Description

US Industries (?USI?) is an interesting financial and operational turnaround play, largely the result of recent asset sales which have helped the company significantly deleverage and skirt a serious liquidity crisis. USI, in its current form, is mostly a producer of Bath and Plumbing Products (it owns the Jacuzzi, Zurn, and Eljer brand names, which account for 90% of sales), but it also owns Rexair (10% of sales), a leading producer of premium vacuum cleaners under the ?Rainbow? name. Having sold off five different businesses in the past year, which collectively raised $630mm in net proceeds to pay down debt, and having effected an exchange offer on its bonds and renegotiated its bank lines, which extended its maturities to late ?04 and ?05, respectively, USI has successfully avoided a cash crunch, is now well-positioned to benefit from an economic upturn, and can refocus its energies on expanding margins at its remaining businesses. The stock currently trades for only 8.7x forward EPS and 5.5x TEV/EBITDA.

History. USI was originally spun off from Hanson PLC in 1995, at which point it was a very debt-laden hodge-podge of 34 disparate businesses. Over the ensuing several years, the company sold off many of its diverse assets and real estate holdings but, rather than paying down debt or redeploying the proceeds in an accretive, value-enhancing way, management spent the money buying back stock at much higher levels ($376mm spent in 1999 and 2000 for 25.5mm shares, or $14.75/share) and by overpaying to purchase Zurn Industries, a producer of ?behind the wall? plumbing products. USI bought Zurn in mid-1998 in a stock deal valued at $765mm including the assumption of $210mm of Zurn debt. USI ended up paying 1.2x Zurn?s LTM sales of $634mm, 12x EBIT of $64mm, and over 26x net income of $29mm (excluding extraordinary items).

By June of 2001, USI?s net debt had swollen to $1.35bb (about 6x EBITDA) and, worse, the majority of its debt was due to mature within a three month period this past fall (the $830mm bank line, which had previously been restructured in August ?01, was set to expire at the end of November ?02). Therefore, in late 2001, USI?s Board announced a comprehensive Disposal Plan to sell non-core assets and pay down debt; original estimated net proceeds were $492mm, so in raising a net of $630mm, management exceeded most expectations during what was a difficult time period to shed assets. Having completed the last of its five divestitures in October, the banks initially extended USI?s credit facility to 10/03. Subsequently, with the completion of an exchange offer on USI?s 7 1/8% Senior Notes due 10/03 to 11.25% Senior Notes expiring 12/05, the banks further extended the line to 10/04. Admittedly, the refinancings were expensive to USI, with the higher coupon on the Notes and the rate on the credit line bumped to LIBOR + 7%, or about 8.4% now. But, most importantly, the company has bought itself a further two years to maneuver, and now has ample opportunity to sell further assets (specifically, Rexair), expand margins at Jacuzzi (a new manufacturing facility has recently been opened, which succeeds four older sites the company had shuttered), and, hopefully, catch the economic wind at its back, which would help sales for some of Jacuzzi?s premium products. The CEO seems to have renewed confidence in USI?s prospects, as he recently bought about 170k shares at $2.60, while three other directors have also bought stock in the open market (one bought 30k in November at $2.65, the other two lesser amounts in November and May).

Business. As mentioned above, the vast majority of USI?s sales are related to Bath and Plumbing Products, effectively comprised of the Jacuzzi, Zurn, and Eljer brand names. Collectively, these three businesses accounted for $1.06bb in FY02 sales (USI is on a Sept. FY), or 92% of total sales. Although the name Jacuzzi is generally synonymous with free-standing indoor or outdoor spas, in actuality Jacuzzi?s sales are mostly derived from other products such as whirlpool baths, jetted showers, tubs, toilet seats and sinks (a fairly full spate of bathroom products). Eljer?s business has now been consolidated into Jacuzzi?s. Competition in whirlpool baths and related products comes from Masco, American Standard and Kohler; Masco is the primary competitor in spas as well. While the company does not break out sales or profitability amongst the three units in this segment, our understanding in having spoken to management and through field checks is that Jacuzzi (including Eljer) is about a $775mm business, with spas only accounting for about $125mm and the aforementioned bathroom products the remaining $650mm. We estimate its recent operating margins in the 5% range (pre- allocated corporate), although in prior years it had been well above 10%.

Part of the problem at Jacuzzi in the past two years has been the loss of Home Center business -- both Home Depot and Lowe?s decided to discontinue Jacuzzi as an in-stock item, instead forcing consumers to special order the products. Together, HD and LOW accounted for about $130mm in sales, the full effect of which was felt over a two-year period (FY00 to FY02) and has now almost fully cycled through. Recently, management has publicly maintained it feels it has a reasonable shot of renewed sales to one or both companies and our checks have confirmed this to be a real possibility in FY03, although the view on timing has varied. Nonetheless, our recommendation of USI assumes no incremental sales from HD or LOW, but should it materialize, it would be a significant positive for the company (assuming USI could win back $100mm of the $130mm lost, at an assumed 7% incremental margin, or $7mm in operating income; capitalized at 6x would be $42mm, or 57c/share alone, a 22% kicker from $2.63).

When the HD/LOW business dropped off, Jacuzzi found itself with excess capacity, high fixed costs and margins suffered, being cut in half from over 10%. Jacuzzi?s exposure to new home construction vs. remodeling is about even and, while housing starts and remodeling expenditures have held up well through the past couple years, sales of premium outdoor spas (generally financed) have felt the pressure of flagging consumer confidence. With an economic pickup and, at some point, a commensurate rebound in consumer confidence, our expectation would be for spas to turn the corner, although our estimates reflect little top-line growth (only 2% in FY03 and FY04). In the meantime, the company has taken the appropriate steps to revitalizing margins, recently consolidating four of its older facilities into one in Chino, CA. Management has told us this transition took place smoothly last month and that there have been no operational hiccups, though we have yet to confirm this from other sources. We do understand, though, that the facility is much more automated, with significantly more material handling and less manpower, which should go a long way towards helping renew margins.

Zurn, Bath & Plumbing?s other unit, is an approximate $275mm business, with high market share and operating margins. Zurn mostly produces ?behind the wall? plumbing products such as drains, flush and regulator valves, and plastic pipes. The business is oriented towards commercial and institutional construction, which was down significantly in FY02. Nonetheless, Zurn held its own and was flattish on the top line, as the unit gained share from competition. The market is extremely fragmented but Zurn maintains a 25% share and so, with a product breadth well in excess of its smaller competitors, commands pricing power on many non-commodity-like products. We estimate Zurn?s pre-corporate operating margins in the 25% range, with which management did not disagree.

Rexair, USI?s remaining business, is a leading direct seller of premium vacuum cleaners. The business does about $100mm on the top line and, though growth is unexceptional, it does generate a healthy amount of cash flow (EBITDA margins are in excess of 30%) and is being managed for cash (it is not a capital intensive business). Rexair, under the ?Rainbow? brand name, has about 25% of the domestic market for premium vacuum cleaners, but 50% of its sales are international as well (Europe, A/P, LA). We would not be surprised to see USI sell Rexair in order to further shore up the balance sheet, but we have yet to confirm that it is currently being shopped.

What Now? With the balance sheet considerably improved, USI is finally in a position to concentrate its efforts on expanding margins. The company has hired a new executive to run Jacuzzi and, as stated previously, the new facility is apparently up and running smoothly. Management has told us that in the coming months they will adopt a much higher profile with the Street, and will likely do a mini- roadshow to tell the updated story; in the recent past, interaction with management had been very limited, for obvious reasons. Although we have yet to hear that any of the remaining businesses are actively being shopped, we do keep hearing that there are a number of relatively obvious and high-profile would-be suitors out there (chiefly Masco, Fortune Brands, American Standard, as well as financial buyers). The CEO, David Clarke, though admittedly running the show during the company?s collapse, has also been at the helm while USI extracted decent value from its divested businesses, as a near-distressed seller. We believe the remaining businesses are worth considerably more, net of total debt, to a strategic buyer than the current $2.63/share stock price would suggest.

Valuation. With the stock currently at $2.63 and with 74mm shares outstanding, USI?s market cap is now $195mm. After applying the net proceeds of its five divested businesses and accounting for the exchange offer on its bonds (including purchasing $54mm of its ?06 bonds as well), USI has about $565mm in net debt (down from $1.35bb in June ?01). The Total Enterprise Value is therefore $760mm. The company generated $132.7mm of EBITDA in FY02 (ending this past Sept.), so on a trailing basis the TEV/EBITDA is 5.7x. We are not factoring in a major pickup in either sales or EBITDA this year (we have 2% sales growth and operating margins only expanding 40 BPs to 9.5%, which should be a chip shot considering the more efficient facility). Still, with these assumptions, EPS is estimated to almost double to $0.30 from $0.16 (clean number) because interest expense will decline so dramatically from the debt paydown. We are estimating $60mm in interest expense in FY03 (though the current run-rate is $55mm, as the debt restructuring didn?t get completed until the end of November and so USI carried higher debt for the first two months of its fiscal year). After other expense of $15mm (flat with prior year and composed of miscellaneous items such as bank fees, consultant fees, some legacy items), and a corporate tax rate of 39%, net income should be in the range of $22.5mm, or 30c/share. This would put the stock now at 8.7x FY03 EPS. In addition, we expect USI to generate about $40mm in FCF, or $0.55/share, as capital spending will remain restrained (inclusive of costs related to the new facility). (FCF = $40mm: EBITDA of $139mm less $60mm in cash interest less $28mm in CapX less a use of Working Capital of $10mm and no cash taxes due to prior year carryforwards.)

The real pickup, we believe, should occur in FY04, when the impact of the Chino facility is more acutely felt and other corporate expense reductions already begun kick in (we are looking for operating margins to expand to 11.5% then from 9.5% in FY03, on another 2% sales gain, not unrealistic if the execution is there). EBITDA in FY04 is expected to be $165mm and EPS $0.57, so the current TEV/EBITDA multiple on ?04 (applying the $40mm in FY03 FCF to debt paydown) would be only 4.4x and the P/E on ?04 would be a paltry 4.6x.

We feel a more appropriate forward TEV/EBITDA multiple a year from now should be in the range of 6.0 ? 6.5x, which would put the stock at $6.28 - $7.40, gains of about 140% - 180% from here. (I.e., 6x $165mm in FY04 EBITDA = $990mm in TEV less an estimated $525mm in net debt at that point -- having applied the $40mm of FY03 FCF to the current $565mm in net debt -- for an equity value of $465mm, or $6.28/share on 74mm shares outstanding). The $6.28 - $7.40/share range would equate to P/E multiples (on the estimated $0.57/share in FY04) of 11x-13x, in line with other industrial companies with some financial leverage (at that point USI would be levered at about 3.8x LTM EBITDA, or $525mm on $139mm in EBITDA).

Risks:
> Asbestos exposure. USI does have exposure to asbestos claims, although its insurance policies look to more than adequately protect the company and to date it hasn?t expended a single dollar. The exposure emanated from Zurn, which had in 1967 acquired a manufacturer of industrial boilers, some of which were lined with asbestos. The company never manufactured asbestos itself and the boilers were delivered as a whole, with its parts unexposed. As of 9/30/02, there were about 65,000 claims pending and, to date, 48,000 already settled for an average of only $845/claim. USI estimates its ultimate exposure at about $107mm and its insurance coverage (for which there is no deductible) is in the range of $282mm - $350mm. The insurance coverage is currently given as a range because the company has had a dispute with one of its insurers over the limits of certain excess policies, but we have heard that there has recently been a settlement in principle (not final though) which would insure USI at the upper end of the range. We also understand that the rate of claims filed decreased 8% in FY02 from FY01, the high point for filings.

> Leverage still high. Despite the significant debt paydown, USI is still currently carrying about 4 points of leverage on a trailing basis. However, this is expected to decline further in FY03, with the generation of FCF. Also, interest coverage is expected to be 2.3x in FY03 (1.9x after CapX) and a more comfortable 3x in FY04 (2.5x after CapX).

> Exposure to housing markets. Obviously, USI?s end markets are principally related to residential and non-residential construction, a weakening of which would impact the top line. Still, the remodeling market serves to act as somewhat of an offset, as homeowners deciding not to purchase a new home often increase expenditures on existing homes.

Catalysts. The most important catalyst for USI is already behind the company, in the restructuring of the balance sheet. Over the near-term, we expect management to be more visible in telling its story, and Wall Street to be more receptive to a company with strong brand names trading at very low multiples and with much more breathing room to make further financial and operational strides. In addition, we expect margin expansion at its largest unit, due to efficiency improvements already put in place and, ultimately, the impact of a stronger economy to help the top line. A kicker, though not counted on, would be a renewed relationship with Home Depot and Lowe?s. Ultimately, we expect the entire USI business to be monetized in the form of a sale to a more well-heeled, strategic buyer.

Catalyst

1.) Balance Sheet restructuring, the most important catalyst, recently completed and now mgmt will be more visible in telling the story; 2.) Margin expansion due to consolidation of four facilities into one; 3.) Potential renewed relationship w/ HD and LOW; 4.) Ultimately, a sale of USI to a strategic buyer.