Varun Munjal's  Instablog

Fortune Brands Home & Security, Inc. (FBHS) is considered an explosive grower in the event of a residential construction rebound thanks to leverage. Here's the other side of the story:

Having separated from Fortune Brands Inc. in September 2011, this barely break-even spin-off took out a 5-year $350 million loan and a 5-year $650 revolving credit facility. Owing $400 million on December 31, 2011, it will be paying about $30 million in interest on the 2016 loans. Item 7 of the 2011 Annual Report, under "Liquidity and Capital Resources", reads

Adjusted EBITDA is defined as consolidated net income before interest expense, income taxes, and depreciation and amortization of intangible assets, losses from asset impairments, and certain other adjustments...the credit facility also includes [requires] a Maximum Leverage Ratio of 3.5 to 1.0 as measured by the ratio of our debt to Adjusted EBITDA.

The company's 2011 Maximum Leverage Ratio is 4.5, by my calculations, so more add-backs than I have access to, were added back to net income to arrive at Adjusted EBITDA. The company's funding costs will probably rise with or without a "double dip".

Meanwhile, it's ability to issue stock is limited. Under "Risks Related to Our Recent Separation", Item 1A of the 2011 Annual Report reads

Our ability to engage in significant equity transactions is limited or restricted to preserve, for U.S. federal income tax purposes, the tax-free nature of the Distribution [of our stock, to its shareholders] by our Former Parent...under the Tax Allocation Agreement that we entered into with our Former Parent...without obtaining the consent of our Former Parent, a private letter ruling from the IRS or an unqualified opinion of a nationally recognized law firm, we are prohibited from:

• approving or allowing any transaction that results in a change in ownership of more than a specified percentage of our common stock,
• redeeming any equity securities,
• selling or disposing of a specified percentage of our assets,
• acquiring a business or assets with equity securities to the extent one or more persons would acquire in excess of a specified percentage of our common stock or
• engaging in certain internal transactions

Also, it might have to cover the liabilities of its Former Parent (indemnification agreement). Then add in customer credit risk.

The company's Quick Ratio / Acid Test ratio is just 1.03 ($120 million cash-on-hand). Shareholders are banking on the company throwing off ~$120 million in Free Cash Flow like it did as a subsidiary last year (this time, literally banking).