Central Garden & Pet Looks Attractive On Another Dip

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About: Central Garden & Pet Company (CENT), CENTA, Includes: SMG, SPB
by: Vince Martin
Summary

CENT and CENTA shares plunged after a disappointing fiscal Q1 earnings report last week.

Though there are some minor concerns in the report, the decline seems like an overreaction.

CENT is cheap - and particularly so assuming dry powder for M&A is put to work.

Investors have to trust management and the industry, but there's a nice case to pick up shares here.

The case for Central Garden & Pet (CENT) (CENTA) at the moment is reasonably simple: that the market is misreading the stock. CENT and CENTA shares both fell over 21% on Thursday after the company's Q1 report missed consensus estimates badly. But the quarter really wasn't that bad - and it certainly appears like analyst expectations were far too high given Central's commentary after the previous quarter.

More broadly, CENT (the higher-priced of the two, as it has voting rights) trades at about 10x EBITDA and 17x FY19+ (ending September) EPS guidance of "$1.80 or higher". Both multiples seem at least in the range of attractive (and CENTA shares are even cheaper) - but neither reflects Central's true earnings power. The company has nearly $500 million in gross cash targeted to M&A; FY19 guidance includes the higher interest expense and share count created by the raising of that capital, but zero return.

The combination creates a "buy the dip" argument for CENT/CENTA - but there are risks here. Competition is a worry. Q1 results weren't nearly as bad as the market reaction suggested - but they weren't perfect, either. And the concern I highlighted over two years ago - that the easy money had been made after a major turnaround - still exists. (Indeed, CENT shares are down 6% over that period.)

Still, the risks look priced into at least some extent. I recommended investors buy what looked like a market-driven decline back in October, and four months later at similar levels, the stock looks attractive again. The news in Q1 wasn't that bad, and neither CENT nor CENTA should be this cheap.

The Q1 Sell-Off

From a headline standpoint, Q1 looks disastrous. Revenue did rise 4.5% year-over-year - but that growth rate was more than six points weaker than a two-analyst estimate projected. All of the growth, and then some, came from acquisitions; organic growth declined 1.7%.

Non-GAAP EPS dropped to $0.03 from $0.19 the year before, missing by $0.10. Operating income declined 55%, with margins dropping to 2.2% from 5.1% the year before. Pet revenue dropped 0.6% on an organic basis, with added bad news on the Q1 call. Management cited increased competition in behavior modification products and disclosed that a major retailer was exiting the live fish category. In the Garden segment, which was coming off a disappointing FY18 (organic revenue declined), an operating profit the year before reversed to a loss.

There seems to be little, if any, good news in the quarter. And given a nearly 30% bounce from December lows into the report, the decline back to those lows might make some sense. But, taking a step back, there are several reasons why the quarter was not nearly as bad as it appears.

First, it looks like analyst expectations were simply off. Figures from Yahoo! Finance show that the highest of the two estimates was for $504 million in sales - up 14%, or $62 million, year-over-year. Central did have two acquisitions adding to revenue: live flower grower Bell Nursery and pet distributor General Pet. Central didn't disclose either business's sales beyond saying on the Q2 FY18 call that they were "in the sweet spot" of the $50-$100 million revenue range in which Central traditionally has targeted acquisitions.

But - obviously - Bell's contribution in the winter quarter is relatively small. General Pet, even at the high end, would contribute no more than $25 million. That high estimate, in particular, seems to have assumed organic growth in the mid-single-digits (something like $25 million, or 5%+, assuming $12M from Bell) - which makes no sense. Management had tipped a weak Q1 on the Q4 FY18 conference call; while the commentary focused more on margins, the lack of a price increase in the quarter and the seasonality of Bell suggested that organic revenue growth in the quarter likely was going to be lower than the projected full-year organic rate of 3% or so.

Given fixed-cost leverage and the fact that Q1 is the company's smallest in terms of sales and earnings, overshooting on revenue leads to errors in modeling earnings as well. So while the quarter wasn't great (more on that in a moment), the numbers are not nearly as bad as such as huge miss to consensus implies. That consensus (which, again, appears to have been just two analysts, making that high estimate more important) simply was too high.

The second issue is that the addition of Bell Nursery actually hurt the quarter. The company estimated a $0.10 benefit to last year's EPS simply because Bell wasn't on the books for the first five-plus months of the year. That doesn't explain all of the $0.16 decline in EPS - but it likely accounts for at least one-third. Reverse-engineering an estimated $0.05 hit in Q1 suggests Bell drove roughly half the decline in Garden operating income, and likely a quarter of the drop in the consolidated EBIT figure.

Below the operating line, meanwhile, interest rose $0.9 million (a $0.01+ hit to EPS) due to debt raised last year, and the share count rose 10% owing to an equity offering in August. And on top of all of that, the company saw a shift in timing at a key Garden customer, with a large order moving into Q2 and hitting Q1 revenue and profit. That doesn't appear to be an enormous issue: JD Walker, the head of the Garden segment, said the order literally went from the end of December last year into the first week of January this year. But the shift had a "low-single-digit impact" on overall revenue, per commentary. That's not surprising given the concentrated nature of the business: Walmart (WMT), Home Depot (HD), and Lowe's (LOW) drove 77% of Garden segment revenue in FY18, per the 10-K.

Q1 simply doesn't change the case all that much. The whopping miss to consensus is amplified by too-aggressive analysts. Organic revenue for the company as a whole, per the Q1 call, would have been positive save for the timing shift. Full-year guidance was reaffirmed. The report wasn't great, but looking closely, it simply does not justify a roughly 19% decline in enterprise value. It was a modestly disappointing release in a seasonally small quarter - not a report that suggests a noted change in the potential trajectory of the business.

Risks Mount

That said, even with a full understanding of the moving parts and the impact on a single-quarter year-over-year basis, Q1 did show a few reasons for at least modest concern. I had targeted a share price for the cheaper CENTA in the upper 30s back in October, and with the stock at $36 into the report a small sell-off probably would be justified.

First, the loss of the live fish business at the key customer (which I believe is either Petco or Petsmart; I haven't been able to confirm that) is a modest headwind going forward. Central added to that business through the 2016 acquisition of live fish wholesaler Segrest for $60 million, and there is a potential knock-on effect to sales of aquariums and other supplies.

That said, Walmart exited that category in 2007, and while a questioner in the Q&A of the Q1 call cited some industry disruption around that move, there's no evidence in Central filings of material impact to what was then a smaller consolidated revenue total. (The move wasn't called out specifically, and Walmart's share of pet segment revenue doesn't appear to have moved over that period.) Against a $2 billion-plus revenue base and a $2 billion-plus enterprise value, the exit of a single customer from a smaller industry hardly seems anywhere close to a game-changer for Central on the whole.

The bigger issue seems to be competition. Both segments obviously see intense battles for market share, with Central going up against Scotts Miracle-Gro (SMG) and Spectrum Brands (NYSE:SPB) in Garden and dealing with a highly fragmented industry on the pet side. In Pet, "an aggressive new competitor" led to a decline in behavior modification products, and unspecified timing shifts in the equine business hurt the quarter. Both issues are supposed to be resolved as the year goes on, but it's hardly guaranteed that will be the case.

On the Garden side, the tenor of the Q&A seemed to suggest real fears that recent market share gains will reverse. Even with negative organic growth in FY18, Central management insisted that the company had again taken market share, with the market down overall due to unfavorable weather last year (notably a late spring). The weak start to the year seemed incongruous relative to strong results from both Scotts and Spectrum Brands' garden business, even accounting for the order slip into Q2.

Meanwhile, as an analyst pointed out on the Central call, on its fiscal Q1 call in late January Scotts tipped a move into private label. Central produces private label products for both Walmart and Lowe's, and private label is about 10-15% of revenue in each segment, per Central's Q4 call. More pressure from Scotts adds another potential competitive headwind as FY19 plays out.

And, again, even discounting the analyst expectations and the timing shifts in garden and equine, it does seem like the quarter was a bit disappointing. An analyst specifically asked in the Q&A if that was the case, noting that "it does feel like maybe the quarter was a bit underwhelming even relative to the expectations that you had". CEO George Roeth admitted "some of that would be true" while emphasizing that the diversified business was enough to keep the company "feeling good about reaffirming our guidance".

From a broad sense, then, the concern might be that maybe this really isn't that good a business. The bull case here is that both segments, despite reasonably modest long-term growth expectations, serve attractive end markets. The Pet segment (~60% of profit) serves an industry that's seen a lot of optimism of late, whether it's the moves of J.M. Smucker (SJM) and General Mills (GIS) into pet food, or big gains at stocks like Zoetis (ZTS), Freshpet (FRPT), and Blue Buffalo (before its takeout by General Mills). The category isn't exactly torrid from a top-line growth standpoint, but the 'humanization' of pets (as Blue Buffalo memorably termed it) continues and the market continues to expand.

In Garden, competition from the two large rivals is stiff - but Central has its niche. And having three-quarters-plus of revenue coming from Lowe's, Home Depot, and Walmart seems like a good thing both near-term and long-term.

But it might look like that's no longer the case. Competition might be tougher than thought in 2017-2018. CENT stock hasn't moved in years now. Central certainly executed an impressive turnaround earlier this decade - but it had a lot to fix. One major shareholder called the company "a 'clown show' of investor relations and corporate governance." The manufacturing footprint and supply chain, after years of tuck-in acquisitions, was an inefficient mess.

Central has fixed those problems - but it's also long since lapped the benefits of those operational improvements. And so the question I asked in 2017 and even in October - how much is left? - seemingly becomes more urgent after Q1. EPS is guided potentially down this year, from $1.91 in FY18 to $1.80+ in FY19. Even that guidance requires trust in management projections of substantial margin expansion and earnings growth in the back half, as Q2 is projected to have "flat to modestly up" EBIT and EBITDA on an organic basis - and potentially another decline with Bell included.

Since the low-hanging turnaround fruit was harvested, it looks like Central hasn't really been able to grow earnings all that much - and both classes of the stock now are down since the start of 2017. In that context, Q1 might have been enough for bottom-timers to salvage some profits - and other investors might assume that the seemingly reasonable multiples are justified.

Looking Closer, The Bull Case Appears

The fact is, however, that Central still is growing both revenue and earnings. FY19 guidance looks like a potential decline - but there are three factors driving the year-over-year decline that were detailed on the Q4 call:

  1. Bell is hitting the figure by $0.10;
  2. A higher tax rate provides a $0.15 headwind;
  3. The net effect of the share count, offset by interest income, adds another $0.15 effect.

Backing those out, Central's guidance suggests at least a 15% increase in EPS this year. Even if that guidance is overly optimistic, EBIT and EBITDA should at worst be positive this year - and up on an organic basis as well.

Some growth is priced in, admittedly - but not much, and less than headline multiples suggest, particularly for the cheaper CENTA shares. (The CENTA shares are the class to buy; CENT shares do have voting rights, but founder William Brown still controls the company through Class B shares. CENTA shares actually have more volume as well. Why the discount not only persists but has widened, isn't clear.) CENTA shares are under 16x FY19 EPS guidance (and EPS historically has been relatively similar to free cash flow) and a bit above 10x TTM EBITDA even calculating market cap using the higher CENT share price. Peer comparisons are tough (SPB and SMG have external factors affecting comparability) but I argued in October both multiples seemed reasonable, and I still believe that's the case.

At this point, it's worth remembering that those multiples are based on earnings - as management emphasized in giving FY19 guidance after Q4 FY18 - that don't include any benefit from the $478.7 million in cash sitting on the balance sheet. They do include the costs, however, in terms of both higher interest expense and a larger share count. But that cash is going to get deployed. M&A has taken longer than anticipated, but that's not necessarily a bad thing (from a long-term standpoint, shareholders are better off with management waiting for their proverbial pitch). If those opportunities don't appear, Central will look to invest the cash in the business to either drive new growth opportunities and/or lower run-rate operating costs.

And it doesn't take much for that cash to move the needle. Assuming $400 million in spend, even 5% pre-tax return, less lost interest income, adds close to $0.25 to EPS. Earnings power then easily is in the $2+ range, and CENTA is available for something like 13x EPS and free cash flow - despite years of growth, including pre-tax increases in FY19, and room for more.

That's an attractive price for a stock that has mostly traded in the high-teens/low 20s on a P/E basis over the last few years. And it sets up a path to $40+ - close to 50% upside - in the next 12-24 months, as acquisitions boost earnings and the multiple normalizes as growth returns. Even no multiple expansion probably drives upside: assuming Central can deploy that cash this year, FY20 EPS of $2.20-$2.40 (high-single-digit to low-double-digit organic growth next year) and a 16x P/E moves the stock up 30%.

Obviously, there are risks to upside, which mostly center around trust in management. Investors don't trust the FY19 guidance, and if that gets pulled down even ~$0.20 or so, the business looks stagnant even with all the moving parts. 13-14x $2 in FY20 EPS leaves CENTA dead money at best.

Management has to deploy the cash well - and that may be tough. The company clearly is looking for a business larger than the $50-$100 million range, and one (unlike Bell and General Pet) that is margin-accretive. Even in a fragmented industry, there may not be a target that checks all those boxes.

And competition has to be watched closely. The broad risk in Garden, in particular, is that it's now Scotts and Spectrum executing turnarounds and improving execution - not Central. And thus the share gains seen in that segment over the past few years may end - or even reverse - as those rivals become more efficient and/or more willing to trade price for share. On the Pet side, the shift away from brick-and-mortar superstores to online retailers like Chewy may hit some of the impulse buys for Central's dog beds, toys, and other products. And the two struggling behemoth retailers may look to either squeeze suppliers for extra margin dollars and/or manage inventory more aggressively.

Those risks are real, admittedly. But even with the stagnant share price, it's too soon to just ignore Central management altogether. The turnaround here has been impressive. The business still is growing - and taking market share. A diversified portfolio (~40% other pet products, ~20% dog and cat, 15% fertilizer and garden control, ~25% other garden) provides some protection against pressures in any single product or any single channel. Adjusted EBIT margins of 7.6% in FY18 are below peers, suggesting more room for expansion going forward. And long-term, both industries should be growing.

If Central keeps performing as it has been - and that includes the somewhat disappointing Q1 - the stock is going to rise. Second-half strength, helped by pricing increases and less-tough compares, should move the stock higher. The deployment of capital targeted for M&A provides another catalyst. CENTA is cheaper than it looks - and it's performing better than the market seems to believe after Q1. Over time, the true earnings power should show through - and that, plus a re-rating of the stock, suggests a potentially huge rebound after Thursday's losses.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CENTA over the next 72 hours. 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.