Investing in the Turnaround of a Garden Supplies Business

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

Chuck Royce, CIO of Royce & Associates, is a famous investor who specializes in small cap investing. In the past 15 years, he has managed to deliver a decent annualized return of 10.7%, handily beating the S&P 500’s annualized return of only 4.5%.

At the end of July, he increased his stake significantly in Central Garden & Pet Company (NASDAQ: CENT). He currently owns more than 1.25 million shares of Central Garden. Should we follow Chuck Royce into Central Garden? Let’s take a closer look.

A cash cow with some leverage

Central Garden is considered the leading company in pet and lawn and garden supplies industries in the U.S., operating in two main segments: Pet and Garden. Most of its revenue, $930.8 million, or 54.7% of the total revenue, was generated from the Pet segment, while the Garden segment contributed more than $769 million in sales. The company sells its products to various regional and national specialty pet stores, mass merchants, grocery, and drug stores. In the Pet segment, PetSmart is a big customer, accounting for 12% of sales.

What I like about Central Garden is its positive free cash flow generation, in nine out of the past ten years. However, its free cash flow has fluctuated in the range of $(22) million to $205 million since 2003. In 2012, its free cash flow came in at $50 million. Central Garden employs some leverage in its operations. As of March 2013, it had $475 million in equity, $29 million in cash and short-term investments, and as much as $593 million in debt. Moreover, it booked a high level of goodwill and intangible assets of $287 million.

Low margins but turning around

Investors might worry about the low profitability when compared to its peers Scotts Miracle-Gro (NYSE: SMG) and Spectrum Brands (NYSE: SPB). While Scotts Miracle-Gro and Spectrum Brands have managed to deliver 8.16% and 10.95%, respectively, in operating margin, the operating margin of Central Garden is much lower, at only 4.3%.

What might make investors excited is the company’s ongoing business restructuring to significantly reduce costs and simplify the business.

In 2012, the company reported that it had reduced costs by an annualized exit run rate of around $20 million, including higher asset utilization, SKU reduction, and reduction in the number of ERP systems. In February, John Ranelli was appointed as Central Garden’s CEO. John Ranelli has a lot of experience in turnarounds at several companies including Deckers Outdoor, The Timberland Company, and Beatrice. Under the newly appointed CEO, and chairman Bill Brown with significant ownership, of 57% of the voting shares, Central Garden expects to grow revenue through brand building activities, accelerate innovation initiatives, and reduce costs to improve operating margins.

The lowest valuation compared to its peers

The market values Central Garden at around 8.5 times its trailing EBITDA (earnings before interest, taxes, depreciation, and amortization). Interestingly, it has a much cheaper valuation than Scotts Miracle-Gro and Spectrum Brands. Scotts Miracle-Gro is trading at $52.70 per share with a total market cap of $3.25 billion. The market values the company the most expensively at 16.3 times its trailing EBITDA. Scotts Miracle-Gro is one of the leading companies in branded consumer lawn and garden products, operating in two business segments: Global Consumer and Scotts Lawn Service.

In the near term, the company expects to leverage pricing and trade programs, improve productivity and reduce SG&A expenses without impacting long-term growth so that its margins could improve. The U.S. business would be restructured from four to three regions, with the sales force focusing on merchandising and counseling, rather than in-store selling. In Europe, the business would be streamlined and the corporate G&A would be reduced by 10% so that the European business' profitability could be improved. In 2013. It expects to grow its EPS more than 25% to $2.50 - $2.75, and produce at least $250 million in operating cash flow.

Spectrum Brands also has a higher valuation than Central Garden. At $59.60 per share, it is worth more than $3.10 billion. The market values Spectrum Brands at 12.7 times its trailing EBITDA. Spectrum Brands, a diversified global branded consumer products company, operates in three main businesses: Global Batteries & Appliances, Global Pet Supplies, and Home and Garden Business. It has the presence in six continents, selling its products in around 140 countries.

What investors might like about Spectrum Brands is its leading position in most of its products. The home & garden control products rank second in the U.S. while the Pet supplies products is the number two in global pet supplies and number one in global aquatics. Its market leading position will definitely create a nice moat around the business to drive it forward. For full year 2013, it expects to generate around $240 million, or around $5 per share in free cash flow. By the end of fiscal 2014, Spectrum Brands targets to grow its free cash flow to $7 - $8 per share on an annualized basis.

My Foolish take

I personally think that Central Garden is a good stock to play on its turnaround. Due to a low valuation and the potential for further improvement in the business, investors should realize a good return ahead if they invest in the company at its current price. The probabilities of a successful turnaround seems to be high, given the expertise and high insider ownership of Bill Brown and John Ranelli.

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Anh HOANG has no position in any stocks mentioned. The Motley Fool recommends Scotts Miracle-Gro. 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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