Business Context and Reporting Period
Central Garden & Pet Company filed its Form 10-K for the fiscal year ended September 27, 2014. The company markets and manufactures branded and third-party pet supplies and lawn-and-garden products through its Pet and Garden segments. Fiscal 2014 and fiscal 2013 each comprised 52 weeks.
For the fourth quarter of fiscal 2014, net sales were $374.2 million, gross profit was $107.6 million, and net loss attributable to Central was $4.1 million, or $(0.08) diluted earnings per share.
Financial Performance and Key Metrics
| Metric | Fiscal 2014 | Fiscal 2013 | Change |
|---|---|---|---|
| Net sales | $1,604.4 million | $1,653.6 million | Down 3.0% |
| Gross profit | $454.0 million | $463.9 million | Down 2.1% |
| Gross margin | 28.3% | 28.1% | Up 20 basis points |
| Income from operations | $56.2 million | $40.2 million | Up 40.0% |
| Operating margin | 3.5% | 2.4% | Up 110 basis points |
| Net income attributable to Central | $8.8 million | $(1.9) million | Returned to profitability |
| Diluted EPS | $0.18 | $(0.04) | Improved $0.22 |
| Cash provided by operating activities | $126.5 million | $(28.3) million | Improved $154.8 million |
| Free cash flow | $109.3 million | $(53.5) million | Improved $162.7 million |
- Pet segment sales were $845.5 million, down 4.8%; operating income was $88.1 million, down 7.7%, with a 10.4% operating margin.
- Garden segment sales were $758.9 million, down 0.9%; reported operating income was $41.0 million versus $8.3 million in fiscal 2013.
- Adjusted fiscal 2014 operating income, excluding the Garden product charge and plant-asset gain, was $68.2 million, with a 4.2% adjusted operating margin, compared with $59.0 million and 3.6% in fiscal 2013.
- Inventory declined to $326.4 million from $391.9 million, supporting the improvement in operating cash flow.
- Cash, restricted cash, and short-term investments totaled approximately $103.0 million at year-end, including $14.3 million of restricted cash. Unrestricted cash and short-term investments were approximately $88.7 million.
- Total debt was $450.2 million, down from $472.6 million. The company had $449.5 million of 8.25% senior subordinated notes due March 2018 and no borrowings under its $390 million asset-backed revolving facility; reported borrowing availability was approximately $330 million.
- Capital expenditures were $17.2 million, and management expected fiscal 2015 capital expenditures not to exceed $30 million.
Material Changes Versus the Prior Comparable Period
- Sales declined primarily because of lower Pet branded-product volume, lost shelf space, increased competition, weak flea-and-tick demand, and lower bird, small-animal, and aquatics sales. Growth in sales of other manufacturers’ products partly offset the decline.
- Gross margin improved from 28.1% to 28.3%, aided by lower commodity costs, operational improvements, and product-mix changes. Primary bird-feed grain costs declined approximately 32% year over year.
- Selling, general and administrative expenses fell 4.4% to $397.8 million, although corporate expenses increased $9.3 million. The company recorded a $5.9 million software write-off associated with changes to its SAP implementation plans.
- Fiscal 2014 included a $16.9 million charge for discontinuing two Garden products introduced in 2013 and a $4.9 million gain on the sale of manufacturing plant assets. Fiscal 2013 included an $11.2 million Garden product charge and a $7.7 million non-cash Garden goodwill impairment.
- Operating cash flow improved mainly because inventory was reduced after a fiscal 2013 safety-stock build. Investing cash use increased to $35.2 million, including approximately $20.3 million for the Envincio asset acquisition.
- The company entered into a new asset-backed revolving credit facility in December 2013, replacing its prior facility, and repaid the remaining prior revolving debt by year-end.
Outlook, Commentary, Risks, and Unusual Items
Management stated that it would continue a balanced operating strategy focused on sales growth, margin improvement, customer service, innovative products, efficiency, and lower working-capital investment. No specific revenue or earnings guidance was provided.
- The company believes operating cash flow, supplier credit, and availability under its asset-backed facility should fund working capital, capital spending, and other needs for at least the next 12 months, but cautioned that financing may not remain available on acceptable terms.
- The business is highly seasonal: approximately 65% of Garden sales and 59% of total company sales occurred in fiscal quarters two and three. Working-capital needs and borrowings typically peak before the spring selling season.
- Harbinger Group proposed in June 2014 either acquiring the company at $10 per share or acquiring the Pet segment for $750 million, subject to due diligence. The Board unanimously rejected both proposals in October 2014. Legal and advisory expenses were significant and additional costs were expected.
- Key risks include dependence on major retailers, commodity-price volatility, weather and seasonality, consumer discretionary spending, competition and private-label products, product recalls and regulatory requirements, international sourcing, acquisitions, SAP implementation, cyber risks, environmental liabilities, and potential goodwill impairment.
- Approximately 41% of fiscal 2014 sales came from the five largest customers. Wal-Mart represented approximately 17% of total sales; Home Depot 8%; and Lowe’s 7%.
- Goodwill associated with a Pet reporting unit remained exposed to impairment risk because that unit’s operating income declined approximately 50% year over year, although fiscal 2014 testing showed fair value exceeding carrying value by more than 10%.
- Contractual obligations totaled approximately $810.8 million, including $450.7 million of scheduled debt principal, $129.9 million of estimated interest, $53.5 million of operating leases, and $176.7 million of purchase commitments.
- The company had $12.6 million of outstanding letters of credit collateralized by $14.3 million of restricted cash and up to $5.1 million of potential acquisition-related performance payments not included in the contractual-obligations table.
- No material litigation was reported, but state unclaimed-property examinations were in an early stage and the potential impact was not determinable.
Investor Verification Items
- Verify the sustainability of improved cash flow, particularly whether inventory reductions can continue without impairing customer service or causing future stockouts.
- Assess the Pet segment’s ability to stabilize sales, regain shelf space, and address weakness in animal health, bird and small-animal, and aquatics categories.
- Separate recurring Garden profitability from the $16.9 million product-discontinuance charge and $4.9 million plant-asset gain.
- Review the March 2018 maturity of the $450 million senior subordinated notes, refinancing plans, interest burden, and restrictions under the credit agreements.
- Monitor the Pet reporting unit for further operating deterioration and possible goodwill impairment.
- Evaluate exposure to Wal-Mart, Home Depot, Lowe’s, PetSmart, and PETCO, which collectively accounted for approximately 41% of sales.
- Track continuing Harbinger-related legal and advisory costs, the SAP implementation, commodity purchase commitments, and potential regulatory, environmental, product-liability, and unclaimed-property exposures.