Wait For A Pullback At Hostess
Summary
- Management changes won't affect the company's focus on deleveraging.
- Debt ratio is on the decline, and the approach is to deleverage through increasing cash flows.
- Acquisitions may still be the only way to justify the growth argument, but recent performance has also been impressive.
After coming out of its bankruptcy troubles in 2013, Hostess Brands (NASDAQ:TWNK) has slowly but steadily improved its position in the market. Though the brand's history dates way back to 1919, a lot has changed in the last five years, especially in terms of the management of the company. Other things afoot include a renewed focus on bringing down debt leverage, but by increasing cash flow rather than paying off debt. The key point is that the executive chairman, Dean Metropoulos, is heavily invested in the company and is as focused on deleveraging as the current CEO who is stepping down.
The question: Is Hostess as an investment considering what's happening with the numbers and management? I think it is, at a slightly lower price point, and I'll show why recent performance and the leadership's approach to debt management are a big part of that recommendation.
Hostess is now one of the largest packaged food companies in the U.S. focused on developing, manufacturing, marketing, selling and distributing fresh SBG (sweet baked goods.) The company has now climbed the ladder to become the number two brand in the US SBG category.
Source: Hostess Annual Report 2017
Let's take a look at the market conditions surrounding Hostess Brands' business, and how that plays into the company's future growth prospects.
As is the case with much of the packaged goods segment, the top three brands walk away with nearly 60% of SBG retail sales, according to data from Nielsen.
Though there is a huge shift in consumer preference towards healthier products, the market for SBG still exists, and it's not going to vanish. Hostess notes in its annual report:
"According to a July 2016 study by Mintel, convenience and brand preference continue to influence snack selection, as over half of U.S. consumers rate portability as a key attribute in breakfast items. These consumption trends play to our strengths as our products conveniently come packaged in both single serve and multipack varieties. In addition, we have launched a line of Hostess jumbo muffins, danishes, and glazed donuts, which have been well-received as new breakfast offerings.
"Nearly all U.S. consumers eat snacks at least once per day. The U.S. SBG category is one of the largest categories within the broader $97 billion U.S. Total Snack category, with estimated retail sales of $6.6 billion in 2017 according to Nielsen U.S. total universe for the 52 weeks ended December 30, 2017. The SBG category includes breakfast items (e.g., donuts, breakfast danishes, and muffins) and all-day snacking items (e.g., snack cakes, pies, bars, brownies, blondies, and cookies). According to The Nielsen Company, the Sweet Snacks category (Candy, Cookies, Desserts, Fruit Snacks, SBG) accounted for 59.2% of the Total Snacks category dollars."
As you can see, despite the shift in consumer preferences, the strength of their position in portable breakfast offerings is validated by the market in general. This is not a segment where you can expect perpetual growth in the double digits, but the sub-segment that Hostess operates in within the U.S. Total Snack category appears resilient enough to yield steady growth.
In a market that's fairly fragmented, the current environment will allow Hostess Brands to keep posting low single-digit growth. Moreover, its acquisition of key U.S. breakfast assets of ARYZTA LLC gives it two advantages: first, the Big Texas and Cloverhill brands expand Hostess' distribution into clubs, vending machines and other sales channels; second, the Cloverhill Bakery's bun supply business will bring McDonald's (MCD) as a key client.
Balance Sheet
This holds some downside, but it is actively being addressed by management.
Hostess still remains overleveraged, carrying nearly a billion dollars in long-term debt at the end of its most recent quarter. The company does not pay any dividends, which frees up some cash flow; but when your annual operating income reads $233 million, the debt pile is indeed quite a burden to carry. Apart from the debt load, as of December 31, 2017, there were 44,182,889 public warrants and 12,317,001 private warrants outstanding.
"Each warrant entitles its holder to purchase one half of one share of our Class A common stock at an exercise price of $5.75 per half share, to be exercised only for a whole number of shares of our Class A common stock. Such sales of shares of Class A common stock or the perception of such sales may depress the market price of our Class A common stock." - Annual Report 2017
The debt pile, as well as the existing warrants, do increase the risk profile of the company, but Hostess seems to be in no hurry to pay off its debt; rather, it wants to keep its focus on increasing sales and cash flow to bring down the leverage.
This is what CEO Bill Toler had to say about the matter during the fourth quarter 2016 earnings call:
"Our total leverage ratio as of December 31, 2016 was 4.51 times 2016 pro forma combined adjusted EBITDA of $215.3 million. We continue to expect this rate to come down over the next year given our consistent cash flow generation."
At the fourth quarter 2017 earnings call, this was echoed by executive chairman Dean Metropoulos:
"2018 EBITDA 29.7%, by any measure remarkable number, this great performance on both of those statistics, and end of the year with $135.7 million cash flow, lowering our leverage ratio down to 3.73 times. This is a wonderful cash machine and Hostess is in fact, a very wonderful company."
As you can see, both men were focused on the same thing: bring down the leverage ratio, not by paying off debt but by increasing their cash flow. The leverage ratio has indeed come down, from 4.51 at the end of 2016 to 3.73 at the end of 2017, but it still has a long way to go. So, don't be surprised if Hostess keeps hunting for companies to buy in 2018.
On the management front, Dean Metropoulos remains heavily invested in the company, both in terms of his money as well as time. As of February 27, 2018, the Metropoulos Entities held approximately 23% of the company's Common Stock, including 100% Class B common stock, and The Gores Group held approximately 5% of our Common Stock. The exit of the current CEO, Bill Toler, is definitely a setback and the company is still searching for his replacement, but the transition shouldn't hit the company too hard as long as Dean Metropoulos stays invested.
Recent Performance
Hostess had indeed fired on all cylinders during the fourth quarter, with their top seven brands - which accounted for 74% of the company's net revenue - registering 8.2% growth. Adjusted EBITDA margin came in at a strong 29.5%.
Hostess' solid margins and growing business make them an attractive acquisition target for large packaged goods companies that have found their going hard in the current market.
Although Hostess is trading around 6.8 times current earnings, the valuation seems to be a little on the higher side as consensus forward P/E is around 21.05. Hostess is a HOLD if you already have a position but wait for a pullback to add some more margin of safety before initiating a new position.
This article was written by
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