Is Hansen Natural a Value Trap?

Hansen Natural (HANS) has had quite a run over the past few years. From an average, split-adjusted price of $0.50 in 2002, the stock traded as high as $68.40 as recently as November 2007. Over the past year, however, it has retreated to the mid twenties amid heavy short selling. The stock’s performance earned it considerable press, most notably a citation by SmartMoney magazine as the best performing stock of the decade following 1996 as well as several consecutive years ranking first, second or third on Forbes' “200 Best Small Companies” list.

Yet now it is a fallen star, which begs the question: is Hansen Natural a value trap?

click to enlarge images

Hansen shares were overvalued in 2007. An examination of the market’s expectations for growth at that time reveals overly optimistic expectations built in to the share price for most of that year. We can determine what growth was factored in to the share price because, for any point in time, if we assume that earnings are sustainable and that thereafter there will be no accretive growth we can simply capitalize Net Income by dividing it by the cost of equity. This gives us the value of the firm with no growth. The value of the growth implied by the market price is simply the difference between the market capitalization and the value without growth.

On September 1, 2007 reported Net Income (TTM) was $126.5 million. Dividing NI by a cost of equity of 11%, and then dividing by shares outstanding, we arrive at a price of $12.76. On that date, the market price for one share was $56.68, so the market assumed not only that current earnings would be sustained but also that there would be tremendous growth. Thus this chart indicates that between September 2007 and June 2008, the market’s perception of the present value of Hansen’s growth declined by approximately $4 billion.

This chart correlates closely to Hansen’s historical P/E ratio since they both express the market’s view of future earnings (see Appendix A, “Historical P/E Ratio”), but it has the advantage of breaking out the value of market capitalization into no-growth and growth components.

We will demonstrate in this note that this correction substantially overshot the proper adjustment, that the firm’s remarkable business model remains intact, that its growth prospects remain bright and that Hansen’s shares are currently trading at a level substantially below their intrinsic value.

The Company

The firm has two reportable segments, Direct Store Delivery (“DSD”), whose principal products comprise energy drinks, and Warehouse (“Warehouse”), whose principal products comprise juice based and soda beverages. The DSD segment develops, markets and sells products primarily through an exclusive distributor network whereas the Warehouse segment develops, markets and sells products primarily directly to retailers.

DSD, essentially the Monster and Java Monster energy drink lines, is largely responsible for the firm’s growth. Today it accounts for most of the firm’s revenues and profit and almost all its growth prospects:

Consequently, our analysis focuses mainly on the energy drink segment.

Business Model

Hansen’s performance can be attributed directly to its innovative, two-pronged strategy. Management set out to blend innovative marketing tactics with a lean outsourcing production model to generate tremendous growth on a small base of invested capital.

When Rodney C. Sacks and Hilton H. Schlosberg bought the brand in 1992 for $14.5 million, the business recorded $17 million a year in revenue, mostly from five flavors of natural sodas and apple juice. Originally, they planned to seek growth in the natural beverages category and introduced flavored iced teas, but they were unable to create any point of difference for their new drinks. Consequently, they reassessed their strategy.

Having observed in Europe the beginning of Red Bull’s success in creating the nascent energy drink market, they decided to jump in to the segment. “Hansen’s Energy” was launched in 1997, the same year that Red Bull first appeared in the United States. Initially, the product did not make waves and they quickly realized that the existing Hansen brand would not serve them well. They reformulated the product with extra sugar and caffeine, rebranded it “Monster” and created distinctive, edgy trade dress. Their new slogan was “Unleash the Beast.” As Rodney Sacks told Business Week:

 The Hansen brand had a good-for-you, trusted image. Our consumer was largely female. Energy drink consumers were young males who weren't focused on health and [products that are] good for you. There was always this dilemma of the brands. So we created a separate brand that wouldn't have any of the constraints of Hansen. We put them in 16-ounce cans -- twice the size of Red Bull -- so you got double the drink [for the same price]. That was the market positioning of Monster -- bigger, more aggressive, more cutting-edge.

Having identified their core customer base, young males, they sought to target that group through highly directed marketing actions targeting active young males. From the latest Annual Report:

 Our sales and marketing strategy is to focus our efforts on developing brand awareness and trial through sampling both in stores and at events in respect of all our beverages and drink mixes. We use our branded vehicles and other promotional vehicles at events at which we distribute our products to consumers for sampling. We utilize “push-pull” methods to achieve maximum shelf and display space exposure in sales outlets and maximum demand from consumers for our products including advertising, in store promotions and in store placement of point of sale materials and racks, prize promotions, price promotions, competitions, endorsements from selected public and extreme sports figures, coupons, sampling and sponsorship of selected causes such as cancer research and SPCA’s as well as of extreme sports teams such as the Pro Circuit – Kawasaki Motocross and Supercross teams, Kawasaki Factory Motocross and Supercross teams, Robby Gordon Racing Team, Kawasaki Factory International Moto GP Team, Kenny Bernstein Drag Racing Team, extreme sports figures and athletes, sporting events such as the Monster Energy® Supercross Series, Monster Energy® Pipeline Pro Surfing competition, Winter and Summer X-games, marathons, 10k runs, bicycle races, volleyball tournaments and other health and sports related activities, including extreme sports, particularly supercross, motocross, freestyle, surfing, skateboarding, wakeboarding, skiing, snowboarding, BMX, mountain biking, snowmobile racing, and also participate in product demonstrations, food tasting and other related events. In store posters, outdoor posters, print, radio and television advertising together with price promotions and coupons, may also be used to promote our brands.

While there are now over hundred energy drink brands, Monster is the only competitor to Red Bull to have successfully created a point of difference for its brand. This is reflected in the steady growth that has brought it to a leadership role in the category (see “Outlook” for a discussion of market share).

Unlike its competitors, Hansen does not own or operate its production facilities. It outsources production and manufacturing. From the firm’s latest Annual Report:

 We do not directly manufacture our products but instead outsource the manufacturing process to third party bottlers and contract packers. We purchase concentrates, juices, flavors, supplements, cans, bottles, aseptic boxes, aseptic pouches, caps, labels, trays, boxes and other ingredients for our beverage products which are delivered to our various third party bottlers and co-packers. All of our beverage products are manufactured by various third party bottlers and co-packers situated throughout the United States under separate arrangements with each of such parties. The majority of our co-packaging arrangements are on a month-to-month basis.

Consequently, as of December 31, 2007, the firm employed merely 904 employees, of which 448 were employed on a full-time basis. Of the 904 employees, 191 were employed in administrative and operational capacities and 713 were employed in sales and marketing capacities. This reflects its strategy of outsourcing capital-intensive production to third parties while focusing on sales, marketing and promotions.

Such moderate staffing enabled the firm in 2007 to earn $2,196,158 of revenue per employee and $377,644 of net income per employee. By comparison:

The success of management’s strategy is reflected in the firm’s Return on Invested Capital figures:

Hansen’s ROIC compares quite favorably to other firms in its category:

Comparing Hansen’s ROIC to the cost of capital, we note the extraordinary effectiveness of the company’s deployment of capital:

In the past four years, each dollar invested in the firm has yielded about one dollar and twenty-five cents in value creation. This ROIC-WACC differential remains remarkable and demonstrates the continuing ability of the company to generate tremendous economic profit from minimal capital. As this rate of return is structural, we believe it to be sustainable. This will be demonstrated by a detailed examination of the drivers of the firm’s ROIC improvement.

Performance

By almost any measure of efficiency analysis or profitability ratio, Hansen’s performance shines:

Notably, its TTM performance generally shadows the five-year averages.

Typically, one starts a profitability analysis with Return On Equity (“ROE”). The common DuPont ROE model splits ROE into three drivers of earnings: net profit margin, asset utilization (or turnover) and financial leverage (or equity multiplier). These have been calculated for HANS with average balances for asset accounts:

Often firms face a strategic choice between competing on price or volume. The preceding data would seem to demonstrate that as Hansen grew its net income sevenfold from 2004 to 2007, while doubling its ROE, it suffered a reduction in asset utilization efficiency. However, during this period the firm actually improved its operational efficiency. This contradiction demonstrates a major shortcoming of the DuPont model – it does not distinguish between the effects of operating and financing decisions because it conflates them into the same metric: assets.

In order to gain a clear understanding of Hansen’s operational efficiency gains over time, it is necessary to adjust the DuPont model to separate the effect of financing decisions from operating performance. We will therefore make an analyst adjustment and rearrange both the balance sheet and income statement so that will be able to analyze accurately the firm’s operational performance (see Appendix B for the complete, rearranged Balance Sheet and Income Statement). The revised balance sheet calculates operating assets and operating liabilities separately from financial assets & financial liabilities. The difference between the resulting operating assets and operating liabilities is termed “net operating assets,” while the difference between the resulting financial assets and financial liabilities is simply all the firm’s financial obligations, or its net debt. We can now create a refined DuPont ratio model which calculates ROE in a manner which allows us to understand more clearly the firm’s operating performance, return on net operating assets and also financial leverage:

ROE = Operating + Financing

ROE = Return on Net Operating Assets (“RNOA”) + Effect of Leverage

ROE = (Net Operating Profit Margin * Net Operating Asset Turnover) + ( Proportion of Debt Financing * Spread)

ROE = (NOPM * NOAT) + (FLEV * Spread)

Spread, which is the difference between what new capital funded by debt can earn less the cost of that borrowing, is simply RNOA minus the firm’s effective interest rate, calculated as (RNOA-(Net Financial Expense / Net Financial Obligations)). FLEV is (Net Debt / Equity).

Thus, RNOA relates the operating performance of the firm, Spread relates the cost of borrowing, and FLEV relates the effects of the firm’s capital structure as determined by the relative amount of debt carried. For Hansen, we see:

This analysis leads us to two conclusions. First, starting in 2005, as Monster sales took off, the firm effectively tripled its operating return in two years.

Second, the firm’s capital structure is a tremendous drag on ROE. Note that between 2004 and 2007, RNOA tripled, yet ROE, after peaking, reverted back to about 45%. For many companies leverage, the ratio of debt to equity, positively affects ROE. In the case of Hansen, however, the firm makes large profits, has no debt, does not pay a dividend and thus carries tremendous amounts of cash, cash equivalents and retained earnings on its balance sheet. This causes negative financial leverage because the firm has negative net debt and has major implications for the firm’s profitability measurements. Although ROE has fallen two years in a row, this is mostly a symptom of management’s poor choice of a capital structure rather than any operational setbacks. We shall discuss capital structure later in this note.

First, however, we return to RNOA to examine in depth the operating efficiency of Hansen and to demonstrate that the firm’s remarkable operational efficiency is sustainable. RNOA has been defined above as:

RNOA = Net Operating Profit Margin (“NOPM”) * Net Operating Asset Turnover (“NOAT”), or

RNOA = (NOPAT / Revenue) * (Revenue / Net Operating Assets).

For Hansen:

Hansen’s tremendous gains in RNOA came from an approximate fifty percent gain in margin improvement (NOPM) coupled with a doubling of operating efficiency (NOAT).

With our refined DuPont model, NOAT gives us a much more accurate look at asset turnover. We have removed the effect of excess cash and long and short-term investments by placing them under financing on the balance sheet. They now affect only the financial leverage effect rather than operating efficiency measurements.

We will now compare these results over time to those of four competitors, Coca-Cola (KO), National Beverage (FIZZ), Cott (COT) and Pepsi Bottling Group (PBG):

We can see the effect on RNOA in the next chart:

We see that for these four other firms, NOAT and NOPM have remained more or less static. For example, FIZZ remains a high volume, low margin producer. Hansen has improved both its NOAT and NOPM. Hansen’s new business model of limited invested capital and production outsourcing has enabled it to achieve a RNOA of greater than 100%.

Examining the reformulated Balance Sheet, we see why:

From 2004 to 2007, Net Operating Assets grew by 225% while NOPAT grew by 700%. This was achieved without any meaningful investment in PP&E or Goodwill (through acquisition). As noted above, the firm’s only real fixed costs are SG&A (e.g. marketing and promotion), which between 2004 and 2007 increased 488%, significantly less than NOPAT. This is the main driver of the firm’s efficiency gains.

An examination of various income statement items will explain the margin effect:

To further demonstrate the efficacy of Hansen’s business model, we will compare COGS, SG&A and CAPEX as a percentage of net sales with four competitors. In each instance, Hansen compares favorably:

Similarly, a cash cycle analysis and an inventory analysis (raw materials and finished goods) demonstrate that management has maintained firm control over working capital as the firm’s top line has expanded:

Profitability

The following chart plots Hansen’s EPS over the past ten years. Note that for the past five years the plot has a large standard deviation yet an R-squared very close to 1. This indicates a wide variance (e.g. growth) on a very tight trend. This consistency is clearly visible:

Book value per share reflects the exploding retained earnings, a consequence of huge free cash flows and no dividend. Again, the 5 year standard deviation is large yet the R-squared is very close to 1:

As we compare EPS growth 5-year-average vs. TTM for Hansen and its competitors, we observe two points. First, Hansen’s performance was and remains the best in its peer group. However, we also note that EPS growth is slowing, as the TTM figure trails the 5-year average (and is thus on the right side of the diagonal).

An examination of Hansen’s Net Profit Margin TTM vs. 5-year-average shows again the firm’s superior performance relative to its peers, yet in this case there is near term improvement:

Outlook

Naturally, all that matters regarding a valuation of Hansen is the firm’s financial performance going forward. We have shown the operating efficiencies and value drivers that have created such impressive earnings growth over the past five years. We believe that management retains its operational and marketing focus and is set to continue the firm’s remarkable performance. Because the market seems to be focused on today’s inevitable deceleration of growth in the category, it is overlooking the critical fact that Monster continues to gain share in a segment that is growing.

While the U.S. Liquid Refreshment market as a whole grew by only 1.3% from 2006 to 2007, the Energy Drinks segment grew 25%, increasing its share of volume from 0.8% to 1.0%:

Thus the segment grew by 25% a year even though it is now ten years old. The Beverage Marketing Corporation refers to this rate as “exceptionally vigorous growth” and it is clear that after a decade, energy drinks are a solid, long term trend rather than a fad. In fact, in Europe the segment is fifteen years old and still maintains annual growth of 10-12%.

Monster and Red Bull are settling in to a classic beverage industry duopoly. They are the only two brands with any distinctive point of difference in a crowded field, and consequently together they have in the near term accounted for almost all the growth in the segment. The other major brands (e.g. Rockstar, Full Throttle) have not achieved any meaningful differentiation and thus are, for the most part, already suffering absolute declines as Monster continues to gain share at their expense.

According to AC Nielsen, for the 13 weeks ended June the 28, 2008 all outlets combined, convenience, grocery, drug and mass excluding Wal-Mart, the energy category as defined by Hansen Natural, grew by 13.7% over the comparable period in 2007.

Because only Monster’s YoY sales growth of 42.5% exceeded 13.7%, it was the only brand to gain market share compared to the same quarter last year. Such is the segment and the success of Monster within it that Red Bull could achieve 11.3% YoY sales growth and nonetheless lose share.

Monster Energy has continued to show positive growth both in sales and growth per point. It is now the leading item in the energy category. Sales of Java Monster now represent approximately 10% of the total sales of the Monster brand. International sales for the second quarter were nearly 6% compared to 4.8% for the quarter one year previous.

Finally, in the 2Q earnings call one month ago, on August 8, 2008, management added that gross sales for July were approximately $11.3 million, some 20% higher than gross sales for July 2007. Sales of Monster and Java Monster in July were approximately 21.5% higher than July 2007.

Future top line growth will be affected by four factors: segment growth, share gains, price increases and international expansion. Our analysis of company disclosures leads us to the conclusion that roughly half of the growth in DSD comes from segment growth, one quarter comes from share growth, and the rest comes from international and other factors.

The most important factor going forward is the strongly negative cross elasticity of demand between Monster Energy and gasoline prices. Convenience and gas stations account for 65% of energy drink sales. Monster’s consumer base skews heavily toward the Southwest states where the young men who consume Monster Energy drive a lot. As the oil price spike continues to go down this autumn, falling gas prices should benefit discretionary purchases such as energy drinks over Q3 and Q4. We expect this benefit to compensate for the effects of the macroeconomic headwinds impacting the economy as a whole and the Southwest in particular.

However, with a recession in full force across most if not all of 2009, we do expect the slow down to dent growth rates, but once the economy starts to recover in late 2009 or 2010 we expect category growth to resume where it left off.

Other than top line growth deceleration, the main risk to profits is margin pressure that comes from two factors: SG&A (e.g. marketing and promotional expenses) and COGS (commodity inflation affecting inputs). Management has indicated clearly that they will maintain close watch over marketing and promotional expenses and trim as needed. However, they have also stressed that they are not prepared to cannibalize future growth due to short-term margin concerns, so they appear to be striking a prudent balance on this front.

While the commodity inflation of the past year has created some margin pressure, we do not expect this to affect margins in a substantive way going forward as we enter a period of asset deflation across the broader economy. On January 1^st, 2008 the firm took its first price increase on Monster products, increasing the price of Monster by 6 percent and Java Monster by 12 percent. There was little resistance from retailers since it was the first such increase in the 7-year history of the product. Sales growth appeared unaffected (sales fell off a bit after the new year, but that appeared to be the result of wholesalers stocking up inventory before the price increase). We believe that Hansen will retain flexibility going forward to take price increases on an annual basis, if needed. Red Bull has established such a policy, and it should be accepted by retailers and consumers for Hansen as well. In any case, it appears that commodity prices will continue declining into the near future, so we see such margin pressure moderating.

We have modeled these assumptions in to our discounted cash flow analysis in the “Valuation” section below.

Risk Mitigants & Valuation

Capitalized Net Income (TTM) with no accretive growth going forward implies $17 per share. Adding the approximately $3 cash per share the firm holds leads to a level of $20 per share as the worst-case scenario.

The current share price of $23.70 implies 10% sales growth in 2009 followed by 4% sales growth for each of the next ten years, followed by a perpetual growth value of 2.5%. The market thus has already valued in the bear scenario for Hansen’s prospects.

Our DCF analysis returns an intrinsic value of $41.74 per share. In our valuation we have modeled sales growth of 13.9% for 2008, a slight further reduction to 12.7% for 2009, and then a slight rebound to 19.0% for 2010. We then forecast a 10-year competitive advantage period, during which growth slowly decelerates to perpetual growth of 2.5% for the terminal value calculation. We believe that the imminent short-term dip in growth is a consequence of the macroeconomic situation rather than a maturation of the energy drink category. Furthermore, management’s recent tie up with Coca Cola for international distribution in Western Europe and possibly beyond will greatly benefit international growth prospects, but we have not modeled such growth in our valuation.

We further see two large mitigants to downside risk going forward for Hansen shares. First, at current share price levels, the firm, with a market capitalization of about $2 billion, represents an attractive acquisition candidate. It is an open secret that both Coca-Cola and PepsiCo have already looked closely at a purchase of the firm. As the energy drink brands of Coca-Cola and PepsiCo continue to struggle while Monster continues to gain share such an acquisition will look more inviting, particularly if Hansen shares remain trading in their current band. An examination of recent survey by Cascadia Capital Survey on Beverage M&A activity between 01/20//06 and 08/05/08 reveals:

Hansen, due to its growth prospects and cash flows, would be expected to command a multiple above the mean. A multiple of 14x results in $41.60 per share:

The current share price implies a multiple of 8.5x. Thus, a fair valuation for the firm based on a multiples analysis confirms a valuation in the range of $41.

Finally, the firm’s capital structure, which as noted is a tremendous drag on its ROE, is ripe for change. The firm could easily lever up due to its tremendous free cash flow generation – depending on the credit market situation. We estimate the potential benefit to share price for a moderate D/E ratio in the range of 25%-35% to be between $5 and $10 per share, which depends on the amount of debt and value of the tax shield, decrease in cost of capital, the amount of shares repurchased, the price of such a repurchase, the final effect on EPS, etc. This has not been factored in to our valuation.

Appendix A – Historical P/E Ratio

Appendix B – Reformulated Income Statement & Balance Sheet

Disclosure: no positions

Comments

[eid:]

Very good article but needs to expand by commenting on the international expansion taking place with HANS expanding away from USA into a large number of countries and its use of Coca Cola in expanding its sales. Both these strategies should greatyly enhance the growth of revenue and income to HANS beyond its current and past results and is a reason why the stock price has remained high unlike other stocks in the current economic climate.

2008 Nov 16 03:07 PM

[RMG:]

Very good analysis. Provides basis for investing or at least swapping $ out of some other stocks into HANS.

2008 Nov 16 03:11 PM

[Jeroen:]

Alexander, nice analysis. I believe your duopoly remark is key in how HANS is/should be perceived.

Another shortcut to valuation: even in a status quo/ no growth, without any international expansion, HANS could pay out an annual dividend of about $2 per share, without harming the business. Applying a 5% dividend yield (which not many strong stocks are yielding, even now) implies a price of around $40.

2008 Nov 17 09:06 AM

[Alexander D...:]

Thanks for your comments - that is an interesting additional way at looking at how to value all the cash the company is throwing off.

Regarding the international expansion, I agree that it could be modeled out further. I just mentioned that there was more growth coming there, but it was not factored in to my valuation, so it was just a further risk mitigant with some upside which is almost certainly there. But point well taken.

2008 Nov 17 10:38 AM

[bambooman:]

Great article. I work with a workforce dominated by 20-30 year old males, and originally invested in HANS because at the snackbar, half the guys were buying Monster drinks (they continue to do so). Nice to have this solid analytical backing as well.

2008 Nov 17 02:23 PM