Description

I think I've found a pretty attractive small cap (small, small cap) opportunity in Summer Infant, Inc. (SUMR).

Here's some background info: 

SUMR is a designer, marketer, and distributor of branded juvenile health, safety and wellness products sold principally to large retailers in North America and the UK.  These products include nursery audio/video monitors, safety gates, durable bath products, bed rails, related health and safety products, booster and potty seats, bouncers and a product line of soft goods/bedding.  In fiscal 2008, nursery audio/video monitors and baby gates were their biggest sellers, accounting for approximately 27% and 17% of net sales, respectively.  Approximately 88%, 4%, and 8% of their 2008 sales were made in the United States, Canada and the UK, respectively.  Their products are sold primarily to U.S. retailers including Babies R Us, Target, KMart, Buy Buy Baby, Meijer, Baby Depot (Burlington Coat Factory) and Wal-Mart. 

History:

SUMR's Chairman and CEO, Jason P. Macari founded the original Summer Infant in 2001 after leaving his job as VP and General Manager of product development at Summer's now competitor Safety 1^st.  He grew his new business from $1M in sales in 2001 to $35M in sales in 2005.  Then in 2007, KBL Healthcare Acquisition Corp. II acquired the original Summer Infant, changed its own name to "Summer Infant, Inc" and became listed on the Nasdaq under the symbol SUMR.  Mr. Macari became CEO of this "new" Summer Infant, Inc, which was essentially the same company bolstered with more resources.  He was eventually named Chairman of the board as well.  The "new" Summer Infant, Inc (SUMR) has experienced further high growth since the transaction, growing its sales from $80M in 2007 to over $130M in 2008, representing two small (but complementary) acquisitions and 41% organic growth.  EBIT grew 57% from $5.96M to $9.34M over that same period.

Trouble?

Over the past few quarters, SUMR's business has suffered somewhat from high resin costs, higher labors rates in China (where over 80% of their products are manufactured), and, in their most recent quarter, a dramatic inventory reduction by their customers (major retailers).  In fact, Summer's CEO said in the Q408 earnings call that retailers, in general, seem to have made a shift in operations and are now working on smaller inventories.  While that isn't necessarily bad news for SUMR, it did cause a bad Jan 2009 for them as their customers ordered very little so as to bring inventories down.  Thus far, that break in orders appears to have been just a one time occurrence because, as they say in their Q109 call, point of sale data has remained solid and retailers resumed normal ordering behavior in late Jan 2009 and that remained stable throughout February, March and April.  Also, despite their terrible January 2009, their Q1 sales actually increased ~1% over Q108 (including the increase in sales from acquisitions, assuming both deals had closed prior to Jan 1, 2008). 

Nevertheless, Q109 was a disappointment.  However, while being squeezed on all fronts in Q1 (higher commodity and labor costs, a break in orders, an increase in promotional expenses and a close-out reduction in their own inventory, which included $1M of sales at cost), SUMR still managed $2.4M of EBITDA ($1.5M of EBITDA-CapEx).  While I'd like to chalk up SUMR's Q1 as simply the result of a perfect storm and something probably outside the realm of normal operating conditions, I'll point out later that even if this were to repeat itself each quarter (their business isn't seasonal), SUMR's current share price wouldn't be all that unreasonable. 

On the positive side:

SUMR has a good chance of increasing their profitability going forward even without revenue growth.  First of all, they are seeing stabilization in retail ordering patterns.  Also, a 50% drop in resin costs from their 2008 peak and favorable negotiations with their suppliers should benefit their gross margins beginning in Q209.  In addition, they recently cut their workforce by 10%, which they estimate will save them ~$1M annually, also beginning in Q2.  Furthermore, they are planning a warehouse consolidation, which they estimate will save them another ~$1M annually beginning in Q4 2009, and they are likely to get some efficiency gains by eliminating 25-30% of their SKUs in order to focus on their best sellers (note: these aren't necessarily underperforming products so much as they are underperforming designs and colors, so they believe these can be replaced easily at no harm to sales).

I hate to be this optimistic, but they might even grow their revenues too...

I certainly don't expect them to match the 41% year-over-year organic growth they achieved in 2008 (achieved in the midst of a recession, no less).  However, SUMR's sales actually increased in Q109 despite essentially missing half of January!  They are also forecasting Q209 revenues to be up on both a sequential and YOY basis.  In addition, they have added new retailers every year of their 7-year history, and they have also increased their shelf space at all their major retailers over the past year - another positive sign.  Furthermore, I think they have been building a strong brand.  While I personally haven't had occasion to use any of their products (yet), several indicators lead me to believe that SUMR is probably a pretty good company.  For instance, they've had zero recalls in their 7 year history.  They began implementing tougher safety standards in their products a year before those standards were signed into law, and finally, they differentiate themselves through innovative product development.  This is how they compete at the top of the price range, and how they became the market leader in A/V baby monitors.  

I know, I know... consumer spending is dead, but c'mon, this is a good business to be in:

Despite the overall weakness in consumer spending these days, SUMR operates in an enviable market.  Baby products, especially anything related to baby safety, might well be the last "luxury items" consumers forego.  SUMR's products are mostly at the top of the range, and they typically benefit from this "best for baby" mentality that many new parents seem to have.  In addition to this psychological advantage, SUMR benefits from the trend of couples waiting longer to start families because these couples generally have more disposable income than those of previous generations.

"I'm not just the CEO, I'm also the largest shareholder"

I don't know if SUMR's Chairman and CEO, Jason Macari, ever actually said that, but if he did, it would be a true statement.  In fact, Mr. Macari currently owns over 22% of SUMR's stock including the over 55 thousand shares he purchased between June 12^th and September 5^th, 2008 at an average price of ~ $4.37/share (over twice the current market price).  Another positive for SUMR shareholders is that the approximately 3,633,953 redeemable common stock purchase warrants (leftover from the KBL deal) expired in April 2009.  Also, SUMR recently stated that they are "committed" to running their business cash flow positive going forward, and they expect to pay down at least $3M to $5M of their $42M debt by yearend.  I normally wouldn't give much weight to such CEO comments, but the fact this CEO also happens to own 22% of the company (probably representing a good portion of his personal wealth) gives him a little credibility here.

Valuation

In order to build a framework for evaluating the current market value of SUMR shares, I'm going to consider 3 scenarios. 

Scenario #1:  Q109 was no anomaly.  They experience similarly low gross margins and high SG&A expenses with slower than average sales (i.e., quarterly sales roughly equivalent to Q109 which experienced a 2 week break in orders) for the remainder of FY09.  Full year results would be roughly equivalent four times to those of Q109, with the exception of a $1.4M decrease in full year SG&A due to the head count reduction and their stock option expense being highest in Q1.  Given all this, at its current market value, SUMR shares would still have a P/E ratio of just 12.8!  That valuation may not be the definition of cheap, but its not very expensive either, and besides... I think this first scenario is way too conservative. 

Scenario #2:  The remainder of this year will look a lot like the last three quarters of FY08 (after all, it was a recession year - with a terrible holiday shopping season to boot).  Assuming sales and gross margins remain the same for the last 3 quarters of '09 compared with the last 3 quarters of '08 (even though they expect both to increase in Q209), I estimate FY09 earnings of $4.5M.  This would mean a P/E of 7.  Ok, now we're starting to look cheap (and I still think we're being conservative here). 

Scenario #3:  The steady ordering they've seen in most Q109 and the first month of Q209 continues for the remainder of the year and gross margins improve.  They stated in the Q109 call that if ordering remains stable, they expect revenues in Q2 to be up sequentially.  Also, because Q109 revenues were higher than Q208 revenues to begin with, a sequential rise in revenue would also mean an increase in revenue YOY.  I have no idea how much they expect Q2 revenues to increase, so I'm going to rather arbitrarily model a 5% increase in YOY revenues for the remaining 3 quarters of '09.  I'm also going to take their word for it that gross margins will improve and increase their gross margins by 50 basis points.  These assumptions would mean FY09 net income of $6.2M and a P/E of about 5.  Of course, things could get even rosier for SUMR than what is described in Scenario 3, but I'm not counting on it.  Therefore, considering these scenarios (by the way, I personally consider somewhere between 2 and 3 to be the most probable), I estimate SUMR's shares could be undervalued by as much as 50%. 

(Note: In each scenario, I used the actual Q109 net income in the P/E calculation.  If Q1 were to be considered abnormal enough that it was discarded and scenarios 2 and 3 estimated earnings for the 12 months going forward, resulting P/E ratios would have been even lower.  Also, note: in each scenario SUMR would have generated enough cash flow to pay down at least $3M of debt as is their plan). 

Conclusion:

In summary, Summer Infant, Inc. looks to be a good company in a good market.  Most of the difficulties that led to a poor performance in Q1 2009 probably don't reflect typical business conditions and look to be abating.  Buying shares at SUMR's current market price should provide significant upside potential with adequate cushion should conditions worsen.  Also, significant insider ownership is a big plus!     

Catalyst

• Continuation of stable ordering coupled with easing pressures on margins, a lower cost structure, and the recent focus on efficiency should unlock gains in EPS and cash flow.
• Further revenue growth would magnify those gains.
• Steady repayment of debt will improve their capital structure.