Wednesday, March 15, 2006

Yankee Candle

Yankee Candle (YCC) is a manufacturer, designer, wholesaler, and retailer of premium scented candles with the largest market share (over 40%) in the premium, quality end of the market. The company has also announced plans to enter the “premium mass” market which could add significantly to its wholesale volume.

The company continues to tinker with its retail store initiative, having some 400 stores currently, and has plans to add another 200-300 stores, as it gets its formula right. Retail same store sales have been flat to negative for some time and to some extent has been hurt by the wholesale division’s expansion into supplying stores like Bed Bath and Beyond which has hurt not only YCC retail stores but also small wholesale customers of YCC such as gift shops. The company has recently teamed with Hallmark stores in a line called Celebrate Home.

The premium mass market initiative includes shelf space in Kohl’s, Costco, Target, as well as odor-eliminating candles at PetSmart!

Analysts seem to fret over earnings growth which has slowed down from the heady pace of a few years ago:

Earnings growth
2002 48.1%
2003 19.7%
2004 20.0%
2005 2.9%

The company generates a steady and growing free cash flow stream:

2001 $20.2 million
2002 $60.2 million
2003 $65.9 million
2004 $91.4 million
2005 $92.4 million

Because of the strong free cash flow, the company has returned capital to shareholders with a $100 million share buyback in 2003, followed by two subsequent $100 million annual buybacks. Its fourth buyback program, initiated in 2005 now of $150 million, I understand is more than half completed at this time.

Operating margins are quite impressive at around 22% and return on capital has been very strong at about 27% for last year, though this is down from the last couple of years where ROIC was 32.5% and 39% respectively.

At a current market cap of $1.23 billion, and an enterprise value of $1.4 billion, this business is selling at only 10.3 times EBIT. From a free cash flow standpoint, the business is selling at a FCF yield of 7.5%.

Why is Wall Street waffling here? What’s wrong with the story?

  1. There is some margin pressure because of energy costs and the cost of wax moving higher. The company has addressed this to some degree with a 4% price hike in the fourth quarter.

  2. Insider sales.

  3. Seasonality…this is a company that generates significant sales and earnings in the fourth quarter.

  4. Conflicting distribution channels…can the retail operation be managed to improve same store sales. Can gorwth in new store openings be resumed?
One should be aware that there is a 13D filer in YCC, Blue Harbour Group, of Greenwich, CT with a 5.3% stake. This was filed on January 18th of this year.

The valuation and the free cash flow characteristics are very attractive in my view. Given the share buybacks, the share base has been trimmed from about 54.5 million shares a few years ago to the current fully diluted base of 43 million shares. I view these share buybacks as being very effective.

I find the stock quite interesting and will be buying it after our 24 hour rule. Clients already have a position here.


At 12:23 AM, Blogger Geoff Gannon said...

I enjoyed the post about YCC, a very interesting company. I have been following Blyth (BTH) for some time, but haven't yet gotten around to posting on the company.

Maybe I should discuss both companies at the same time. There are some clear contrasts between the companies; there are also some similarities that might be of interest to value investors.

It is odd to see (comparatively) low P/E ratios in a business that has historically generated such high free cash flow. Both the FCF margins and returns on equity in this business have always impressed me. I don't doubt YCC is the better company – but, I must admit both stocks interest me.

I would, of course, enjoy reading your thoughts on Blyth. It strikes me as odd that two such stocks should appear upon the same fertile patch in an otherwise barren landscape. There may be bargains out there, but I am not seeing a lot of stocks in this kind of business selling at this kind of price.

At 9:40 PM, Blogger Dan O'Leary said...

Though I own shares in the Company, I can think of a few reasons why there is some apprehension in this name:

1. The whopping amount of leverage brought in '05. Most of this debt ($178M in a credit facility) is floating rate at around +85 bp over LIBOR.

-Debt at 1.08x EBITDA versus and average of around 0.47 in '04.

-Equity multiplier of 2.83 versus 1.84 in '04.

2. A/R to TA of 11.98 in '05 versus 8.15 in '04.

3. Finally, while I do not discount YCC's ability to generate significant cash through its operations, it relies heavily on depreciation & amortization. This means that it must continue growing its CAPEX in order to maintain the levels of cash flow that we have all grown to expect.

4. The bottom line is that there was a good reason for Forstmann Little to have taken this company out when it did. I'm sure, given time, it will occur again.

At 9:02 AM, Blogger Rick said...

The credit facility of $178 million is new and actually fluctuates at +50 to +85 over LIBOR.
As to whopping, I'm not so sure. The company generated over $340 million in CFFO in last three years. The credit facility covenant allows debt/EBITDA of 2.25 times whereas last year this ratio stood at 1.12 times.
Essentially, I think the company is involved in a steady recapitalization to lower its cost of capital.
The working capital management of the business has deteriorated slightly, but A/R turnover still appears to be about 17 times (down from 20 times) and inventory turnover is 4.5 times (down from historical 5-6 times)
I am not sure what concerns you regarding a reliance on capex. CFFO does not depend on depreciation, as you know, depreciation is a non-cash charge to earnings. There is no cash flow from depreciation per se.
Return on invested capital has exceeded 30% in the last three years...who would argue with reinvesting in a business like that?

At 11:24 AM, Blogger Dan O'Leary said...

Cash flow from operations does indeed depend on depreciation & amortization expense (you add D&A to NI because it is a non-cash expense to the income statement).

Here's what I mean about CAPEX:

A firm buys fixed assets at t=0 in order to generate revenue over time (say to t=10). Rather then expense the cost of the fixed asset at t=0, the firm amortizes the cost over the 10 years. Assume that at t=9 the firm is still a going concern, the assets it purchased at t=0 are getting old, and it doesn't purchase any more assets. Well since it didn't put up the capital for new equipment, it will lose the depreciation effect in CFO. An additional implication is that if Capex isn't replenished, the firm will probably have to reverse the deferred tax assets that were created from the 'temporary' difference between depreciation on the financial statement versus depreciation on the tax bill.

Now let's examine parts of YCC's statement of cash flows:

% of CFO:
2005 2004 2003
D&A: 23.3% 17.9% 17.1%
Def. Tax: 7.4% 12.2% 10.7%
A/R: -14% -3% 1.21%

Now as for the debt part, to give you and idea of the magnitude of the addition:

2004 LTD/TA is: 22%
2005 LTD/TA is: 50%
...and retained earnings went negative...

The bottom line is that I like this company, but i'm concerned about the operating leverage (and now financial leverage) inherent in their business model.


The Intrinsic Value

At 1:17 PM, Blogger Rick said...

I understand that depreciation is added to net income to come up with CFFO. However, depreciation does reflect a diminution in the value of capital...machinery and equipment will have to be replaced. Ergo my comment.
I agree that the company will have to pay cash taxes if it fails to reinvest. The deferred tax asset will disappear. But that is hardly unique to YCC. Most companies that have grown their businesses are in that position.
Your comments re the balance sheet structure are valid...that's what I am referring to with respect to my recapitalization comments. Deploying a reasonable amount of leverage should lower the cost of capital and given the comfortable level of interest coverage, I believe management has improved its capital efficiency.


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