Wednesday, December 26, 2007

Jarden Earnings Set to Implode?

Jarden (JAH) is by no means a new, or unique short idea. Jim Chanos has been talking about this stock for years (often through his mouthpiece, Herb Greenberg). More recently, Amit Chokshi has done some good work on Jarden here. I recommend both those articles as a good starting point for those unfamiliar with JAH. I agree with them that, though Jarden has already fallen a good deal, there is room to go and that catalysts are likely to be coming as soon as next quarter. Given the state of the balance sheet, the end of easy credit, the nature of how Jarden's discretionary products would likely fair in a recession, and JAH's extreme leverage, even a small deterioration in the business could result in greatly reduced earnings and, in more extreme circumstances, the possibility of a dilutitive equity raise and, depending on the loan covenants, the possibility of bankruptcy. The bulk of this article will focus on issues that have not been covered in past publicly available write-ups, or go into more detail on issues that have, so I hope it will be useful to those both new and familiar with the story.

The argument for a Jarden short is very simple: Jarden is a highly leveraged consumer products company at the peak of an economic cycle. Furthermore, it's performance has been artificially inflated by a series of acquisitions which gave the illuision of growth and operational improvement. In reality, Jarden owns a collection of cyclical business for which it paid too much. The company has no means to make anymore meaningful acquisitions. As the economic cycle turns, and as the effect of Jarden's most recent acquisitions wears off, it should become clear that Jarden is unlikely to deliver on its promises of higher margins, and that it is likely to experience a double whamy of deceasing revenue and declining margins in the next year. Given its high leverage, even a small degree of deterioration in the underlying business will have a big impact on net income.

The End of Easy Credit
Jarden was built on the prospect of easy credit, which allowed them to leverage themselves as an LBO would to purchase a variety of consumer products companies. The company had been so active in purchasing companies over the last few years that it has been very difficult to separate the growth and performance of the Jarden on businesses vs. the growth attributable to acquisitions. The acquisitions and charges are so frequent that the company reports all its numbers as adjusted earnings and EBIDTA, which strip out a variety of "one time charges." Jarden has not made the analysis very easy either, refusing to disclose pro-forma financial, and (as I will argue below) releasing misleading pro-forma numbers when it does. As Jarden's
acquisition binge has been forced to cease recently, we can for the first time begin to get a good sense of how these businesses are performing. And the picture that emerges is bleak.

The Questionable Timing of Jarden's Latest Acquisitions

As I dug into the story, I was surprised that I have found no mentions of a blatantly simple sign of manipulation and acquisition inflated earnings growth on Jarden's part: namely, that JAH's
last two acquisitions were purchased in the quarters in which those businesses show greatest seasonal strength, allowing JAH to book its acquisition's quarterly earnings as its own earnings. I think it is likely that these acquisitions were made to show misleading profit growth, and to mask the deterioration of Jarden's other businesses.

In Q2, the company acquired Pure Fishing, a leading supplier of fishing supplies. The deal closed early in April, which is the beginning of Q2. Coincidentally Q2 is also the peak quarter for earnings and revenue for marine and fishing supply companies. One comp I found booked nearly 95% of its EBIT (Earnings before interest and taxes) and 34% of its revenue in Q2. Another (K2's marine division, with a comparable product mix to Pure Fishing), booked 32% of its revenue and 43% of its EBIT in Q2. By closing the acquisition of Pure Fishing at the beginning of the 2nd quarter, JAH was able to pad its earnings by including Pure Fishing's most profitable quarter in its financials. Their decision not to release Pro Forma numbers further aided this concealment.

Jarden's Q3 Sleight of Hand
A couple after the Pure Fishing Acqusition, in late April, JAH announced a pricey acquisition of K2. The deal was expected to close in early July (the beginning of JAH's Q3). Coincidentally, Q3 in 06' accounted for 45% of K2's EBIT (though only 26% of its revenue). Once again, JAH
found itself purchasing a business at a time that conveniently allowed JAH to book it's its acquired company's strongest quarter as its own. Unfortunately, the deal took a bit longer than expected to close, and ended up closing August 8th, over a 1/3rd through Q3. Analysts lowered expectations based on the closing date, figuring Jarden would miss out on some of K2's juicy Q3 profits. They were surprised, then, when JAH reported a stellar Q3, reporting adjusted EBIT of $60.7M in its outdoor segment (under which K2 is included).

Jim Chanos accused JAH of "springloading" its Q3 acquisition by essentially having K2 manipulate its earnings before being acquired so it would show stronger profits when integrated into JAH. Though I am not sure exactly what method JAH and K2 used to inflate Q3, I believe the evidence points strongly to something very fishy going on. Let's take a look at the math:

JAH's EBIT in Q3 is composed of its EBIT from the K2 acquisition, Pure Fishing, and JAH's
outdoor segment before both those acquisitions. Based on comps and details released about Pure Fishing at acquisition (I can explain the math in comments if anyone is interested), Pure Fishing likely did about $5.2M in EBIT contribution to Q3. The math is more simple for JAH outdoor pre-acquisition: this segment did $13.7M in Q3 06', and we know that in Q1 (in which there we no acquisitions messing up numbers) EBIT grew 4%. I estimate it actually declined in Q2, but lets be generous and assume 4% EBIT growth YoY, which would give us an EBIT of $14.2 for this segment. So, using some simple algebra (60.7-5.2-14.2, we can assume that K2 must have posted $41.3M in EBIT in the less than 2 months it was a part of JAH.

But, looking at their numbers last year, it's easy to see that this is impossible. K2 generated $38.7 in all of Q3 and, assuming a growth rate in line with Q1, that'd only get us to an EBIT of $42.7M for all Q3 07'. Keep in mind this is an extremely generous assumption, given the extent to which macro-economic conditions have deteriorated since then. Adjusting for the fact that K2 was only part of Jarden for 54 of 92 days in Q3, that give us an expected EBIT of only $25M vs. the $41.3M implied by the performance of JAH's other businesses.

Where did that extra $16M come from? This is not a rounding error (it's over 25% of the reported EBIT in that segment!). Even if you give Pure Fishing a bit more EBIT, and give K2 a bit of a benefit for August and September being stronger than July, you still get nowhere close on this one. The numbers just don't add up, and it calls into question not only the credibility of management and the accuracy of their reporting, but also the company's ability to meet analyst estimates without the benefit of acquisition accounting shenanigans.

Jarden's Misleading Pro-forma accounting
In Q3, the company released consolidated pro-forma results for Jarden and K2 to help show what the results of the combined company would have been on a year over year basis. These results don't include any of management's rosey adjusted numbers, and instead show a company with declining profitability and slow revenue growth. Though these numbers are bleak enough on their own right, it's worth noting that this picture neglects to adjust for the acquisition of Pure Fishing, making the numbers appear even better than they are. Adjusting for the Pure Fishing acquisition, this becomes a no-growth story:

2007 Q3 2006 Q3 Growth
Rev as reported 1442.7 1390 3.8%
Adj for Pure Fishing 1,390.4 1390 0.0%

2007 9 months 2006 9 months Growth
Rev as reported 4001.8 3792.9 5.5%
Adj for Pure Fishing 3,852.7 3792.9 1.6%

The performance of Jarden's Other Business Units
Management has sold the JAH story as a rollup that will generate operational improvement through synergy, scale, and other buzzwords that are easy to say but harder to deliver. Until now, these numbers have not mattered much, as cheap debt and continued acquisitions have allowed JAH to show growth on a consolidated basis. With the acquisition valve off for the foreseeable future, JAH is going to have to grow its earnings through good old fashioned operational improvement, in an increasingly difficult macro environment (declining consumer spending, rising input costs). So, how have these business fared in the hands of the operational experts at JAH, with their scale advantages and synergies? Not very well at all, especially recently.
Note: Numbers based on 2007e mix.

Consumer Solutions (40% of Sales, 45% of Adjusted EBIT)
This segment includes a hodge podge of value household products that are likely to be tied largely to discretionary consumer. If you believe the shopping trends coming out of Target, this segment looks due for a hit in Q4. Prior to the recent consumer slowdown, this segment grew sales a whopping 2% in Q1 and Q2, though EBIT admittedly fared much better, growing 41% and 17% respectively. But as macro headwinds have emerged, trends appear headed the opposite direction. In Q3, sales were flat, and Adjusted EBIT dropped 7% YoY. Analysts, in their unbridled optimism, continue to expect low single digit, positive growth.

Branded Consumables (17% of sales, 17% of Adjusted EBIT)
Branded consumables is a random assortment of items, including
"arts and crafts paint brushes, children’s card games, clothespins, collectible tins, firelogs and firestarters, home safety equipment, home canning jars, jar closures, kitchen matches, other craft items, plastic cutlery, playing cards and accessories, rope, cord and twine, storage and workshop accessories, toothpicks and other accessories. " I must admit my ignorance to the lucrative collectible tins and jar closures markets, but according to the financials this segment has been hard hit in Q2 and Q3 revenue dropped 6% and 4% respectively. EBIT dropped 15% and 20% YoY.

JAH Outdoor, excluding acquisitions (23% of sales, 18% of EBIT in 2006)
Though the year numbers in Q2 and Q3 look stellar, thanks to acquisitions, the underlying business pre-acquisitions has been eroding by my estimates, especially as of late (it's weakness has been concealed, conveniently, by the recent acquisitions). We know in Q1 that Revenue declined 7% while EBIT increased 4% . I estimate that the top-line has continued to decline in outdoor in the high single digits, and its only a matter of time before this shows up in profitability decline (if it hasn't already).

It seems as though many of the issues which shorts have complained about for years with this name are finally coming to light. If the consumer does slow down considerably, I expect all of JAH's business lines to be hit, and unless JAH can invent some new creative accounting (which, I admit, is a real risk to a short thesis here), the company could be facing some serious trouble. As the story unravels over the next year, I expect analysts estimates of low single digit growth, and continued operating margin improvement to reverse itself, providing several nice short term catalysts for continued downward pressure on the stock price.

Note: Author is short JAH

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