A Good Business With a Weak Balance Sheet

Mark is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Batteries and pet food are common purchases you make every month without even realizing. Consumer products like these are non-discretionary and need to be replaced frequently. This contributes to the strong free cash flow and profitability of Spectrum Brands (NYSE: SPB), a global consumer products company selling consumer batteries, small appliances, and pet supplies among other products.

Unfortunately, while I like its business, its capital management practices leave much to be desired, especially its weak balance sheet. It is also expensive at 1.9 times PEG and I will not recommend that investors buy into the stock now.

I love consumer products, just like Warren Buffett

Why do I like branded consumer products companies like Spectrum Brands?

Firstly, the consumer products that Spectrum Brands sells are not priced at a premium and make up a relatively small proportion of a consumer’s budget. In times of economic stress, Spectrum Brands is not affected by the cut in big ticket items, since the cost of batteries and personal appliances is small compared with furniture and freezers. Spectrum Brands also benefits from consumers downgrading to cheaper goods, as it has always positioned its products as ‘same for less” -- cheaper alternative products with similar performance attributes.

Secondly, these products are non-discretionary in nature. Consumers are unlikely to starve their pets or stop replacing batteries. In addition, Spectrum Brands also sells batteries for hearing aids and other medical instruments, for which the continued operation of medical devices is critical.

Last but not the least, most of Spectrum Brands’ products such as insecticides are consumables need to be replaced frequently. As a result, demand for Spectrum Brands’ products remains relatively constant, given the short replacement life cycle of most of its products.

But capital management practices fail to impress

Since Spectrum Brands emerged from bankruptcy in October 2009, which was a result of aggressive acquisitions and a huge debt load, it has delivered positive free cash flow and profitability for the past four fiscal years. It also initiated regular quarterly dividends of $0.25 per share beginning in fiscal 2013. However, it seems that it has not learned from its previous mistakes.

Spectrum Brands’ credit ratios raise warning bells. It is highly leveraged with a gross debt-to-equity ratio of 346%. Current ratio is decent at 2:1, but quick ratio, a more stringent measure of short-term liquidity, is below 1.

Spectrum Brands has stated its intentions to grow its pet supplies and home & garden products businesses by way of selective bolt-on acquisitions to increase its scale. While I acknowledge that acquisitions are common in the branded consumer products space, acquisition driven growth is inherently risky, exacerbated by its weak balance sheet which reduces operational flexibility.

Finally, I prefer dividend paying stocks with strong free cash flows, debt-free balance sheets, and minimal growth capital expenditure needs. While Spectrum Brands is a free cash flow generator, its huge debt load on top of an acquisition growth strategy suggests that dividends are of a lower ‘quality.’ Although Spectrum Brands’ forward dividend yield of 1.70% is not very significant, I prefer that Spectrum Brands uses the excess cash flow set aside for dividends to reduce debt instead.

Peer comparison

Spectrum Brands’ peers include Energizer Holdings (NYSE: ENR) and Procter & Gamble (NYSE: PG).

Energizer has put in place several initiatives in the past year to boost its share price. Firstly, its cash conversion cycle was pretty long at around 120 days for fiscal 2012, and it has targeted a 400 basis points reduction in working capital-to-sales ratio, which will result in savings of up to $200 million based on management estimates. Secondly, like Spectrum Brands, it initiated its first quarterly dividend in July 2012, representing a 25% payout of 2012 earnings.

Last but not the least, Energizer stepped up its investor relation efforts by organizing quarterly conference calls and providing annual financial outlook. Energizer has been rewarded for its efforts with a 34% increase in its share price for the past 12 months. Trading at 1.22 times PEG, Energizer is cheap relative to its peers, but still overvalued on an absolute basis.

The story for Procter & Gamble in the past few years has been one of it ceding market share in many of its product categories. Critics point to issues such as noncompetitive pricing and insufficient investment in marketing and innovation. In May 2013, it announced that Alan George Lafley has rejoined Procter & Gamble as President and Chief Executive Officer; he was previously President and Chief Executive Officer from 2000 to 2009.

I am optimistic that Lafley’s return will help steady a boat that has seen significant management turnover in recent years. Among the three stocks, Procter & Gamble has the highest forward dividend yield of 3.10% and the best balance sheet with a gearing of 47%.

Conclusion

I love the branded consumer products business just like Warren Buffett, but at the same time, I am averse to weak balance sheets and acquisition driven growth. Spectrum Brands does not meet my expectations in these areas. In addition, it also used its free cash flow to pay dividends, instead of reducing debt. Furthermore, it is overvalued at 1.9 times PEG. I will not consider this stock, unless it reduces gearing to a more acceptable levels and valuations become more reasonable.

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Mark Lin has no position in any stocks mentioned. The Motley Fool recommends Energizer Holdings and Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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