Stock Your Shelves with This Cash Machine
We think the market underestimates Prestige Brands' persistently high cash flow.
Prestige Brands (PBH) is a typical small, fly-under-the-radar company, which is exactly what we like. It also happens to have an unusual business model--another plus in our book. Best of all, the company currently trades for less than 6 times free cash flows. We figured we'd find some hair on the company--and we did--but not nearly as much as we expected. Prestige is not a great company by any means, but it is dirt cheap, and there are some reasons to believe that performance will improve over the next few years. We wrote about this firm in Morningstar Opportunistic Investor on June 8. We subsequently purchased Prestige Brands for about $6.30 per share. Although the stock is up a bit since then, we think it's still an attractive opportunity.
First, let us introduce Prestige's most important product lines: Chloraseptic (sore throat medicine), Clear Eyes (eye drops), Compound W and Wartner (wart removal), and Comet (cleaning solution). These are the most important bits of its portfolio, but Prestige also owns things like New-Skin (liquid bandages), The Doctor's Nightguards (anti-teeth grinding), Little Remedies (infant medicine), Spic and Span (cleaning spray), Cutex (nail polish remover), Murine (ear drops), and many more.
At this point, you may be a bit confused. How did a little company like Prestige end up with this huge basket of brands? The answer is that they were all acquired. Prestige's business model is simple: It buys small, niche brands, injects some marketing into them, and tries to generate as much cash as possible. These tend to be small in absolute sales but are strong and well-known within their individual categories. We think most readers would recognize most, if not all, of their top brands. The company outsources most manufacturing, distribution, and even some R&D. Instead, it focuses on account management and marketing. Marketing is key to this story. One of this business model's most powerful engines is that the acquired brands were often ignored by their previous owners or underinvested in. By committing greater resources, both in introducing new product extensions and in additional marketing, Prestige attempts to rejuvenate these properties.
Prestige's business model is not novel. Chattem (CHTT) and Church & Dwight (CHD) are doing similar things. Both of these companies have done very well following this playbook. They would acquire brands from companies such as Johnson & Johnson (JNJ) that are too small for J&J to care about. Then they would devote the focus, resources, and marketing muscle that the brands were lacking before and boost sales growth considerably. For example, Chattem was able to deliver annual organic sales growth around the mid- to high single digits since 2002 despite selling relatively boring products like Gold Bond, Icy Hot, and Selsun Blue.
But what works for some does not work for everyone. Prestige perennially seems to be the lame duckling in this trio. It hasn't had nearly as much success in delivering improved performance to its acquired brands, and it's been hit by numerous setbacks. As a comparison, organic growth at Prestige veered nearer to 2% in the past few years, considerably below Chattem. Not all of this underperformance can be attributed to being in slower-growing product categories.
The most serious recent setback was within wart removal--a core product line. Basically, results suffered in 2008 as major retailers wanted wart removal manufacturers to reduce their products' package size. Prestige refused, thinking the move would lower profits for the entire product category. Unfortunately, its competitors agreed to the retailers' request. Thus, not only was Prestige forced to change its packaging anyhow, but retailers also refused to stock Compound W and Wartner until Prestige complied. Wart removal is a seasonal business that peaks during the summer, so losing market share for those few months is especially painful. The company doesn't break out sales by product, so we cannot exactly quantify companywide impact. However, revenues in the OTC segment (where wart removal is located), dropped almost 8% for the June 2008 quarter--a big number for a usually steady business. The company repackaged its products and sales improved, but the damage was done.
Aside from this singular event, the company has been suffering from several weak cold/flu seasons in a row, impacting Chloraseptic. Furthermore, Prestige is trying to restructure its brand portfolio. Basically, it's starving brands with weaker market positions and slower growth prospects of resources, amounting to about one third of total revenues. Concurrently, it's concentrating on the remaining two thirds of the portfolio with stronger prospects. For the past year or so, management has been reviewing "strategic alternatives" for the weaker brands. No buyer has stepped up, and we don't think these properties would fetch much in an auction now. Currently, the starved brands are declining rapidly, making companywide sales growth anemic at best.
Prospects for Improvement
First, inventory destocking has been fierce this year as suppliers, retailers, and consumers scrambled to preserve cash. Prestige was hit with a double whammy of "pantry destocking" (where consumers burned through everything in their cabinets instead of shopping) and inventory destocking by store chains. However, given the basic, staple nature Prestige's products, we expect this headwind to gradually reverse itself.
Second, several of Prestige's brands actually benefited somewhat from the downturn. Comet, for instance, is a lower-tier cleaning product that's performing strongly as consumers trade down. Cutex, the nail polish remover, also enjoyed a good year, perhaps as people traded down from nail salons to do-it-yourself. In isolation, these small pockets of strength would not overcome a slide in consumer spending in general, but they do help.
The next two trends are positives in the long run. We really like Prestige's new emphasis (they have been stressing it for the past year or so) on slimming down the brand portfolio and focusing on the strongest bits. The company had assembled too many disparate brands under the same roof, and it was difficult to manage them all. As the worse brands languish and become less important, the better brands' faster growth would eventually begin to show through. This has to be true by simple arithmetic. Granted, the firm will never be a blistering grower without acquisitions, but there is a huge difference between a company that consistently grows by a small amount each year and one that is stagnant or even declining.
Finally, Prestige is making an effort to change its sales force structure to in-house direct sales from one that's reliant on brokers. In-house direct sales seem to be the standard in the industry, and the company thinks this will foster a closer relationship with its biggest customers ( Walgreens (WAG), for example). Erin Swanson, the Morningstar analyst covering Prestige, Chattem, and Church & Dwight, tells us that this transition usually leads to some incremental operational improvements, but there is a big lag before results show up. Prestige is only a few months into its switch.
None of these changes is game-changing by itself, but the cumulative effect may be significant. The market seems to be giving no credit to Prestige right now. We think at the very least, Prestige can move from "bad" to "okay," and that makes a big difference to valuation.
Valuation and Other Considerations
Prestige uses virtually all of its free cash flows to retire debt. The company has a private equity background, and its founding firm still holds a big chunk of its shares. A result of this background is over $300 million of net debt (thankfully there are no imminent maturities). However, the company is skirting close to its maximum leverage debt covenant. Our thesis is that things will start to improve very soon, so we're not concerned at the moment.
Prestige generates massive free cash flows as a virtue of its business model. Thanks to outsourcing, it pays nearly zero capital expenditures. Last year, it spit out about $65 million, versus a market cap of $360 million. Right now, we see no indication that any of its major brands has been impaired through the downturn, so we expect these cash flows to remain fairly stable going forward. We think the company will continue to deleverage, and in just a few years, the balance sheet will look much healthier than it does today.
Morningstar's fair value estimate is $13 per share, translating to a 10% free cash flow yield, or about 11 times enterprise value to trailing EBITDA. This seems reasonable considering the lack of capital requirements. Although the stock is up from the Opportunistic Investor's initial buy price, we think it's still a bargain at $7.25.
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Michael Tian does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.