Nothing Is Coming Easy For Spectrum Brands (NYSE:SPB)

There’s always a gap between what managements want to do and what is actually possible given current circumstances. Mike Tyson said it better, “everybody has a plan until they get punched in the face” and Spectrum Brands (NYSE:SPB) has taken more than a few hits as management tries to restructure the business around a more profitable core.

Efforts to structurally improve procurement and both supply and manufacturing costs have been challenged by difficult labor and supply chain situations over the past year-plus. Then consumer spending slowed meaningfully, leaving retailers with excess inventory and sparking a destocking cycle. Last and by no means least, the U.S. Department of Justice has dug in its heels in opposition to Spectrum’s attempt to sell its Hardware and Home Improvement (or HHI) unit to Assa Abloy (OTCPK:ASAZY).

If Spectrum can push the HHI deal to completion (either with Assa or on similar terms to a different buyer) and continue its self-improvement plans, I can get to a mid-$70s fair value pretty easily, and that’s excluding a planned spin/sale of Home & Personal Care that could add more value. On the other hand, destocking challenges aren’t over yet, and a failure to find a buyer for HHI would suggest too little upside from here to make the shares worthwhile.

Tough End-Market Trends Undermine The Quarter

Fiscal first quarter results reflected a lot of the ongoing challenges at Spectrum, but also some encouraging signs about what the comprehensive restructuring plan could ultimately produce for shareholders.

Revenue declined almost 10% in organic terms (excluding HHI as a discontinued operation), missing by about 6%. The miss was driven in large part by meaningful destocking at retailers, and particularly with respect to small appliances – a situation that corroborates a lot of what I’ve seen in retailer data.

Revenue in the Home & Personal Care (or HPC) business declined 15%, which was actually slightly better than the Street expected. Global Pet Care (or GPC) sales declined close to 4%, a modest miss, while sales at Home & Garden (or HG) declined 5% and came in a little better than expected.

Gross margin declined 70bp to 28.3%. While Spectrum has been putting a lot of effort into improving its procurement and reducing supply costs (as well as reducing manufacturing costs through automation), the company is also purging higher-cost inventory through this destocking process, which depresses margins.

Adjusted EBITDA fell 19%, beating by more than 5%, with margin down 90bp to 5.6%. While each of the segment lines came in below expectations, the misses were relatively small and Spectrum did well at the corporate expense level (driving the beat), and I find it encouraging that management could control costs in a challenging sell-through period.

At the segment level, HPC adjusted EBITDA declined 52%, with margin down 350bp to 3.6%. GPC declined 4% (margin up 40bp to 13.3%), and HG was loss-making ($2M versus a year-ago loss of $7M). The company was also loss-making at the GAAP operating profit line ($20M versus a $24M loss last year), and only GPC was profitable (with a margin of 8.2%).

Destocking Has A Little Further To Go

After a disappointing holiday season, retailers were left with excess inventory across a wide range of categories (particularly kitchen appliances, as it relates to Spectrum). These retailers have by and large chosen to run down excess inventories slowly and have avoided sweeping clearance sales. With still-weak consumer spending, though, that’s lengthening the inventory correction cycle.

Management revised its FY23 guidance to flat revenue (a roughly 2% cut relative to the Street), with underlying volume declines. With pricing and cost actions, though, management is expecting low double-digit growth in adjusted EBITDA.

I do see some risk to this outlook, and my expectations are lower. I’m concerned that consumer spending is going to underwhelm, further stretching out this destocking cycle, and I think retailers are likely to be more cautious in restocking toward the end of the year, taking their chances on being understocked rather than have a repeat of the last 12 months or so, and particularly in light of a weakening economy (though a strong job market) and a weak housing market (small appliance sales don’t correlate as well with housing, but there’s some link).

Weaker sales will make double-digit EBITDA growth harder to achieve, but I think there could be some relief from input/supply costs, and there’s more to be gained from the company’s restructuring efforts. Even so, I am looking for double-digit growth, even if just barely.

Can Spectrum Close Its HHI Sale?

When announced back in 2021, the sale of the HHI segment to Assa Abloy for $4.3B looked like a win-win for both parties, with the sale allowing Spectrum to accelerate its restructuring and refocusing efforts, while also getting a chunk of cash to drive debt reduction. The DOJ did not see this as a win, though, and filed suit to block the deal a year after it was announced (September of 2022).

Assa Abloy has offered the remedy of selling its Emtek and Smart Residential businesses to Fortune Brands Innovations (FBIN), and while this would seem to resolve the antitrust issues (at least as far as the Herfindahl-Hirschman Index goes), the DOJ flatly rejected it. Management at Spectrum has taken some public swipes at the DOJ’s position and maintains that they’ll close the deal this summer.

Last week there was a joint status report filed ahead of the potential start of the court case, and that report said that all three parties were “close to an agreement” and that there would be another update (potentially a joint stipulation that would settle the matter) before February 20.

A negotiated settlement would likely be best for all parties. While I generally think that the DOJ has been too passive about M&A over the last 10-20 years, this seems like a strange hill on which to make a stand, particularly given the remedy proposed by Assa Abloy (the sale to Fortune Brands). Still, going to court is always risky, particularly when the DOJ wins about 85% to 90% of these cases, and a settlement likely ends up as the best option.

The Outlook

What happens if Spectrum can’t sell HHI to Assa Abloy would be an article for another time, but in the short term, it would be bad for sentiment and bad for valuation, as Spectrum has a lot to gain from deleveraging the balance sheet and moving along with its restructuring plans.

Speaking of which, while I do think that the disposal of HPC is a “when, not if” prospect, the reality is that the business needs to stabilize before a disposal is really viable. I believe a sale to private equity would be the preferred option, but a spin-off is a possibility, as is a sale to a strategic buyer.

Given all of the above, I value Spectrum with the HHI sale going through and HPC remaining a part of the business for the time being. I expect modest revenue contraction this year and long-term revenue growth in the low single-digits. I could see strategic acquisitions and brand innovation driving some upside, but I don’t see this as a market-plus growth business today.

I’m expecting adjusted EBITDA margins to improve from 9% in FY’22 to almost 10% this year, 11% in FY’25 and 12% in FY’28. I do expect working capital to drive higher free cash flow in the short term, but over the longer term, I expect FCF margins in the mid-to-high single-digits, driving normalized FCF growth in the mid-single-digits.

Discounted back, and including the HHI proceeds, I get a fair value in the mid-$70s. I get a similar fair value on the basis of a margin/return-driven EV/EBITDA process that gives me a forward multiple of 8.5x on FY’24 EBITDA; discounting back a year, I get a fair value of around $73.50. In this case, given the destocking pressures, I think looking forward a year is reasonable, as I don’t think FY’23 results are necessarily a fair representation of core earnings power here.

The Bottom Line

The trailing returns from Spectrum Brands over the last decade have been terrible, but I do think management is actively pursuing a new business model that can generate higher sustained profits, margins, and returns, and I believe that will translate into better results for shareholders. That said, management can only control what’s in their power and there have definitely been some external challenges of late. I do see enough value here to make this worth a closer look as an event-driven turnaround/restructuring idea, but investors should note that the risks here are higher than average.

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