Description

Enesco (ENC) is a major manufacturer of gift and collectible items with $269 million of revenue in 2001, a $93 million market cap, $7 million of total debt and $8 million of cash. The company manufactures and distributes a wide variety of porcelain and resin figurines, ornaments and home accessories licensed under names such as Precious Moments and Cherished Teddies as well as Disney and Looney Tunes characters. While the collectibles business is not the most robust growth industry, Enesco is positioned to benefit from a shift in distribution methods, new management, new product lines and a significantly reduced cost structure.

While Enesco only had EPS of $0.08 in 2001, it is likely the company will make at least $0.70 in 2002 even on flat sales driven primarily by a significantly reduced cost structure. This implies a P/E of 9.6x current year earnings for a company with no net debt, strong free cash flow, dramatically improving margins and the opportunity to derive future revenue benefit from shifting distribution patterns. The shares are currently trading only slightly above tangible book value of $5.50. In addition, buying the shares in the current range gives investors an entry point in line with the $6.50 strike price of the new CEO’s 300,000 options.

The benefit of new management began in March, 2001 when the company hired new CEO Dan DalleMolle, a former high-ranking manager with Newell-Rubbermaid, a company known for cultivating strong management talent. DalleMolle previously served as president of several different operating divisions within Newell-Rubbermaid and background research has indicated a history of strong operations experience and increasing the profitability of low margin businesses through efficiency improvements.

The new CEO is using his former relationships as an operating division president at Newell-Rubbermaid to add distribution through the mass merchants such as Wal-Mart, Target and Kmart to supplement the traditional distribution channel of specialty gift and card stores that has grown stagnant in recent years. The gift and collectibles industry was already trying to move towards mass merchant distribution. However, through the experience of DalleMolle and his management team, Enesco appears to be the only giftware manufacturer to understand this channel and should have a significant advantage over its competitors in the mass merchant channel. DalleMolle has hired additional Newell-Rubbermaid alumni to serve as the head of sales and the head of operations giving Enesco an infrastructure suited to serve the mass merchants effectively, a key advantage over its competitors. Enesco is currently testing over 100 SKU’s in 100 Wal-Mart stores. The 20 square foot section dedicated to Enesco products in the test stores is reportedly tripling Wal-Mart’s minimum sales criteria and the base of test stores will be expanded by 40 in the 2nd quarter of 2002. Enesco is also expanding its product line to include more home accessory items which will also begin to be sold through Wal-Mart stores in the 2nd quarter. The company significantly expanded distribution of its traditional products through drug store chains such as Walgreens and CVS in 2001 and is targeting Linens ‘N Things and Bed, Bath & Beyond as distribution channels for its new home accessories in 2002.

In keeping with the new CEO’s efficient operations expertise, Enesco implemented significant cost reduction programs in 2001. These efforts included a total headcount reduction of 25% of the company’s employees, the closing of a manufacturing facility and the exit of at least one expensive lease agreement for showroom space. The closing of facilities and headcount reduction are expected to provide about $12 million in annual expense reduction and should have little impact on the company’s ability to meet demand as the majority of manufacturing is contracted with independent manufacturers in the Far East. The company has also favorably renegotiated terms with its contract manufacturers which should provide gross margin benefit in the 2nd half of 2002. Any future sales growth should be highly leveraged by the reduced cost structure dropping a larger portion of incremental sales to the bottom line.

The largest risk to the story is that sales have declined for the last 3 consecutive years. While the traditional distribution channel has grown stagnant in recent years, the company believes it can maintain flat sales into the specialty gift store channel while ramping up revenue to the new mass merchant channel. Also, all gift and collectibles items have lost momentum in recent years, but the industry as a whole hopes to benefit from a rebranding and repositioning effort to enter the home accessories market. While margin improvement should be substantial for Enesco (look for 6.5% operating margin in 2002 versus 1% in 2001), the company will likely always have lower margins than its competitors such as Russ Berrie and Department 56 because it primarily pursues a strategy to license brands (i.e. pay royalties that reduce margins) rather than internally developing brands like its competitors.

Catalyst

Catalysts should come in 2002 from positive announcements regarding relationships with the mass merchant channel and improved operating performance as the first full year of the lower cost structure unfolds. Assuming modest sales growth and a return to a 5.5% net margin, EPS could reach $1.25 within a couple of years. A multiple of 10x would suggest a double in the share price. Also the company should be able to grow free cash flow from $9 million in 2001 to in excess of $20 million over the next 4 years. This stream of free cash flows discounted at 15% yields a present value of $17. Downside risk appears limited by the strong balance sheet and $5.50 tangible book value. In addition, the new CEO just bought 17,300 shares.