While Spectrum Brands was written up in 2011 I believe  the company’s 2012 acquisition is a transformative event. The acquisition of HHI should allow for material free cash flow generation that is unappreciated by the market. Given the quality of the acquired business, the secular tailwinds that HHI business has, and the synergies from bringing HHI into the Spectrum platform add up to significant future free cash flow growth. Combining HHI with Spectrum should enable the combined company to earn $7+of free cash flow per share by 2015, and using a 12x multiple would value the business at $80+ per share. The company is currently trading at $54.

Stock Price:             $54

S/O:                            53.3m

Market Cap:             $2,900m

Net Debt:                  $3,151m

Enterprise Value:    $6,050m

Spectrum consists of 4 businesses -  

1. Global Batteries and Appliances – FY2012 Revenues of $2.25bn and EBITDA of $308mm. This includes the global battery business under the brand names of Rayovac, Varta, Remington, and Russell Hobbs.

1. Global Pet Supplies – FY 2012 Revenues of $616mm and EBITDA of $616mm. Brands include Tetra, Dingo, Furminator, among others. The interesting part of this business is that SPB has a large infrastructure which enables the company to do many accretive bolt on acquisitions whereby they acquire the brand, integrate it into their internal manufacturing facility and use their sales force to grow sales.

1. Home and Garden – FY 2012 Revenues of $387mm and EBITDA of $87mm. Brands include Spectracide, Hot Shot, Black Flag among others. Similar to Global Pet Supplies they can make very accretive bolt on acquisitions.

1. Hardware and Home Imprvoment  - see discussion below.

The Spectrum Value Model is the glue that binds the businesses together. It is Spectrum’s philosophy of providing the same performance that the leading brands do at a lower price thereby providing better value to both the consumer and the retailer. SPB focuses on #2 brands in markets with high barriers to entry and is able to get win placement by providing better margin to the retailer. I won’t focus on the 3 former businesses as they were addressed and instead focus on what I believe is misunderstood which is the upside from HHI.

Hardware and Home Improvement: HHI was acquired in late 2012 for $1.4bn in cash from Stanley Black and Decker. The brands acquired include the #1 US and Canadian residential lockset (Kwikset, Weiser brands), #1 US luxury hardware residential lockset (Baldwin), #1 US Builder residential lockset (Stanley, National Hardware), and the #4 U.S. faucet business (Pfister). The business was unloved within SWK as the company focused on “higher growth” businesses and therefore was run independently, making the transition to SPB fairly easy. I believe there is a lot of pent up opportunity within HHI given Spectrum’s relationship with key suppliers, the recovery in residential construction, and new products within HHI’s portfolio.

In the LTM ending 9/30/12 HHI did $985mm in revenues and $144mm in EBIT.  

The relationship with key suppliers: HHI will have a dedicated sales force for the first time which should enable them to get better placement, better fill rate management, and win more line reviews. From our channel checks we know that there are large retailers who are very excited to provide more shelf space and more support to the HHI brands. Furthermore, we think that with SPB’s international sales support they can take the business into new markets and geographies.

Recovery in Residential Construction: HHI’s business is 3/4 replacement and 1/4 new residential construction with similar margins. Incremental margins are north of 30% which makes the growth in residential construction highly accretive. If one assumes a new home starts increase to 1mm starts the incremental EBIT to HHI would be $15mm. Given the NOLs this would fall to the bottom line, increasing EPS by ~ $0.30/ share. At 1.4mm starts that would add $0.75 per share.

New Technologies: SmartKey is one of HHI’s most successful innovations that uses patented disruptive technology that changes the lockset business. The product allows the consumer to rekey their key themselves in less than 30 seconds without removing the lock from the door. It has improved security functions and is drill resistant. The reception from consumers has been tremendous. Under SWK SmartKey received very little marketing and sales support, however under Spectrum that will change. Vendors are excited and this product is patented globally.

The Financials:

Pro Forma EBITDA             $675m

Cash Taxes                            $(65m)

Interest Expense                 $(230m)

CapX  - 2013                        $(75m)

Working Capital                  $(15m)

Free Cash Flow                  $290mm

Per Share                             $5.44

Sensitivities:

1)    In 2014 SPB can refinance their 9.5% notes, so assuming a 5% interest rate that would add $45mm or $0.84 per share.

2)    Cash restructuring charges included above of $25mm related to the Russell Hobbs acquisition in 2010 will be finished, adding $0.47 per share.

3)    If we assume housing starts of 1mm per year, that adds $15mm or $0.30/share.

2014 Estimated Financials

Free Cash Flow from Above                    $290mm

SPB Refinancing of 9.5% Notes              $45mm

Cash Restructuring Savings in ’14         $25m

1mm home starts in ’13 or ’14              $15m

2014 Ending Free Cash Flow                 $375mm

Per Share                                                     $7.04

Final Thoughts:

Harbinger: Harbinger owns ~56% of the company through their publicly traded vehicle Harbinger Group. This reduces liquidity in the stock and some people are uncomfortable owning SPB given questions about Harbinger’s motivation and recent performance. We have looked into this in depth and feel comfortable that the investment is held within HRG and that HRG is interested in growing Spectrum and seeing the company succeed.

NOLs: The company has ~1.3bn of NOLs in the U.S.