Zep is a largely forgotten spinoff from a couple of years back which might pay off for the patient value investor. There are a couple of ways to win, and downside is relatively limited.

First off the quick description, in their own words: "Zep Inc. is a leading producer, marketer, and service provider of a wide range of cleaning and maintenance solutions for commercial, industrial, institutional, and consumer end-markets. Zep Inc.'s product portfolio includes anti-bacterial and industrial hand care products, cleaners, degreasers, deodorizers, disinfectants, floor finishes, sanitizers, and pest and weed control products as well as high performance products and professional grade chemical products for the automotive, fleet maintenance, industrial/MRO supply, institutional supply and motorcycle markets through newly acquired Amrep, Inc."

Zep was spun out of Acuity Brands October 31, 2007. As a subsidiary of Acuity
Brands, Zep's role in the portfolio was to provide consistent cash generation and operate the business with a low risk profile. It was largely viewed as an unattractive collection of low-growth assets and the stock languished.

Under the hood, management was doing the relatively unglamorous story of blocking and tackling. John Morgan is Chairman, President & CEO. Before joining Zep in mid 2007, he grew the lighting business of Acuity Brands from $600 million to over $2 billion in annualized sales. Morgan began to overhaul Zep in the same way.

Under-used assets such as buildings in Atlanta were sold off, distribution centers were rationalized, the number of SKUs was drastically reduced (over 50%), largely without affecting the end users (many formulations were essentially the same) and the sales staff and incentive system was overhauled - underperformers were weeded out and a new hiring process was implemented. In addition, the company began to pursue the retail and distributor sales channels in parallel to their sales force model.

The company established four main goals at the time of spinoff:
1.) Revenue growth in excess of the market, without benefits from significant acquisitions.
2.) EBIT margin improvement of 50 basis points per year.
3.) EPS growth of 11 - 13% per year.
4.) Returns on invested capital of greater than 15%.

Fast forward a couple of years and the company has failed to reach its targets but has done reasonably well, given the horror show of 2007-8. The stock began trading at $14, rose to $21 around a year later and then collapsed with the market to a low of $7, before recovering to $17 today. The company has faced headwinds of de-stocking by customers and its small business customer base facing tough conditions. The distributor channel strategy has been slow to take off and it may be a few more years before the targeted contribution of 10-15% of sales is achieved.

Per the company 70% of volume decline was attributable to the economy and 30% was related to their strategic initiatives (cutting out unprofitable sales of low volume products and underperforming sales people). A small amount of unfavorable foreign currency translation on international sales also contributed (internaional is a small segment but with potential upside). They faced a lot of customer de-stocking and small business attrition over the last few years.

Managment broke things down by end market on a call last year:
"One of our largest end markets...is in the transportation area. ...that includes of course things like car dealerships, which are an important part of our business. That's been a little bit difficult over the last year, as you might expect -- vehicle wash, airline, trucking, and so forth.... That has, I would say, stabilized; but it's just bouncing at the bottom. As you know from the broader economic indicators, there is no major turnaround in the transportation sector, certainly in North America.
Food is another important area for us, food processing and food preparation. That's been a relatively stable market. We anticipate that that will continue to be a relatively stable market. Apparently, we still like to eat, and so that has been a pretty good business for us. In fact in food processing, the focus is on the at-home markets; that's been a pretty good market segment.
Of course, products in the construction area, that has been very difficult to come by over last year. Residential construction has somewhat increased, still bouncing along a bottom, but as you know from the broader indicators has increased somewhat. Non-residential construction has been very difficult.
Government markets have been pretty robust over the last year. We anticipate that that will continue in the coming year
The only other area that has a significant impact... is the general industrial manufacturing segment. And I think everybody knows industrial production is way off and continues to be off relative to production utilization."

Through the recession, managment has plugged away steadily in difficult times and the company has done reasonably well in the downturn.I would argue that the company has taken its lumps, refashioned itself and begun to slowly crawl forward on a positive path.

Valuation:

Zep does not screen as obviously cheap on P/E at 17x 2010 and 13x 2011 EPS estimates. The company trades at a low EV/S in comparison (0.7x vs 0.9x - 1.8x) and EV/Gross Profit (1.4x vs 3-3.7x). There are no exact peers but I use NLC, FUL and ECL. The main issue is scale. ZEP suffers because it can't leverage its fixed costs and because it doesn't carry enough weight in the channels. Despite excellent gross profit margin, ZEP has EBITDA margins in the 5% range vs peers in the 12-17% range.

The two paths to a positive outcome for Zep that I see are:
1. Management continues to pursue the blocking and tackling strategy. Slow increases in volume (GDP+) and very minor organic gains are augmented by acquisitions such as Amrep and allow them to leverage their fixed SG&A costs to get net margins to ~9%
2. A competitor buys Zep for its brands and sales relationships and folds in their 50% margins.

As a standalone company, ZEP is interesting enough - about 13x NTM EPS (FYE Aug 31) which will be the first full year of Amrep results. GDP+ topline growth should allow for 10-15% EPS growth over time barring a double dip. Tuck-in acquisitions at lowish mutliples could add a bit more. Not that exciting, but reasonable. If they can leverage SG&A and ultimately move towards competitor EBIT margins on higher sales this will be a nice slow ride upwards for shareholders

What would ZEP be worth to an acquiror? At lowish but comparable multiples of Revenue (say 1x) ZEP would be at ~$25. At a low comparable Gross Profit multiple you get over $40. I fully accept that the gross profits may not be entirely comparable to peers, and that increasing distributor sales and sales from Amrep may lower Gross Profit margins overall. Nonetheless the value to an acquiror seems obvious.

Risks:
There are certainly still risks. The company is exposed to small businesses, manufacturing and everything that hurts in a downturn. There is a real risk of management doing bad deals. The dead money risk is also real, but at ~13x August 2011 EPS, the downside should be limited, and the takeout option provides some serious upside potential even if the turnaround stalls. At $17 the risk/reward seems favorable

 

No hard catalyst. Further acquisitions, or continued execution on the business plan.