Add Back Depreciation To Free Cash Flow Because It An Analysis of Energizer Holdings (ENR)

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An Analysis of Energizer Holdings (ENR)

Energizer Holdings (ENR) owns two of the world’s great brands: Energizer and Schick. Currently, about 70% of the company’s sales come from the battery business and 30% come from the razor and blades business. International sales (from both businesses) account for almost exactly half of all sales.

Energizer’s acquisition of Schick was a steal. In 2003, the company bought Schick – Wilkinson Sword from Pfizer (PFE) for just under $1 billion. In 2005, Schick contributed just under $120 million in profit. This figure does not properly allocate certain shared costs to Schick; but, it does include depreciation expense in excess of maintenance cap ex. Therefore, I believe $125 million is a good estimate of the true economic benefit provided by Schick in 2005. Over the next few years, further margin improvements are likely at Schick; because, between product launches, fewer razors and more blades will be sold. Energizer’s cost of capital for the Schick acquisition was very low. Most of the purchase price has been refinanced as fixed debt carrying an interest rate of less than 5%.

Over the next thirty years, Energizer will become primarily a razor business and primarily an international business. When looking at Energizer today, this fact is difficult to see; however, it is an important truth. Here, I disagree with many other commentators on Energizer’s business. They are far more optimistic about the battery business and far more pessimistic about the razor blade business than I am. We both have access to the same information, so why the disagreement?

I believe Energizer’s highly profitable battery business will slowly wither away. It will remain in some form. Even decades from now, there will still be Energizer batteries sold all over the world. But, how many will be alkaline batteries?

A lot of analysts note that Energizer is particularly well positioned in the markets for lithium and rechargeable batteries, and therefore believe a transition to such batteries would not necessarily spell doom for the little pink bunny. Energizer’s sales of these products has recently been growing at a 20% clip. With so many personal entertainment devices finding their way into consumers’ hands (and under their Christmas tress), it looks like Energizer has a wonderful growth opportunity to exploit.

Unfortunately, that’s not how I see it. Energizer will look to grow its sales of lithium batteries – as it should. But, don’t let the flashy growth fool you. There are two parts to the value equation: growth and profitability.

In the long run, lithium batteries are unlikely to be anywhere near as profitable as alkaline batteries. They are more durable and less visible. This is a deadly combination for the likes of Energizer and Duracell. A battery that is bought by the manufacturer rather than the consumer is not something these companies look forward to. There is very little price competition in alkaline batteries. Energizer’s brand name and its distribution system is the key to its ability to charge high prices on alkaline batteries. Those advantages are mitigated in the market for lithium batteries.

Alkaline batteries won’t be going the way of the Dodo anytime soon. It’s important to note alkaline battery sales have not yet decreased by volume. This is as true in the U.S. as it is overseas. In fact, unit sales of alkaline batteries have consistently increased over the past few years.

This fact has been obscured by changes in the retail business. More and more customers are buying batteries in bulk. Some analysts have expressed concern. They believe this means brand loyalty is eroding. Despite being generally pessimistic about the battery business, I disagree with that sentiment.

Brand loyalty is not eroding. More people are shopping at retailers that sell in bulk. Therefore, more people are buying larger packages of batteries. There is no evidence to suggest there is a trend toward cheaper, less prominent brands. In fact, there is no real evidence to support the idea that consumers actually want larger packages of batteries.

It’s clear they want to shop at the stores that sell larger packages of batteries, but that isn’t necessarily the same thing. Most consumers would be happy to buy batteries in smaller packages. That’s exactly what they’d be doing, if they weren’t shopping at superstores and the like. Consumers have not suddenly taken to buying their batteries via in – depth comparison shopping. Falling unit prices in the battery business have been caused by changes in retail methods, not changes in consumer tastes.

The strength of the major brands was evidenced last year when Energizer raised battery prices and Duracell followed suit. For the most part, Energizer has not been hurt by rising materials costs, because it has simply raised prices. Many investors haven’t really noticed the rise in materials costs, because these costs haven’t affected Energizer’s bottom line. Energizer’s pricing power has made this blissful ignorance possible. True, Energizer’s battery business doesn’t have as much pricing power as its razor business; however, it still has far more pricing power than the vast majority of American businesses.

Energizer’s battery business will produce a ton of free cash flow for years to come. The company will likely remain in the battery business even after alkaline batteries account for a much smaller part of the market. As a result, the profitability of Energizer’s battery business will decline.

This won’t happen today or tomorrow. There are still tons of products that are far too cheap to take more expensive, more durable batteries. There are also opportunities for Energizer to gain market share in developing countries (who will likely be moving away from super cheap carbon zinc batteries). The combined distribution infrastructure of Energizer and Schick will help both businesses gain market share overseas. But, there is far less opportunity for growth in the battery business than there is in the razor business.

An investor should value Energizer Holdings’ battery component as a no growth business. This isn’t quite as bad as it sounds. First of all, the battery business is not truly a no growth business. Both unit sales and dollar sales have increased in the recent past. Whatever growth does occur will add value to Energizer, because the battery business will continue to earn a very good return on incremental capital.

Unfortunately, the trend of rising unit sales of alkaline batteries will not last forever. Some alkaline batteries will be replaced by rechargeable and lithium batteries. Energizer will be hurt by such replacements. Even if the company does establish a strong position in the lithium battery market, its pricing power will be far less than it is in alkaline batteries.

It is important to note that the total volume sales of batteries, taken in the aggregate, will still grow. Although some rechargeable and lithium batteries will replace alkaline batteries, other rechargeable and lithium batteries will be used in completely new products.

Even thirty years from now, it is hard to imagine a world with lower unit sales of batteries than the levels of 2005. However, it is the mix of those batteries sales that will ultimately determine Energizer’s profitability. I am far less optimistic than most about the profitability of that mix.

There is a very real risk that selling lithium batteries will prove to be an inherently less profitable business. Most analysts have not yet addressed this issue. I can not say whether their silence on this matter is caused by a lack of concern or by a lack of interest. Regardless, I believe such silence is dangerous, because the future profitability of the battery business is an important part of any valuation of Energizer Holdings.

Increased durability and reduced visibility generally lead to lower brand awareness, less customer stickiness, and greater price competition. Therefore, the economics of the alkaline battery business and the lithium battery business are not as similar as they first appear to be. It may be sometime before the economics of the lithium battery business become clear.

In the mean time, investors would be best advised to view any migration from alkaline batteries to lithium batteries as a net negative for Energizer Holdings. Shareholders will want to follow this trend closely; however, it may be several years before a full understanding of the economics of the nascent lithium battery business is possible.

Energizer’s future growth will come from its razor business – especially international sales of its Schick products. In the recent past, the razor and blade business hasn’t experienced tremendous growth. This has lead analysts and investors to overlook the great long term growth potential in this business. Schick is a very strong international brand supported by Energizer’s already established worldwide distribution infrastructure.

Over the next thirty years, the worldwide razor business will become even less fragmented. Gillette and Schick will make large gains in their share of total unit volume, and even larger gains in their share of total sales dollars. Their brands already have worldwide reach. In the long run, far greater penetration is inevitable. There are no other similarly positioned competitors. No one will be able to compete with their distribution infrastructure, their R&D, and their advertising.

The razor business will be dominated by near continuous new product launches for a very long time to come. Don’t be fooled by those who downplay any increase in sales at Energizer or Gillette that is the result of a new product launch. Getting consumers to trade up for pricier models will be the real engine of growth in the razor business.

I believe it is a sustainable business model. Long term economic and demographic trends are favorable to such a model. As segments of overseas populations become more prosperous, increased spending on pricey, branded consumer products is sure to follow.

The two major competitors’ brands and their new products have a strong hold over men. It is likely their grip will only tighten. For a man, there is an important psychology attachment to his razor. A man’s experience with his razor is regular and ritualistic. He also uses very few other personal care products of any consequence. Therefore, he is likely to develop the kind of relationship with his trusted razor that will make him a super sticky customer.

This psychological attachment to a razor is not as strong for women. However, both Schick and Gillette are working to increase customer stickiness among women. So far, their efforts seem to be fairly productive. If successful, high end razor sales to women will provide an even greater source of growth for both businesses, because they are coming off a much lower base.

Societal trends in much of the world will also favor high growth among sales to women for this sort of pricey, branded personal care product. As a result, the strong international brands of these two razor companies should become even more valuable in the years to come – and those brands can not be replicated.

Schick is a true franchise. This fact often goes unnoticed, because Schick’s market share is dwarfed by Gillette’s. Both companies will grow their share of the international market, but Schick may very well grow its share more rapidly. There is nothing particularly surprising about this. Schick is starting from a smaller base, and is, in many ways comparable to Gillette.

What real advantages does Gillette have over Schick?

True, Gillette has a greater market share, but where is the actionable advantage in that? Can’t Schick achieve similar economies of scale at each of its production facilities? Doesn’t Schick posses a similar distribution system (largely provided by Energizer)? Doesn’t Schick have at least some brand recognition in most of the same countries as Gillette? Won’t Schick be able to match Gillette’s spending in both promotion and innovation?

Simply put, what can Gillette do that Schick can’t? Or, what can Gillette do better or more cheaply than Schick can?

One could argue Gillette’s absorption by Proctor & Gamble (PG) gives it some superiority in distribution, advertising, and R&D. But, whatever advantages exist in these areas are slim. There is no evidence Gillette has an advantage in new product development over Schick. True, no one can match Proctor & Gamble’s distribution system or its economies in advertising; but, Energizer comes awfully close. The combined Energizer Holdings has great enough resources to make Gillette’s advantages in these areas little more than academic. Once a company enjoys these advantages on the scale of an Energizer or Gillette, what real difference do they make?

Gillette’s competitive advantages over Schick are greatly exaggerated. Schick will not wrest control of the razor market from Gillette. But, that isn’t the important question. The important question is this: will Schick grow its international business profitably for many years to come? The answer to that question is an emphatic yes.

In fact, while I concede the fact that Gillette is a tough competitor and a first rate business, I believe the probabilities favor faster long term growth at Schick than at Gillette. The combination of the razor business and the battery business makes sense. Schick will continue to benefit from this combination.

More importantly, being the second player in a business like razors isn’t a bad racket. Look at the records of other companies who found themselves in the same situation. An investor would be just as foolish to dismiss an investment in Energizer on account of Gillette’s dominant position in the razor business as he would have been to dismiss an investment in Pepsi (PEP) on account of Coke’s (KO) dominant position in the cola business. As an investor, you aren’t looking for the biggest business – you’re looking for the best bargain.

Energizer’s management is shrewd and shareholder oriented. I have to refute the claims I have heard (reported in several places) that Energizer’s management has been anything less than superb in its stewardship of the owners’ capital. There are several complaints; none of them have any merit.

The most frequent complaint is that Energizer doesn’t hold quarterly conference calls. Good for them. If you’re part owner in a battery and razor blade business in which a quarterly conference call is necessary, you’re in the wrong battery and razor blade business. Energizer’s disclosures are absolutely first rate. Management just chooses to make those disclosures on paper. Anyway, the conference call is really more of an issue for analysts than it is for shareholders – and Energizer has no obligation to pander to analysts.

The company’s annual report is a good model for others to emulate. It reports comprehensive income within the income statement, instead of opting for a separate disclosure. This should be standard practice. Several footnotes in the report lead to tables instead of long lists of numbers in tiny print. This should be a standard reporting practice as well.

Energizer breaks its business down into three common sense business segments: North American Battery, International Battery, and Razors and Blades. It reports all items for these segments in the body of the report. This means cash flow and balance sheet items are provided right next to income items. That allows anyone with third grade math skills to calculate returns for each business segment and to judge each unit on its cash flows instead of relying solely on the income statement.

Within the body of the report, the company breaks down sales across all business segments by geography. This means, with just a little subtraction, one can break each unit (batteries and razors) down into North American and International sales. Battery sales are also divided into three common sense product categories: alkaline batteries, carbon zinc batteries, and other batteries. This is another really useful disclosure.

The company even volunteers exact estimates on event – driven sales of batteries (e.g., hurricanes) and benefits from the timing of production at certain plants. In both cases, the information is provided so the reader can lower his estimate of normalized earnings, not raise it.

Very few companies will prominently mention how an unusual number of hurricanes helped them, or how the same volume of output in the next calendar year would not result in equally high earnings. Energizer volunteers both pieces of information without resorting to the use of footnotes.

The one crucial fact that isn’t explicitly provided is the sales mix between razors and blades within Schick. That would be a nice touch. Energizer isn’t alone in not providing this breakdown. Most public companies in refill/repair businesses don’t provide this particular detail, despite its great economic importance.

Energizer’s share repurchases enhanced shareholder value. A lot of analysts would rather see a dividend. They’re wrong. Once a company starts paying a dividend, it effectively promises to keep doing so. On Wall Street, cutting a dividend is viewed as a mortal sin. Healthy companies just don’t do it. Even unhealthy companies go to ridiculous lengths to maintain regular dividend payments (e.g., GM). By not paying a dividend, Energizer maintains its flexibility. It can make an acquisition, it can buyback stock, or it can pay down debt. In this way, the company is able to put its capital to the best possible use.

To date, that’s exactly what it has done. All share repurchases were made at discounts to intrinsic value. The acquisition of Schick is a rare example of a large corporate acquisition that was well worth the price. In both cases, the money borrowed was cheap.

Of course, it remains to be seen if Energizer will continue to put its capital to the best possible use, or whether low interest rates and a low stock price were just happy coincidences and Energizer will continue to borrow heavily and buy back stock regardless of its cost of capital and the stock’s discount to intrinsic value. Past actions and statements from management lead me to believe Energizer will continue to allocate capital wisely – but, one can never be sure of management’s intentions.

Energizer has proven to be more shareholder oriented than most companies, not less. So, ignore the occasional uneducated complaints made about Energizer’s corporate governance. Energizer’s actions prove the company’s commitment to enhancing shareholder value. Those actions back up the words with which the annual report begins:

“Going forward, we are focused on two clearly defined financial objectives – to generate consistent annual earnings per share growth and to maximize free cash flow. We fully intend to achieve those objectives by successfully executing our ongoing business strategies – investing in our brands for future growth, using cash flow to acquire operating earnings and opportunistically repurchasing our shares.”

While I believe Energizer is a suitable investment on qualitative grounds, every investment decision ultimately comes down to price. At a steep discount to its intrinsic value, Energizer Holdings would make an excellent long term holding. So, what is its intrinsic value?

Energizer is worth at least $7.5 billion. The company’s current enterprise value is about $5 billion. So, at today’s price, the margin of safety is not much greater than 33%. I consider this to be an insufficient margin of safety. As an individual investor, not restricted by having a large amount of money to invest, there is no reason to accept a margin of safety of less than 50%, if you are willing to hold a concentrated portfolio. Of course, if you want to be widely diversified across 30 or more stocks at all times, you will often have to accept a margin of safety of less than 50%. For such widely diversified investors, Energizer provides an attractive investment opportunity at the current price.

Of course, estimates of intrinsic value will differ from person to person. That’s normal. In this case, the two key (and potentially controversial) assumptions are the decline of the battery business and the growth of the razor business.

To give you some idea of the importance of these assumptions, I came up with an estimate based on the worst case scenario of a relatively rapid decline in the battery business as well as an estimate based on the best case scenario of strong, sustained growth in the razor business. The worst case scenario yielded an intrinsic value of $5.25 billion; the best case scenario yielded an intrinsic value of $12 billion. Both of these estimates are within the realm of possibility. In neither case did I make any obviously unreasonable assumptions.

For instance, a very rapid decline in the battery business would yield a much lower intrinsic value than $5.25 billion. However, I do not believe such a rapid decline is a reasonable assumption.

On the other side of the scales, very strong growth in the razor business would yield an intrinsic value much higher than $12 billion. I believe such growth is unlikely, unless there is some catalyst I am unaware of. If you believe there will be sustained, strong growth in the demand for high priced razors among large populations overseas, $12 billion becomes a low end estimate. Personally, I believe $12 billion is very much a high end estimate.

I always try to err on the side of caution. So, I’m sticking with $7.5 billion as my best conservative intrinsic value estimate for Energizer Holdings.

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