If this thesis is correct, the bunny won't hold
When it comes to Energizer (NYSE:ENR), most investors probably get the main bearish thesis. This thesis can be summed up as:
- (Regular, Alkaline) batteries are slowly becoming obsolete and being substituted by Li-Ion device-integrated batteries. Pretty soon, there won't be a market.
This thesis has long been espoused by me, as well as other authors. With alkaline batteries still representing nearly 60% of ENR's revenues, it's easy to be worried about this dynamic towards Li-ion batteries.
However, with the notion of Energizer being a brand, deterioration being slow or seemingly even stagnating, and the diversification through a recent car fragrance acquisition, investors seem to have been able to forget the bearish thesis. ENR has launched into a powerful rally, to such an extent that it actually acquired a premium valuation. ENR now trades at 22x FY2016 EPS consensus, which is certainly stretched for a company still seeing shrinking revenues in the mid single-digit range.
Moreover, ENR has also been talking favorably about some of its segments compensating the regular battery business decline. For instance, the company had this to say regarding its North America sales (North America represents ~53% of revenues and ~63% of segment profits):
In North America, we would expect volumes to decline low single digits over time, but value is estimated to trend more positively, naturally a result of the mix shift that we're seeing occur to premium performance and specialty, and away from the price value segments.
Read superficially, this seems like a positive development. So let's check what this premium performance includes:
Source: ENR Presentation, red highlight is mine
We can see that the segment includes (among other things) rechargeable batteries. Rechargeable batteries have long been in the market, namely through NiCd and NiMH chemistries. However, also for a long time, they had a couple of failings, which kept them from being practical, such as:
- High self-discharge, meaning that if you stored a charged battery for later use, you could find yourself with a dead battery when you needed it.
- Poor cycle life, especially if neglected. Meaning, you'd end up with a dead battery after a few cycles.
Such reality, however, has changed. It changed starting in 2005, when Sanyo introduced LSD (Low Self Discharge) NiMH batteries, branded Eneloop.
The (Other) Bearish Thesis - Going From Subscriptions To Upfront Sales
It is with the advent of the Panasonic/Sanyo Eneloop brand, that the new bearish thesis started taking form. These batteries didn't just implement the LSD NiMH technology and showed low self-discharges which allowed customers to charge and store them for later use, they also married this characteristic (which made them more akin to regular alkaline batteries) with a massive cycle life.
These batteries could be charged 1000x, and as such has meanwhile evolved towards as many as 2100x recharges. Moreover, NiMH excels in high-drain applications, so while a regular alkaline battery might theoretically display a higher theoretical capacity, in practice, it will often deliver a much shorter battery life than a rechargeable battery.
Of course, Energizer had to respond to this development, so today, it also sells rechargeable NiMH batteries with low self-discharge and 700x-1500x cycle life.
So how is this wonderful product part of a bearish thesis? Consider the following:
- Each of these LSD NiMH batteries costs ~5x-7x the price of a regular alkaline battery.
- Then, these batteries can easily be used 1000x.
- So, when selling one of these batteries, ENR will record 5x-7x more revenues than when selling a single alkaline battery.
- But then, Energizer will forego the sale of another 999 alkaline batteries over time.
Here, we basically have a situation that's the opposite of when a company transitions from selling software to selling subscriptions. When that company is selling software, it registers all the revenue upfront and then collects no more payments on that software over its life. Whereas when it sells a subscription, it then continues receiving the subscription year after year. Think Microsoft (NASDAQ:MSFT) with the Office vs. Office 365, or Adobe (NASDAQ:ADBE) with its creative suite.
When a company does such a "model change" towards subscriptions, it initially sees revenue and earnings drop. However, the market generally understands that these revenue and earnings drops are temporary and that going forward, both revenues and earnings will be more stable and predictable (and quite possibly higher). The market's reaction is usually to award such a company a higher earnings multiple, which either compensates the lower immediate earnings, or sometimes even overcompensates them given the higher future stability.
So what ought to happen here? The market ought to understand that each sale of these LSD NiMH batteries brings forward the sales of 1000 alkaline batteries. It's like going from a subscription model (the non-rechargeable alkaline batteries) to an upfront sales model (the NiMH rechargeable batteries which will keep the customer away for more than 5 years). For that, the company is registering 5x-7x upfront revenues, but will then lose sales amounting to ~99.3% of what it would otherwise have collected.
Let's make an example. If instead of selling one alkaline battery at $0.40, you sold one NiMH rechargeable battery at $2.50, and then the NiMH rechargeable battery got used 1000x, that would be the same as selling each "alkaline equivalent" battery for $0.0025. That's not a typo.
Hence, when Energizer says its performance segment (whose composition and weight is not otherwise disclosed) is benefiting U.S. sales, that's not exactly a positive. Each LSD NiMH battery being sold today is displacing 1000 alkaline batteries in the future. That's the unsung bearish thesis.
Reductio Ad Absurdum
Let us for a second think that ENR replaced all its present alkaline sales for NiMH sales over a single year. That year would be fantastic and ENR would probably show 2-3x higher revenues (considering alkalines will often last less than one year).
What would happen over the next 5-6-10 years, though? Sales would drop to near zero (except for new cumulative demand)! ENR would quickly go out of business, after that immense 1st year success. Hence, it's obvious that selling LSD NiMH batteries pads the revenues and earnings short term, but makes for inevitable drops in business activity over the next few years.
Of course, reality isn't as radical as this absurd example. But the outcome is more or less the same. While Li-ion displaces batteries in new devices, the steady selling of LSD NIMH batteries displaces batteries even in existing devices (as well as new ones still using regular batteries).
Still, it bears recalling that these batteries are more expensive than regular alkalines by a factor of 5-7x. So again, all of this happens while misleadingly padding immediate revenues and earnings. So is there something to be celebrated in revenues not dropping as fast in North America due to the Performance segment? Not likely, quite the contrary…
Even beyond the steady adoption of Li-Ion integrated batteries in new devices, there's yet another bearish dynamic which will be eating away at ENR's business over the medium term. This dynamic, however, actually makes things seem better in the short term, while making the negative outcome 1000x more likely.
Due to this dynamic, ENR should be valued as the polar opposite of a business going from upfront sales to subscriptions. Here, the subscriptions are the alkaline batteries, and the upfront sales are the rechargeables.
If a business going to the subscription model deserves higher multiples, ENR, going the other way, deserves a large discount. Instead, what we have is a shrinking business trading at a premium in spite of near-term numbers being inflated by this bearish thesis' dynamics. Over time, this reality ought to deliver very significant downside to ENR.
Disclosure: I am/we are short ENR.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.