Reynolds Consumer Products (NASDAQ:REYN), the maker of Hefty trash bags and Reynolds Wrap aluminum foil, sold 47.2 million shares at $26 each on January 30 for proceeds of $1.2 billion. The first billion-dollar listing of 2020, it is the largest offering by a household goods company.
The company marketed its stock at a price range of $25 to $28 a share. On the first day of trading, Reynolds stock gained a respectable 9.8%, closing at $28.55. While it didn’t quite meet the first-day open of 1Life Healthcare (NASDAQ:ONEM), an operator of primary care clinics in the U.S. which gained 58% in its trading debut, Reynolds did show that boring names can deliver the goods for investors.
Reynolds products aren’t sexy, but it believes it’s got a compelling investment thesis.
“What’s attractive to investors about our company is steady proven growth over a long period of time,” Reynolds Chief Executive Officer Lance Mitchell said in an interview. “We have a very consistent, durable demand and investment thesis that’s compelling.”
Here are seven reasons you shouldn’t buy into the Reynolds IPO hype.
Don’t Buy The Hype: IPO Investors Got Hosed
Reynolds, as I said in the intro, sold its shares to the public for $26 each.
Based on 202.6 million shares outstanding after the IPO, it went public with a market cap of $5.3 billion. As I write this, it’s trading above $30, an $800 million increase in its market cap in just three days of trading. That gives Reynolds an enterprise value of $8.5 billion on a pro forma basis.
If you turn to page 51 of its prospectus, you will see that Graeme Hart, the company’s owner and chief beneficiary of its IPO, contributed $77.2 million in equity to control 77% of the company post-IPO. For anyone that’s counting, he paid 50 cents a share for his ownership stake.
Meanwhile, IPO investors paid $1.2 billion or 26 cents a share for the remaining 23% of the company. That’s quite a deal. Hart’s $77.2 million investment is now worth $4.7 billion.
How did he get to this point?
Hart’s private equity firm, Rank Group, acquired Reynolds from Alcoa (NYSE:AA) in December 2007 for $2.7 billion, much of the payment made with borrowed funds.
In 2018, Hart said the following about his leveraged buyout strategy:
“Be bold,” Hart said in a speech at his alma mater in New Zealand. “That means buy as big as you can, borrow as much as you can and then work the asset as hard as you can.”
He did that at the expense of those buying IPO shares.
It’s Got a Ton of Debt
As I stated previously, a big chunk of the purchase from Alcoa was made with borrowed funds. Then, in 2010, Reynolds acquired Pactiv Corp., the maker of Hefty trash bags, for $4.4 billion and the assumption of $1.5 billion in debt.
That was a significant acquisition for Reynolds because today, Hefty accounts for 46% of the company’s overall revenue. Without it, Reynolds wouldn’t have nearly as interesting a story to tell IPO investors.
As the “Use of Proceeds” section states, Reynolds will use the net proceeds to pay down some of the $4.1 billion in debt it had before its IPO. It has arranged a new term loan facility of $2.475 billion, of which $2.45 billion of it will replace the old debt. It will also have a new $250 million revolving facility that is undrawn as of the IPO.
The long and the short of it is that the company’s long-term debt hasn’t changed, but Hart and his related companies have gotten the funds they borrowed to buy and grow Reynolds repaid.
Again, remember that $77 million is all it took to build a company with an $8.5 billion enterprise value.
Very Little Growth
As CEO Mitchell stated in the interview I referenced in the introduction, Reynolds has a history of proven growth over a long period. For this reason, he believes Reynolds is a compelling investment.
I see things a little differently.
In 2014, Reynolds had sales of $2.72 billion. In 2018, it had annual sales of $2.81 billion. That’s a compound annual growth of less than 1% in a period of reasonably healthy economic expansion. In my eyes, that’s anemic growth, at best.
The company’s prospectus brags that of its four key areas of focus, two of them: Cost Reduction and Automation, have to do with cutting costs rather than growing the top line.
Meanwhile, Reynolds’ adjusted EBITDA grew from $523 million in 2014 to $647 million in 2018, a 5.5% CAGR. That, too, isn’t what you would call hitting the leather off the ball.
Sure, the company discusses paying out a quarterly dividend of 22 cents a share, but I suspect in 2-3 years, that will be the only thing attractive about REYN stock.
Little Growth at a Reasonable Price
In the first nine months ended September 30, 2019, Reynold’s adjusted EBITDA grew by 4.2% over the same period a year earlier, 130 basis points lower than its four-year average. I’ll assume Reynolds’ 5.5% growth rate stays intact for 2019. That works out to adjusted EBITDA of $674 million, which means its enterprise value of $8.5 billion is almost 13 times EBITDA.
That’s certainly not expensive when compared to other household products companies. However, the likelihood of the company’s adjusted EBITDA growing at a pace that keeps up with its market cap and debt accumulation growth, suggests its valuation could get expensive in a hurry.
Further, Reynolds’ 2018 free cash flow was $448 million. If we assume it will be 10% higher in 2019, you get $493 million. Based on an $8.5 billion enterprise value, its free cash flow yield is 5.8%. That too isn’t half bad.
Again, just as in the case of adjusted EBITDA, it’s likely not going to be increasing its free cash flow each year at the same pace as its market cap and debt accumulation, which means its free cash flow yield won’t get more attractive in the years to come.
This means you’re buying REYN stock today for little growth at a reasonable price. Tomorrow, you’ll be getting a low growth for a nosebleed valuation.
There are much better buys given the risk/reward profile.
Innovation Can’t Happen Fast Enough
One of Reynolds’ business strategies is to drive growth through new and innovative products. To that end, it says that 21% of its revenue in fiscal 2018 was from products that were less than three years old, exceeding its annual goal of 20%.
In the prospectus, it mentions several innovative products, including the Hefty Ultra Strong product line, which was named one of 2018’s most innovative products, according to Nielsen. In fact, it mentions the words innovation or innovative 101 times in the prospectus.
The problem is all companies push innovation these days.
In its fourth-quarter conference call, Church & Dwight (NYSE:CHD) management mentioned these same words a total of 12 times.
“We’ve really picked up the pace of innovation for vitamins. If you look at ’17 and ’18, we kind of averaged six new items a year, we had 22 new items in 2019, we got 17 more coming in 2020,” stated Church & Dwight CEO Matthew Farrell.
Reynolds sells aluminum foil, garbage bags, food and storage bags, party cups, etc. Innovation can be a good soundbyte, but there’s not a whole lot of change the company can bring to the table.
It’s a Controlled Company
As I mentioned previously, New Zealand billionaire Graeme Hart owns 77% of Reynolds post-IPO (74% if the over-allotment is exercised). This means that Hart will be able to act in his own best interests rather than the company.
I realize that it doesn’t make sense for someone to act against the best interests of a company they control because, ultimately, they might want to sell it. However, it happens more often than people realize.
It’s one thing to have a significant stake in a business, but when it’s more than 50% of the outstanding shares, corporate governance often goes out the window.
As an interesting aside, page 32 of the prospectus states that two subsidiaries of RGHL Group, which is owned by Graeme Hart, have defined benefit pension plans that are currently underfunded by $900 million. Should things go sideways with these pensions, Reynolds could find itself in the middle of a nasty lawsuit because it’s a controlled company.
Now, the likelihood of this happening is remote, but it’s something to consider when considering this slow-growth business,
International Expansion Going Will Be Tough
Reynolds cooking and baking division generates a small amount of revenue outside the U.S. Here in Canada, where I live, it owns the Alcan brand of aluminum foil. It’s very popular at Costco (NASDAQ:COST). Outside North America, it has the Diamond brand. In total, the company sells its wares in 54 different countries.
However, it is the U.S. and Canada that account for 99% of its sales. It estimates that its addressable market outside North America is $7.2 billion. Based on $2.98 billion in 2018 annual sales, its international revenues were $298 million or just 4% of its estimated addressable market.
While this seems like an obvious area of expansion for the company, it’s important to remember that it participates in product categories that aren’t exactly cutting edge or new to the world. Established brands outside North America aren’t going to give up market share just because it says Reynolds or Hefty on the box.
Whatever profitability Reynolds currently enjoys could partly disappear if it were to up spending outside North America. Therefore, I believe investors must view this opportunity as a double-edged sword.
Be careful what you wish for because you just might get it.
At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.