Central Garden & Pet Company: Trading At Fair Value (NASDAQ:CENT)

After an impressive run-up in price, shares in Central Garden & Pet Company (CENT) are

After an impressive run-up in price, shares in Central Garden & Pet Company (CENT) are taking a breather, retracing from their 52-week highs, and currently trading at $37.8 per share.

The company has benefited from the change in consumer behavior as restrictions were placed to combat the spread of COVID. We have seen that strength translate to retailers such as The Home Depot (HD), Tractor Supply (TSCO), and competitor Scotts Miracle-Gro (SMG), all showing impressive year-to-date results and pointing to an industry enjoying the tailwinds from a shift in discretionary spending towards categories such as gardening and pets, as consumers find themselves with more time spent at home.

As it relates to CENT, the company’s Q3 was its best-performing quarter in its history driven by robust consumer demand. The company ended the quarter with $495M in cash and a leverage ratio of 2.4x, within management’s targeted range.

While the company still expects strong demand in Q4, management guided for a slight earnings loss in Q4 as they increase levels of spending towards e-commerce, digital marketing, and cost control measures. As a result, management expects full-year EPS to be at or above $1.90, implying negative EPS of minus $0.08 in the upcoming quarter. However, it’s important to keep in mind that Q4 is the smallest earnings quarter for the company. For example, in Q4 of 2018 and 2019, the company did $0.03 and $0.04, respectively in diluted EPS.

From a valuation point of view, the company is trading at a forward P/E multiple of 19x, approximately in-line with its 5-year average of 22.8x. We believe CENT is trading at fair value and the stock price is already pricing in the favorable outlook for CENT’s business segments (mainly Pet products and Garden Products). We also believe revenue growth through acquisitions might be hard to come by in a hot market. M&A has been the main growth driver for CENT, having completed 50 acquisitions since 1992. However, with strong tailwinds lifting the sector, management might have trouble finding a suitable deal at a reasonable valuation.

To sustain forward earnings of 18x, organic growth needs to remain resilient, which would depend in part on how the pandemic develops in the upcoming quarters. If a vaccine takes longer than expected, then it is reasonable to assume consumers would keep spending their discretionary incomes towards categories such as pets and gardens.

That said, with CENT trading at a fair value multiple, we would rather wait for a bigger margin of safety before initiating a position to account for the unpredictability of the current market. We are neutral on the company.

Tailwinds drove CENT’s best quarterly results

CENT reported third-quarter sales of $833M, up 18% on a year-over-year basis, and beating expectations by $110M. The company also reported a GAAP EPS of $1.27, beating the consensus by $0.43.

There was strong demand for both CENT’s product segments. The company experienced organic sales of 18% in Garden, and 15% in Pets compared to the prior-year period.

Operating margins came in strong for the quarter as well, given the increase in sales and the leverage of overhead. In the Garden segment, operating income for the quarter was up 46% to $78M compared to the previous year, with margins increasing 360 basis points to 18.5%. The Pet segment also saw an increase in operating income of 45% to $51M on a year-over-year basis and an increase in margins of 230 basis points to 12.3%.

Can the tailwinds persist?

One interesting trend coming out of the pandemic is the increase in the rate of adoptions of pets, which looks to be at all-time highs. For instance, management estimates that pet ownership has increased by 4% this year. While at first, it looked that people were adopting pets to clear the shelters before they were shut down due to the pandemic, it now appears people are adopting pets realizing that maybe they won’t be traveling as much, or they need a good company in times were social distancing is keeping friends and family away:

Shelters, nonprofit rescues, private breeders, pet stores – all reported more consumer demand than there were dogs and puppies to fill it. Some rescues were reporting dozens of applications for individual dogs. Some breeders were reporting waiting lists well into 2021. Americans kept trying to fill voids with canine companions, either because they were stuck working from home with children who needed something to do, or had no work and lots of free time, or felt lonely with no way to socialize. – washingtonpost.com

For CENT, the increase in pet ownership is an opportunity for long-term sales and cross-sell opportunities in different product categories, such as treats, bedding, health, habitats, and other consumables. Even management at Tractor Supply believes their pet supplies business could be a long-term growth pillar:

So pet and animal, both, I would just say, are going to be 2 of the primary pillars as we look forward not only this year but for the years to come to drive comp and drive the overall business. – Tractor Supply Q2 conference call

There is another trend that can benefit CENT on a longer-term, which is the sudden interest of people looking at real estate in the suburbs:

The pandemic has transformed American lives in ways large and small. One of the more surprising side effects: The suburbs are suddenly the hot place to live. This may help to explain why in August aspiring home buyers looked at suburban home listings 53.9% more than they did the previous year, according to the realtor.com analysis. – realtor.com

If more people move into the suburbs, it is not hard to imagine that with more space and bigger backyards, CERN could see a benefit in both of their business segments,

The Bottom line

While it is impossible to predict if the change in consumer behavior is a permanent event, we believe the strong tailwinds could persist for a few more quarters. Without a cure to the pandemic, the discretionary income consumers used to spend on travel and entertainment is finding a new home in other activities.

People are also finding themselves spending more time at home, and with the idea of a “hybrid” workplace floating around, it could lead to a permanent change in consumer habits.

These two trends support the long-term growth opportunities for a company like CERN. That said, we believe the stock price already reflects the positive outlook for the company. With CERN trading at a forward P/E multiple of 19x, we believe the stock trades at a fair valuation. Given the uncertain environment, investors should demand a margin of safety before deploying their capital. We are neutral on the company.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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