Last week, the market finally caught on to the “buy at any price to drive EPS scheme” and JAH may be in the midst of a revaluation. It’s been rather interesting to observe the level of damage control CEO Martin Franklin tried to establish by his appearance on CNBC followed by the announcement that he and CFO Ian Ashken purchased a paltry $2.0MM in JAH shares following the approximate 10% haircut in valuation. Table I outlines the total JAH stake held by Mrs. Franklin and Ashken along with their total 2006 compensation.
Given that the CEO and CFO made $5.0MM and $2.3MM in total compensation in 2006, respectively, and already own stakes in JAH worth $201MM and $35MM, respectively, the notion that the Company would feel it necessary to issue a press release stating that these two men purchased $2.0MM in JAH stock seems ridiculous. What’s more, readers should note that management receives cash compensation based on EPS targets, as opposed to equity compensation for achieving those milestones. While management already owns significant JAH equity, this is mostly in the form of “free” options and stock awards granted by the Company’s “clubby” Board of Directors so the fact that management can receive a boatload of equity any time makes the purchase price of acquisitions nearly irrelevant as far as their overall compensation is concerned.
In addition, JAH shareholders should not overlook the fact their CEO and CFO are also busy focusing their efforts on the acquisition of hedge fund GLG Partners by their recently established shell company, Freedom Acquisition Holdings (“FRH-U”). Mr. Franklin serves as FRH-U’s Chairman, owning approximately 20% of the shell company and JAH shareholders should either be impressed or concerned that their CEO and CFO can effectively divide their time from integrating acquisitions in JAH while also maintaining a significant economic stake in a shell company merging with a large hedge fund.
One look at the Company’s latest quarterly results illustrates how weak JAH’s balance sheet has become. Table II presents a summary balance sheet from the Company’s latest Q. The highlighted portions demonstrate significant areas of weakness in terms of the Company’s capital structure. The most critical weakness is the negative tangible book value. JAH’s overpriced acquisition spree in recent years led to accumulation of significant Goodwill and Intangible assets.
As a basic consumer products manufacturer, the real value of this goodwill and intangible assets will come in to question in the coming years, particularly if a consumer slowdown significantly impacts the performance of certain acquired brands. Keep in mind that some of JAH’s brands had previously experienced financial difficulty a few years ago before the Company acquired them.
Using debt to acquire targets at reasonable prices is a good strategy and growth can be generated through rapid deleveraging. The problem with JAH is that it continues to overpay for businesses that offer average to below average cash flow generation and significant working capital needs which results in a high debt balance that never delevers and rising interest expense to the structure of the debt issued. The Company has a great deal of exposure to general consumer/retail demand with its outdoor/recreation offerings and household appliance focus which will likely place additional pressure on the Company in the coming year.
Even focusing on JAH’s July 17, 2007 8-K which outlines the pro forma combined JAH/K2 (“KTO”) entity shows a weak enterprise. The combined entity’s LTM EBITDA would be $577MM which of course includes typical JAH adjustments with $76MM in addbacks not including D&A. Further, the synergies from the transaction should result in an additional $68MM in savings resulting in $644MM in pro forma adjusted EBITDA. However, the return metrics are not that spectacular given the Company’s valuation.
Assuming JAH achieves $644MM in EBITDA, its tax provision should be in the $110MM range resulting in $534MM in EBITDA less Cash Taxes which results in an ROIC of just 12.7%, not very attractive considering the significant pro forma adjustments which may or may not materialize. If these cost savings are not achieved, ROIC drops to 11.3%. Finally, if one is skeptical about the variety of addbacks including perennial “one-time” reorganization and integration costs and accountings, ROIC could be under 10%, resulting a spread over JAH’s WACC that is not very attractive, especially considering the amount of gearing required to get to the stated ROIC.
JAH is at best a 25% gross margin company that can generate operating margins of 7-9%. The depreciation generated by the Company is more than offset by the capital expenditures and working capital needs result in a business with unimpressive cash flows. With a management team that is focused on a variety of other considerable projects such as FRH-U, a softening consumer market, and a Company with increasing balance sheet risk, JAH should remain an attractive short for the coming year.
Disclosure: Author manages a hedge fund that is short JAH