Description

INVESTMENT THESIS
After three consecutive downward revisions to guidance combined with a balance sheet that many view as overleveraged, the market has put SPC in the penalty box. However, given the geographically and categorically diversified stream of cash flows, the core portfolio of brands provide enough sustainable cash flows with a margin of safety to cover interest payments and covenant requirements for the foreseeable future. However, should management execute well on its plan, then the de-leveraging of its balance sheet to a sustainable level over the next few years and the growth in cash flow should push the stock substantially higher. Through integration synergies, other cost savings initiatives and achieving price increases, the company has a high probability of moving current free cash flow from roughly $180MM in C2005 to over $240MM by 2008. By 2008, debt levels should be $1.8bn and we expect the company to trade at a 12x-14x multiple to its free cash or $56/share-$65/share.

SUMMARY
Over the last 9 years Spectrum Brands, a consumer products company, has driven growth through a series of acquisitions and expansions. This allowed the company to globalize its battery business and then diversify into other categories, leveraging the company’s global infrastructure.

When Tommy H. Lee Partners, LP (“Lee”) acquired the company in 1996, it was solely a North American consumer battery business sold under the Rayovac brand name. Lee put in the current management team, who cut costs and invested in the brand. They IPO’d the company only a year later. Over the next several years, with the acquisitions of ROV ltd., Varta, Ningbo and Microlite, the company expanded its battery business globally into Europe, Latin America and China. Remington was added in 2003 to diversify outside of batteries into electric shavers and grooming products and electric personal care products. In 2005, the company acquired United Industries, Tetra and Jungle Labs to further diversify the company into lawn and garden, household insect control and pet supplies and leverage its global distribution capabilities.

As a result of these acquisitions, the company has significantly levered up its balance sheet. With this high leverage position, the company also faced a number of untimely challenges this past fiscal year. Commodity price increases in urea, zinc and diesel fuel negatively impacted earnings and is expected to further impact earnings next year. A challenging macro environment in Europe significantly impacted margins in the battery business as private label continues to grow share there. Finally, inventory buildups at major retailers and the slow transition to its new marketing strategy for its alkaline battery business in North America resulted in significant price promotions and lower unit sales in Q4 to get rid of old inventory (note that the company did not lose market share during this inventory correction). Due to these unforeseen events, the company missed estimates three times in a row since July, multiple analyst downgrades ensued and the share price declined to 52-week lows going from over $38 to as low as $16.20.

The market has severely over-reacted to these challenges and investors are discounting the significant free cash flow growth that lies ahead. Management has a successful track record in integrating its acquisitions and achieving synergies beyond original estimates in a timely manner. In addition, this management team has a successful history of managing businesses with substantial leverage.

With successful execution by the Company’s management team, free cash flow could grow from current normalized proforma levels of $180MM to at least $240MM by 2008. We expect free cash flow to grow through, 1) attaining previously identified integration synergies of $100MM on an annual basis by fiscal 2008; 2) achieving $20MM in restructuring initiatives over the next two years primarily through operational efficiencies in Europe that include moving manufacturing to lower cost countries; 3) recovering $30MM of increased commodity costs via increased pricing in specific categories in lawn and garden and battery; 4) continuing the successful rollout of Remington in Europe and Latin America; and 5) improving the North American alkaline battery business through its new marketing message, new product packaging, improved product performance and improved retail placement at Walmart. Assuming the company executes on these opportunities, the market cap should triple within the next 3-5 years.

INVESTMENT HIGHLIGHTS

Proven Management team:
David Jones, Chairman and CEO, and Kent Hussey, President and COO, were placed in the company by Tommy Lee in 1996 after Lee acquired and recapped the Company. They had previously worked together as the senior management at the Regina Company, a manufacturer of vacuum cleaners and other floor care equipment. Randall Steward, the Company’s CFO, initially joined the Company in 1998 but previously had worked as CFO of Thermoscan while David Jones served as its CEO. Thermoscan, also a Tommy Lee company, recruited David Jones as its CEO before placing him at Rayovac.

This management team has worked together for over 10 years and during this time has created significant shareholder value growing revenues and earnings per share (EPS), 24% and 21% CAGR respectively. This has been achieved through timely integration of acquisitions and attaining considerable cost savings from merger synergies averaging approximately 11% of net sales or approximately $90MM on total sales of $820MM from three acquisitions. We are confident that the current setback is only temporary and this management team will continue to drive shareholder value through the successful integration of United and Tetra and will likely achieve more than the current estimate of $100MM in cost savings as it only represents 8% of net sales while they have achieved 11% historically.

Improvement in North American Battery:
The Company has initiated a new marketing campaign to reposition its brand as a compelling value proposition to Energizer and Duracell. Previously, Rayovac alkaline batteries were offered 6/pack while competitor batteries were offered 4/ pack and the tag line was “50% more” for similar prices. Naturally, consumers perceived this as a lower quality battery that would not last as long and therefore the manufacturer was offering 6 batteries per pack to make up for the poorer performance. In reality, the performance is not noticeably different among any of the alkaline batteries. Therefore, the company is repositioning its brand as a value brand for similar quality as the premium brands priced at approximately 15-20% less. The new tag line is “Performance guaranteed or your money back.” The company is seeing positive point of sale results where the new products with the new packaging are in place. However, as of the end of September, the company was only 80% through with the transition to the new inventory, which should be completed by the end of December. Because of the unexpected slow transition and general inventory buildup of batteries at their major retail customers, the company was forced to significantly increase its promotional activity in the last quarter and get rid of the old inventory that had the old packaging and marketing message. This was the primary reason for the margin and revenue decline in their North American business. With this correction behind it, the company should see significant improvement next year. It is also important to note that market share has remained stable at 10-11% over the last several years and competition has been rational and the company. In the middle of last year, competitors began increasing prices for the first time in many years.

Significant opportunity to consolidate a fast growing pet supply industry:
Spectrum Brands is well positioned to consolidate the highly fragmented industry, which is one of the fastest growing consumer product categories over the last five years growing 7-8%/year. The three largest players have a combined 20% share with Central Garden and Pet leading with 8% share, SPC with 7% and Hartz with 5%. Combining United and Tetra created scale, size and a global infrastructure (including sales and logistics) with strong leading #1 and #2 brands. We believe that the Company will benefit disproportionately as favorable demographic and leisure trends continue. The key demographic trends supporting industry growth is the growth rates of children under 18 and the number of adults over 55. Another trend that is expected to continue to support growth is the humanization of pets where families tend to treat their pets as members of their family and spend accordingly – 86% of people purchase pet for companionship.

Rational competition in Lawn and Garden supported by favorable demographic trends:
There are only two other competitors of size including Scotts Miracle-Gro and Central Garden and Pet. Scotts is a well-run premium branded product company with 48% market share while SPC is a strong value alternative brand with the second highest market share at 25%. SPC exclusively provides the value house brand at Lowe’s, Home Depot and approximately 50% of Walmart’s house brands depending on product line while Central Garden and Pet provide the other 50%, mostly in grass seeds. Competition has been rational and pricing is expected to increase in January to recover high commodity costs. Over the last several years, industry trends have been favorable with 4-5% growth; these trends are expected to continue with the growth of the baby boomer generation in the 55-64 age group, which is the primary target for this category. Additionally, new home growth at or near two million new homes per year will support increased demand. Finally, the retailers are largely consolidated with the top 3 having 60-70% of total industry sales. We expect the company will continue to maintain its market position and margins with the price increases expected in January. Longer term, we expect the Company to grow this category internationally as their retailers expand globally.

Significant Merger Synergies should be realized:
The Company should be able to realize a minimum of $100MM in annual pre-tax synergies by 2008 primarily from its merger with United Industries and Tetra. There is a lot of low hanging fruit in achieving these synergies because United Industries had recently bought United Pet Groups, which was a rollup itself, and which had never integrated its acquisitions. The company expects $50MM in savings from operations initiatives which include consolidating manufacturing and moving more production offshore, reducing its 14 distribution facilities down to 5, integrating purchasing globally, sourcing more in low cost countries, and managing the supply-chain. $15MM of savings is expected from consolidating sales and marketing organizations into regional business units. The company is also moving acquired business units to its SAP IT platform, which will save $13MM annually. Finally, the company should save $22MM by consolidating administrative functions including corporate functions such as finance, human resources, and management. By the end of fiscal 2006, 2007, and 2008, the Company expects $35MM, $80MM and $100MM of annual cost savings, respectively. Note that these synergy estimates are likely to be very conservative given management’s historical record of integrating acquisitions and achieving 11% of net sales versus the assumed 8%. Taking 11% of Tetra/United sales of $1.2bn for potential synergies gets us to approximately $135MM, a significant margin of safety to the $100MM management has guided to Wall Street.

Other Cost Savings Initiatives Above the Synergy:
The company expects to save $20MM ($10MM next year and $10MM in 2007) restructuring its European battery operations and North American operations. Given the weakness in the macroeconomic conditions in Europe, the company is in the process of rationalizing its operations and believes there are opportunities to improve efficiencies and move more production to Eastern Europe and China.

Remington growth opportunity in Europe and Latin America:
Remington is already a strong brand in the UK and is being rolled out to the rest of the continent. Based on our conversations with the Company, it is not unreasonable to believe that the potential opportunity for the rest of Europe could eventually match the current sales in the UK of $160MM –. Additionally, the company is in its first year of rolling out Remington products in Latin America. The current low base of $3MM could easily grow to a bare minimum of $30MM in three years.

Compelling Valuation – This is a merger/deleveraging story for a Company that should be able to increase its operating margins from proforma 10.5% in fiscal 2005 to the low to mid teens or 14-15% on revenue of over $3B by fiscal 2008. If this happens, the Company should generate approximately $450MM in operating income and about $540MM in EBITDA by the end of 2008. During that time, we expect the Company to use its excess cash to deleverage the balance sheet. The 2008 market/FCF and EV/FCF multiple would be 4.3x and 6.6x, respectively. Note also that the proforma 2005 market/FCF and EV/FCF multiple is still only 5.7x and 9.3x, respectively. This is extremely cheap for a diversified branded consumer products company.

COMPETITION

The markets where the Company primarily competes include North America, Europe and Latin America. In batteries, there are only four global companies that compete including Energizer, Duracell (now owned by Procter & Gamble through the acquisition of Gillette), Matsushita (manufacturer of the Panasonic brand) and Spectrum Brands (manufacturer of Rayovac and Varta brands). In the US, Rayovac (10-11% share) is positioned as a value brand priced 20-30% cheaper than the premium brands of Energizer (28% share) and Duracell (49% share). Private label is less important in the US and has declined in share now making up only about 5% share down from 8% several years ago. We expect that share will continue to remain stable among the three top players. Rayovac may be able to increase share slightly with the additional shelf space won in Wal-Mart combined with the new marketing message for repositioning the brand. Margins and cash flows should be protected as the big three increased prices this year for the first time since the late 1990’s.

In Europe, however, private label has gained share, which now sits at approximately 30% up 10 points in the last three years. Varta is the #2 brand with 25% share while Duracell is the leader with 27-28% share. Unfortunately, we do not see any catalyst for change from this trend. Private label will most likely continue to take share effecting margins for SPC as 30% of their European business comes from lower margin private label. The impact should be reduced going forward as the company lowers its cost base to be in line with these industry trends.

In Latin America, Rayovac is the market leader with over 40% share, while Energizer is a distant #2 with 20% share. We expect industry growth to be in the high single digits as disposable income continues to grow in the region. As the market leader, the Company is testing price increases in several regions, which should benefit margins going forward.

In the electric shaving and grooming market, the Company competes with Norelco, a division of Philips Electronics, and Braun, a division of Proctor & Gamble. Remington, owned by SPC, and Norelco are mainstream brands while Braun is a high quality high price point brand. We believe Remington will continue to drive growth in the North American market through innovation and the introduction of new products at higher price points. The real opportunity for Remington is in penetrating markets (e.g. Latin America, Rest of Europe excluding UK) where they don’t participate in shaving products today but already have sales and distribution infrastructure and retail relationships in place from its other product lines.

For now, the lawn and garden segment is solely a North American business competing against Scotts Miracle-Gro and Central Garden & Pet. We believe that Spectrum should continue to grow with the industry and expect that retailers will continue to support a premium brand and a value brand. As Lowe’s and Home Depot grow internationally, Spectrum should be in a strong position to expand its brand outside North America.

The Pet Supply industry as mentioned above is highly fragmented with over 500 manufacturers in the US consisting of small companies with limited product lines. The largest competitors are Central Garden and Pet and The Hartz Mountain Corp. There is no private label in pet supplies and the two largest retailers, Petco and Petsmart, have share of under 10%. There is significant opportunity for the company to grow share as retailers would like nothing better then to consolidate their suppliers. Consequently, we believe that SPC will grow share and drive operating margins higher as they leverage their SG&A.

RISKS
• Macro-economic conditions curb consumer spending and/or we have our first US consumer recession after over a decade – although, we believe that things like batteries, shavers, fish food, etc. are somewhat defensible. If anything consumers may trade down to value brands which is positive for the company
• Promised merger synergies and cost saving restructuring initiatives not achieved
• Continued sustained high oil prices could materially impact shipping and energy costs
• Continued high natural gas prices effect urea prices which is a main ingredient for fertilizers; company is raising prices in January
• Continued economic decline in Europe
• Near term headline risk that Thomas H. Lee sells its shares when the firm’s lockup for half the shares expires in February
• Significant decline in any category or region may cause the company to break its debt covenants potentially increasing restrictions, interest rates, and/or forcing bankruptcy

Catalyst

• As many VIC writers say, value is its own catalyst
• Analyst upgrades on stabilization of businesses
• Synergies achieved in a timely manner
• Management credibility returns after achieving promised earnings guidance