Spectrum Brands: In Need of More Than Doggie Doo Relief (SPC)

| About: Spectrum Brand (SPB)

Shares of Spectrum Brands, Inc. (NYSE: SPC), formerly known as Rayovac Corp. (as in batteries), are trading down (47.5%) in the last 52-weeks. The only stakeholders in the Company, which also makes pet foods, lawn and garden products, and insect control products, who seem to have made any money, are the directors and top executives.

In FY 2005, David A. Jones, Chairman of the Board and CEO, Kent J. Hussey, President and COO, and Randall J. Steward, CFO, each earned salary and (cash) incentive compensation of $918,500/$938,000, $548,500/$462,00, and $428,000/$281,000, respectively.

Spectrum Brands filed its DEF 14A on March 24, 2005, which revealed that David A. Jones also made "Other Compensation" of $272,000, including approximately $37,000 for use of a company-owned automobile, $44,500 related to personal use of Company aircraft and $191,000 related to a supplemental executive retirement program.

Kent J. Hussey picked up an extra $159,000 in "Other Compensation,"including approximately $24,000 for use of a company-owned automobile, $20,000 related to the use of Company aircraft and $115,000 related to a supplemental executive retirement program.

Randall J. Steward brought home $118,000 on "Other Compensation," including approximately $8,000 for relocation, $20,000 for use of a company-owned automobile and $90,000 related to a supplemental executive retirement program.

The Company also disclosed that a previous employment agreement with David A. Jones granted him the right to purchase his Spectrum-owned home for one dollar. In April 2004, the CEO waived such right in exchange for the Company paying him the fair market value of the property, $993,000, plus an amount equal to 50% of leasehold improvements to the property of $38,000.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. On February 7, 2005, the Company completed the acquisition of all of the outstanding equity interests of United, a leading manufacturer and marketer of products for the consumer lawn and garden care, pet supplies, and household insect control markets in North America. Excluding options, the Company’s CEO and trusts for his family members, collectively owned approximately 203,000 shares of United common stock as of immediately prior to the Merger, which shares were converted into an aggregate of approximately 36,000 shares of Company common stock pursuant to the merger, worth approximately $1.4 million.

For fiscal 2006, Directors will get paid an annual retainer of between $40,000 and $50,000 (dependent on committee memberships) for their service as directors, excluding share rights, too. Each director shall also receive $1,500 for each meeting of the Board of Directors that he or she attends ($750 if participating telephonically) and $1,500 (or $2,500 in the case of committee chairpersons) for each meeting of a committee of the Board of Directors.

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Now that the 10Q Detective has exposed to our readers some of Spectrum Brands' dirty laundry, we will comment on what our readers really want to know — Is Spectrum Brands an attractive valuation at current prices? [ed. note. for more on Spectrum’s goings on, we recommend that our readers read the March 27, 2005, comments of Michelle Leder from footnoted.org].

On January 31, 2005, Spectrum Brands Inc. said that its first-quarter profit was dragged down by the discontinuation of some operations and weaker sales, as it faced what it described as "tough consumer spending environment and significant inflationary pressures."

The Company reported earnings from continuing operations in the latest quarter ended January 1, 2006, of 12 cents per share, on revenue of $620 million, compared to pro forma share-net of $0.30 on sales of $490.8 million last year.

The 26% increase in net sales for the fiscal 2006 was is due to sales of products of the companies acquired in fiscal 2005, partially offset by declines in legacy battery (13.7%), shaving and grooming (8.1%), and personal care products (11.1%).

Analysts polled by Thomson Financial, who typically don't include charges in their estimates, expected the company to earn, on average, 22 cents per share for the quarter on $684.8 million in revenue.

Shares of Spectrum Brands, which have traded between $16 and $46.11 over the last 52 weeks, fell 11.9% to $18.91 per share from the prior day’s close.

In recent weeks, anticipating a turnaround in the Company’s operating environment, investors have bid the stock price of Spectrum Brands back to pre 1Q EPS valuations. Citing management’s ability to pass on rising commodity costs and additional cost savings from ongoing restructuring efforts, some analysts who follow the Company believe that the stock cannot be ignored at current prices.

For the full year 2006, Spectrum Brands is proffering sales guidance of $2.7 billion, and said it expects diluted earnings of between $2.10 and $2.20 per share, while analysts are looking for $2.09 per share on $2.78 billion in revenue. Next year, consensus analyst estimates call for Spectrum Brands to earn $2.54 on revenue growth of approximately 1.1% to $2.81 billion.

Spectrum Brands looks like a bargain, discounted at 8.4 times 2007 EPS compared to its peer group: Matsushita Electric Industrial Co. Ltd (MC-$21.71) goes for 26.2 times FY 2007 EPS estimates, Energizer Holdings, Inc. (ENR-$54.17) priced at 11.8 FY 2007 numbers, and a 21 multiple on the personal products industry.

Reality check— remember, you read it here first . The 10Q Detective does not believe that FY ’06—or FY ’07—estimates are tenable, which means that the valuation of Spectrum Brands will have to be re-calculated—at lower stock prices.

Although Spectrum Brands is successfully diversifying away from its dependence on battery sales, consumer batteries still account for approximately 41% of net sales [compared to 90% in FY ‘04].

The Company’s general batteries category includes alkaline and zinc carbon. Spectrum sells a full line of alkaline batteries (AA, AAA, C, D and 9-volt sizes) for both consumers and industrial customers. In the U.S. alkaline battery category, the Rayovac brand is positioned as a value brand. In Europe, the VARTA brand is competitively priced with the competition. In Latin America, where zinc carbon batteries outsell alkaline batteries, the Rayovac brand is competitively priced with the competition.

Spectrum Brands is currently the largest worldwide seller of hearing aid batteries, sold through retail trade channels and directly to professional audiologists under several brand names and under several private labels, including Beltone, Miracle Ear, Siemens and Starkey; Rechargeable batteries and chargers are sold under the Rayovac and VARTA brands; and, the Company’s specialty battery products include photo batteries, lithium batteries, silver oxide batteries and keyless entry batteries.

In August 2005, to combat significant increases in raw material costs, Spectrum Brands raised the retail prices of Rayovac brand alkaline and zinc carbon battery by 6% to 7% in the U.S. This price hike was quickly followed by its competitors, including Energizer, Panasonic (Matsushita), and Duracell (Gillette).

Zinc continues to be Spectrum Brand’s largest commodity exposure, with current per metric ton pricing significantly higher than last year. The price of zinc has more than doubled in two years, driven by commodity fund buying, weather-disrupted issues (such as the recent hurricane that disrupted Australian operations), and strong industrial demand. Prices recently touched record highs of $2,530 a metric ton for three-month delivery.

Going forward, the 10Q Detective does not believe that Spectrum Brands will be able to offset continued increases in raw material costs through cost control efforts or efficiency gains. Also, the Company continues to lose share to private label offerings, which carry substantially lower gross margins.

According to industry forecasts, demand in the $10.7 billion U.S. battery industry will grow 5.5 percent per annum through 2007. Growth will be driven by strong demand for battery-powered electronics (e.g., digital cameras, wireless phones), and increasing production of electrical/electronic equipment. An ongoing shift toward improved, more expensive batteries (e.g., high-rate primary alkaline and lithium) will also support gains.

Despite forecasted growth in the battery industry, the 10Q Detective does not believe that Spectrum Brands will see any meaningful top-line growth in THEIR battery business. The battery category remains highly competitive—for limited shelf space and consumer attention.

The Company also faces competition from the private label brands of major retailers, particularly in Europe. The offering of private-label batteries by retailers creates pricing pressure. According to Spectrum Brand’s management: “Typically, private-label brands are not supported by advertising or promotion, and retailers sell these private label offerings at retail prices below competing brands. The main barriers to entry for new competitors are investment in technology research, cost of building manufacturing capacity and the expense of building retail distribution channels and consumer brands.�?

According to the China Industrial Association of Power Sources, Mainland China is the leading producer of primary batteries with an annual capacity of 19 billion units. The industry is valued at more than US$4 billion annually. There are estimated to be more than 2,000 manufacturers in the region, 300 of which export.

Industry pundits also point out that battery manufacturers in the mainland are rapidly increasing production of [higher-margin] rechargeable batteries. While China currently lags Japan and Korea for rechargeable batteries, the country is expected to become the main producer of these batteries by 2010.

Readers should know by now that unlike Wall Street analysts, the 10Q Detective does not have to play nice with any CEO, CFO, or COO. For example, the management of Spectrum Brands believes that they can capture share by engaging in an “alkaline marketing strategy in North America centered around an improved value position.�?

What the h-ll does that statement mean? Correct us if we are mistaken, but the 10Q Detective believes that corporate is euphemistically saying that the Company is negotiating with its trade channels to shift to product mixes that feature larger package sizes with lower per-unit prices.

As previously mentioned, the Company is also sweating under the bathroom lights in its Remington brand personal care products segment(s), too: shaving/grooming and electric personal care products net sales fell 8.1% and 11.1% in the 1Q:06 compared to last year.

Looking ahead to the 2H:06—when analysts expect profits to ramp up—we expect the contrary to happen. Realization of forward price increases in the U.S. (which will probably happen in August 2006) will be delayed by holiday promotions, thus delaying the benefits of material cost inflation.

Spectrum Brands has grown the scope and sales of its business segments the last three years through acquisitions. For example, pet products as a net percentage of total revenue rose from nothing to 21.4 percent in the 1Q:06 compared to last year. Excluding the $133 million contribution of the pet segment, aggregate sales would have been flat with the prior year quarter’s reported $491 million.

This strategy of growth through acquisitions is starting to leak oil. The 10Q Detective has unearthed some problems in Spectrum Brand’s engine:

  • The Company’s substantial indebtedness could adversely affect its business, financial condition and results of operations in the coming quarters. As of September 30, 2005, long-term debt (net of current maturities) was a staggering $2.3 billion, or 275% of shareholder equity. Spectrum Brand’s times-interest-earned ratio, which shows how many times the business can pay its interest bills from profit earned, was an anemic 1.5 times (down from 2.4X in FY 2005). If you were a bondholder, contrast that to competitor, Energizer Holdings Inc, which could meet its debt obligations 11.6 times over.
  • Sensitivity Analysis: According to corporate projections: “As of September 30, 2005, a 100 basis point rise in underlying interest rates would lead to a $7.1 million fair value loss in outstanding interest rate derivative instruments. The net impact on reported earnings, after also including the additional reduction in one year’s interest expense [due to corporate exposure to variable-rate notes outstanding] on the related debt, would be a net loss of $0.5 million."
  • In fiscal 2005 approximately 45% of net sales and 43% of operating expenses were denominated in currencies other than U.S. dollars. The Company benefits from increases in the value of the Euro against the U.S. dollar. Significant increases in the value of the U.S. dollar in relation to foreign currencies could have a material adverse effect on Spectrum Brand’s business, financial condition and results of operations. Year-to-date, the Euro has risen 1.22% versus the U.S. dollar. However, some analysts forecast that with the Fed raising its funds rate by another 25 bps to 4.75%, and more increases likely to follow, that this should spark a renewed rally in the dollar.
  • The Company ‘seems’ to be constantly jiggering its Net non-current Deferred Tax Liabilities—blaming the constant updates on a plethora of reasons, such as differences in book basis and tax basis of trade names to undistributed earnings of the Company’s foreign operations (which are intended to remain permanently invested to finance future growth and expansion). Shareholder Beware: Tax Tinkering can often be used to boost profits—and will inevitably invite examinations by the IRS and other taxing authorities (which could lead to Financial Restatements).
  • Pension Plan Concerns: The Company recorded an additional minimum pension liability of $24.3 million and $16.2 million at September 30, 2005 and 2004, respectively, to recognize the under funded position of its benefit plans.
  • Spectrum Brands is dependent on a small number of key customers for a significant percentage of its sales. As a result of retail sales company consolidations in the past decade, a significant percentage of the Company’s sales are attributable to a very limited group of retailer customers, including Wal-Mart, The Home Depot, Carrefour, Target, Lowe’s, PetSmart, Canadian Tire, PetCo, and Gigante. Wal-Mart Stores, Inc., the largest retailer customer, accounted for approximately 18% of 2005 net sales.
  • At an October 2005 meeting with Wall Street analysts, Wal-Mart said that it was planning a shift in its inventory strategy. According to conference transcripts, Thomas Schoewe, CFO, was quoted as saying: "Is there anybody in management here that thinks that we are doing as well as we should in managing inventory? The answer is no.�? Any elimination of products and/or reduction in inventories held by Wal-Mart could potentially have an adverse material effect on Spectrum Brand’s fundamentals.

    The Company has consistently attributed a stagnant consumer-spending environment as an additional reason for poor product sales. The 10Q Detective believes that the core weakness facing Spectrum Brands is management itself.

    Spectrum Brands is being lead by a team that believes innovation can best drive top-line growth by acquiring it. What our readers need to know is that we believe that this boardroom of executives have confused consumer wants with consumer marketing.

    On March 20, 2005, United Pet Group, a Spectrum subsidiary, announced that it had signed a licensing agreement to bring to the pet market a new canine diarrhea treatment, Canine G.I. Relief.

    Sorry to disappoint, but doggie-doo-doo will not bring back profitability to Spectrum Brands. AVOID/SELL.

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