The Short Case for Jarden Corporation

Jun.28.06 | About: Jarden Corporation (JAH)

Jarden Corporation (NYSE:JAH) is a leading provider of branded niche consumer products. The company operates in four divisions: Branded Consumables, Consumer Solutions, Outdoor Solutions, and Process Solutions.

The Branded Consumables segment (20% of sales) consists of products such as arts and crafts supplies, garage tools such as hangers and hooks, food storage products, and leading playing card brands such as Bicycle and Bee. The Outdoor Solutions (24% of sales) consists of Coleman, a leading brand among outdoor and camping enthusiasts while the Process Solutions division (5% of sales) offers two small businesses focused on custom injection molding and zinc applications for coinage, eletronics, and corrosion prevention. The Consumer Solutions division (51% of sales) focuses mainly on small kitchen appliances under the Holmes, Oster, Crock-Pot, and Sunbeam brand names.

Except for the Process Solutions division, JAH's products are sold mainly through large retailers and department stores such as Wal-Mart and Sears.

Certain products sold under the Outdoor Solutions and Branded Consumables divisions are sold through similar outlets as well as sports retailers, arts and crafts stores, and home improvement retailers where applicable.

JAH's Consumer Solutions segment is the largest contributor to the company's revenues. While this division maintains leading brands such as Oster, Mr. Coffee, Crock-Pot, and Holmes, it faces competition from other appliance manufacturers such Applica (APN), Salton (SFP), and Helen of Troy (NASDAQ:HELE). These competitors are considerably smaller than JAH and have largely struggled in operating performance due to both company specific issues as well as softness in certain product markets.

APN is best known for the Black & Decker Household Products line which includes various coffee makers, blenders, mixers, and automated jar openers. APN recently had difficulties with a line of coffee makers which had to be recalled and, as a result, may face uncertainty regarding Black & Decker's desire to maintain APN as the licensee for its household products line.

While SFP has struggled with its operations for many years, it has a broad portfolio of recognizable brands such as the Georg Foreman grill, Farberware, Toastmaster, and Juiceman.

Finally, HELE is a tangential competitor to JAH as its products primarily target personal care applications. HELE's product line include branded personal care appliances such as hair dryers, massagers, curling irons, hair setters, and clippers from brands such as Dr. Scholl's, Vidal Sassoon, and Visage Naturel.

Investment Rationale

The opportunity to establish a short position with JAH arose through a stock screen intended to identify companies that would face limited operational flexibility during challenging economic periods. JAH matched this screen's criteria because the company maintains significant debt levels while also experiencing declining operating margins.

While its operations are stronger than competitors such as APN and SFP, the company's working capital and interest expense significantly run through its operating income such that there is little cushion in the event of a business shortfall.

As a result, if the Company's product sales experience a minor hiccup, the result could be much more significant to JAH, which based on our analysis of management's expectations was already overvalued.

Additionally, a quick analysis of certain retailers such as Gander Mountain, a specialty retailer focused on camping and outdoor enthusiasts, indicates that retailers relevant to JAH's operations were struggling, which could serve as an early warning for future JAH results.

Further, retailers such Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) have been focused on inventory management and have been narrowing down overall product offerings in anticipation of lowered consumer demand. This has been reported by a variety of consumer products companies ranging from Playtex to even behemoths such as Proctor & Gamble.

In this case, JAH's operations could experience significant drag if certain products are not selected by large retailers. It is also likely that the stronger retailers are using price point even more aggressively than in the past in negotiating with product suppliers, such that even if products are carried by these retailers, supplier margins will suffer.

Overleveraged

JAH maintains approximately $1.4 billion in net debt, nearly 8.0x its LTM Free Cash Flow of $175.2 million. The debt was the result of the company's strategy to acquire a variety of consumer products businesses such as American Household Inc. and The Holmes Group. The general investment thesis was that once these businesses were fully integrated with JAH, cost savings would be realized and operating margins would expand.

This is basic M&A strategy for many companies, but in the case of JAH, it appears that by even factoring in management's expectations, operating margins would barely exceed 10% by 2008. Even worse, Free Cash Flow margins would likely be between 6%-8% due to the intensive working capital requirements (mostly in the inventory account) for JAH.

The Company also burned over $150 million in cash, or 65% of its cash balance, in its most recent quarter. Ultimately, JAH's debt balance limits the Company's flexibility. JAH's ability to service its $90 million in annual interest expense is not too impressive under fairly healthy operating conditions, let alone conditions in which retail markets may cool.

Based on cash flow, JAH does not have the capacity to borrow additional funds if it chooses to acquire another business, which has been the cornerstone of the company's strategy. In addition, after subtracting out its annual interest expense, the company has little cash available to greatly enhance its internal businesses.

Recent Cashless Earnings

Cashless earnings sometimes serve as a good warning of impending trouble and JAH's most recent quarter presented investors with cashless earnings.

While the Company reported EPS of $0.09 per share, its Cash Flow per Share [CFS] was -$0.87 per share. Cash flow is far more important than artificial accounting earnings and JAH's most recent quarter can serve as a warning sign of future trouble down the road. While this performance could be seasonal due to a slowdown from the prior holiday quarter, the magnitude of the difference between EPS and CFS is still much larger than expected.

Poor Corporate Governance

While poor corporate governance isn't always an immediate contributor to a company's performance, it can serve to demonstrate how aligned management and shareholders are. Based on the company's proxy, it is fairly easy to conclude that JAH has very poor corporate governance and oversight in place.

The Company maintains a 3-class staggered board with most of the board members part of an investment banking and LBO network. This fosters an environment of tenure and makes it difficult for investors to affect significant changes when necessary.

In addition, JAH management has excessive compensation packages in place given the company's size. JAH's market capitalization is approximately $1.9 billion. CEO Martin Franklin earns $1.8 million in salary, a discretionary bonus awarded by the Board of 100% of his salary, and another operating bonus of 100% of his salary to take in $4.5 million in total cash compensation.

However, the real offense is committed in the massive share grants, whereby Franklin receives $43.5 million is restricted shares, bringing his total compensation for 2005 to nearly $50.0 million or nearly 3% of the company's equity value.

In addition, the CFO and COO earned compensation of approximately $20.0 million and $8.0 million, respectively. These compensation figures do not include the $18.1 million of in-the-money options Franklin was granted or the $5.5 million and $2.1 million of in-the-money options the CFO and COO were granted.

In aggregate, the CEO, CFO, and COO's total compensation including options accounts for 5.5% of JAH's equity value.

The Board of Directors is protected by the staggered format and treats the company as a piggy bank for management, in effect doling out stock with no regard for common shareholders. In fact, because of the excessive stock grants, JAH has spent significant cash to acquire shares in the open market to reduce the impact of share dilution. This cash could be used for other purposes but is essentially being used to pay a fat management team.

Insider Sales

While insider sales are not always synonymous with company trouble, in JAH's case the level of insider sales simply demonstrates the lack of belief in the Company's prospects as well as the poor corporate governance that results in excessive stock grants to insiders.

Insider activity at JAH has consisted of market sales, option exercises, option sales, and stock grants. The last time an insider purchased shares in JAH was in May 2004. In fact, CEO Martin Franklin has never purchased shares himself, primarily because the Board of Directors has granted him nearly $45 million in JAH stock. Franklin has capably helped himself by cashing out $25 million in JAH stock since February of 2005 while COO James Lillie has cashed out $2.7 million in stock over the same time period as well. Not to be left out, CFO Ian Ashken cashed out $13.5 million in stock over the same time period.

High Level of Execution Risk

JAH's strategy has been to grow by acquiring various consumer brands. In order to acquire its chosen targets, JAH has issued both substantial amounts of debt and equity, with private equity firm Warburg Pincus owning 22% of the company through JAH's acquisition of American Houseland, Inc.

While growth through acquisitions can work for certain companies (Fidelity National Financial for example), JAH's growth required tremendous levels of debt and equity financing, which have diluted common shareholders and also increased the company's overall risk profile.

When adjusting for the acquisitions impact on revenues, JAH offers very modest organic growth prospects. Further, the Company has basically exhausted its financing capacity for acquisitions and its current capital structure allows for very little financial and operating flexibility.

As a result, there is a heightened focus on management's ability to streamline its operations to generate EPS growth. Execution risk for companies in which managers are true operators or have a strong management background is not always high but given Martin Franklin's past history as essentially a deal maker where he cobbled companies together and sold them in the private market results in a much higher level of execution risk.

Undisciplined M&A Strategy

The Company has appeared to maintain a "buy at any price" strategy over the past few years. JAH has acquired just $441.6 million in net assets over the past two years yet has paid $1.5 billion for these assets, resulting in goodwill of approximately $1.1 billion. While high levels of goodwill can be understandable for businesses with high levels of value through new technology and/or intellectual property, the businesses JAH acquired are manufacturers of basic household appliances and consumer goods.

Although some of these are leading brands, performance by competitors such as Salton as well as the prior bankruptcy of American Household, Inc., which owned the leading Sunbeam brand, demonstrates that brand leadership may not be as valuable in the consumer goods and small appliances sector.

While Franklin believes these acquisitions will be accretive to EPS, it is conceivable that the value of these businesses will prove to below the consideration paid, resulting in an eventual impairment of goodwill.

Weak M&A Target

One potential threat to a short position would be an acquisition by a suitor. In JAH's case, this threat does not appear likely for two reasons: valuation and debt levels.

The Company is currently valued at 10.5x LTM EBITDA and aggressive forward estimates peg the Company's P/E at 10.7x. While this may seem cheap, buyers would likely be skeptical of this figure as just four analysts cover JAH and more importantly, news from various consumer products companies suggest retailers are narrowing their inventory and pushing back certain previously ordered products.

As a result, JAH could be much more expensive on a forward P/E basis. On an Enterprise Value/EBITDA basis, JAH is fair to overvalued. Businesses such as JAH should not command multiples much higher than 7.0x because of the low margins and operating metrics. There is nothing special about JAH's management team, its operating model, or brands to warrant a premium valuation.

This high valuation will likely give pause to potential acquirers. In addition, this valuation is way too high to be taken private by a financial buyer.

The second reason why the company would be an unlikely M&A target is its significant debt levels. An acquirer would have to assume the $1.5 billion in debt on the company's balance sheet to consummate a transaction.

Given the company's operating performance, its current stage in terms of streamlining operations, and its valuation and debt levels, it does not appear that a buyer would be willing to pay much to buy JAH. However, the flip side of this belief is that JAH is a relatively small company at just $1.9 billion in market cap and $3.6 billion in enterprise value which could be readily acquired by a much larger appliance company. Even so, the larger appliance companies such as Whirlpool (NYSE:WHR) are still less than $10 billion in enterprise value and JAH would not be an immaterial transaction.

Stock Significantly Off Annual Highs

JAH peaked in September 2005 at about $42 per share, representing its annual and historical high. Since then, the stock has experienced pressure, dropping to $25 before rebounding to $35 through the spring of 2006. Currently, JAH trades for approximately $28 per share or about 33% off its 52 week high.

Leading Market Brands

Despite the news of other consumer products companies facing difficulties from retailers that are reducing product inventory, JAH does possess leading brands across a number of appliances and products. In the event of an inventory reorganization by major retailers, the Company should be well positioned to have many of its products make the cut in obtaining shelf space.

Nonetheless, other appliance manufacturers such as SFP and APN maintain leading brands in their own niche consumer appliances as well and as performance by these companies (the formerly bankrupt American Household, Inc, and larger companies such as WHR) have proven, brand names do not always carry the same cachet in the small appliance category.

Short Squeeze Potential

JAH's short interest has been high over the past year, but fairly consistent in overall short interest.

Currently, approximately 13% of JAH shares are held short while Days to Cover has increased to 14.4 from 12.0 the prior month. This presents the opportunity for a short squeeze which could cause substantial losses to a short position.

Full Disclosure: The author's fund is short JAH

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