Energizer Holdings, Inc. (NYSE:ENR) – Investment Memo – 5/31/16

Recommendation: Short Energizer Holdings, Inc. (NYSE:ENR) equity

Current Stock Price: $47.53

Target Stock Price: $25.00 (52.6% upside)

Timing: 6 – 18 months

Catalysts: disappointing earnings, dilutive acquisitions

Summary Thesis

Energizer sells batteries and flashlights globally and is the #2 producer behind Duracell

The battery market is in secular decline as a result of next generation smart devices

primarily utilizing rechargeable lithium ion battery technology

ENR bulls have given too much credit to the idea that the battery market can structurally

improve as a result of Berkshire Hathaway’s acquisition of Duracell and have

underestimated the potential for private label players to compete more aggressively

The market has bought into the idea that Energizer can successfully transform into a

consumer household goods platform company despite a constrained balance sheet and

significant execution challenges

Energizer’s valuation is unjustified by its business profile or financial condition and

trades at a significant premium to the implied valuation from Berkshire Hathaway’s

acquisition of Duracell

Energizer could see its stock fall by as much as 35% to 60% over the next 6 to 18 months

as a result of disappointing earnings and poorly conceived acquisitions

Company Overview

Energizer traces its roots to the 1890’s when David Misell figured out that by lining up batteries

in a tube he could power a light bulb at the end of the tube, creating the world’s first flashlight.

Misell’s invention was commercialized by the American Ever Ready Company and ownership of

the battery and flashlight business has changed hands numerous times over the past 115 years.

In 2000, Energizer Holdings was spun out of consumer conglomerate Ralston-Purina into a

publicly traded company on the NYSE. Under the leadership of then CEO J. Patrick Mulcahy,

the company expanded into personal care products by acquiring companies in the shaving,

feminine hygiene, and sunscreen businesses. The personal care products strategy was successful

and Energizer’s revenue grew from $1.9 billion in 2000 to $4.5 billion in 2014. Energizer’s stock

price appreciated by 12.4% per year (including dividends) from the time of the Ralson-Purina

spin to the period right before the 2015 Edgewell/Energizer spin.

In July 2015, Energizer’s battery business was again spun-off into a publicly traded pure play

battery and flashlight company. The rationale behind the most recent spin was that the personal

Capitalization Financials Valuation

Market Cap $2,939 2015 Sales $1,632 EV / 2015 EBIT 13.4x

Cash $326 2016 Growth 6.3% EV / 2016 EBIT 12.8x

Debt $1,087 2015 EBIT $276 EV / 2016 Sales 2.1x

Enterprise Value $3,699 2015 Margin 16.9% Price / 2016 EPS 19.7x

Note: USD in millions. Projections based on consensus estimates as of 5/31/16, PF for Handstands deal.

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care business, now known as Edgewell Personal Care (NYSE:EPC), could focus on managing a

personal care platform while Energizer (NYSE:ENR) could be managed for capital return to

shareholders and build a househouse products platform.

In its current form, Energizer manufactures and sells alkaline batteries (high-end), zinc-carbon

batteries (low-end), flashlights, and car air fresheners. Its key brands include Energizer and

Eveready which hold the #1 or #2 (combined) battery market share in most geographies.

Energizer flashlights have 15% share of the US flashlight market. In May 2016, ENR acquired

HandStands which is a top 3 producer of car air fresheners.

Est. Sales by Product LTM Sales and EBIT by Region

Energizer’s Core Battery Business is in Secular Decline

Energizer’s primary products, alkaline and zinc-carbon batteries, are in secular decline due to the

proliferation of lithium ion batteries in next-gen devices. Smart phones are responsible for much

of the initial shift to lithium ion power as many of the devices which have traditionally used

disposable batteries have been disrupted (CD players, clocks, Gameboys, digital cameras, ect.).

Management argues that most of the disruption from smart devices has already occurred and that

there are many emerging applications for disposable batteries such as internet of things devices

and health monitoring devices. While I do contend that there will always be some level of

demand for disposable batteries, the technological trends show that smart devices are creeping

more expeditiously into our lives and the overwhelming preference is for rechargeable lithium

ion batteries in these devices.

Alkaline Batteries

59%

Other batteries

and lighting products

33%

Car Air Fresheners

7%$858

$114

$360

$283 $250

$23 $46 $69

29%

20%

13%

24%

0%

10%

20%

30%

40%

$0

$250

$500

$750

$1,000

NorthAmerica

LatinAmerica

EMEA Asia Pacific

Sales EBIT EBIT Margin

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The data backs up this observation. According to the below chart from Deutche Bank, US battery

sales volumes have consistently fallen over the past 15 years and the battery companies have

been unable to consistently pass along price increases.

US Battery Sales

Google Trends data also shows a ~50% decline in searches for “Energizer” and “batteries” over

the past 12 years.

2%

3%

4%

5%

7%

13%

18%

Radio

Health

Digital Cameras

Smoke Alarms,Clocks

Flashlights

RemoteControls

Toys

Source: company filings.

Battery Applications Disruption by Smart Devices

Communications Music player Watches / Clocks LED flashlight Remote control for smart TVs Remote control for home automation

Personal health monitoring devices

Home automation device: powered by lithium ion batteries, controlled by smart phones

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Google Trends Searches

Financial performance at ENR has largely tracked the market. ENR has seen sales and earnings

decline; however, ENR has been able to mitigate much of the earnings declines by a deep cost

cutting program initiated in 2013 (more on this later).

Benefits to the Battery Industry from an Oligopolistic Market Structure will be Limited

In the US, the battery market consists of Duracell, Energizer, Rayovac, and private label

offerings. Internationally, the players are largely the same, but there are a few additional regional

players and private label has a much larger share of the market (20% – 30%).

20

30

40

50

60

70

80

90

100

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Energizer batteries

Energizer Historical Financials

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 LTM

Total Revenue $2,059 $2,147 $2,376 $2,474 $2,110 $2,200 $2,196 $2,088 $2,012 $1,840 $1,632 $1,614

Growth % 4.3% 10.7% 4.1% (14.7%) 4.3% (0.2%) (4.9%) (3.6%) (8.5%) (11.3%) (8.1%)

EBIT $365 $375 $390 $421 $353 $388 $337 $326 $366 $340 $276 $273

Margin % 17.7% 17.5% 16.4% 17.0% 16.7% 17.6% 15.4% 15.6% 18.2% 18.5% 16.9% 16.9%

EBITDA $432 $447 $461 $494 $423 $458 $417 $382 $421 $381 $313 $303

Margin % 21.0% 20.8% 19.4% 20.0% 20.0% 20.8% 19.0% 18.3% 20.9% 20.7% 19.2% 18.8%

Capex $73 $55 $54 $80 $82 $39 $37 $38 $18 $28 $40 $30

Sales % 3.6% 2.6% 2.3% 3.2% 3.9% 1.8% 1.7% 1.8% 0.9% 1.5% 2.5% 1.9%

EBITDA - Capex $358 $392 $406 $413 $341 $420 $380 $344 $403 $352 $273 $273

Margin % 17.4% 18.3% 17.1% 16.7% 16.2% 19.1% 17.3% 16.5% 20.0% 19.1% 16.7% 16.9%

Note: 2005 - 2011 financials represent the ENR battery business with corporate overhead allocated.

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US Battery Market Share

A key bull argument is that Berkshire Hathaway’s purchase of Duracell (closed in Q1 2016) will

improve the market structure for disposable batteries. Duracell’s prior owner, Proctor and

Gamble, prioritized market share and engaged in very promotional activity to drive share. While

P&G was successful in taking share (see above chart), it came at the expense of industry pricing.

In 2014, P&G’s aggressive pricing led to Duracell beating out Energizer in Sam’s Club and

Family Dollar stores.

Duracell, under the new ownership of Berkshire’s Marmon Group, will likely be managed for

cash and return on capital (not market share). Under this framework, there may be some room for

modest price increases at the high-end of the market. However, at the low and mid end of the

market, where Energizer also competes, Energizer must still face Rayovac and private label

offerings which have also been known to compete aggressively on price. As game theory

dictates, it merely take one irrational player to make an industry more price competitive.

It is also possible that private label offerings will keep the branded players in check. Bulls are

quick to dismiss private label; however, a quick search revealed that Amazon’s private label

battery offering has 4.5/5 stars and more than 3x the number of reviews compared to Duracell or

Energizer batteries. Amazon is selling their AA batteries for $0.27/unit vs. $0.42/unit for

Duracell online. Consumers may naturally prefer a branded option but if the price gap between

branded and private label options is exceedingly wide, private label may gain share. Many easily

searchable studies show that Rayovac/private label batteries have very comparable performance

to Energizer and Duracell.

The other big reason why the Battery producers may not benefit from a consolidated market is

because the barriers to entry are not very high. Manufacturing a battery is not particularly

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difficult because the raw materials are fairly accessible and there is no need for highly

specialized equipment; in fact, you can make low efficiency batteries at home. If the branded

players were to raise price to such an extent where the industry returns were exceedingly

attractive, a new entrant could try to capitalize on the situation. For example, one of the private

label manufacturers could take a shot at selling a branded battery.

CFO Brian Hamm gave a nod to this idea on the Q2 2016 conference call when explaining that

organic sales outside of the US were facing increased competition from private label: “As we

stated last quarter, we expect the competitive environment in these markets to remain elevated

through the balance of the year due to increased private label activity driven by certain discount

retailers.”

Even if the industry becomes more rational and is able to take price, at best the industry would

be able to pare volume declines. Energizer’s management has predicted that battery volumes will

decline by a low-to-mid-single digit rate. In my opinion, if the industry were to improve its

pricing discipline, it could raise price by a similar low-to-mid-single digital annual rate.

However, if the trend towards lithium ion batteries were to accelerate, accelerated battery

volume declines would follow.

Energizer’s sales results from the past two years show that even when isolating currency and

other factors, negative “organic growth” will be difficult to offset.

Total Revenue Growth Detail

FY 2013 FY 2014 FY 2015

Organic Growth (2.9%) (6.8%) (3.6%)

International Go-to-Market 0.0% 0.0% (0.9%)

Venezuela 0.0% 0.0% (0.9%)

Currency (0.8%) (1.7%) (5.9%)

Total Sales Growth (3.6%) (8.5%) (11.3%)

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Energizer’s Recent Financial Performance

Energizer is currently trading at highs since its spin-off last year. Energizer beat both first and

second quarter earnings and investors have cheered the company’s recently announced

acquisition of HandStands. However, a closer read into the earnings shows that these were low

quality beats.

In the second quarter, the company reported 0.5% organic growth attributable “primarily to

distribution and space gains and storm related volumes”. Backing out the 3% growth related to

distribution gains would print a 2.5% organic sales decline and an overall sales decline of 9.4%

(including FX and other factors). On the bottom line, investors had to add-back $13.6 million (or

$0.22 in EPS) in spin costs and restructuring to earnings – without these add backs, ENR would

have missed estimates.

CEO Alan Hoskins commenting on the second quarter conference call: “Overall in the quarter,

organic revenues were up 0.5% as distribution gains in the U.S. and Europe, Middle East and

Africa were able to offset the prior year EcoAdvanced launch activity. Due to heavy shipments in

the first quarter, we estimated that retail inventories were above historical norms and expected

to de-load in the second quarter. However, this did not occur to the extent we anticipated. We do

still expect retail inventories to return to a more normalized level over the next 2 quarters, which

will likely impact our year-over-year revenue comparison for the balance of the year.”

The first quarter was a bit stronger due to sales of a new EcoAdvanced battery, but Q1 also saw a

large part of the quarter’s sales growth attributed to distribution gains and a shift of revenue from

the 4th quarter. Notably, there was little benefit from price improvements despite the introduction

of the high-end EcoAdvanced batteries.

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CFO Brian Hamm commenting on the first quarter conference call: “There's a lot of moving

parts within the quarter. And even over the balance of the year, it's going to be a bit choppy. The

way to think of our organic sales for globally, a 9.5% organic sales increase. About 3% was

driven by timing, those sales shifting from quarter 4 into quarter 1. We knew that there was

going to be a soft prior year comparison we get that benefit. About 3% was EcoAdvanced sales,

innovation -- which we launched in the second quarter, so we had a favorable year-over-year

comp there. We had the 2% driven by the quarter 2 sales, the early replenishment shifting into

quarter 1. And the final piece, it's 1% of distribution and pricing gains.”

In FY 2015, ENR had $150.2 million in spin costs and restructuring or 9.2% of sales on top of

the $71.7 million it incurred in 2014 and $150.6 million in 2013 (the 2013 figure is not adjusted

for spin but is primarily attributed to the battery segment). While I understand that there are real

and significant costs to spinning off a business and cutting costs, the persistence and size of the

restructuring charges is a red flag that should be monitored.

As a result of the aforementioned restructuring, the company claims to have saved $218 million

in annual expenses by shutting half of its manufacturing plants, a quarter of its distribution

centers, and exiting unprofitable markets. Bulls would make the case the company can continue

to cut significant costs; however, given the significant cuts already made to date, it appears

unlikely that similar sized cost cuts remain. Energizer has recently implemented zero-based

budgeting and I believe that the company will continue to find efficiencies over time, but as a

newly spun-off company, ENR has an additional ~$30 million in new standalone costs to deal

with. ENR will also be faced with the cost headwind of dis-economies of scale as battery

volumes fall over time. Finally, the company’s new acquisition-led growth strategy will lead to

cost inflation as ENR ramps up new departments.

Another key aspect of Energizer’s battery strategy is the company’s ability to grow outside the

US. The company believes that it is well-positioned to grow in developing markets where a

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rising standard of living will lead to consumers using more battery-powered devices and

upgrading from low-end to high-end batteries. ENR’s results over the past 3 years show that this

thesis has not yet played out. Management has admitted on the quarterly calls that markets

outside the US are more competitive and private label tends to take a greater share. I also

believe, that a rising standard of living in these markets will increase the penetration of smart

devices, allowing consumers to leapfrog many disposable battery-powered devices and

accelerate the global volume decline in battery sales.

Future Acquisitions may be Value Destroying

A big part of the new standalone Energizer’s strategy is acquisition-led expansion into other

categories of consumer products. Management seeks to repeat the success of the predecessor

company’s acquisitions of personal care companies. The underlying thesis is that the company

can lean on the free cash flow from the battery business to make accretive acquisitions and

quickly pay down debt. Significant cost synergies would result from better utilization of ENR’s

existing global supply chain and marketing infrastructure.

I believe this thesis is flawed and risky because the management team that executed on this

strategy at the predecessor went to Edgewell. ENR’s management team did not make any

material acquisitions while they ran the battery subsidiary of the predecessor. Furthermore, the

spin-off left Energizer with a levered balance sheet that is even more levered than it appears due

to the recently announced acquisition of Handstands and almost all cash being held abroad.

Finally, this strategy relies on the company’s ability to make acquisitions at advantageous prices

and successfully execute on integration and realizing synergies – this creates significant

uncertainty and operational risk.

On May 24, 2016, Energizer announced the acquisition of Handstands for $340 million in cash.

Handstands primarily makes fancy car air fresheners and is the 2nd largest player it its market. In

2015, the company generated sales of $128 million and EBITDA of $34 million (26.5% margin).

ENR expects to generate ~$5 million in cost synergies and believes the acquired business will

grow at a mid-to-high-single digit rate. The implied price paid by ENR is 10x EBITDA or 8.7x

synergized EBITDA.

Energizer Organic Growth by Region

FY 2013 FY 2014 FY 2015

North America (5.5%) (12.2%) (7.7%)

Latin America 4.0% (0.8%) 0.3%

EMEA (0.7%) (1.3%) 2.3%

Asia Pacific (0.8%) (0.7%) (1.6%)

Total (2.9%) (6.8%) (3.6%)

Note: Organic growth excludes the impact from FX.

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Handstands appears to be an OK acquisition but certainly not a great acquisition. Car air

fresheners is an average quality business because it is capital light (most manufacturing is

outsourced) but highly competitive (at least 4 direct competitors). The business is growing at a

mid-to-high single digit rate and likely has high return growth opportunities. However,

Handstands does not own any widely recognizable brands and is not operationally synergistic to

the core battery business. The price paid for the acquisition seems fair but was not a bargain

purchase. The acquired business will represent ~12% of pro-forma EBITDA. Therefore, the

battery business will continue to dominate financial performance.

Handstand’s Industry Profile

Energizer’s management has stated that they have been extremely proactive and “aggressive” on

M&A. However, with the announcement of the Handstands acquisition, I believe the company

has limited balance sheet capacity to make another acquisition in the near term without an equity

issuance.

Pro-forma for the Handstands acquisition, Debt / EBITDA is ~3.2x and Net Debt / EBITDA is

~2.2x. However, over 90% of cash is held abroad and would need to be adjusted by ~30% for

taxes. This is consistent with how credit rating agencies would view the foreign cash. After this

adjustment for foreign cash, Net Debt / EBITDA is ~2.5x. This may seem reasonable, however,

it is important to keep in mind that >85% of EBITDA is generated from products in secular

decline. If overall EBITDA were to decline by 20%, Net leverage would jump to 3.1x and gross

leverage would jump to 4.0x.

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Today, ENR has a BB junk credit rating from S&P and its bonds issued May 2015 (pre-spin)

yield 5.7%. If ENR were to raise more debt for an acquisition, its cost of debt would be much

higher without an equity issuance. It is also worth noting that ENR currently pays $60 million

per year in dividends but only generates $75 million in US cash flow (before adding potential

cash flow from Handstands). The dividends limit the company’s flexibility to grow inorganically

and service a growing debt load.

Given Energizer’s fairly constrained balance sheet and “aggressive” M&A strategy, future

acquisitions would likely be dilutive (or financially crippling) and could serve as a catalyst for

the shorts.

Valuation is Not Justified

The final nail in the coffin is Energizer’s current market implied valuation which is untethered to

reality. Energizer currently trades at 12.3x forward EBIT and 18.4x forward P/E. On a relative

basis, this appears cheap because other consumer products companies trade at a mid-teens

multiple of EBIT and greater than 20x P/E. However, ENR isn’t a good comp to this typically

used peer set because it is still primarily a single-product battery company vs. a consumer brands

platform and its core business is in secular decline.

Bulls would argue that it is appropriate to pay a higher multiple for ENR because one needs to

factor in growth from future acquisitions which will be more meaningful for ENR vs. peers.

Bulls would also point to ENR’s above average return on capital ratio as a stamp of quality.

However, this line of thinking is flawed because as pointed out earlier, ENR may not actually be

able to make accretive acquisitions and the management team is unproven. Also, ENR’s return

Energizer's Balance Sheet Profile

LTM 3/31/2016 Handstands Deal PF Handstands

Revenue $1,614 $128 $1,742

EBITDA (1) $303 $39 $342

Margin % 18.8% 30.5% 19.6%

Total Debt $997 $90 $1,087

Total Debt / EBITDA 3.3x 3.2x

Total Cash $576 ($250) $326

Net Debt $421 $761

Net Debt / EBITDA 1.4x 2.2x

Adj. Cash (2) $421 ($175) $246

Adj. Net Debt $576 $841

Adj. Net Debt / EBITDA 1.9x 2.5x

(1) Assumes $5 million in guided cost synergies from Handstands deal.

(2) 90% of cash is foreign cash. Foreign cash adjusted for taxes at a 30% rate.

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on capital ratio is declining over time as earnings tied to its battery business fall. This is a classic

value trap setup.

If publicly traded peer comparisons are less useful, how should we value Energizer? We are

extremely fortunate because Warren Buffet just gave us a recent private market value appraisal

of a battery company. Berkshire closed on its acquisition of Duracell from P&G in Q1 2016.

P&G also sold its China battery business in the same period and disclosed the financials from

those businesses and the proceeds received in the same line items. The implied sale price at

announcement of the deal was ~6.9x EBIT. It may seem silly to base ENR’s valuation off of one

data point, but P&G’s battery business is the most relevant data point.

Using the implied valuation from P&G’s battery business sale, we can back into what a private

market buyer would pay for Energizer. Using Warren Buffet’s price as the floor and 9.0x as the

high implies that Energizer should be worth somewhere between $20 and $30 per share or 35%

to 60% lower than the current trading price of ENR’s stock.

Relative Trading Value Analysis

Enterprise Market Dividend EV / EBIT Price / Earnings LTM FCF NTM Sales '16 EBIT '16 EBIT LTM

Company Name Ticker Value Cap Yield % LTM NTM LTM NTM Yield % Growth % Growth % Margin % ROC % (1)

Procter & Gamble PG $237,460 $216,755 3.3% 14.7x 13.8x 24.7x 21.0x 5.5% (7.9%) (12.2%) 21.6% 10.7%

Colgate-Palmolive CL $68,814 $63,038 2.2% 17.6x 15.1x 25.6x 24.5x 3.4% (0.3%) 5.2% 26.2% 36.4%

Kimberly-Clark KMB $53,810 $46,258 2.8% 16.7x 12.8x 42.4x 20.8x 4.0% 1.2% 5.0% 18.2% 24.4%

Newell Brands NWL $25,022 $21,811 1.6% NM 9.2x NM 17.0x 1.1% NM NM 14.6% 6.0%

Clorox CLX $18,590 $16,776 2.4% 17.0x 14.3x 25.0x 25.0x 4.0% 3.4% 1.9% 18.9% 27.6%

Church & Dwight CHD $13,555 $12,598 1.4% 19.6x 16.1x 30.3x 26.7x 4.7% 3.4% 6.9% 20.8% 13.9%

Spectrum Brands SPB $10,966 $6,950 1.2% 17.1x 11.3x 31.6x 21.8x 5.5% 4.4% 13.9% 14.0% 7.8%

Edgewell Personal Care EPC $5,947 $4,748 0.6% 20.1x 13.0x NM 23.0x NM 0.6% 23.2% 15.5% 4.3%

Helen of Troy HELE $3,137 $2,738 N/A 19.4x 13.5x 27.1x 15.9x 6.0% 3.1% 10.8% 11.3% 7.0%

Mean $48,589 $43,519 1.9% 17.8x 13.2x 29.5x 21.8x 4.3% 1.0% 6.8% 17.9% 15.3%

Median $18,590 $16,776 1.9% 17.4x 13.5x 27.1x 21.8x 4.3% 2.1% 6.1% 18.2% 10.7%

Energizer ENR $3,699 $2,939 1.6% 13.6x 12.3x 34.4x 18.4x 4.3% 8.8% 10.2% 17.1% 20.6%

Source: Capital IQ, Wall Street consensus estimates. Data as of 5/31/2016. Energizer is PF for the acquisition of Handstands.

(1) Return on Capital = Tax-effected EBIT / (Total Debt + Total Equity)

Sale of P&G Battery Business (Duracell + China assets)

2013 2014 2015

Sales $2,465 $2,552 $2,226

Growth % 3.5% (12.8%)

EBIT $513 $548 $479

Margin % 20.8% 21.5% 21.5%

Deal Value At Announce At Close

China deal value $560 $560

Duracell deal value (1) $4,700 $4,200

Cash on balance sheet $1,500 $1,800

Total deal value $3,760 $2,960

EBIT multiple 6.9x 6.2x

(1) Represents P&G stock held by Berkshire Hathaway

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Concluding Thoughts

Energizer’s trading price today bakes in a rosy scenario where the battery companies will

become more profitable despite deteriorating market conditions and where Energizer will be able

to execute on value generating acquisitions. Even if shareholders receive all that they have been

promised, it is pretty tough to justify ENR’s current valuation and it’s unlikely that a third party

would be willing to pay twice what Warren Buffet paid for the #2 player.

Bridge to Target Stock Price

Low High

2016E EBIT $289 $289

EBIT Multiple 7.0x 9.0x

Enterprise Value $2,020 $2,597

Net Debt $761 $761

Equity Value $1,260 $1,837

Diluted Shares 62.3 62.3

Target Share Price $20.22 $29.48

Current Stock Price $47.53 $47.53

Implied return 57.5% 38.0%

Note: Projections based on consensus

estimates as of 5/31/16, PF for Handstands.