I came across Spectrum Brands (SPB) while I was looking into Goodhaven Funds, the new value investment fund created by two former Bruce Berkowitz lieutenants, Larry Pitkowsky and Keith Trauner. While examining the current holdings of Goodhaven what I found most interesting, other than the fact that Larry and Keith have none of the bullishness their former boss has towards the financial sector, is that their largest holding is in Spectrum Brands, a company focused on marketing a variety of consumer products. Their bullishness on the company's future prospects and previous track record of success led me to dig deeper.
The origin of Spectrum can be traced back to Rayovac, a Wisconsin based battery company founded in 1906. Weary of simply marketing batteries, the company went on a debt fueled acquisition binge in the early 2000’s that led to the company branching out into among others, pet, garden and insect control. While the company become more diversified through these acquisitions, it also became weighed down by the large interest payments it had taken on.
Unable to sustain the heavy amount of leverage it was operating under, Spectrum entered Chapter 11 in 2/3/2009 and exited on 8/28/2009, having wiped out the previous equity holders. Today, the company operates in three main segments:
- Global Batteries
- Pet Supplies
- Home and Garden
Through these segments, Spectrum markets and sells a variety of consumer brands such as Rayovac batteries, Remington shavers, George Foreman grills and Hot Shot insect repellent, amongst many others. The products that Spectrum offers are positioned in the “value category” meaning that they function just as well or better than the more “name brand” products but are markedly cheaper. Spectrum believes this is the correct strategy to continue to pursue as the macroeconomic picture is still pointing to depressed consumer spending in the near future. The company traditionally targets top line growth of at or slightly above GDP, with EBITDA at 2-3x GDP.
Free Cash Flow Yield
The most appealing aspect of Spectrum as an investment opportunity is it’s current free cash flow yield. For fiscal year 2011, the company was able to generate $190M of free cash and is projecting at least another $200M in 2012, or $4 a share. At the company’s current market capitalization of $1.3B, this is a FCF yield of 15%, a high yield considering that the company possesses stable and diversified streams of revenue and a portfolio of products that are considered non-discretionary. Buffett disciple Mohnish Pobrai believes that a company with no growth but consistent cash flows should be valued at around 10x free cash flow, which implies that Spectrum is currently undervalued by 50%.
Company management has been using the excess cash to aggressively pay down debt while also searching for accretive bolt on acquisitions, such as their recent purchases of Black Flag and TAT brands which were added to their Home and Garden division. The company was able to make $225M of debt reduction payments in 2011, reducing their current leverage to 3.4x EBITDA. Two years ago it was 5x, demonstrating management’s commitment to lowering the company’s debt burden.
Investors can expect two ways that the company will further grow their free cash flow over the coming years. Operational cash growth through top line expansion and cost cutting measures should provide 1%-3% growth while debt reduction/bolt on acquisitions should provide another 8-10% increase. Spectrum’s current long term debt is $1.5B at an average interest rate of 9%. If the company cannot find any additional accretive acquisitions, they can simply pay down their debt and grow free cash flow that way.
Typically high cash, low growth companies come accompanied with some type of dividend. As it stands, Spectrum cannot issue a large dividend based on debt covenants it currently operates under. However, the company will have the opportunity to refinance a large portion of it’s debt in August 2012. Given its fast improving capital structure and large free cash flows, this refinancing should have the duel effect of lowering the company’s effective interest rate and open up the possibility of using a large portion of future cash flows towards dividend payments once the restrictive debt covenants have been removed. Spectrum’s management is compensated in large part on their ability to grow free cash flow; ensuring that their interests are in line with shareholders.
The Wild Card
By far the largest shareholder in Spectrum Brands is Phil Falcone, who through Harbinger Capital Partners and Harbinger Group owns over 50% of the company. Mr. Falcone has very recently been in the financial news for all of the wrong reasons.
There was the notification that he was under possible investigation by the SEC for, among other things, allegedly giving Goldman Sachs preferential treatment by allowing the investment bank to withdraw $100M from Falcone’s flagship fund while at the same time denying other client’s redemption claims. This will only increase the the number of attempted withdrawals from Harbinger Capital which has already seen itself shrink from a 2008 peak of $26 billion to $5.7 billion due to long bouts of underperformance.
Adding to Mr. Falcone’s problems, news has recently broke that LightSquared, his $3 Billion bet on the future of telecoms, is running out of cash. As stated in the article, the company needs “to raise substantial capital beyond the beginning of the second quarter of 2012 in order to have sufficient liquidity.” Being by far the largest equity owner of LightSquared, Mr. Falcone will most likely have to find ways to raise cash for the company if he does not want to see his investment fold. This brings us back to Spectrum.
Whenever there is negative news surrounding a controlling shareholder of a company, the company tends to see its stock depreciate as collateral damage. However, this merely provides a better entry point for investors whose decisions are not solely guided by New York Times' headlines. The stock depreciation caused by the negative press currently being experienced by Mr. Falcone has nothing to do with the operational aspects of the company. The free cash flow yield for 2012 will still be $4/share and the only consequence of a falling stock price is a higher FCF yield. If the company starts to approach the low $20’s level, investors would be well served to take a closer look.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SPB over the next 72 hours.