Blue Buffalo (NASDAQ:BUFF) has been a common target for pessimism since its IPO. The whole "pet humanization" trend has been a divisive one, but it is one I've put some weight behind, such as via Trupanion (NYSE:TRUP). Overall, I think the market has been a little too cautious on the trend. Growth in spending by American households on pets has been on a strong tear over the past decade, and that growth did not even get stopped by the 2007-2009 Recession. I see this is in my own life as I've spent several thousand dollars treating one of my own pets that ruptured a disc in his spine. That was done without hesitation, and there are millions of pet owners like me that don't hesitate to only provide the best for their little buddies. That includes pet food, particularly pet food billed as wholesome and organic. While I don't personally use Blue Buffalo, it is clear that the company has plenty of market clout, with sales eclipsing more than $1B in 2015. The growth has been there, but has the value of Blue Buffalo equity gotten too far ahead of itself?
Margins Are A Mixed Bag
Back in 2011, Blue Buffalo managed 40% gross margins on $523m in revenue. Over the past several years, that number has not changed much, with only some fluctuations incrementally up and down. However, fiscal 2016 has seen a marked improvement on this measure. Gross margins have run to 44.2% for the first six months of the year, driven by continued ramp from Heartland, which is the company's in-house food manufacturing plant. Prior to its decision to construct Heartland, Blue Buffalo had to source all of its products from third-party manufacturers, a decision that would come back to bite the company later. Given management has high standards for production, which limits potential suppliers, the new optionality of producing food in-house fundamentally changes the company, likely for the better. Fully 230bps of gross margin expansion was driven by Heartland thus far in 2016 y/y, with favorable network mix (160bps), and higher net pricing realization (70bps) boosting margins over the 39.6% gross margins the company managed in 2015.
Unfortunately, any incremental improvement in gross margin has been offset by pressure on the SG&A side of the income statement. Blue Buffalo has been investing substantially on advertising to drive brand awareness and promote new product releases. This has been a long-running strategy that the company has embarked on to force larger players in the industry to cede market share. Given the growth on the top line that is running double that of underlying market growth, it is clear the company is making progress on that front.
Incremental losses also have mounted from the Nestle Purina litigation, which alleges Blue Buffalo misrepresented the quality of its pet food compared to products like Purina. This all came down to the claim that Blue Buffalo does not include poultry byproduct in its food. The general adage for pet owners today is to look at the top three ingredients on their dog food. Those top three ingredients should ideally not include grain, with the primary ingredient being animal protein. Poultry is the cheapest meat-based protein to use in dog food, but it is high in omega 6, which leads to inflammation and other problems. Pet owners as a result tend toward lean beef or fish-based pet food.
Unfortunately, Blue Buffalo found out that a supplier had misrepresented what was in the food it was producing for the company. Not surprisingly, Blue Buffalo is pursuing legal action against the supplier and it has also sued Traveler's and Hartford for not covering legal expenses in accordance with its insurance that was supposed to cover legal expenses in cases like this.
Is it any surprise that Blue Buffalo is moving pet food production in-house? Likely not, given the headaches that the company has bore from this debacle. I don't believe the company is really out of the woods either in its claim of ignorance. Nestle/Purina has a valid point that Blue Buffalo should have been continuously auditing its supply chain to ensure that its products were being made in-line with company standards. So when we think about operating leverage, particularly when it comes to SG&A/Revenue, it is difficult to see the path to that margin expansion until the litigation issues are settled and advertising expenses moderate.
Revenue Still Projected To Rise
Wall Street consensus sits at 1.15B for fiscal 2016 (12% annual growth), which seems attainable given that revenues are up 12% y/y in the first half of 2016. The Street expects more of the same in 2017, with revenue growth expectations for 10% y/y. All analysts covering the stock rate it as a buy or better, which, even for the Street, is incredibly aggressive.
Earnings expectations are rather attainable, despite the aggressive buy recommendations. Analysts expect no margin expansion heading into 2017. That is where Blue Buffalo is more likely to surprise going forward - something the company has proven to have an ability to do before. While operating history is incredibly short, the company has beat on bottom line expectations since going public. There are a whole host of possible outlets for margin growth: continued margin expansion driven by Heartland, falling input costs (cattle futures have been plummeting all year) and continued network/product mix improvement.
While there has been a lot of negativity surrounding Blue Buffalo, there isn't any catalyst that really could send the shares lower, outside of some surprise regarding the Purina litigation. The company benefits from extremely low leverage (net debt of only $100M on roughly $250M of likely 2016 EBITDA), so it will take some really large swings in margins or revenue to drive outsized misses on earnings per share. I'd caution anyone considering going short purely on valuation alone - that is a game that many have played, and very few have won.
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