Spectrum Brands Bets Big on a Smaller but Brighter Future

In this segment from Industry Focus, Vincent Shen and senior Motley Fool contributor Asit Sharma conclude their discussion of mid-cap consumer goods conglomerate Spectrum Brands (NYSE: SPB), including the strategy behind its $2 billion sale of the Rayovac battery business.

As it turns out, there's some method to the madness of selling off 40% of your annual revenue stream. The cast unpacks that rationale and the reasons why investors should be cautious but hopeful as they evaluate Spectrum Brands for their own portfolios.

A full transcript follows the video.

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This video was recorded on March 6, 2018.

Vincent Shen: What else has jumped out to you in terms of the stock and this story, Asit?

Asit Sharma: This story isn't quite as rosy, to date, as the Pool Corporation story. The stock has given a decent return to investors. Over the past five years, it's returned exactly 100%. That's not a bad return. However, it's seeing some of the same challenges that its larger peers are experiencing. The strategy that this management team is taking, vis- à -vis the more aggressive risk profile, is a combination of what we've discussed on the show, two of our favorite companies to talk about, Procter & Gamble and Unilever. It's taken strategies from both of their playbooks. Procter & Gamble sold its own Duracell battery business to Warren Buffett's Berkshire Hathaway in 2016. Nobody wants to be in this battery business. It's a low-margin business. In fact, batteries dragged down the operating margin of this segment to 11%, while other segments, such as the home segment, generate operating margins of 22% for Spectrum Brand Holdings. So it's getting rid of a low-margin business, taking that money that's been set, and it's going to buy some faster-growing businesses in more promising sectors.

First item of business, of course, is to take care of that debt, as Vince mentioned. It's a little highly leveraged. It has a debt to EBITDA multiple of about 5x, which is a bit high. That'll come down after it gets this infusion of cash. Looking at Unilever, what Unilever has done, which we've talked about on the show, they've been very aggressive in buying up small companies in what it deems to be promising sectors. Like P&G, divest the stuff that isn't making money, and like Unilever, spend that cash for bolt-on acquisitions in the areas like home improvement and pet care, and perhaps even some more of these products such as the Black Flag and the auto Armor All, STP, that we talked about. The company wants to leverage its financial structure after it pays down debt, we've seen this before with consumer goods companies.

The bottom line is, like its larger competitors, so far, Spectrum Brands, if you look at their most recent quarter, has 2% organic revenue growth. It's just in line with that bigger sector. But it's a smaller, tinier company than a company like Unilever. So the path to growth is a lot smoother if they buy the right businesses. That's the magic. It's not just going out and spending when you're flush with cash. It's identifying the ones which are a good fit for your business and your management team.

I think it's at sort of an inflection point here. Although that stock chart doesn't look quite as attractive as Pool Corporation, I think going forward, they have the tools to spark some revenue growth and some operating income growth, which may lead to a higher valuation, which I'll talk about in just a second. What are your thoughts on the strategy and valuation, Vince?

Shen: I'll just add a little bit of detail about some of the things you said. For example, on that debt side, 5x, I agree, that's definitely higher than where management wants to be. They have over $4 billion of debt on their balance sheet. But management has also said they're not going to dedicate too much of the proceeds that they're getting from the sales of their appliances and batteries business to reduce that level. They're thinking something in a range of maybe 3.5x to 4x, something more sustainable. Then, the bolt-on acquisitions, definitely something the company is looking at, it's something they have emphasized in their communications to the investment community.

And every company is, of course, always working on this, but they're also trying to work on better marketing and product innovation, and crossing some of the current businesses that they're in into new categories, as you mentioned. More channels, more categories, more countries. On those first two, for example, it might be expanding, in terms of their Armor All auto care business into air fresheners for the car, and for pet foods, for example, getting into mass channels and improving the distribution for these products.

In terms of valuation, the stock has taken a beating in the past year, down 25%. Though, looking out further to about 5 to 10 years, it's managed to outperform the broad market. In terms of valuation, this is a little bit difficult because of all the changes that are going on at the company. That battery business was 40% of the top line previously. It was considered the core of Spectrum Brands, the company. If you look back five or seven years, it was by far the biggest part of the company. Now, for them to exit it, I think it surprised a lot of investors.

The stock trades about 23x forward estimates. There's still some uncertainty in factoring how things change with that merger with HRG, too. This one was really tough on the valuation front and looking out into the future, for me to grasp everything that's going on. I don't know how you felt about it, Asit.

Sharma: Yeah, it's complex. There are a lot of moving parts and pieces. Some of the things which hit the stock in the past year included restructuring charges that the company took on some of those lower-growth businesses, as well as consolidating its footprint for its Auto business in Dayton, and also consolidating its Hardware and Home Improvement distribution in Kansas. Those were some one-time events that really pushed the stock down a little bit. But then, with this merger, that makes it a little bit more difficult to value. Although, the merger, as we said, is with their major stockholder, which already owns 60%.

I want to point out one thing about that merger. The company which now will be the combined entity by merging, has an insurance company that they've picked up, an insurance arm. I think this will be something that gets divested in a few years. This is a $10 billion deal, as we mentioned. The insurance company is called Front Street Re, it's based in Delaware. That's owned by HRG, the majority shareholder. It's not a great fit with this combined consumer goods business. That could lead to a little bit of a bounty a few years down the road. We've seen sometimes, when we see consumer goods companies shuffle the deck and play cards and trade pieces back and forth -- that one piece that doesn't fit tends to get spun off in a few years, which rewards shareholders.

One last thing from my side to add, I do like the idea of these brand expansions. As you mentioned, Vince, they have a number of opportunities in the global side of things, and maybe employ something like Coca-Cola's model, which Coke calls "lift and shift". That's lifting a domestic brand and shifting it onto another continent. Spectrum is doing that with the Iams pet food, which is very popular in the U.S. They're lifting that and shifting it to Europe. That's just one example.

All in all, don't plunge your whole portfolio into this company. But definitely keep it on your radar screen. As I said, I think it's at an inflection point. If we see a few quarters of good performance, let these acquisitions settle, this might be a very interesting play in the mid-cap space which would grow faster than its peer competitor conglomerates that we talk about, like the P&Gs and Unilevers, which only stay 1% to 2% above the market over the long term.

Shen: Thanks, Asit! I'll just add to that in terms of, if you take a position, it's definitely a case where you have to believe in the story that management's telling regarding the new direction of the business. This decision to spin off the battery business and small appliances, and their strategy in terms of how they're going to leverage the remaining segments, those businesses, and grow them, whether that's with new channels or into the new countries with that strategy you just mentioned, Asit.

Asit Sharma has no position in any of the stocks mentioned. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool recommends Pool. The Motley Fool has a disclosure policy.