Central Garden & Pet: Appealing Despite Concerns (CENT)

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Earlier this year I discovered that the Central Garden & Pet Company (NASDAQ:CENT) has had a strong 2021, with a few deals expected to see a stronger 2022. The expected strength was not seen 2022, which is proving to be a flat year, which along with poor cash flow conversion has raised some question marks among investors.

Some background

Central Garden & Pet has had a strong 2020 against the backdrop of the pandemic as this momentum inspired confidence as the company announced two significant deals at the end of the year which left some question marks with me at the time.

The company operates in two key verticals, a $100 billion pet industry and a $33 billion gardening segment, as both markets have seen strong demand due to the pandemic, with people spending more time and resources on their homes and Families spend, pets and gardens. In terms of business attribution, it’s the pet supplies industry that accounts for just over half of the company’s revenue.

The company is essentially a product of many deals followed over a long period of time, creating a $2.4 billion business in 2019 that reported earnings of $1.60 per share became. With operating performance flat for years and shares trading at 17 times earnings, that valuation looked broadly fair. The company grew sales to $2.7 billion for fiscal 2020 (reported November 2020), posting earnings of $2.20 per share, the result of the boom fueled by the pandemic.

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The company announced two major deals later in the year, with the purchase of Hopewell Nursery (of which few details were given), as the company paid $542 million to acquire Green Garden Products, with those deals and few financial disclosures left some question marks.

Dealmaking led to solid growth in 2021 as the company experienced some margin pressure as core business momentum reversed. The company ended up growing 2021 revenue 23% to $3.3 billion as earnings came in at $2.92 per share, a $1 higher than its original guidance for the year. Net debt fell to three-quarters of a billion, which translates to 2.3 times the debt ratio based on $330 million EBITDA, as the company forecast 2022 earnings of around $3.10 per share.

With shares trading at $52, Central Pet was trading at around 17 times earnings, while leverage was manageable as the two deals appeared to have gone well in late 2021. Realizing that my skeptical view has made me a bit too cautious, I hoped to become a buyer should any significant dips in 2022 occur.

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Fast forward between early January and today we see shares falling from $52 to $37 as many Covid-19 beneficiaries have seen their business performance and share price return.

On the corporate front, things have been relatively quiet this year with no major (M&A) events outside of regular quarterly earnings forecasts. After first-quarter revenue grew 12%, the company held to guidance for 2022, which called for earnings of $3.10 per share or more. That outlook was maintained alongside its second-quarter earnings report in May, even as revenue growth slowed to just 2%, which of course was a red flag.

With risks to the outlook clearly looming on the horizon, Central Garden announced a month later that a poor gardening season had forced it to cut its full-year guidance. The company now expects earnings to be at or slightly above last year’s earnings of $2.75 per share.

Third-quarter revenue declined just over 2% to $1.02 billion as earnings for the first three quarters of the year were $2.82 per share, up two cents year over year. The revised guidance implies that fourth-quarter earnings are likely to be around break-even levels, which is no surprise given the seasonal nature of the business.

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Net debt rose to $990 million as working capital conversion was poor this year, especially as inventory levels rose. With EBITDA broadly in line with last year’s performance, leverage has increased to almost three times.

What now?

With the stock price performance faring worse than the earnings outlook cut, a 17x earnings multiple has dropped to 13-14x earnings, which in itself looks very interesting, but poor cash flow conversion is a real concern since debt is quite high and the focus should be on cash flow conversion in the near term.

Amidst all of this, it’s now time to be positive on the stock, although I’m not that impressed with the cash flow performance this year, leading to minor leverage concerns. If these are addressed through sound cash flow management over the coming year, the undemanding multiple should look interesting enough to buy the dip.

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