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Rayovac: Plenty of Juice for Growth

By Howard Choe Battery maker Rayovac (ROV

; recent price, $26) is a top pick in Standard & Poor's Equity Research Group's household-products segment. We like what we view as its fast-growing, diversified product line, a strong track record of making and integrating profit-generating acquisitions, as well as improving market positions in key product categories and geographic regions.

We also consider Rayovac one of the most undervalued stocks in our household and personal-care universe, based on relative and

discounted cash-flow analysis. The stock carries S&P's highest investment recommendation of 5 STARS, or buy.

SHAVING ACQUISITION. Rayovac is best known as the leading U.S. value brand manufacturer of general alkaline batteries. It's also the world's leading manufacturer of hearing aid and zinc carbon household batteries, as well as a top marketer of rechargeable batteries and battery-powered lighting products. Thanks to its recent acquisition of Remington, it also makes electric shaving and grooming products.

Rayovac sells in over 100 countries and serves 9 of the 10 largest retailers in the world. Globally, it operates seven manufacturing plants, 18 distribution centers, and has 4,300 employees.

It is organized and managed according to three geographic regions: North America (41% of sales in fiscal 2003, 49% of operating profit), Latin America (14%, 13%), and Europe and the rest of the world (46%, 38%). Batteries now account for 74% of sales, with shaving and grooming products accounting for the balance.

BROADER REACH. Acquisitions in the past 18 months underscore Rayovac's ambitions to become a leading global consumer-products outfit. In October, 2002, Rayovac acquired the consumer battery business of Varta AG for $258 million, equivalent to 6.2 times EBITDA (earnings before interest, taxes, depreciation and amortization). Varta is the leading Europe-based battery manufacturer of general batteries and the market leader in Germany and Latin America. We estimate that Varta boosted Rayovac's sales by more than 50% in fiscal 2003 (ended September), to $922 million.

The acquisition was crucial to Rayovac's geographic diversification strategy, reducing its exposure to the highly competitive domestic battery market. Sales of North American alkaline batteries now account for just 17% of its total, vs. 40% prior to the acquisition. In addition, we think Varta has provided Rayovac with significant scale, low-cost manufacturing and distribution -- and enhanced its position with major global retailers. The acquisition was integrated in 12 months, and the deal's synergies are expected to yield $45 million in annual savings.

Rayovac then borrowed a page from its chief competitors by adding shaving implements to its product mix. In September, 2003, it acquired Remington Products for about $322 million, including debt assumption, a price equivalent to 6.6 times EBITDA. Remington is the largest selling brand in the U.S. in the combined dry shaving and personal-grooming products categories, on the basis of units sold. We estimate that Remington will add approximately $400 million to Rayovac's sales in fiscal 2004, reflecting distribution expansion and greater sales of core products, and account for about 26% of total sales.

ASIAN BEACHHEAD. The Remington deal represents Rayovac's first diversification outside of the battery and lighting businesses and provides many benefits. Remington's sales have had a steeper growth trajectory than Rayovac's, averaging about 17% in the past five years (Rayovac has posted organic growth of about 1%). Remington's operating margins, at about 12%, are superior as well to its acquirer's fiscal 2003 figure of 10.6%.

We believe Remington's growth prospects are bright, given solid expansion in the product category (a five-year compounded annual growth rate for the industry of 3%), market-share gains, and new products aimed at the higher-margin premium segment. Rayovac also has the opportunity to leverage its global battery distribution network to help sell Remington products. Remington's integration is expected to be completed by the end of calendar 2004 and is projected to yield annual savings in the range of $30 million to $35 million.

Recognizing tremendous growth opportunities in China, Rayovac agreed to acquire an 85% stake in The Ningbo Baowang Battery Co. in January, 2004, for $24 million, equivalent to 7 times EBITDA. Ningbo Baowang is expected to provide Rayovac with a low-cost manufacturing plant with capacity to produce one billion batteries per year and an established brand name in Baowang. The deal is likely to serve as Rayovac's beachhead for an Asian expansion. The transaction is expected to close in March or April and add to the bottom line in the first year.

FATTER MARGINS. We expect Rayovac's fiscal 2004 sales to climb about 45%, driven primarily by the Remington acquisition. In the battery segment, we believe European and Latin American sales will grow on healthier regional demand and pricing trends. We anticipate continued weakness in North America because of a highly competitive environment that includes archrivals Duracell, made by Gillette (G), and Energizer (ENR).

We expect margin improvement in fiscal 2004, largely based on integration benefits stemming from the Varta and Remington acquisitions. Because the intensely competitive battery category often features price discounting, we project that fiscal 2004 advertising and promotional expenses as a percentage of sales will be similar to fiscal 2003 levels.

We see fiscal 2004 EPS advancing to $1.80, from $1.27 (excluding unusual items) in the previous year. In fiscal 2005, we're projecting sales growth of 4% and a 7% EPS gain. With projected lower interest expense, we estimate EPS growth of 15% in fiscal 2005, to $2.07.

DECENT EARNINGS QUALITY. In the longer term, Rayovac said at the end of fiscal 2003 that it plans to double its annual sales to $3 billion in the next three to five years, driven by acquisitions and organic growth. Despite our expectations of healthy growth from existing businesses, which is likely to be driven by new products, distribution gains, and developing markets, the industries Rayovac is in are relatively mature. Therefore, we expect the bulk of future growth to come from acquisitions.

We believe Rayovac's profitability and cash flow will improve over the coming years, as it continues to wring benefits from acquisitions and takes advantage of its larger scale. Given its diversification and growth strategy, we believe earnings growth will be less volatile and at the high end of the range of our expectations for the overall household-products segment over the next several years.

The quality of Rayovac's earnings is modestly above average. After a series of adjustments to its net income from continuing operations (on a GAAP basis) and before extraordinary items to conform to Standard & Poor's Core Earnings methodology, Rayovac's fiscal 2003 net income per share of $1.27 would be reduced by 10%, to $1.14. This gap compares favorably to the average 12% reduction for our household-product universe.

LIKELY OUTPERFORMER. For fiscal 2004, we're projecting S&P Core Earnings of $1.61 a share, also a 10% decrease from our operating EPS estimate of $1.80. The reduction for option expense accounts for 20 cents of the difference, while a credit for the combination of post-retirement costs and pension adjustment accounts for one cent.

We view the stock as attractively valued at a recent level of 15 times our fiscal 2004 EPS estimate, slightly below the valuation of direct competitor Energizer (4 STARS, or accumulate; $46), a significant discount to Gillette (3 STARS, hold; $38), and a 33% discount to the p-e multiple of the S&P SmallCap 600.

Our discounted cash flow (DCF) analysis derives a value of $38 per share, significantly above the current price. Based on our DCF value and our target p-e of 15 for estimated fiscal 2005 EPS, we have a 12-month target price for Rayovac of $33, approximately 24% above recent trading levels. Based on this assessment, we believe the shares will significantly outperform the S&P 500.

Potential risks to our investment recommendation and our target price include: Increased promotional activity in the domestic battery market, which could hurt volume and pricing, integration risk associated with Rayovac's strategy of growing partly through acquisitions, insufficient market acceptance of new products, and its inability to generate sufficient cash flow to fund internal growth, acquisitions, ongoing operations, pension plan contributions, and payment of debt obligations. Analyst Choe follows household products stocks for Standard & Poor's Equity Research Group

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