Seeking Alpha
Hedge fund manager, long/short equity, bonds
Profile| Send Message|
( followers)  

I've received a few emails regarding my short position on Jarden Corp. (JAH or the "Company") given the market malaise which has taken all stocks down. Most of the emails, irrespective of whether the person was an investor, a short seller, or just an observer of JAH, expressed curiosity whether I was still short the Company. The short answer is "yes" and given JAH's latest Shareholder Rights/Poison Pill announced on November 20th, I thought it might be a good time to provide an update. The Shareholder Rights plan was adopted because JAH's Board wanted to protect investors from opportunistic investors or buyers given the current share price. I can understand management wanting to seek maximum value for its company but I found the notion of JAH being attractive to any strategic buyer at even the current price laughable, considering JAH's weak balance sheet in the current macro environment and the lack of any real assets other than intangible brand names and goodwill.

EXHIBIT I: JAH Q308 BALANCE SHEET

As Exhibit I illustrates, JAH is a highly levered company with $2.6B in net debt. While maturities are not an issue as most of the Company's debt is due well past 2010, the concern is that the Company caters to the consumer when the U.S. is heading into one of the nastiest, and really first, modern-era consumer-led recession. JAH's debt load alone would serve as a major deterrent for a potential buyer even at current prices and valuations considering the acquirer would have to assume this debt.

Second, what would an acquirer really get by purchasing JAH? A strategic buyer might have similar products with lesser known brands or vice versa. The buyer could stop rolling out its lesser known brands of playing cards and just keep JAH's while eliminating some of JAH's lesser known items relative to the buyer's. Doing this would allow the buyer to command higher price points and drive gross profits. In addition, the buyer could rationalize redundant functions and save in SG&A expenses. The combined result would be a boost in sales for the two companies where only the best brands/products are kept, resulting in better price points, less competition and thus higher gross profits which flow through a streamlined organization with controlled SG&A - resulting in high operating income.

That's the typical M&A pitch but the execution is tricky and JAH's balance sheet leaves no room for error. First off, it's important to note that JAH itself is in a perpetual state of reorganization, recording reorganization and M&A charges since 2005. This likely lowers the prospect of a buyer experiencing a smooth integration experience. Next, as Exhibit I shows, a buyer really doesn't get much in the way of real assets by acquiring JAH. JAH has some fixed assets in PPE that could be of use in production or possibly be rationalized by a strategic buyer, meaning the PPE would have little value. Aside from the PPE and some inventory, an acquirer would be stuck with $2.6B in assumed debt, $1.1B in intangible assets consisting of trademarks for JAH's various brands like Crock Pot, Bicycle playing cards, Coleman, K2, Rawlings, and other brands, and $1.7B in goodwill related to JAH's purchases of these brands. Excluding goodwill and intangible assets, JAH actually has a $1B shareholders' deficit, meaning there really is no tangible book equity. With $2.7B in intangible assets and goodwill, not to mention additional goodwill from having to pay a premium to buy JAH, any buyer would have to assume that JAH's various brands could generate significant value such that assuming $2.6B or more (depending on financing) of debt and additional goodwill would be judicious use of a potential buyer's capital and generate an adequate return on invested capital.

This comes back to determining how attractive JAH is to not only a strategic buyer but also a passive investor. The Company is a consumer products company selling household goods and leisure products in a consumer-led recession that has been increasing in severity since October. This would be tolerable for a company with a clean balance sheet but the current deflationary environment can be brutal for debt-laden companies, particularly those that are working capital intensive and do not generate any real free cash flow until after Q4, like JAH.

JAH's management points to its Net Debt/EBITDA coverage which excludes certain debt components and includes a variety of add-backs, meaning at the very least net debt is understated. "One-time" add-backs have been a consistent part of JAH's reporting since 2005 and apparently as long as the add-backs are disclosed, they're valid. My issue is that one year of add-backs can be understandable but when this occurs every year and these add-backs become a material part of adjusted EBITDA, its viability can be questioned.

EXHIBIT II: JAH GAAP TO NON GAAP RECONCILIATION

What's clear is that while analysts buy the inflated numbers, the markets have become more skeptical. Nonetheless, to illustrate the impact of equity deflation against a highly levered company like JAH, let's utilize the LTM Q3 08 "as adjusted EBITDA" figure which is ~$650MM. With the consumer-led recession increasing in severity, what is a reasonable price to pay for JAH's EBITDA? Buzzwords like "staycations" and "cocooning" used by management have been fully bought by the analysts but the prevailing issue is that JAH sales are likely going down on a comparable basis in 2009. This means trailing valuations should be fairly low for JAH given 2009 results will be under major pressure.

EXHIBIT III: JAH EV/EBITDA VALUATION ANALYSIS

The yellow area is where I think JAH should ultimately trade. Some might be skeptical, asserting that JAH should trade for well above 6.0x EBITDA and that at those prices JAH would trade at a low multiple against forward estimates. In a strong consumer and economic environment, JAH could justify a higher multiple. If JAH had a clean balance sheet, it could justify a higher multiple. But heading into a year where results will be under major pressure, it's more likely that 2009 consensus estimates are far too high for JAH and the Street is ignoring potential balance sheet problems. Also, the $650MM in EBITDA is As Adjusted for a variety of items including a $119MM Fair Value inventory adjustment, $50MM in reorganization costs, $5MM in other integration costs. These are a lot of add-backs and it's tough to have it both ways where an inflated EBITDA figure loaded with add-backs and stock comp gets the benefit of a high market multiple.

When future results come under pressure, valuations generally experience compression on a forward basis to coincide with future sales growth moderation and operating margin compression. This is due to optimistic Street estimates that usually are not founded in reality so a 2.0x forward EPS could really be 8-10x EPS after the fact. For a levered company like JAH, margins matter even more because the Company needs to stay within its leverage ratio which has a maximum allowable ratio of 4.25x Net Debt/EBITDA. To JAH's credit, these covenants were set when bankers were, as Chuck Prince said, "dancing", so they are fairly loose as Net Debt excludes the $250MM in securitization facilities and EBITDA allows for a number of add-backs. On that basis, JAH's leverage is 3.6x Net Debt/EBITDA as there's roughly $2.35B in net debt when excluding the A/R facility and about $650MM in adjusted EBITDA. However, in September 2009, the leverage ratio will be stepped down to 4.0x Net Debt/EBITDA and I think the Street may be ignoring the possibility that JAH could face the risk of breaching that ratio.

Q308 was viewed as a good quarter for JAH due to higher margins and better than expected sales. However, 2008 is really the first full year of the K2 integration and the important takeaway is that Q308 sales of $1.45B were just 0.8% higher than Q307 sales on a pro forma basis, which assumes K2 was acquired at the start of 2007. More importantly, Q308 benefited from sales tied to Hurricanes Ike and Gustav, not necessarily a repeat occurrence one can count on in 2009. For 2008, JAH will generate about $5.5B in sales and should have gross profit margins of 27-28% for the year and about $1B in SG&A expenses. The Street looks fairly aggressive in 2009, projecting just a ~2% sales decline and in many cases margin improvements. This seems rather unrealistic and is why I feel JAH's depressed stock price can still fall further.

The Company operates four key groups: Consumer Solutions (33% of sales), Outdoor Solutions (46%), Branded Consumables (15%), and Process Solutions (6%). Since 2006, the Consumer Solutions, which sells blankets, coffee makers, blenders and humidifiers, has experienced slightly negative sales growth per year, which is looking to continue in 2008. The same can be said for Branded Consumables, which sells playing cards, firelogs, matches, smoke alarms, arts and crafts and other items, which has been flat at roughly $800MM in sales per year. So during generally good times in 2006 and 2007, these two units experienced no sales growth. Process solutions, which offers plastic products such as cutlery and packaging for OEMs, is around a $340MM business and should be flat from 2007. The biggest segment, Outdoor Solutions, which offers various outdoor and sporting goods such as baseball gloves, skis, and tents, has been bolstered through the K2 and Pure Fishing deals but 2008 pro forma sales figures would indicate there's been very little organic growth. Some of that growth, as previously mentioned, was influenced by hurricane-related sales. These sales results were produced in better times relative to what's coming in 2009, yet these segments really have not generated much in terms of growth.

Going into 2009, the Street is projecting a sales decline of just about 2% and I think this could be very optimistic. Listening to the conference calls and reviewing results for companies like Dick's Sporting Goods (NYSE:DKS), Big 5 Sporting Goods (NASDAQ:BGFV), Cabellas (NYSE:CAB), and Gander Mountain (GMTN) indicate leisure / sport / outdoor sales are under pressure like much of broader retail. Big-box retailers like Wal-Mart Stores (NYSE:WMT) might be outperforming their peers but "on the ground," sales even at the best retailers that cater to a tough consumer environment are under pressure. Target Corp (NYSE:TGT) is also struggling and most importantly, many of these companies have scaled back their expansion plans so the Company will not get the usual "tagalong" benefit in terms of sales growth. The aggregate growth in retail space is moderating and some companies, like Linens N Things, are liquidating. All of these factors will have a negative influence on JAH. In addition, nearly 35% of the Company's sales are in foreign currencies. With the USD benefiting from a flight to quality against other currencies, if this trend persists JAH sales growth will face additional headwinds in terms of currency translation losses.

So in summary, JAH had organic sales that were rather weak during healthier economic periods and is now entering a severe consumer spending slowdown in 2009. I think it's very possible that JAH sales for 2009 are closer to $5B, reflecting a 9% decline, compared to the -2% decline by the Street. If the USD appreciates about 3% against JAH's foreign currencies and U.S. sales go up 3%, JAH's aggregate sales will be flat in 2009. On a pro forma basis, JAH's sales growth in 2008 has been 0.8% on a pro forma basis and as previously stated, other segments have experienced flat to negative growth in recent, more prosperous years. The potential drop in sales in 2009 is where the risk really presents itself.

EXHIBIT IV: JAH 2009E CREDIT ANALYSIS [click to enlarge]

Exhibit IV assumes JAH sales decline by 9% and shows its sensitivity level in terms of debt coverage based on gross margins. SG&A for JAH should be ~$1.04B in 2008 and JAH should achieve gross margins of about 28%. If sales decline by 9% in 2009 and JAH maintains similar gross margins, it will basically be hitting the stepped down leverage covenant in 2009 (September is when the covenant steps down) and will make its bankers nervous. In a tough environment, it's difficult to preserve margins, and gross margin degradation of 100 basis points or more is not implausible. To be generous, an "As Adjusted EBITDA" row was included which allows for another $100MM in additional add-backs that JAH management will "find" from the traditional estimated EBITDA figure. In addition, no reorganization charges were included in the P&L despite the fact that these charges are commonplace yet are always ignored by analysts in terms of the impact to EPS. In summary, Exhibit IV presents a very clean overview of JAH's P&L as the Company would report it to the Street.

One could consider a 9% sales decline too severe but even with a 6% decline and gross margins just ~50 basis points below 2008 gross margins, JAH would press up on the Net Debt / "As Adjusted EBITDA" stepped down covenant. In addition, that Net Debt of $2.35B excludes the receivables securitization facility JAH employs while the "As Adjusted EBITDA" allows for $100MM in whatever add-backs I'd envision management could find. And despite that, it does not take much to encroach on the Company's leverage covenants. That's the real risk with JAH. The 2009 estimates analysts are currently using look ridiculously optimistic and the downside to utilizing the Street's assumptions is the possibility of encountering credit issues, given the Company's considerable debt load heading into a prolonged consumer-led slowdown.

DISCLOSURE: SHORT JAH

Source: Analyst Estimates for Jarden in 2009 Look Ridiculously Optimistic