Central Garden & Pet Company (CENT) Earnings Call Transcript & Summary

So the deal we struck with for 80% is we're going to pay about EUR 340 million at close, which we expect to be in our Q2 of fiscal '27. Then we've got the additional earn-out based on their calendar 2026 performance, which would be up to potentially another EUR 60 million, and that would get paid out in our Q3 or Q4. We don't know even when we're going to acquire the additional 20%. The minority partners are very interested in participating in the upside over the next several years. They're very bullish as are we in terms of what we can do with the business together. I think at some point, should they decide to retire, then we're definitely going to take a look at it. We have first right of refusal on it. In terms of cash and leverage, as I mentioned earlier, we're sitting on over $1 billion. I think we're over $1.1 billion as I speak, in cash, which is a record level. Our net leverage is approaching 0, which is an enviable position to be in. And when we look forward, we're pretty bullish about our earnings and working cap trends going forward. As a result, we're very comfortable using existing cash on hand to pay for the transaction next year. And then when we consider not only our own -- or what we project going forward for our organic business, but also the incremental EBITDA lift from having TRIXIE, we expect to stay below 1.5x net leverage and below 3x gross leverage even after payment.

And so when you think about the U.S. and Europe and how you balance where you see the better opportunity in terms of M&A, is it strictly, sort of, like, what comes across the desk and opportunistic? Or is it, sort of, more of a 10-year whiteboard plan?

I would say we're actively looking at opportunities on both sides of the pond. Obviously, we need to get to close on TRIXIE before we pull the trigger on any of those in Europe. It really comes down to where we're seeing the opportunities that will offer the best returns. I think we're agnostic on whether they're in Europe or in the U.S. right now. What we're targeting either way remains consistent. It hasn't changed. I mean we want high-margin, fast-moving consumable businesses, brands with a clear right to win. We prefer larger deals. Smaller deals tend to take as much work as larger deals. But we are open to bolt-ons, TDBBS, which we did a few years ago is a perfect example of that in our Dog and Cat business. There are white spaces that are very important for us to get into. I mentioned Cat earlier. Pet supplements is another space that we're really interested in. And then I would say also, and I know I've brought this out publicly a number of times over the last couple of years, tucked within our Pet segment, we have a really lucrative business that manufactures professional and consumer insect control brands for the agriculture, animal health, specialty pest control and public health vector control markets. We are very, very interested in deals within that space and are actively on the hunt there.

So we've talked about the horse pill before.

Yes.

So I hate to talk about the pet cycle. Every time I talk about the pet cycle, the woman who runs my business makes me put money in basically a swear jar. And COVID feels like a fever dream a long time ago. But where do we think we are in the normalization process? Where do you see in pet owning households either in the U.S. or Europe? And where do you think we get to in the next couple of years?

So Cat, as I mentioned earlier, continues to grow. It never stopped after COVID, and we expect that to continue for a number of reasons. It's an easier pet to own, lower cost of ownership versus dog, suitable to small living spaces. Horse ownership is stable, and we expect that to continue for a number of reasons. I mean people -- horses are very expensive to own. They're pretty much members of the family, and we don't expect that to go either up or down in the future. I would say when I look at the latest data, small dog, freshwater fish, pet bird and reptile ownership appear to be stable at this point, finally, and we could potentially start to see some, I think, solid evidence of growth in 2027. Interestingly, with reptile, it's always been kind of an edgy, niche-y sort of a pet that's really appealing to younger kids, and there's an emerging school of thought that that actually may be taking over as a child's first pet. So we'll see how that plays out, but that's kind of a new trend that we're starting to see. If I look at large dogs, saltwater fish and small animals such as guinea pigs, unfortunately, that has not stabilized. We still see some further downward trends there, particularly in large dog, and it could take a bit longer. People fortunately continue to spend on their pets. Their pets are living longer as well. People view them as family members. And so it's been really surprising to us in the pet industry, how resilient that category has been around consumer spending. I mean people will spend on their pets and make trade-offs in grocery and other essentials to do that, which has been encouraging. And given the younger owners, ongoing pet humanization, premiumization, we expect that to continue.

Trying to imagine my wife's face if I brought home a reptile. It would not.

We can help you out.

I don't think that actually helps me, but thank you. So let's talk a little bit about the last quarter and the exit of Pet distribution. So reported third quarter sales were down 8%, but organic sales grew 2%. Gross margins expanded about 130 basis points. How much of that mix benefit was the distribution exit? And then how should investors think about the exit in terms of improving the go-forward quality of the revenue and margins, working capital intensity and cash conversion?

So we exited the Pet distribution business given it was high cost, high complexity and low margin. And for that business to be healthy, it really needs to have national scale and be super lean and efficient, and we felt having Phillips take that over really gave it the best chance for success. So now that, that's out of our portfolio, I mean, what investors should expect over the next few quarters is a lower revenue base, maybe down around 20% roughly in Pet or 10% total company, but with a structurally meaningfully higher operating margin and lower working capital requirements. Distribution was very inventory intensive. Very little impact on operating income dollars, though, given the distribution business had such low margins and was in decline. Very important to underscore, though, once we close TRIXIE in Q2 of next year, we will have replaced most of that lost distribution sales with branded sales, delivering a much higher gross and operating margin.

So there are other parts of the portfolio that would be potentially pruned like that? I mean over the years, you guys have done a lot of portfolio optimization. And you continue to kind of exit these businesses that I think the world doesn't realize that you own.

Yes. Yes. I would say we continue to look at our portfolio. The vast majority of the opportunities have been taken advantage of around pruning. There's a few areas that we continue to look at in terms of further optimization. Live plants is probably at the top of the list on the Garden side. It's very volatile, very dependent upon weather. A high portion of that business is consignment and it's highly concentrated in a single customer. So it's challenging in a number of ways. When weather is great, it prints money. When weather is suboptimal, which seems to be the case all the time these days, it's a lot more challenging. I think the team has done -- we have a fantastic team at the helm there, and they've done a really nice job of optimizing that business over the next few years. But we continue to look at store and SKU rationalization to try to reach a more predictable level of sales and profitability and looking for ways to reduce customer concentration and moving more of the business gradually from consignment to PO. So more to come, but I would say that's really the biggest one that we're focused on.

Got it. And then in the third quarter, the adjusted OpEx margin was up 90 basis points, and you guys have made, sort of, really steady step improvements over the last couple of years there. So as you separate portfolio mix from productivity, how much of the improvement do you view as durable? And where do you think the next layer of margin opportunity is?

So most of the operating margin gain in Q3 was definitely related to the distribution exit. As I mentioned earlier, that is going to be an ongoing benefit to us having that outside of our portfolio. And from an equity investment perspective, once they get their synergies in place a few years down the road, we could start to see some amount of income from that JV. However, aside from distribution, I also think our portfolio mix improvements we're seeing from the continued growth in some of our higher-margin businesses such as professional and equine and the pet side are going to help our overall profitability going forward. So I think there's -- so I think the mix benefits are durable, and I think we've got a bit more to come in the coming years there. On the productivity side, cost savings has been a meaningful driver of both gross and operating margin expansion this year. And I would say we still have some opportunity for structural cost savings in our base business over the next few years. But really, the next big frontier in productivity savings is going to be AI-related productivity improvements, which I mentioned earlier.

Yes. And then you just sort of finished or at the end of Project Horizon, which was the consolidation of the Garden distribution footprint into 4 major hubs. So maybe talk about some of the benefits from that and what those hubs look like.

Yes. So we've -- since 2022, we've closed in that initiative 13 facilities, and opened 2. So we transformed what had been a separate business unit -- separate business unit distribution networks into a unified 4-node national network, which we call the Central Logistics Network. We've definitely seen cost savings from this initiative. We don't talk about -- we don't quantify it publicly, but it was meaningful. And -- but equally important, as our throughput continues to increase through this network, we're seeing some really nice improvements in productivity, service levels and customer responsiveness. I mean if we look at this network, we now are at a point where we're able to offer 2-day e-com fulfillment to over 90% of the U.S. population, which for us was a huge win. But I don't -- we're not done in this area. I mean the next step of the journey is really to evaluate opportunities to leverage AI, robotics and process automation to further gain efficiencies there.

So on robotics, and I apologize for this question in advance. The Barclays team is very bullish on the outlook for humanoid robots in distribution centers. And I was wondering if you guys have thought about that or had any thoughts on it or if you were trialing it?

We're not that far along. We've thought about humanoid robots, but I would say that most of our reinvestment these days is into our brands, innovation, e-commerce, data, AI and other automation. Humanoid robots are probably a step beyond.

Okay. We'll keep the terminator off to the side there. As you realize these savings, where are you deliberately investing? Brand innovation, e-commerce, data, you mentioned AI, automation, thoughts on that?

Yes. So what we've shared publicly in past discussions, we've got -- we've invested in direct-to-consumer e-commerce capabilities in our businesses from the West Coast to the East Coast, and that's enabling what I mentioned earlier in terms of our 2-day e-com fulfillment capabilities to substantially all of the U.S. population. Innovation, we're investing an increasing amount of money there around capabilities, both commercially as well as in product development. Another thing we've talked about in this example is data and AI. We are investing a significant amount in our data warehouse to make it AI ready by the end of next fiscal year. And that's really going to unlock enormous sales and profitability opportunities. And I'm excited in particular about that one because when we look at our competitors, by and large, they are smaller than us. And so they don't necessarily have the financial wherewithal to develop the same level of capabilities around use of AI that we can. And I think that's going to create an increasing competitive advantage for us.

You mentioned AI with sort of internal efficiencies, distribution center efficiencies, sort of, marketing ready, I guess, is the way I would phrase the way you put it or like LLM ready for when people purchase there. I think broadly, the market is trying to struggle with what AI does for corporations like you. Do you think it ultimately reduces headcount over time or it just increases sort of throughput and efficiency for you? if we sort of play for a couple of years now.

Yes. Really tough to predict what it's going to look like because it's moving so quickly, as we all know. Right now, we've -- as I mentioned, we've already started using AI to support our commercial activities and are just starting to use it in operations. Our biggest area of focus now is on, as I mentioned, getting our data foundation in order and AI ready to leverage AI on a more comprehensive scale. I would say the opportunity now is to make our people more productive, automating repetitive work, improving decision-making, allowing our teams to spend more time on high-value activities. The next stage is to be able to redesign processes around these capabilities rather than simply layering AI on top of what we already do. Could that ultimately affect headcount down the road? Yes, for sure. But reducing headcount isn't the objective in and of itself for us. We would expect the gains in productivity to allow us to grow with fewer incremental resources, reduce the need to backfill certain positions and in some areas, operate with smaller teams. I mean our objective really is to build a simpler, faster, more productive Central and be able to grow earnings and absorb future acquisitions without adding overhead at the same rate of revenue.

Where do you think we are in the core U.S. consumer today relative to the start of the year? Better, worse, largely unchanged TBD?

I would say that the -- versus kind of where we were at the beginning of the year, for pet supplies and lawn and garden, the consumer remains resilient, but they're increasingly pressured for money in their purchase to seek value for money in their purchases. In Pet, you have to really separate between existing pets and new pets. They continue, as I mentioned, the spend on the pets that they currently have, given that strong human-animal bond connection. They're sticking to the brands that they trust, but they're increasingly looking for ways to get what they want for less money. I mentioned earlier the channel shifting that we're seeing to Walmart, to Costco and e-com as examples of that. However, given the financial pressures, they're continuing to hold off on getting new pets. And so I know the last few years, we've always been asked when new animal ownership trends are going to revert back to normal, as I mentioned earlier, with the exception of Cat, they haven't. We're finally seeing some stabilization, but we're not yet fully back to growth there. With Garden, in the biggest categories we play in, fertilizer, grass seed, our branded controls business, wild bird, fortunately, once the consumer is in these categories, there is some amount of recurring annual maintenance spend that's required. And so they want to maintain their lawns and gardens and they want to continue their birding hobby. So we're seeing resilience in the garden space as well. But as I mentioned in Pet, a real focus on getting value for money. And I would say with Garden, in the categories we play in, consumers really recognize our products as offering really exceptional value for money in our branded offerings as well as in our private label. If we look at fertilizer which is really the one category in Garden where we have seen some trade down to private label. We really, really have gained share there. People really are happy with the quality of the product and the price points that we offer.

I'm, sort of, in our last minute here. As I said in the overview, I'm the credit analyst, so I don't make the equity call. So I'm going to let you make your own equity call. But if you want to tell folks what you think the market most misunderstands about Central or why you think your equity is a compelling value right now?

Friederike and I were actually talking about this on the taxi ride back home from -- to the hotel from the airport last night. I don't think investors fully appreciate how much the underlying quality of Central has changed. I mean, over the last few years, we have drastically simplified the portfolio. We've improved our margin structure. We've strengthened the balance sheet. We've continued to invest behind our brands and capabilities. And that's enabled Central to deliver record results these past few years without particularly strong consumer, without normal levels of new animal ownership, without a decent garden season and without the benefit of M&A. So over the next year, I think the evidence will be fairly straightforward. Can we consistently generate organic growth, sustain, continue to improve margins and convert earnings into free cash flow and deploy capital through M&A at attractive returns? And if we do these things against a relatively modest category backdrop, I think it demonstrates that Central has become structurally just a better earnings compounder. And on top of that, with significant additional upside once we have eventual normalization in new animal ownership, housing activity and consumer purchasing power.

Great. Thank you very much.

Thank you.