Description

 

NWL Rubbermaid - Short ($42)

 

We are recommending a short position in Newell Rubbermaid (NWL), a consumer products company operating across 5 segments – Writing (30% of Sales; 48%% of Segment Income), Home Solutions (28% of Sales; 23% of Segment Income), Commercial Products (15% of Sales; 11.6% of Segment Income), Tools (15% of Sales; 11% of Segment Income), Baby/Parenting (13% of Sales; 6.5% of Segment Income).

 After a rough decade in which several different CEOs undertook multiple restructurings, Newell hired another new, charismatic CEO in the middle of 2011, Michael Polk. Like his predecessors, Mr. Polk laid out another restructuring program – named Project Renewal – designed to permanently alter the cost structure. The savings achieved would enable a material step-up in “core” growth (via increased ad. Spend) and steady margin expansion.

 

While Mr. Polk’s tenure has co-incided with an astonishing turnaround in Newell’s stock performance, the actual operating performance has been considerably less impressive. Indeed, we believe Mr. Polk has fostered the illusion of progress in both margin expansion and “core” sales growth by relying on two wholly unsustainable levers to drive performance; Venezuela Hyperinflation and accounting shenanigans.  Below we analyze how this has been done and quantify the impact this has had on its results.

We believe there are several catalysts over the next 12-18 months that will enable investors to get a more accurate picture of Newell Rubbermaid’s operating results. As this happens, both earnings power and multiple will have to be re-appraised, leading to substantial downside. Our base case calls for a $28 Price Target, or roughly 30% downside. We believe this downside is attractive for a large cap, relatively low beta name without massive short interest.

 

 

 

 

Venezuela

 

 

 

Venezuela is a hyperinflationary disaster yet, for political reasons, the country has refused to devalue the official currency to acknowledge this reality.

 

 

 

 Prior to February ’15, there were 4 rates in Venezuela, the official Cencoex rate (6.3 Bolivars to $), SICAD 1 (12 Bolivars to the $), SICAD 2 (50 Bolivars to the $1), and the black market rate (200 Bolivars to the $). The discrepancy between the black market (actual) rate and the “official” exchange has created profound distortions in how companies are reporting results. In effect, many multi-national companies have been able to experience the benefits of hyperinflation (in Local Bolivar terms) while translating these hyper-inflated results back at MASSIVELY overvalued FX rates. To be sure, companies have slowly moved to weaken the FX rate they use, but the adjustment has occurred at a much slower rate than inflation.

 

 

 

This has had two effects

 

 

 

1. Core Growth has been overstated because “core” growth in Venezuela will always be equal to rate of inflation. If 3% of a company’s prior year Revenues were from Venezuela, and Venezuela’s inflation rate is 100%, Venezuela will contribute 300 bps to total company core growth. For large CPG companies where the difference between 2% and 4% “core” growth is everything, this Venny contribution has been a gift.

    

2.  Not only are hyperinflated results being translated at a relatively fixed, overvalued exchange rate, but the Government also enables certain companies (as well as friends and family!) to  import $ denominated goods at preferred foreign exchange rates. For example, a company with access to Cencoex (6 VEB to 1) or SICAD 1 (12 VEB to 1) will pay 6 VEB or 12 VEB to import $1 worth of goods. The firm can then sell these goods on the open market at rates that approximate the black market rate (200 VEB/$). As inflation rates spiral, and Black Market rate collapses, these companies input prices stay constant, and gross margins explode.

 

 

 

Yet if these Bolivar profits were translated into $ at the real exchange rate, or even SICAD 2 (50 VEB to $) almost all of these operating profits would be wiped out. This is not a simple translation of assets issues (though that would occur as well as Bolivars are revalued on balance sheet) but an issue that speaks to earnings power.

 

 

 

This issue is even more pressing now as Venezuela has recently scrapped SICAD 2 (50 VEB) in favor a more market driven rate, the SIMADI (200 VEB to $). So far in Q2, several companies have moved to SIMADI. That said, there are several companies at SICAD I (12 VEB) who had refused to move to SICAD 2 (50). They must now confront having to move to SIMADI (200). That they will do so is inevitable, but several management teams (including NWL) have sought to delay the day of reckoning, enabling them to massively overstate operating results in the meantime.

 

 

 

The Effect on Newell of Venezuela Hyperinflation

 

 

 

 Venezuelan hyperinflation has had an extremely beneficial (if subtle) influence on Newell’s results. The impact has been felt in the tow areas where Newell was in need of the most help – “Core” growth and operating margins.

 

 

 

1. Core Growth

    

   2012/2013

    

   In ’12, Venezuela represented just 1% of NWL’s Revenues of $5.5 billion, or ~ $55 million. In ’13, Venezuela represented 1.4% of Newell’s revenue, or $80 million. This 55% YoY increase occurred despite a change in FX rate used from 5.3 Bolivars to 6.3 Bolivars per $ made in early ’13. To achieve this 55% $ denominated increase in Venny Revenues despite a 17% devaluation of the currency necessitated a “core” Venezuelan growth rate of ~ 75%.

    

   As Venezuela had been 1% of Revenue in both ’11 and ’12 (with no FX change in ’12), it is safe to assume that this 75% YoY increase was a noticeable step up from the previous year. With 1% of Revenues increasing 75%, Venezuela contributed 75 bps to Newell’s total reported “core” growth of 320 bps, or ~25% of total. It should be noted that the 3.2% core growth rate was roughly 80 bps increase from 2012 “core” growth rate of 2.5%. In other words, Venny hyperinflation explained almost all of the acceleration.

    

   2013/2014

    

   In 2013, Venezuela represented 1.4% of total NWL sales. In 2014, Venezuela also represented 1.4% of total NWL Sales. So Venny sales (in $) were flat despite an early ’14 shift ix FX rate used from 6.3 Bolivar/$ to 12 Bolivar/$. To achieve this result –flat $ sales despite a nearly 45% drop in FX – required Venny Core Sales increase ~ 90%.

    

   With Venny 1.4% of ’13 Sales, a 90% increase in Venezuelan “Core” would have contributed 130 bps of the 310 bps of NWL’s “core” growth rate in ’14. This 130 bps marks not only an acceleration from the ’13 Venny contribution, but was almost 40% of “core” growth achieved during the year.

    

   So Venezuelan hyperinflation contributed ~25% of “core” growth in ’13 and ~ 40% of “core growth” in ’14. This explains almost all of the acceleration in core growth management has tried to pass off as a result of internal initiatives. Put differently, if we strip the effects of Venny hyperinflation from NWL results, the acceleration in core growth would be non-existent.

    

2. Margins

    

   Even greater than the influence on “core” growth has been Venny’s effect on NWL’s operating income and operating margins. While Venny was 1.4% of Revenue in ’14, it was 5.4% of operating income. This reflects Venny’s 80% OPM’s vs. 13% for rest of the company.

    

   Every quarter, Newell quantifies the influence of a 10% weakening of the Bolivar would have on its annualized Revenue and annualized Operating Income. Below is this sensitivity from Q1 ’13 through Q4 ’14. 

    

    

   

    

    

   What this shows is that Venenzuela has increased from an annual run rate of $50 million in net sales and $20 million in operating income to annual run rate of $80 million in sales and $60 million in operating income by end of ’14. This suggests that ~ $30 million of Newell’s Operating Income Variance from ’12-’14 can be explained by Venezuela. It also means that the margin expansion attributed to internal restructuring was, instead, a product of the increase in contribution from Venezuela.

    

 

 

 

Pro-Forma

 

 

 

 So what will NWL’s results look like if they revalued to the SIMADI of 175? (Actually lower, but 175 will suffice for illustrative purposes).

 

 

 

 Below I translate 2014 numbers and the sensitivity provided in NWL’s 2014 10-K.

 

 

 

 

 

 

Beyond just the magnitude of the immediate earnings impact hit, the decline in margins would produce serious questions about what really has driven the steady margin expansion of past few years despite the incremental advertising headwind. Contrary to management assertions, it does not seem to have been “Project Renewal.”

 

 

 

 A secondary impact will be felt on subsequent “core” growth and operating income. Once the Bolivar is marked to market, Venny sales/Total Sales will effectively fall to 0%. This will, in turn, lower core sales growth in ’16 as Venny’s hyperinflationary increases would be off a negligible base.

 

 

 

 The same goes for operating income. When they mark Bolivar to market, Newell will not only lose 5.4% of operating income but the fastest growing and highest margin part of its operating income. As this is reduced to 0%, it will become impossible for Newell to reach its operating income targets.

 

 

 

Accounting Shenanigans

 

 

 

 Yet despite having the (substantial) optical tailwinds from Venezuelan hyperinflation, Newell has still had to employ various accounting distortions to produce its desired results. Collectively, these shenanigans have been a substantial driver of operating income variance and have had, almost without exception, the effect of making margins appear more robust than they would otherwise be.

 

 

 

Beyond the serial restructuring associated with Project Renewal (addressed later), the following artifices have been meaningful contributors to NWL’s OI growth since Polk’s tenure.

 

 

 

1. Reduction in Allowances as % of Doubtful Accounts

    

   

    

    

2. Reduction in Provisions as % of Gross Inventory

    

    

   

    

    

3. Undisclosed LIFO Liquidation

    

    

   

     

    

   Adjusted Operating Income Variance for Newell Rubbermaid

    

   

    

 

 

 

Restructuring Costs/ Projects

 

 

 

The numbers above are interesting when viewed against Project Renewal’s original goals for Project Renewal. Launched in late 2011, Project Renewal has had three phases. Phase I and Phase 2 will be completed by mid ’15 at an aggregate cost of $340-$375 million ($300-$340 million cash) with run-rate savings ranging from $275 to $325 anticipated upon completion. A third phase was announced in October ’14. This will consist of $200 million (all cash) in spend in hope to achieve $200 million in incremental run rate savings by end of ’17.

 

 

 

 Below shows the cumulative amount of Project Renewal Spend incurred through ’13 and ’14 and the proportional amount of savings that would be anticipated. I average run-rate savings at end of ’13 and ’14 to arrive at an estimate for realized savings in ’14. I then subtract the incremental advertising spend to get what an expected operating income variance.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Yet actual, organic variance in operating income from ’11-’14 was $60 million, or roughly 35% of the $167 that would have been anticipated. Moreover, of this $60 million, 60% can be attributed to changes in discretionary assumptions (Allowances and Provisions), 20% to Venny Hyperinflation, and 15% to increases in LIFO liquidation profits. So if we normalize for these unsustainable drivers, Newell’s organic operating income was flat despite $300 million in restructuring costs during that time.

 

 

 

We believe these “savings” are likely real, but the structural weakness of selling to Big Box Stores demanding ever greater concessions means that little of the savings stick to the ribs of NWL. In effect, the incessant restructuring expense is a very real cost of doing business with its customer base. If NWL did not restructure, reported margins would collapse.

 

 

 

Other

 

 

 

 

 

 

 

• Former CFO resigned in July ’14 to become CFO of Spectrum Brands, a smaller company. He had been appointed by current CEO Polk and had been at NWL for 30 years 

• Increase in non-GAAP add-backs unrelated to Project Renewal Restructuring

• Have boosted Cash from Ops in past by retaining Receivables of Divested Companies. Note CFO is a compensation driver and this enabled them to meet hurdles.

• WMT is 11% of Sales, but 17% of US Sales.

• Large exposure to ODP/Staples and results would suffer if merger is consummated

   

   

  Catalysts

   

 

Move to Simadi Exchange Rate. Several companies (Coke, Ingersoll Rand, Kimberly Clark) have all already made this adjustment in Q1 ‘14. It will happen, but the issue is when management teams are willing to fess up. Despite Coke’s movement to Simadi, Pepsi (the very next day!) refused to move to Simadi and used SICAD 1. This occurred despite (or perhaps because of) Pepsi’s larger dependence on inflated results out of Venny. So timing is hard to predict, but the eventual move is not.

 

 

 

 

 

 

 

 

 

Valuation

 

 

 

 

 

 

 

If I mark 2015 guidance to market (using SIMADI), I get $1.98 in adjusted EPS vs. $2.16 consensus. Moreover, my estimates in out years are materially lower than street estimates because the $1.98 will also grow more slowly than the $2.16 (because Venny as % of total OI and EPS falls to 0% and it was fastest growing segment).

 

 

 

 

 

 

 

Do to the incessant restructuring (almost all cash costs), NWL converts only about 85% of adjusted Net Income to FCF over time despite engaging in no real growth cap. Ex. Assuming 85% of adjusted EPS converts into FCF/share, and using a (very generous) 3% terminal growth rate and 9% cost of equity capital, NWL should trade at a roughly 6% FCF Yield, producing  28% PT, or 40% downside.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

We think 9% Cost of equity is appropriate in this environment as its business as is fairly steady but company does already have over 2x of Leverage.

 

 

 

 

 

 

 

 

 

Risks

 

 

 

1. Short term refusal to move to Simadi could enable them to beat numbers and reported EPS. As previously shown, the move from Cencoex (6 VEB/$) to SICAD 1 (12 VEB/$) from ’13 to ’14 meant that the $ Revenues out of Venny were flat in ’14 despite 70%-80% Local Revenue increases. If no adjustment is made to SICAD 1 in ’15, then $ Revenues should track closer to underlying Venezuelan growth as the fx headwind would be minimal.

    

   We would stress that this would all be optical illusion as no money can be paid out at SICAD 1. Indeed, it would simply expand the gap between reported results and actual results. Yet the analyst community has been willing to ignore the sources of growth, so it is not altogether clear that investors would see through it.

    

    

2. Even the move to SIMADI would not inhibit this year’s reported “core” growth. This is because “Core” growth is a function of the previous year mix. As Venny was 1.4% of Revenues in ’14, a 50% increase in Bolivar denominated Revenues would generate a 70 bps contribution to 2015 “core” growth. Given this dynamic, it is virtually impossible for Newell to miss on its “core” growth targets because any shortfalls can be remedied by boosting pricing in Venezuela.

    

   That said, “core” growth will slow in subsequent year after the Venny FX is marked to market (as Venny Revenues will fall from 1.4% of Previous Year Revenues to 0% of Previous Year Revenue).

    

3. Management might make a large acquisition and announce it concurrently with the move to SIMADI. At 2x leverage (2.3x marking Venny Cash at $0), there is some capacity. This would be done to avoid downward adjustments to EPS. One would think the higher leverage required to meet the same EPS numbers would lead to multiple compression given the higher risk profile. Yet the current environment does not discriminate between EPS accretive and NPV positive deals. With after-tax cost of debt at zero, EPS shortfalls can quite easily be covered up by purchasing just about anything, regardless of return. Management seems to have taken a step in this direction with 3 deals in rapid succession at end of ’14.

    

 

 

 

 

 

Update (Q1 ’15 Numbers)

 

 

 

 

 

All of Newell’s tricks were on display in Q1 ’15.

 

 

 

 

 

Core Growth

 

 

 

Reported "Core" Growth of 4.7% looked impressive at first glance. Even more impressive, "Win Bigger" businesses had "core" growth of +7.4% YoY. Yet both these numbers were deeply distorted by two things, Venezuela contribution and the decision to "divest" the Medical Carts business within Commercial Tools segment. 

 

 

 

Venezuela

 

 

 

Venezuela was 1.6% of Q1'14 Revenue and 2% of Q1'15 Revenue. Q1 '14 used an average FX rate of 7.7 VEB whereas Q1 '15 used 12 VEB. The 25% increase in Venezuelan Revenue despite a 40% drop in FX suggests local currency Revenue increased ~ 100% YoY (in-line with Venny inflation). 

 

 

 

With 1.6% of Q1'14 Revenues growing at 100%, Venny contributed 160 bps of the 4.7% "Core Growth".

 

 

 

In other words, ex-Venny,

 

 

 

- "Core" growth would have been + 3% not +4.7% 

 

 

 

-  Lat. Am "core" would have been +2% not + 25.5%

 

 

 

-  International "Core" Sales would have been - 2.1% not + 4% YoY

 

 

 

-  Writing (where all Venny is) would have been +3.1% not + 9% YoY 

 

 

 

-  "Win Bigger" businesses would have been + 4.4% not + 7.4% YoY

 

 

 

 

 

 

 

Divestiture of Medical Cart business w/in Commercial Products

 

 

 

"Planned" Divestiture had not been disclosed until the quarter results were announced. The revenues from the divested unit were, conveniently, down substantially YoY, so the decision to "divest" the business, and drop it from the comp base, had a substantially positive effect on "core" sales of Commercial Products, Win Bigger (because Commercial Products is in Win Bigger), and Newell itself.

 

 

 

 

 

Absent this "planned" divestiture,

 

 

 

- Commercial Products "Core" + 4.4% vs. +9% reported

 

 

 

- Total Newell "Core" lower by 70 bps

 

 

 

- Win Bigger lower by 110 bps

 

 

 

Removing the beneficial effects of both Venezuela and "planned divestiture",

 

 

 

- Core NWL growth was +2.4% vs. +4.7% reported

 

 

 

- Win Bigger was +3.4% vs. +7.4% reported.

 

 

 

 

 

Margins

 

 

 

Margins were stronger than analysts estimated but this was wholly a function of stronger than expected margins in the Writing Segment. The increased margins in the Writing Segment are, of course, wholly attributable to Venezuela.

 

 

 

 

 

Other

 

 

 

- After just expanding Project Renewal in November '14 by an incremental $200 million through '17, NWL decided to expand it by yet another $150 million through '17. That is $50 million of incremental cash expense/ annum in addition to the $70 million from the Nov'14 expansion.

 

 

 

This only strengthens my previously mentioned belief that adjusted EPs cannot be used to value NWL as cash restructuring costs of $100 million per annum have been recurring for 15 odd years and show zero signs of ever going away. Given the weak FCF conversion of adjusted Net Income, FCF must be used to value it.

 

 

 

- Management was deceptive about Venny, stating that the impact (of moving to Simadi) would be limited in 2015 numbers. Yet the reason is because they pulled forward Venny Sales massively into Q1 '15. As they say in the 10-Q, this was due “to higher volume in Venezuela in advance of price tagging on packaging requirement”. Giving a sensitivity for the last 9 months when you pulled forward all the profits into Q1 '15 is truly misleading. 

 

 

 

 

Catalyst

 

Catalysts

  

 

• Move to Simadi Exchange Rate. Several companies (Coke, Ingersoll Rand, Kimberly Clark) have all already made this adjustment in Q1 ‘14. It will happen, but the issue is when management teams are willing to fess up. Despite Coke’s movement to Simadi, Pepsi (the very next day!) refused to move to Simadi and used SICAD 1. This occurred despite (or perhaps because of) Pepsi’s larger dependence on inflated results out of Venny. So timing is hard to predict, but the eventual move is not.