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Central Garden & Pet: No Longer A Dog

Summary

Central Garden & Pet is active in the US pet supplies and garden categories.

Company had a rough couple of years as a result of commodity inflation, increasing competition and resulting sales and margin erosion.

Turnaround appears well underway with sales and margins recovering substantially during 2015.

Progress may be sell-fulfilling since improved financials will allow the company to refinance expensive debt and increase its net margin as a result.

Central Garden & Pet (NASDAQ:CENT) (NASDAQ:CENTA) is a company focused on products for domestic animals and the garden. The company has gone through a couple of very difficult years with significant margin erosion and pressure on revenues. During the reported nine-month period of fiscal year 2015, which recently ended at the end of September, the company made significant progress with regards to stabilizing its revenue performance and improving its margins.

As a result of this improvement, the company's share price has delivered remarkable gains from rather depressed levels seen only last year. However, the company's valuation remains rather modest on such metrics as price/sales (around 0.5) even after the significant run in its stock price. Since I believe that the turnaround can provide the company with a more or less self-propelling motion towards an improving bottom line, the current price level may well provide an interesting entry point.

Competitive position

A potential concern regarding an investment in Central Garden & Pet is its relatively weak competitive position in both of its product segments. In the garden products segment, which includes such items as grass seeds and bird feed, the company is the perennial underdog to Scotts Miracle-Gro (NYSE:SMG), while in the pet products segment the company runs into strong competition from Spectrum Brands (NYSE:SPB) and Hartz Mountain among others.

The latter is nowadays owned in roughly equal parts by consumer products company Unicharm (OTCPK:UNCHF) and Sumitomo (OTCPK:SSUMF) from Japan. On top of this, competition in dog and cat treats and premium pet foods also comes from branded consumer behemoths like Mars, Nestle (OTCPK:NSRGF), Colgate-Palmolive (NYSE:CL) and J.M. Smucker (NYSE:SJM). Needless to say, these well-known companies can rely on their marketing muscle and financial staying power to sustain a competitive advantage. Given the breadth of their product offerings, it is also fair to state these larger companies have more leverage with retailers like Wal-Mart (NYSE:WMT).

This last retailer accounted for roughly 17% of 2014 revenues at Central Garden & Pet, but its reliance on big retailers does not stop there. Companies like Home Depot (NYSE:HD), Lowe's (NYSE:LOW), PetSmart (NASDAQ:PETM) and PETCO are also very significant customers. Since Central Garden & Pet is substantially smaller than all aforementioned competitors and retailers, the company in my opinion has a competitive disadvantage not only with regards to the competition but also with regards to its own customers.

An important way the big retailers have impacted Central's business is through the development of private label brands for instance, the impact of which the company has sought to soften through acting as a manufacturer of such products. While this has been beneficial to sales and its utilization of manufacturing capacity, it is also potentially hurtful to its branded business.

It is also somewhat unclear how this development impacts its shelf space, as most retailers would have a strong incentive to prioritize private label products over branded ones. Either way, Central probably believes large retailers will have the opportunity to source their private label needs somewhere in the marketplace, which means it might as well be them supplying it. I think this makes sense as long as the margin earned is somewhat decent.

Their added role as private label supplier also serves to fill up their supply shipments, thereby decreasing cost per product shipped, which is also a positive factor. Another way the company tries to enlarge the sizes of its shipments is by including third-party brands into its logistics chain. This works well in the pet segment especially because the pet supplies industry is still fragmented and therefore has a lot of small competitors who have limited distribution capabilities of their own. A potential positive side effect is that the company can learn a lot about what competitor products work well in the marketplace and establish relationships that may one day turn into acquisitions (which Central actively looks for).

Recent financial performance

Fiscal year 2014 was a difficult year with the second sales decline in a row and some margin pressure due to the deleveraging effects of a lower revenue base. Sales were down by -2.98% due to lower sales in both the pet (-4.8%) and the garden segments (-0.8%). Reported gross margin was up slightly to 28.3% from 28.05% a year earlier, while the operating margin moved up to 3.5% from 2.43%.

However, the prior year period did include charges related to the discontinuation of certain garden product lines introduced in 2013. Charges of $11.2 million and $16.9 million were taken against operating income for 2013 and 2014 respectively as a result of this decision, which was necessitated by poor consumer acceptance and the resulting lack of support for these products from retailers. This also means that the underlying results for 2014 and 2013 look somewhat different once you correct for these items.

First of all, there is the fact that the underlying gross margin improved from 28.7% in 2013 to 29.2% in 2014, which is notably better than the reported margin improvement. And secondly, the fact that the underlying revenue change was closer to -2.74%, which is also somewhat better than GAAP results. The result of this is that the underlying operating margin also improved more than reported GAAP numbers would suggest; it moved to 4.2% from 3.6% a year earlier. There is no doubt that the GAAP numbers offer a better reflection of the company's financial...


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