Zep Looks To Clean Its Blemishes

By Ryan C. Fuhrmann | January 20, 2012 AAA

Cleaning and maintenance product provider Zep Inc. (NYSE:ZEP) has ambitions to outgrow its competition and boost profits by the double digits annually. Unfortunately, since becoming an independent firm back in 2007 it has had to deal with a credit crisis and is currently struggling with higher commodity prices. At some point though, the macro environment should work in its favor.

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First Quarter Recap
Sales fell 2.5% to $153.5 million, which management blamed on pressure on sales volumes that more than offset $5.4 million in price increases to try and offset higher commodity prices.

Zep cited strength in the automotive aftermarket, food processing, industrial maintenance and repair end markets, but said volume declines in the government and vehicle washing, and home improvement (Home Depot (NYSE:HD) accounts for about 10% of total sales) markets were more than enough to send top line growth into negative territory.

Higher raw material costs sent gross profits down 6.6% to $72.9 million. Management was able to lower selling, distribution, and administrative operating costs slightly, but wasn't that helpful as operating income plummeted 23.3% to $7.4 million. A slight uptick in other costs resulted in a net income decline of 27.5% to $3.6 million, or $0.16 per diluted share. (To know more about income statements, read Understanding The Income Statement.)

For the full year, analysts project modest sales growth of 3.5%, total sales of nearly $669 million, and earnings of $1.04 per share. This would represent year-over-year reported profit growth of 7%, though last year included close to $2 million in restructuring and merger integration charges.

Zep has stated long-term goals of outgrowing its market, boosting earnings between 11 and 13% annually, and achieving returns on invested capital in excess of 15%, up from around 10% currently.

Trends Since the Spinoff
Since its spinoff from lighting product and services firm Acuity Brands (NYSE:AYI) in 2007, Zep has relied on a steady stream of acquisitions to boost sales and offset the effects of weak organic trends due to the credit crisis and subsequent drop in demand from its end markets. Since 2007, sales are up 14% and reached $646 million last year. Profits are up closer to 15%, though with the solid growth projected for the coming year will be up closer to 53% since the spinoff occurred.

These qualify as respectable growth trends, but management remains far off its long-term goals of double-digit annual profit growth. Zep still considers itself in the early stages of transforming into an independently traded company and has admittedly had to deal with a "broad economic downturn" in many end markets that are cyclical.

Higher commodity costs are also denting profits in the near term. Zep counts crude oil and chemicals such as propylene, ethylene and acetone as key inputs to its cleaning products and is seeing double-digit price increases for many of these materials. So while gross margins have fallen steadily over the past few years, management has cut administrative and other corporate costs.

The Bottom Line
At a forward P/E of 10.95, the stock is reasonably valued but isn't likely to move significantly until Zep starts consistently posting higher sales and profit growth. If and once this occurs, the stock could be awarded a higher multiple more in line with rivals such as Ecolab (NYSE:ECL) and WD-40 Company (Nasdaq:WDFC), which trade at 20 times and 16 times, respectively. (For additional reading, check out 5 Must-Have Metrics For Value Investors.)

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At the time of writing, Ryan C. Fuhrmann did not own shares in any of the companies mentioned in this article.

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