Describe the thesis behind of one of your favorite current ideas, Hain Celestial [HAIN].
Philip Tasho: Hain is the largest marketer of natural and organic foods, a niche that’s growing 20% annually and now broadening out from specialty retailers like Whole Foods to more mainstream grocery stores. It’s only 2.5% of the food industry, so there’s still a lot of room to run as Yuppies get older and focus on healthier eating.
This may not matter, but is there solid evidence that eating natural and organic foods is better for you?
PT: Given that this is such a young industry, the data is still inconclusive. Intellectually, though, people appear to increasingly believe that the fewer impurities in what they eat, the better. Mostly through acquisition, Hain has the broadest product line in the industry – under brands such as Celestial Seasonings, Terra and Health Valley – and leading share in 13 of the 15 most popular natural food categories. There are two big convention-center trade shows for natural foods – the last one was just in Baltimore – and Hain products probably take up 25% of the space. The company has also expanded into natural personal-care products like lotions and shampoos, a segment that is growing faster and has higher margins than food. The strategy is similar to what it has been for food: buy promising existing products and then grow by taking advantage of an already well-established distribution system.
Hain hasn’t always been held up as a great operator. Do you see that changing?
PT: Because they’ve grown largely by acquisition, there have been integration issues and they haven’t operated as efficiently as they should. Revenues have grown around 20% per year over the past five years, but margins have been flat. Part of that has been competition in the Celestial Seasonings tea business, but we generally see an ability to operate more efficiently as a key upside here and the company is serious about it, having hired people from big-name food companies to focus on better execution. Management has targeted an increase in gross margins from 29% today to 33-35%, and are working to get selling, general and administrative costs from 20% of revenues down to 16%. We think both are achievable, as they rely more on internal growth than acquisition going forward.
Doesn’t the mainstreaming of the category also have risks, as Safeway launches its own “natural” line or big branded-foods companies launch competing products?
PT: We actually think it’s great to get the category away from the specialty aisle, which will expand the market tremendously. Hain has natural-specific brands with already-leading shares, which should serve them very well as competition increases. There’s clearly risk of new competition, but I’m not sure how easy it’s going to be for a company like Kraft to translate its brand to natural and organic foods.
What potential do you see for the shares, currently trading at $32?
PT: Because we see this as a top-line story, we’re setting our valuation targets based on revenues. A multiple of 2x sales – where the shares have traded before and which we think is reasonable if the company continues to grow revenues 20% annually while also improving operating efficiency – would translate to a share price of $45 over the next 12 to 18 months. A big food company like Kellogg trades at 2x revenues and doesn’t have nearly the growth potential.
Why do you consider price/sales the most relevant valuation metric?
PT: Earnings for a lot of small-cap companies are volatile, so we often find valuations based on forward P/Es to be less meaningful. There are many things I think are more important to the thesis for Hain than stable growth in earnings. That’s not to say margins and profitability aren’t important – in fact, I’m only comfortable targeting a 2x price/sales ratio because I believe the company is doing the right things to improve margins – it’s just not what I consider the primary driver of valuation. That certainly may change in the future as the business evolves, but it isn’t the case right now.
One could imagine Hain as an attractive acquisition target for a bigger player. Is that part of your bet?
PT: I never think that way. It happens to many of the companies we own, but I have never found a potential buyout to be an important reason to own something.