Central Garden & Pet: Appealing Despite Concerns (CENT)

At the start of this year I observed that Central Garden & Pet Company (NASDAQ:CENT) has seen a strong 2021, with a stronger 2022 expected following some dealmaking. That anticipated strength was not seen in 2022 which turns out to be a flattish year which together with poor cash flow conversion has raised some questions marks among investors.

Some Background

Central Garden & Pet has seen a strong 2020 on the back of the pandemic, as this momentum inspired confidence with the company announcing two substantial deals late that year, leaving some questions marks with me at the time.

The company is active in two major industries, operating in a $100 billion pet industry and a $33 billion garden segment, as both these markets have seen great demand on the back of the pandemic, with people spending more time and resources on their homes, families, pets and gardens. In terms of the business allocation it is the pet industry which is responsible for just over half the sales of the company.

The company is essentially a product of many deals pursued over a long period of time, creating a $2.4 billion business in the year 2019 on which earnings of $1.60 per share were reported. With the operational performance stagnant for years and shares trading at 17 times earnings, that valuation looked largely fair. The company grew fiscal 2020 sales (reported in November 2020) to $2.7 billion on which it posted earnings of $2.20 per share, the result of the boom induced by the pandemic.

The company announced two large deals towards the end of the year, with the purchase of Hopewell Nursery (on which few details were announced) as the company paid $542 million to acquire Green Garden Products as well, with these deals and few financial disclosures leaving some question marks.

Dealmaking resulted in solid growth in 2021 as the company has seen some margin pressure as the momentum of the core operations reversed. In the end the company grew 2021 sales by 23% to $3.3 billion as earnings came in at $2.92 per share, a dollar ahead of the initial guidance for the year. Net debt fell to three quarters of a billion, translating into a 2.3 times leverage ratio based on $330 million in EBITDA, as the company guided for 2022 earnings around $3.10 per share.

With shares trading at $52, Central Pet traded at around 17 times earnings, while leverage has been manageable, as the two deals late in 2021 appeared to have played out all right. Recognizing that my skeptical opinion has made me a bit too cautious, I hoped to become a buyer on significant dips in 2022 which have arrived.

Dipping

Fast forwarding between early January, and today we see shares down from $52 to $37 as a many Covid-19 beneficiaries have seen their business performance and share price revert.

It has been relatively quiet on the corporate front this year, with no major (M&A) events taking pace outside the regular quarterly earnings schedules. After posting 12% revenue growth in the first quarter, the company maintained the 2022 guidance which called for earnings of $3.10 per share, or better. This outlook was maintained alongside the second quarter earnings report in May, even as revenue growth slowed down to just 2%, which was a warning sign of course.

With risks to the outlook clearly appearing on the horizon, Central Garden announced a month later that after that a poor garden season it was forced to cut the full year guidance. The company now sees earnings equal to, or just above last year’s earnings number of $2.75 per share.

Third quarter sales fell just over 2% to $1.02 billion as earnings came in at $2.82 per share for the first three quarters of the year, two cents ahead of last year. The revised guidance implies that fourth quarter earnings likely come in around break-even levels, no surprise given the seasonality of the business.

Net debt inched up to $990 million as working capital conversion has been poor this year, notably with inventory levels being on the increase. With EBITDA largely in line with last year’s performance, leverage has increased to nearly 3 times.

What Now?

With the share price performance being far worse than the cut in the earnings outlook, a forward 17 times earnings multiple has fallen to 13-14 times earnings which in itself looks really interesting, yet poor cash flow conversion is a real concern as debt is quite high and focus should be on cash flow conversion in the near term.

Amidst all of this, now is the time to get upbeat on the stock, although I am not that impressed with the cash flow performance this year resulting in minor leverage concerns. If these are addressed by solid cash flow management in the upcoming year, it is the non-demanding multiple which should look interesting enough to buy the dip.