TLDR

• Spectrum Brands has a deal in place to sell a key business unit for gross proceeds equal to nearly 90% of its current enterprise value.

• Regulatory fears have led investors to largely discount that agreement.

• But both parties seem intent on satisfying regulatory requirements, and even without the deal, SPB is getting in the range of fair value.

• Risks abound, and a cheaper price would help, but SPB looks intriguing here.

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13 months ago, Spectrum Brands SPB 0.00 agreed to sell its Hardware & Home Improvement business to Assa Abloy (ASAZY) for $4.3 billion, and $3.5 billion in net proceeds. After a 59% decline year-to-date, at Friday’s close of $42.10, Spectrum has an enterprise value of $4.7 billion.

That simple math shows the impressive upside potential in SPB simply as a kind-of merger arbitrage play. But it also shows how the market is discounting the likelihood of the deal actually closing.

Of course, there are reasons why the market is discounting the possibility of a sale. Notably, U.S. antitrust authorities have sued to block the deal. And in this inflationary and (possibly) recessionary environment, a deal termination is far from the only risk facing Spectrum and SPB stock at the moment.

Even considering those risks, however, and even accounting for a scenario in which the Assa Abloy agreement falls through, SPB is getting to a point where valuation is pricing in too many things going wrong, and too little potentially going right. In this market, there’s no need to rush necessarily, but there is a strong long-term case for upside.

Introducing Spectrum Brands

As it stands at the moment, Spectrum Brands operates in four segments (totals may not foot due to rounding):

• Hardware & Home Improvement (35% of revenue in FY21, 40% of segment-level Adjusted EBITDA) includes residential locksets and door hardware, with the Kwikset brand the best-known; kitchen and bath faucet and fixture manufacturer Pfister; and builders’ hardware.

• Home & Personal Care (27% of revenue, 14% of EBITDA) is split ~60/40 between Home Appliances and Personal care. Home Appliances includes the well-known George Foreman grill and Personal Care includes shavers, flat irons, and haircut kits under the Remington and LumaBella nameplates.

• Global Pet Care (24% of revenue, 29% of EBITDA) runs 70/30 between Companion Animal revenues — cleaning and training products, rawhide chews, and the Iams and Eukanuba brands in Europe — and Aquatics, which covers both aquarium kits and accessories along with consumables.

• Home and Garden (13% of revenue, 17% of EBITDA) includes household and outdoor insect control products, Cutter and Repel pesticides and insect repellents, and Rejuvenate cleaning products.

Spectrum Brands has been altering its portfolio for a few years now, since merging with former majority owner HRG Group. (Jefferies (JEF) was a major shareholder of HRG and distributed SPB shares as a special dividend back in 2019.) The company offloaded its Rayovac batteries and its global auto care businesses to Energizer Holdings (ENR) in two separate transactions in 2019. It acquired a pair of pet businesses in 2020, and picked up Rejuvenate for $300 million last year.

In February, Spectrum paid $325 million for Tristar Products, which manufactures appliances and cookware under the Copper Chef and PowerXL brands, as well as licensed product from well-known chef Emeril Lagasse. Tristar is being folded into the HPC segment. Per the Q3 call, the businesses have already been carved out internally ahead of a spin or sale in FY23.

The goal of selling HHI and spinning HPC is to create a more narrow business focused on pet care and home and garden. Unfortunately, at the moment it seems like Spectrum Brands was a bit too slow in accomplishing that goal.

Self-Evident Risks

As noted, SPB is down 59% this year. It’s not terribly difficult to see why.

Results have been disappointing. The Q3 report in August was particularly soft, with adjusted EPS of $0.54 missing consensus of $1.42, and revenue growing more than thirteen percentage points slower than the Street estimated.

After the quarter, Spectrum lowered its full-year guidance to project an Adjusted EBITDA decline in the mid-20% range, which in turn suggests a decline of roughly 30% excluding the contribution from Tristar. (That guidance does not include HHI, which is being treated as discontinued operations. After the Q4 FY21 report, Spectrum limited its disclosure surrounding the segment.) At the beginning of the fiscal year, Spectrum was modeling a low-single-digit increase in profit.

Those results could get worse. HPC is subject to the same post-pandemic trends facing so many consumer goods manufacturers. Inventories have risen. Inflationary pressures are hitting across the board: Spectrum is guiding for ~$300 million in such impacts this year, nearly 10% of revenue. Currency is another issue, given that ~60% of FY21 sales (again, excluding HHI) came from outside North America.

The balance sheet amplifies those risks. Pro forma net leverage after Q3 — this figure does include HHI — was 5.4x trailing twelve-month EBITDA. Spectrum’s 2031 unsecured notes yield 9.1%. Barring an HHI sale, debt will need to be refinanced down the line, and a new, more normalized interest rate environment implies sharply higher funding costs.

The Assa Abloy agreement is in clear jeopardy from a more activist U.S. Department of Justice. Should that deal fall through, it not only removes the premium Spectrum should receive — SPB stock gained 17% the week the agreement was announced — but leaves the company owning a home improvement business into an apparent housing bust.

It goes without saying that this is a high-risk play. This is an idea that can go very wrong long-term, and also a stock that can see yet another leg down in a continued broad market sell-off.

The Merger Arb Angle

We’ve been comfortable (and perhaps a little too comfortable) with these kinds of high-risk/high-reward plays of late for a couple of reasons.

First, we’re far from convinced that the ‘safer’ stocks are necessarily good places to hide in this kind of market environment. If an investor is going to be long, be long for the, well, long-term.

More importantly, as we wrote in July these sell-offs are the time to buy risk, at least for portfolios that can stand that risk.

Of course, it has to be the right kind of risk. Not the risks bought by investors who misquote some maxim supposedly from Warren Buffett1 while buying a company that hasn't been relevant since 1993. There's a solid case that SPB indeed is the right kind of risk.

That starts with the HHI sale. It is exceptionally simple: if the deal closes, SPB gains sharply, no matter what else happens.

Again, the agreement is for $4.3 billion gross, and an estimated (by Spectrum) $3.5 billion after taxes and adjustments. Spectrum closed Q3 with net debt just over $3 billion. Slap an 8x multiple (more on the choice of that multiple later) on FY22 consolidated EBITDA from continuing operations and add $500 million in net cash, and the stock goes to $67 — about 60% upside from here. There’s more potential upside from cost-cutting, capital allocation (Spectrum plans to remain 2x to 2.5x leveraged post-close), and a cyclical upturn in the business, when it arrives.

Between the DOJ, U.S. housing pressure, and a plunging market, it would seem on its face exceptionally unlikely that the deal will close. But that actually doesn’t appear to be the case. Last month, after the DOJ announcement came through, Assa Abloy issued a press release which said they and Spectrum “remain confident in the merits of this transaction and will jointly defend it.” On Friday, Reuters reported that — per three sources — Assa Abloy is considering selling two of its lock brands to satisfy regulators.

In a red market, SPB gained 4% in trading Friday after the news came out. All told, it gained nearly 8% last week against 1.5% for the S&P 500. It’s not difficult to see why. Assa Abloy can’t walk away from the deal until 30 June 20232, but it could prepare to do so. Were Assa inclined to let HHI go, it would have no incentive to leak its intentions to Reuters — its ADRs declined 4.5% on Friday following that report.

The agreement to sell HHI represents exceptionally valuable optionality at these levels. Again, assuming the deal does go through, the entirety of the rest of the business, with FY22 revenue above $3 billion and Adjusted EBITDA (even assuming Q4 misses implied guidance) of ~$280 million, is available for $1.2 billion or so. The news on Friday strongly suggests the probability of that option being paid is higher than investors believe.

It’s far too early to believe the stock has bottomed for good. But the 4% bounce provides at least a bit of short-term evidence that intrepid investors are seeing some of the potential value here.

HHI Performance

To be sure, the deal is not guaranteed to close. It may not even be likely to close. But it’s not as if SPB stock is obviously overvalued if Assa Abloy walks away.

After all, Spectrum will still have the HHI business. And while color on the business’s performance in FY22 has been limited, it does seem to be holding up reasonably well. CEO David Maura said after Q3 that “HHI is performing well and actually better than its competition in the industry…they’ve had to absorb a lot of inflation, and that’s hurt their short-term performance like all of us [sic], but they’re getting their pricing in.”

Per the 10-Q (see p.47), HHI did see lower volume in both Q3 and the first nine months of the year, and lower depreciation and amortisation. But the business still generated $188.9 million in after-tax income in the first three quarters, down 18% year-over-year against a tough, pandemic-driven comparison. After-tax profits in Q3 were down only 12% y/y.

To be fair, that performance doesn’t necessarily square with Maura’s contention that HHI is outperforming peers. Fortune Brands Home & Security (FBHS), the owner of Moen, saw revenue and operating income in its Water Innovations segment each decline 2% in the first half of this year. But it’s not clear to what extent non-cash charges are impacting HHI’s GAAP figures.

After Q3, Maura said that HHI in “recessionary times” was “probably a $240 million, $250 million [EBITDA] business. And when everything is running right and pricing is good, it’s probably a $300 million EBITDA business.” Notably, his Q4 target, provided on the call, suggests roughly flat year-over-year EBITDA (versus $57.8 million in Q4 FY21).

Valuing SPB If The Deal Breaks

We can assume, then, that a Spectrum Brands with a deal break is generating probably $525 million in EBITDA, perhaps a touch more. That assumes ~$280 million outside of HHI (-28% year-over-year against guidance for a mid-20s decline), and ~$245 million for HHI (in line with FY20, in Maura’s “recessionary” range, and -18% from FY21). This tracks with the post-Q3 net leverage calculation, which suggests $558 million in trailing twelve-month Adjusted EBITDA including HHI, with our full-year figure assuming a Q4 decline across the business.

We also know that Spectrum gets a $350 million termination fee from Assa Abloy if the deal is scuttled based on regulatory concerns3. Spectrum has significant net operating loss carryforwards that would shield a chunk of the gain on sale in an HHI deal, and presumably could shield nearly all of that fee from cash taxes.

Post-Q3 enterprise value is $4.739 billion; pro forma for the termination fee it’s about $4.4 billion. That’s 8.4x our $525 million FY22 estimate. On a trailing twelve-month basis, FBHS trades at 8x EBITDA. So does Central Garden & Pet (CENT) (CENTA), whose two segments line up with what Spectrum plans to close with the Assa Abloy deal and spin the Home Products business.

It’s a reasonable debate as to whether SPB merits a premium or a discount to FBHS. Spectrum is much more leveraged (5x+ EBITDA vs 2.3x), but FBHS’ other two businesses look less impressive, most notably its cabinet segment. That segment is likely a key reason why Fortune Brands is splitting into three companies, but that split also raises the risk of dis-synergies that will pressure overall profits in the future.

Central Garden is larger than a slimmed-down Spectrum would be, and it’s less leveraged, but the two companies’ EBITDA margins would be roughly similar (it’s tough to measure precisely without knowing what Spectrum’s corporate costs will be). That company also has more of its pet business in supplies rather than Spectrum’s more defensive consumables.

Given likely September quarter pressures for those rivals (which likely will lead to some modest multiple expansion simply based on lower profits), an 8x multiple for SPB doesn’t seem out of line.

On its face, that seems to set up a “heads I win, tails I don’t lose much” argument, as SPB at 8x our $525 million EBITDA estimate still is valued at about $37, when accounting for the termination fee from Assa Abloy.4

But in this environment both EBITDA and the multiple have clear risk of compression. The risk/reward seems skewed in favor of a long position, but that absolutely does not mean that downside risk is modest.

The Case For Spectrum Brands Stock

But there is some help on the way. Layoffs of salaried employees should save more than $30 million in FY23. Working capital hit Q1-Q3 free cash flow by $154 million; those factors historically reverse in Q4, and a focus on moving inventory will provide a further tailwind. Against a $1.7 billion market cap, $100-$150 million in Q4 FCF ($2.50-$3.50/share) helps the cause.

It’s too aggressive to assume that $42 is pricing in zero chance of the HHI deal closing. An official deal break would no doubt send the stock lower, and from a fundamental perspective it probably should. Based on peers, guidance, and the response to current pressures, fundamental fair value probably sits around $35.

That in turn suggests the market is pricing in about 25% odds that Assa Abloy actually closes the deal. Those odds seem a bit too low if the potential acquirer indeed is willing to make major concessions — but not quite low enough to make SPB a steal. Even 50% odds would in theory value SPB at $51, or ~20% upside. Given the short-term risk in the name, that kind of upside is intriguing, but not yet compelling. On a scenario-weighted basis, fair value is likely in the high 40s right now. But that fair value includes a healthy dose of near-term pricing risk, as well as the potential for a Q4 whiff when Spectrum reports next month.

What does help long-term is the fact that peer multiples here look potentially enticing; all three of FBHS, CENT, and SPB look attractive as standalones. Each is getting a multiple that suggests peak profits, yet that’s not necessarily the case. For SPB, home and garden and pet care should be reasonably defensive, while HHI (close to half this year’s consolidated profit) is attractive enough that Assa Abloy wanted to pay almost 16x FY21 Adjusted EBITDA (and in fact still wants to!). The Home Products business could be an albatross: a spin is unlikely to be well-received, and a sale will be difficult, to put it mildly. At ~10% of this year’s EBITDA, the segment at least is a manageable problem.

It’s too cute, perhaps, to argue that either SPB gets a short-term pop on good news surrounding the HHI sale, or investors simply wait out the cycle and hope to profit on the other end. There’s a third path in which Assa Abloy walks away, lower profits balloon the leverage ratio to 6x-plus even with the termination fee, and the stock keeps slipping.

But if antitrust authorities can be satisfied there are real odds of a 50%+ upside in the next twelve months. If not, SPB is trading at ~7.7x FY18-FY19 EBITDA, with some defensiveness in pet care, home and garden. Plus the repair and renovation portion of HHI revenue.

There are risks here, certainly. But those risks are amplified versions of those facing the overwhelming majority of public companies right now. The rewards available here, however, are not available with most other stocks in the market.

Tickers mentioned: SPB 0.00 $ASAZY FBHS 0.00 CENT 0.00 CENTA 0.00

As of this writing, Vince Martin has no positions in any securities mentioned.

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