins.

Declining Market Share
• Duracell (G): 48% (from 47% in ’99-’00)
• Energizer (ENR): 32% (from 33%)
• Private label: 13% (from 10%)
• Rayovac (ROV): 7% (from 9%)

Over the past 5 years, Duracell and the private labels have taken share from primarily ROV and less so ENR. In the same period of time, overall volumes have decline ~4-5%.

Description
Rayovac Corporation (ROV) is a marketer and manufacturer of batteries, battery-powered lighting products, electric shavers and accessories, electric grooming products and hair care appliances. Rayovac distributes its products through mass merchandisers, home centers, hardware stores, consumer electronics stores, warehouse clubs, food, drug and convenience stores, department stores, hearing aid professionals, industrial distributors. Recent acquisitions include: Ningboa Baowang Battery Company (3/31/04) and Microlite S A (6/1/04).

Investment Highlights
1. Slow growing core battery business
2. Highly competitive battery business
3. “Growth-by-acquisition” strategy
4. Benefited from low interest environment
5. Weak #3 player in competitive market
6. Declining market share
7. Little R&D spend – compete on price, not innovation
• ROV averages ~1.6-2.3% on R&D as % of sales; competitors average 2.2-2.7% (much more in absolute $ terms)
8. Walmart exposure: 17% of sales (may be larger post-REM acquisition)
9. Long-term secular pricing and volume declines
10. Microlite acquisition: exposure to volatile Brazilian market
11. Highly leveraged balance sheet
12. Stock-based compensation: large % of earnings
13. Weak operating cash flow: ~$60-65mm (after merger expenses)

Rayovac-specific issues
• Weak #3 player with declining price and volume trends
• No dominating positions in any market (outside of Brazil)
• Negative volume growth in alkaline batteries – 3 of past 4 years
• 9/11 boosted sales in ‘01
• Y2K boosted sales in ‘99
• Hurricanes will give temporary boost in ‘04
• Declining market share to rivals, private labels
• Walmart: 17% of ROV business – constant pressure to lower prices
• Little advertising spend: <4% of revs; competitors spend 10x or more
• Over 60% of revenues come from international

Core Battery Business
• 68% of revenues
• Highly competitive – Gillette (G) and Energizer (ENR)
• Stagnant growth
• Pricing and volume declines
• Wal-Mart exposure

Growth-By-Acquisition Strategy
Currently, ROV is focused on integrating its acquisitions and executing on its strategy. Since ROV exhibits little organic growth and has stated it plans to grow sales and earnings by 15-20%; it has no choice but to pursue an acquisition strategy or otherwise slow growth down and watch its multiple contract. The problem ROV faces in such a strategy is:
• If funded with stock, it dilutes current stockholders
• If funded with debt, it increases risk of the acquisition/integration – especially as leveraged as ROV currently is and how interest rates have climbed
• If price of an acquisition is too high – it adds no value/becomes dilutive
• ROV typically pays between 6-7x EBITDA (see last 5 acquisitions); increasingly unlikely find such acquisitions at the scale needed and price desired
• Example: ROV issued $350mm 8.5% coupon debt to fund the REM acquisition. Since that time, interest rates have gone up (+100bps for B3/B– rated debt) and ROV is more highly leveraged.

Stated Goals
• Grow revenues from $1.4B today to $3B in 3-5 years
• Growth-by-acquisition strategy
• Great deal of pressure to execute/grow once REM anniversaries (9/30 quarter)

Remington Acquisition
Thus far, the REM deal has gone smoothly – posting a significant increase in revenue from new product introductions. Also, it has diversified ROV away from the crappy alkaline battery market – from ~90% pre-merger to ~68% post-REM. Historically, REM has only posted a 2-3% organic growth and it has been inconsistent. REM also faces stiff competition in its core business (electric razors) – from Braun in Europe and Philips in Japan. Innovation is key in this business – however, REM only spends ~1% in R&D yearly and a cumulative $10-15mm in the last 3 years.
• 9/30 acquisition anniversary
• Purchased for 7x EBITDA
• Inconsistent revenue growth
• Increases ROV seasonality: ~45% of revenues and ~80% of earnings in December quarter
• Increases risk of earnings misses
• Increases risk of inventory write downs
• Reported growth will plummet after quarter; another acquisition in the offing?

Operating Results
• PF Q3 04 EPS: $0.39 vs. $0.31 in Q3 03
• Q3 04 Revs: $308mm vs. $271mm, +14% over Q3 03
o N. America Revs: $136.4mm, +9% (44% of global revs)
o Latin America Revs: $35.3mm vs. $30.4mm, +16% (12% of global revs)
• EBIT margins declined to 8.2%, -1000bps
o European Revs: $136mm – flat YoY (44% of global revs)
o Organic growth of 7% (excl. acquisitions)
• Remington revs: +20% YoY growth; $30-35mm in synergies projected
• PF Gross Margin: 43.7%, +10bps
• FY04 guidance:
o $1.35-1.4B
o $1.78-1.81 EPS
o $60-65mm in cash flow from ops
• FY05 guidance: $2.05-2.10 EPS; +15-16% (less than 15-20% goal)
• Projecting mid single digit organic growth

Quality of Earnings

Valuation
• Market Cap: ~$843mm
• Enter. Value: ~$1,670mm
• Net Debt: ~$827mm
• ROV is trading at ~12x ’05 P/E and ~9x TTM EV/EBITDA
• Historically, ROV has traded between 7.8x – 20.2x forward P/E and 7.0x – 13.4x TTM EV/EBITDA
• 2005E First Call Consensus EPS: $2.12

Assuming you believe next year’s earnings and EBITDA doesn’t materially deteriorate (big assumptions in this case) – applying trough multiples of earnings and TTM EBITDA…
• @8x P/E = ~$17/share
• @7x EBITDA = ~$14.40/share

Put simply, I believe shorting ROV will yield 30-40% returns over the next year. ROV reports Q4 and FY04 earnings before market open on 11/11/04. I don’t expect them to miss the quarter given the increase in hurricane-related business. However, I do believe 2005 earnings are at risk, since it is predicated on acquisition-related (not organic) growth. Also, ROV laps the Remington (REM) acquisition and will lose its acquisition-related synergies.

Comparables Analysis
Both Gillette and Energizer face the same secular and industry headwinds as ROV, but I argue both are better positioned and capitalized and less strained financially. ROV trades on a 10-50% discount to these companies:
• Gillette (G): 22.5x ’05 P/E; 15.4x TTM EV/EBITDA
• Energizer (ENR): 13.2x ’05 P/E; 10.4x TTM EV/EBITDA

Risk: ROV – Potential Acquisition Target
While there is a risk that ROV itself gets acquired, I don’t believe that is a viable option for either of its competitors since both G and ENR are trying to diversify away from batteries and ROV possesses too low of an organic growth rate to benefit either – still at some price, it is attractive.
• Example: ENR purchase of Schick-Wilkinson Sword in March 2003 for 1.4x sales and 9.5x EBITDA

Conclusion
What do you get when you combine: bad industry, bad business, weak competitive position, highly leveraged balance, and little free cash flow? Add in a rising rate environment, political/economic risk, foreign currency exposure, a depressed stock currency and questionable accounting – well if I didn’t say ROV, I probably would answer a shipwreck waiting to happen!

Recommendation: Short ROV to $16 – for a return greater than 30% in the next 6-18 months. The company faces massive headwinds and has little opportunity to maneuver in its quest for growth without severely diluting shareholders (and profiting short sellers). Short interest is relatively low (<10% of float) and I see little upside in the stock once REM acquisition (and related synergies) are fully digested.

Catalysts
• Any slowdown in the sales or earnings growth
• Any acquisition – most likely dilutive and expensive, given higher interest rates and ROV’s lower currency
• Battery price war
• Earnings miss
• Secondary offering
• Political instability in core markets
• Negative FX translation: over 60% of revenues international; dollar has depreciated ~10% since 10K
• Rising component commodity costs
• China

Catalyst

• Any slowdown in the sales or earnings growth
• Any acquisition – most likely dilutive and expensive, given higher interest rates and ROV’s lower currency
• Battery price war
• Earnings miss
• Secondary offering
• Political instability in core markets
• Negative FX translation: over 60% of revenues international; dollar has depreciated ~10% since 10K
• Rising component commodity costs
• China