Imagine a company that operates in the traditionally stable consumer staples sector, throws off industry-beating free cash flow, and trades at a substantial discount to competitors. Sounds worth a look, right? Well, Fools, welcome to the world of small-cap niche player Prestige Brands (NYSE:PBH).
An unusual strategy
Never heard of Prestige? That's fine, because you likely are familiar with its over-the-counter, household, and personal care brands, which include Chloraseptic, Compound W, Comet, and Cutex. Similar to Church & Dwight (NYSE:CHD) -- a name that's frequently won my praise -- Prestige has built up its portfolio partly by acquiring brands that large-cap competitors consider more of a distraction than an asset. And with less big-name competition tromping around in its product categories, the company's marketing and innovations efforts have the potential to score big.
Building up under-loved brands in niche markets, however, is not the only strategy that distinguishes Prestige. Unlike peers, the company outsources the cash-intensive manufacturing, warehousing, and distribution of its products. It's a practical approach: At just more than $300 million in annual revenue, Prestige would struggle to attain scale-driven efficiencies as an operator of factories, trucks, and other clunky thingamajigs that rust, break, and otherwise devour cash.
You don't have to take my word for it, though. For the company's recently completed quarter -- and most of its quarters -- virtually all operating cash flow becomes free cash flow! Furthermore, when it comes to cash operating margin and free cash flow as a percentage of sales, Prestige wallops heavyweights Colgate-Palmolive (NYSE:CL), Procter & Gamble (NYSE:PG), Clorox (NYSE:CLX), and even my consumer-staples favorite, Church & Dwight. A long-lived tax asset does help boost those metrics, but minuscule capital expenditures play their ample role.
Mr. Market's Cinderella?
OK, if this is all so great, why do Prestige shares trade at a price-to-free cash multiple of 5.4 against, say, P&G's 26.9? One word: Debt. Lots of it.
Traditionally, investors value free cash flow because it represents a company's ability to increase shareholder value through acquisitions, dividends, and stock buybacks. But in Prestige's case, it may need substantially all of its free cash to pay down roughly $360 million in debt, all of which matures in the next five years. Sure, refinancing is a possibility, but in this environment, who knows on what terms, if at all?
Now that we've got Prestige's warts out in the open, should you run screaming for the nearest tube of Compound W, or actually consider buying shares? I say the latter. First, even if Prestige is unable to refinance its debt, free cash should be able to cover the upcoming maturities, although with little margin for error.
Second, I don't think it will come to that. Prestige has strong brands and good distribution across multiple channels, including CVS Caremark (NYSE:CVS) and Family Dollar Stores (NYSE:FDO). Also, management is realigning the sales model and making a stronger push into the Canadian market, both of which should lift future results. Ultimately, as the balance sheet improves, Prestige's access to the credit markets will broaden.
Most importantly, the market may decide that Prestige's current-year P/E of 9.6 is, well, unfairly non-prestigious. Instead, a multiple in the low teens -- closer to where peers trade -- would reflect company improvements, and mean a nice gain for investors who get in now.
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