Ensemble Capital Client Call Transcript: Prestige Brands Update
We recently hosted our quarterly client conference call. You can read a full transcript HERE.
Below is an excerpt from the call discussing our investment in Prestige Brands (PBH)
Excerpt (Sean Stannard-Stockton speaking):
Another position we established in our portfolios in early 2017 is Prestige Brands. Prestige Brands is a small company that owns big brands in small markets. While their competitors include huge companies like Novartis, Johnson & Johnson, and Procter & Gamble, within the niche markets where they compete, their products generally hold #1 or #2 market position and often have market share of well over 50%. As a comparison, Coke holds 42% market share in carbonated soft drinks and so Prestige’s market share in their niche markets can be seen as more dominate than the hold Coke has on the soda market.
The company sells over the counter consumer health products that typically do not have any kind of prescription competition or any direct relationship with the health care or health insurance system. This is important because it means that the health insurance system, which we view as fundamentally broken and likely to undergo significant changes in the decades ahead, has not inflated prices in their end markets (in other words, customers pay 100% out of pocket for Prestige’s products), yet the demand dynamic is driven by the same steady, non-cyclical growth dynamics that drive the health care sector.
With no prescription competition, the company operates in markets where customers use brand as a key signal of quality and effectiveness. If you have a sore throat, itchy eyes, a wart, or your kids are car sick, you want to be sure that what you buy works and buying an established brand is the best way to make sure you get what you paid for. Whether you go to the drug store or order online to treat the conditions I just mentioned, you are very likely to buy products from Chloraseptic, Clear Eyes, Compound W, and Dramamine. All of these brands are made by Prestige and every one of them has the #1 market share position.
Owning these strong brands, in small niche markets, results in Prestige generating the highest profit margins in their industry. While Procter & Gamble and Johnson & Johnson might be a lot more well known, Prestige Brands turns every dollar of revenue into 34 cents of profits while P&G and J&J manage to squeeze our just 26 cents of profits.
We believe the company will continue to use its prodigious cash flow production (generated by outstanding returns on tangible capital of over 100%) to acquire brands that fit their criteria (those that have been orphaned by a larger company or bought from a private equity firm that has been underinvesting in the brand and/or which has untapped market extension opportunities). While Prestige Brands is a small company, it owns big brands. Five of its brands do over $100 million of revenue each year. Over the counter health care brands this big are rare and despite Pfizer and Johnson & Johnson having market caps over 100 times larger than Prestige, these companies do not have any more $100 million OTC brands than Prestige does. While we own Prestige in our portfolios due to how attractive the returns will be to shareholders on a standalone basis, it seems likely to us that at some point they will be acquired by a larger competitor after they have further built out their portfolio of brands.
It is important to recognize that Prestige is a brand management company more than a product producer. They outsource most of the capital-intensive production aspects of the business. This capital light, outsourcing approach means the company only employs 520 people, generating an amazing $1.7 million per employee. In comparison, most health care and consumer staple companies do closer to $500k per employee and Apple, which has the highest revenue per employee in the technology industry does only slightly more at $1.9 million. Until their acquisition of Fleet a year ago, Prestige had only 259 employees and was doing an amazing $3.1 million per employee.
In managing their brands, they look to drive usage through new form factors or use cases. For example, when they acquired Dramamine (the #1 product for motion sickness) it was marketed only to adults. After doing market research they learned that parents were cutting the pills in half manually to give to their young children for car sickness. So they successfully launched a children’s version and increased distribution in gas stations, where parents were stopping during road trips with their kids. They also learned that the main reason people did not want to take Dramamine was the fact it makes you drowsy. So they launched a natural version (using ginger) for people to take when they are concerned about this side effect. These actions have driven 10% annualized sales growth since they acquired the brand.
When they acquired Hydralyte, it was simply the leading product in Australia to address vomiting and diarrhea-induced dehydration. Over the last three years, they’ve driven over 60% sales growth by extending the marketing message to position the brand as the best way to deal with excessive alcohol consumption, heat exhaustion, pregnancy, fever, and travel. Google searches show that so-called “mommy bloggers” in Australia were touting the hangover relieving effects of Hydralyte at least as far back as 2006, so this is a case of Prestige recognizing an opportunity through market research that the former owner just missed.
Prestige operates in slow growth end markets. The number of people who have a sore throat or itchy eyes is not going to grow dramatically. But it also isn’t going to shrink. In order to be an attractive investment, the stocks of slow growth businesses must offer investors high levels of current free cash flow yield. With Prestige’s free cash flow yield hitting 10% in November, we added significantly to what had been a small position for us. We believe the stock offers the potential for steady, dependable returns over the long term that exceed the market. Importantly, these returns are not dependent on a strong economy as even in the midst of a recession, demand for their products is unlikely to drop significantly.
You can read the full transcript HERE.
Clients, employees, and/or principals of Ensemble Capital own shares of Prestige Brands (PBH).
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