Management chose to halt the asset sale, now focussing on the RemainCo’s operational performance.
Share repurchases have been suspended and deleveraging continues at a slower pace.
Owners of the company have digested the Q3 conference call positively but debt investors apparently do not share this view.
After Fitch, S&P also downgraded Newell’s debt to junk territory, a rating that the company tried to avoid.
The share price has bounced off the recent low and is now in an uninspiring territory. I suggest to lock in gains.
In my previous article published in late October 2018, I laid out my investment thesis for Newell Brands (NWL). I came to the conclusion that the company is undervalued at $16 per share and communicated conservative and optimistic price targets of $22 and $39, respectively, based on adjusted-present-value (APV) estimates. In February 2019, after the FY2018 earnings call, I revised my target range to $18 - $25. The initial calculations assumed substantial share repurchases at depressed prices as outlined by management in early 2018. Key aspects of the transformation plan have been:
- approximately $10 billion in after-tax proceeds from divestitures
- a brand portfolio corresponding to approximately $9 billion in sales
- significant simplifications from a corporate perspective
- vastly improved working capital management
- normalized operating margin in the high teens post-2020 and >15% in 2020
- reduction of the share count by over 40% (assuming a share price in the mid-$20 range)
A comparison of the 2018 10-K and the Q3-2019 10-Q reveals that to date, less than 13% of the float has been repurchased, resulting in 423 million shares outstanding. NWL extinguished 40% of its 2018 gross debt (i.e. a reduction from $10.6 billion to $6.3 billion) and the FY2019 leverage ratio is expected at around 4x net debt to EBITDA. Clearly, management is now pursuing a different route, having repurchased less shares and, at least intermittently, accepting a worse leverage ratio than announced. Fitch downgraded NWL’s debt to BB+ in February 2019 and S&P followed suit after the Q3-2019 earnings call, with the downgrade to junk territory. While equity investors have received the Q3-2019 earnings call positively, sending the share price to over $20, bond investors do not seem to share this optimism. Exemplarily, the 2046 notes (CUSIP 651229AY2) fell by 500 to 700 basis points and are currently trading around par. I understand this (feeble) sign of pessimism, especially in light of the partly unjustified optimism following the aggressively announced transformation plan in early 2018. This article discusses recent corporate decisions and provides an updated valuation with a concise sensitivity analysis.
Recent Corporate Decisions
With the new CEO Ravi Saligram, NWL is looking to improve from an operational perspective and decided to not only keep the Rubbermaid brand but also Mapa/Spontex and Quickie. Probably, the company faced reality in a difficult retail environment and was unable to sell these assets. However, the businesses’ operating margins have been reported to be ahead of the company average and thus, keeping it in the portfolio could be justified. Saligram admitted that the restoration of brand value is a key aspect and that it is not only Rubbermaid that needs to improve. Other iconic brands such as Coleman desperately need to undergo revitalization and this can only be achieved by an innovative product pipeline and a commitment to quality, setting the brand apart from lower-cost competitors. Social media trend following is another important aspect that has apparently not been one of NWL’s key priorities but this should change under Saligram. With Steve Parsons, NWL hired a CHRO who has already worked with Saligram at OfficeMax. While the CEO values the existing workforce of NWL, as can be learned from his comments on the Q3-2019 earnings call, he must have deemed the situation improvable since Parsons has been hired as a talented recruiter of skilled people.
It remains to be seen whether NWL shows improvements in terms of its cash conversion cycle, as has been announced by Saligram during the Q3-2019 earnings call. Note that in 2018, NWL reported a cash conversion cycle of over 115 days when the peer group benchmark was 70 days. This suggests substantial headroom for improvement. The days payables outstanding metric is an integral part of the cash conversion cycle and explains the importance of delaying vendor payments. However, with a credit rating in junk territory, NWL will likely face difficulties in negotiating much-improved payment terms. Management would need to slacken inventory days or days sales outstanding, the latter of which I suspect to be difficult to accomplish in a competitive retail environment. Improving inventory turnover is arguably difficult yet doable for a conglomerate like NWL. Management has reduced complexity by selling a number of businesses and is now in the process of SKU rationalization. Likewise, demand forecasts will be executed on a much more sophisticated level in the future. The fact that management focuses on improving operational performance can be illustrated exemplarily by reviewing capex. While the divestitures reduced sales by 35% ($14.7 billion versus $9.65 billion), I estimate that 2019 capex is reduced by roughly 43%. Thus, the reduction in capex cannot be exclusively associated with the sold-off revenues.
Revisiting NWL’s Valuation
NWL is arguably difficult to value, given the back and forth in terms of divestitures and potential discrepancies in going-forward operating margin and growth rate. The sale of the US Playing Cards business, which is expected to close in FY2019, concludes the divestitures program. Taking the remaining $966.7 million in assets held for sale into account, I expect net debt to hover around $5 billion by the end of FY2019. With EBITDA expectations of $1.25 billion and going-forward depreciation expenses of approximately $220 million, the normalized operating margin stands at 10.7%. Capital expenditures of $230 million, working capital requirements of 12% in terms of sales and operating lease liabilities of $750 million, discounted at 3% p.a., seem justifiable. Interest expenses should come down to $200 million and the tax rate should stabilize in the mid-20% range. I assume no further share repurchases and hence a float of 423 million shares. A conservative long-term growth rate of 0.5% p.a. thus translates to an APV of $13 per share. The model is sensitive to growth and margins. If management delivers as outlined in the transformation plan (operating margin of 15%) but growth remains at 0.5% p.a., the shares would be worth $24. However, if growth stabilizes at 2% p.a., the shares should change hands for over $30.
From a fair value perspective I find a terminal growth rate of 1% p.a. sensible, taking into account that NWL still experiences core sales contraction due to competition and lack of innovation. Careful investors should also consider the margin-disrupting potential of competitors like Amazon (AMZN). Significant investments in terms of A&P and R&D are a necessity and these will put a (temporary) lid on the operating margin, which could stabilize at 14%. Under these assumptions, the company would be fairly valued at $23 per share.
I am disappointed that management did not deliver as promised in terms of share repurchases and asset sales but am cautiously optimistic in terms of operational improvement. Investors now have to rely on a new management team and its capabilities in terms of brand value and growth restoration. In part, prospects of an investment in NWL remain positive and the stock probably has some room to run in light of the major indices testing new all-time highs. I locked in gains since I suspect the road to operational efficiency to be rather bumpy and the margin of safety to be too small at the current share price of almost $21.
Thank you for taking the time to read through my article. If you have any comments or criticism, I would be happy to read from you in the comments section below or via private messaging.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.
Additional disclosure: I wrote this article myself and the content only serves an information purpose and may not be considered investment advice. I cannot be held responsible and accept no liability whatsoever for any errors, omissions or for consequences resulting from the enclosed information. The writing reflects my personal opinion at the time of writing/publication.