Report Entitled: "Arm Yourself To Get Hammered"
Spruce Point is pleased to issue a unique investment research opinion on Church & Dwight (CHD or "the Company"), an S&P 500 company, and roll-up acquiror of personal care and consumer products. Under its older leadership, management pursued a conservative strategy to leverage its core Arm & Hammer brand by diversifying and integrating acquisitions, while still prioritizing product innovation, and manufacturing excellence.
With the elevation of Matt Farrell to CEO in 2016, Spruce Point believes CHD’s strategy has pivoted towards extreme financial engineering, aggressive accounting, and managerial self-enrichment practices. As fundamentals deteriorate in CHD’s retail environment, and it’s now clear that 60% of its legacy Power Brand acquisitions are failing, Spruce Point believes that CHD’s recent Waterpik and FLAWLESS levered acquisitions were made in desperation at outlandish valuations, and with financial and accounting control problems that will disappointment investors. With CHD’s shares at a 8% premium to average analyst price targets, and debt rising, investors seeking safety in CHD’s stock face 35%–50% downside risk ($42 - $50/sh).
Old School Brands Traditionally Following A Copy-Cat Like Strategy Against Leaders Proctor & Gamble, Clorox, And Others:
- Best known for its iconic Arm & Hammer brand, CHD embarked on an acquisition strategy in the early part of the 2000s to diversify into condoms, sex toys, hair care, rectal cream, vitamin gummies, oral care and other assorted product categories. However, we believe 6 out of 10 of its “Power Brands” acquired pre-2017 are struggling or outright failures
- With 23% of sales through Wal-Mart (WMT), and reliance on struggling brick-and-mortar channels such as ULTA, Sally Beauty (SBH), Bed, Bath & Beyond (BBBY), pharmacy (ex: Walgreens (WBA), CVS, Rite Aid (RAD)), and discount stores (Dollar General (DG) and Big Lots (DG)), we believe CHD is experiencing channel pressures (including through Amazon (AMZN), and has been slow to transition to online sales and marketing to millennials. These factors, along with an increasingly promotional environment, has been pressuring margins
- Long promising international growth opportunities, CHD hasn’t been strategic about acquiring brands that can readily be sold in foreign markets (most notably vitamins) and has failed to implement common sense strategies (e.g., multilanguage labeling) to accelerate and scale the “export” strategy. Our research indicates that recent international success is attributable to new market entries, establishing distribution agreements and putting through significant price increases. We don’t believe that any of these drivers are sustainable and that CHD is now too late to many of its core product categories around the world. As a result, we believe that international growth is likely to disappoint
Investors Fail To Appreciate The Change of Leadership Style Under Matt Farrell, An Executive Who Blind-Sided Investors At Alpharma:
- In early 2016, Matt Farrell and Rick Dierker were appointed CEO and CFO, respectively. Based on our interviews of former employees in key roles, CHD experienced a culture shift that would deemphasis manufacturing, R&D and supply chain investment in favor of greater financially engineered acquisitions. One former employee even described management as “financial magicians”
- We believe investors fail to appreciate the abysmal failure overseen by Farrell when CFO of Alpharma (formerly NYSE: ALO). While we acknowledge that some of Alpharma’s issue may have pre-dated his arrival in 2002, there is evidence that under Farrell’s leadership, the situation became even worse, culminating in Alpharma issuing more material weaknesses, a “non-reliance” opinion on its financial statements, a covenant breach, and later a DOJ settlement for bad sales and payment practices to promote unsafe products
- Now as the CEO, and in a position to reap large gains, our behavioral analysis shows both Farrell and CFO Dierker are using highly promotional language to talk up deals, while evidence points to financial control and accounting challenges, most notably to game bonus compensation targets
Under Pressure To Financially Engineer Results, CHD’s Two Recent And Expensive Deals Already Showing Signs of Disappointment:
- In August 2017, CHD spent $1 billion to acquire Waterpik, a dental water flossing product that has been flipped twice by private equity owners. From the deal conf call, management showed little understanding of the business, punting on simple questions such has what % of sales is online, and the split of kit vs. consumable sales. When we asked a former long-time executive about the deal: “Waterpik has been for sale for years, and I’m a bit surprised they bought it given product liability concerns”
- Sales Decline Quickly Post Acquisition: CHD obscured the contribution of sales by Waterpik post acquisition, lumping results in consumer domestic and international with smaller acquisitions Anusol and Viviscal. However, total consumer revenues from acquisitions declined from $102m (Q4’17), to $85m (Q1’18), to $79m (Q2’18) in the following quarters that can be cleanly analyzed. The FDA also recalled products mid 2018 from safety issues
- Margins Already Failing: Documents show Waterpik’s gross margins were 47.7% - 49.1% pre-acquisition, and the CFO said he expected 200-300bp gross margin expansion. Fast forward to early 2019, the CFO’s recent comment that gross margins are now “on par” with the company’s gross margin (pre-China tariffs), indicate that margins have contracted lower and are now closer to 44%
Spruce Point Has Identified Many Flaws In The Flawless Acquisition That Should Give Investors Grave Concerns:
- In May 2019, CHD announced it acquired FLAWLESS hair care removal product for $450m. The product has grown quickly to $180m of sales since its 2017 launch, but has unproven staying power in a rapidly maturing category. Management is using bold and potentially misleading language to promote the deal, even claiming to be creating a “brand new category” for an “unmet need” and that it will “blow out” sales
- A former CHD executive told us bluntly the deal was, “Horrible, Horrible, oh Horrible” and should be “Dumped” immediately
- The seller is managing the business under an opaque long-term service agreement that allows it to reap another $475m of incentives through an earnout agreement that still allows it to get paid if targets aren’t achieved
- Spruce Point finds undeniable evidence of aggressive accounting, revenue recognition problems, and operational delays at FLAWLESS: Notably, we have sourced Nielsen retail data for recent FLAWLESS product introductions. The data shows slowing growth for its headline Finishing Touch FLAWLESS brand, and rapid maturation cycles historically for new product introductions. FLAWLESS and CHD’s Batiste are sold at ULTA Beauty, which just cut guidance, and said recent new product cycles in women’s cosmetics are not driving growth
CHD Touts Its Industry Leading Cash Conversion >100% of Net Income, But It’s Not As Sexy As It Appears
- Aggressive M&A Accounting: On average, CHD accounts for 96% of its deal values as intangibles and goodwill, enabling it to receive tax deductions over 15yrs that improve cash flow. As an example of how aggressive management has been towards applying this strategy, it said on the FLAWLESS conference call that it had no synergies, yet later marked $82m of the value as goodwill and attributed it to synergies!
- Increased Factoring: CHD factors receivables, and by its own admission in 2015, its cash flow should be adjusted for it. Ever since, CHD has obscured its factoring programs, and only reports it annually. In May 2019, CHD increased its factoring program from $150 to $250m
- Cash Conversion Limitations: After steadily improving from 2014 to 2017, the metric worsened in 2018. It bottomed in Q3’17 at 15 days and now stands at 24 days. Nonetheless, the CFO touts that it has a 3 – 4 year plan to drive working capital to zero. When we asked former employees if this was achievable, a few snickered at the suggestion, and all agreed it was a “stretch”
- Slowing Dividend Growth: CHD has a history of annual dividend increases. In early 2019, it increased the dividend by just 4.6%, the lowest in history. We believe this is a signal of management’s weakening confidence in its cash flow outlook
- Undisclosed M&A: We find that CHD completed an undisclosed acquisition in the UK in Q1’2018 that bolstered organic growth
- Inflated EBITDA: CHD’s uses a misleading presentation of its Credit Agreement EBITDA by not adjusting for two key non-cash items
CHD Touts Its Industry Leading Cash Conversion >100% of Net Income, But It’s Not As Sexy As It Appears
- In 1986, CHD formed Armand Products, a 50/50 joint venture with Occidental Petroleum to produce and market potassium (bi)carbonite. We believe the transaction was motivated to shift, potentially environmentally challenged, assets off CHD’s balance sheet
- In Spruce Point’s opinion, CHD’s current equity method accounting treatment is at best highly aggressive, and at worst outright flawed. By applying the equity method, it avoids consolidating an entity it appears to control. Under full consolidation, we believe CHD’s operating margins, working capital, and free cash flow would all be lower due to the heavy manufacturing aspects of the business
- Evidence of control includes: JV formation documents showing key management and the Board all being CHD members, current management's operation of the business from CHD’s office, and receiving a management fee for administrating the entity, CHD appears to be the largest related party purchaser from the business, and the business has been run under an obscured CHD legal entity
- We believe the JV has been under pressure, with deteriorating margins. We estimate Armand has ~$100m of revenues and CHD accounts for 15% – 25% of sales. We conservatively estimate that JV accounting treatment allows CHD to inflate EBITDA by $13 - $27m and free cash flow by $5 - $10m. While small in context of today’s CHD’s overall business, years ago when it was formed, it was highly material, and illustrates the aggressive methods management has used to inflate performance. We believe a full restatement is necessary
With Little Equity At Risk, Management Has Turned To Gaming Compensation Targets For Self-Enrichment Purposes
- CHD insiders own just 2% of the stock and have little at risk if the company fails. Spruce Point finds it highly unusual that all its executive officers serve at the discretion of the Board except Steven Katz, the Financial Controller and Chief Accounting Officer, who serves at the discretion of Farrell, who is both Chairman and CEO. Moreover, as the longest serving executive employee having been hired in 1986 (ironically the same time the questionable Armand JV was formed), Katz is selling stock in an oblique manner that circumvents disclosure practices
- CHD’s annual cash incentive plan is tied to net sales, gross margins, diluted EPS, and operating cash flow. None of these targets are adjusted for management’s tricks being used to inflate performance. The most egregious example is gross margin and Diluted EPS:
- Gross margin: CHD did not call out an inventory accounting method change as a 10bp benefit to gross margin in 2018. The timing of the change in 2018 is curious, given that headline gross profit contracted 140bps. Yet, management still exceeded its threshold gross profit level for its annual incentive compensation calculation with unexplained adjustments. By our calculation, CHD failed to meet the target threshold by adjusting for the accounting change
- Diluted EPS: A more egregious example is its Diluted EPS calculation. CHD’s 2017 acquisition of Agro BioScience started underperforming, and it reversed the earnout liability down in 2018, which boosted earnings by $7.5m. Shareholders should be appalled that management reaped bonuses for hitting its EPS target, yet the Board (controlled by Farrell) didn’t adjust EPS downward for a failed deal and an accounting change
- Overall: CHD proclaimed great performance in 2018, going so far as to reward employees and management with a special 15% bonus. This is a complete charade in light of collapsing margins, failed deals, subtle accounting changes, and numbers that don’t add up
- Recommendation: Spruce Point believes Farrell’s CEO/Chairman role should be divided, and management should return unjustly earned compensation. In addition, the Board should institute new metrics tied to organic sales growth (not poorly acquired revenue), and adjust future EPS targets for share repurchases which reward management for boosting EPS by overpaying for CHD’s expensive stock
A Terrible Risk / Reward With An Implied 8% Downside To The Average Analyst Price Target
- In our experience, when stocks trade above the average analyst price target, it represents a unique short opportunity. Recent examples include Penumbra, iRobot and Mettler Toledo. In the case of CHD, a majority of the analysts are Neutral/Hold on the stock, and the Street high price targets is $88. Three directors recently sold stock around $79 to $80/share in the last two weeks of August and early September
- CHD’s valuation multiple has expanded rapidly to all-time highs, partly explained by sector rotation into “defensive” consumer staples as global instability and trade wars escalate, and partly on investors’ belief that new management can competently steer the Company for sustained growth and implement improvements to fix 2018’s challenges. We believe both of these are poor reasons to own CHD:
- Safety From Trade Wars: CHD is exposed to China tariffs primarily through its Waterpik business. In addition, CHD wants to expand more globally, especially into China, notably through a new distribution arrangement with Shanghai Jahwa. Lastly, instability in Hong Kong is another potential underappreciated headwind. We find that 22% of CHD’s imports come through Hong Kong and China, by far its largest import region
- Competent Management: As discussed and documented, we believe management is hyper promotional, potentially deceptive and highly aggressive at inflating the financials to maximize its self-interested compensation objectives. We believe its focus on financial engineering versus operational and product enhancement will result in failing to achieve long-term margin and organic growth objectives
- CHD’s stock is valued at 5x, 22x, and 32x 2019E Sales, EBITDA, and EPS – a significant premium to its peers for a few extra percentage points of potential growth, which we believe will fail to materialize. The risk / reward is not favorable in light of our bona fide evidence of dubious related party accounting that could necessitate a financial restatement and issuance of a non-reliance statement on its financials
- Valuing CHD at peer multiples on our normalized financials to reflect its mediocre brand portfolio, weak management, substandard governance practices, and failing acquisition strategy, we can justify a price range of $40 – $52/share (35% – 50% downside)
This research note and our presentation expresses our research opinions. You should assume that as of the publication date of any presentation, report or letter, Spruce Point Capital Management LLC (possibly along with or through our members, partners, affiliates, employees, and/or consultants) along with our subscribers and clients has a short position in all stocks (and are long/short combinations of puts and calls on the stock) covered herein, including without limitation Church & Dwight Co., Inc. (“CHD”), and therefore stand to realize significant gains in the event that the price of its stock declines. Following publication of any presentation, report or letter, we intend to continue transacting in the securities covered therein, and we may be long, short, or neutral at any time hereafter regardless of our initial recommendation. All expressions of opinion are subject to change without notice, and Spruce Point Capital Management does not undertake to update this report or any information contained herein. Spruce Point Capital Management, subscribers and/or consultants shall have no obligation to inform any investor or viewer of this report about their historical, current, and future trading activities.
This research note and our presentation expresses our research opinions, which we have based upon interpretation of certain facts and observations, all of which are based upon publicly available information, and all of which are set out in this research presentation. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward looking statements, expectations, pro forma analyses, estimates, and projections. You should assume these types of statements, expectations, pro forma analyses, estimates, and projections may turn out to be incorrect for reasons beyond Spruce Point Capital Management LLC’s control. This is not investment or accounting advice nor should it be construed as such. Use of Spruce Point Capital Management LLC’s research is at your own risk. You should do your own research and due diligence, with assistance from professional financial, legal and tax experts, before making any investment decision with respect to securities covered herein. All figures assumed to be in US Dollars, unless specified otherwise.
To the best of our ability and belief, as of the date hereof, all information contained herein is accurate and reliable and does not omit to state material facts necessary to make the statements herein not misleading, and all information has been obtained from public sources we believe to be accurate and reliable, and who are not insiders or connected persons of the stock covered herein or who may otherwise owe any fiduciary duty or duty of confidentiality to the issuer, or to any other person or entity that was breached by the transmission of information to Spruce Point Capital Management LLC. However, Spruce Point Capital Management LLC recognizes that there may be non-public information in the possession of CHD or other insiders of CHD that has not been publicly disclosed by CHD. Therefore, such information contained herein is presented “as is,” without warranty of any kind –whether express or implied. Spruce Point Capital Management LLC makes no other representations, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. You should assume all statements made are our opinions, unless sourced as facts where practical.
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Disclosure: I am/we are short CHD.