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.
If you want to see evidence of the misunderstandings that can
result from this lack of disclosure, look no farther than the
market's reaction to Lexmark's (LXK) recent announcement that its
earnings were better, because its printer sales were worse.
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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