Flowers Foods: Wrong Bake

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About: Flowers Foods, Inc. (FLO)
by: The Value Investor

Summary

Flowers Foods has disappointed investors (again).

Management has claimed that it is turning around the business, but margins remains lacklustre as focus on innovation (through M&A) has failed to deliver as well.

While shares are down quite a bit from recent trading levels, I fail to see  appeal at current levels, requiring a bigger drop in the shares before I become interested.

Flowers Foods (FLO) is one of those high dividend consumer plays which has seen its fair share of struggles, notably being the result of a consumer shift away from traditional bread and baked goods. Management has claimed to be on the verge of a turnaround quite a few times now in recent years, but continues to disappoint investors. To address the issues it resorts to restructuring and acquisition of promising growing businesses in niche segments, but that strategy is not yet working either.

Therefore, I am not buying the promises of management as moderate leverage, lack of growth and 20 times multiple (even after tax reform) make that the valuation is still rich enough despite a recent setback.

The Business

A quick refresh for those readers not that familiar with the company, as it is not covered a great deal on this website. Flowers Foods is a $3.9 billion bread business, including the number 1 brand in loaf and organic bread, with a near 100% consumer awareness in the US.

Roughly 60% of its sales come from the branded retail channel (through which it mostly sells bread, although a few snack cakes as well). The remainder of revenues comes from distribution to store branded retailers as well as other channels.

The company has 47 bakeries across the US as the near 10,000 employee base supply the 1,000s of distributors. While the overall $25 billion retail fresh bakery business is flattish in terms of sales, the company holds an impressive market share of around 15%. To combat the overall market is facing pressure from a shift out of bread to other forms of food, the company has made a big bet on the rapidly growing organic fresh packaged bread market.

About The Numbers

Flowers Foods reported $3.92 billion in sales in 2017. Excluding a small divestiture; this implies that organic sales grew by 0.4% last year. That looks better than it is as volumes were down by 0.2% amidst a mere 0.6% increase in realised prices.

The company reported a 0.7% fall in adjusted EBITDA to $450 million, for margins equal to 11.5% of sales. Adjusted earnings fell by four cents to $0.89 per share. Note that the number was quite adjusted as a result of continued restructuring costs associated with the streamlining of the operations.

For 2018, the company outlined pretty ambitious targets (given its challenges), seeing sales anywhere between flat and up 1.6%. Adjusted earnings were set to increase to $1.04-$1.16 per share, a $0.15-$0.27 per share improvement from 2017. Roughly a $0.16 per share improvement is seen from tax reform, while cost savings should allow for the remainder of the earnings growth.

That relative good news only lasted so long as the company warned for increased marketing efforts as well as higher input and transportation costs when it released second quarter results. Consequently, it maintained the sales guidance but cut the earnings guidance to $1.00-$1.07 per share. That is pretty disappointing. If we add the benefit of tax reform, 2017 earnings came in at $1.05 per share.

The disappointing results showed that shares have pulled back from a high of $22 in May to $19 again as the third quarter results indicated more weakness. Further margin weakness showed that adjusted earnings are now seen at $0.90-$0.95 per share.

The Financial State

Flowers Foods ended the quarter with $50 million in cash, with debt amounting to $825 million. This net debt load of $775 million remains very manageable with adjusted EBITDA totalling $450 million last year. So far, seeing a $25 million negative delta in EBITDA this year, I peg EBITDA at roughly $420 million this year, for a 1.8 times leverage ratio.

That leverage ratio will see a modest increase as the company actually announced a small bolt-on deal. The company aims to add some growth into the mix with the purchase of gluten-free baking company Canyon Bakehouse for $205 million, or $175 million after accounting for tax synergies.

Having been founded as recent as 2009, the company has rapidly grown to an anticipated sales number of $70-$80 million in 2019. That works down to a 2.3 times forward sales multiple, as earnings accretion is seen from 2020 onward. With net debt jumping to $980 million, and assuming 10% EBITDA margins at Canyon, I peg the new leverage ratio at 2.3 times.

With Flowers Foods being awarded a $4.0 billion equity valuation at $19 per share, and the enterprise being valued at $4.8 billion, the company is trading at 1.2-1.3 times sales. This indicates that an improved growth profile does come at a big cost for Flowers, and its shareholders.

Management Has To Start Delivering

The 4% dividend yield has been a key factor why investors have been attracted to Flowers Foods, yet management has failed to deliver on its promises. The company has not seen any growth and while the company was very much unleveraged in recent years, yet it has been increasing net debt as the dividend payout exceeded actual earnings and it has made some premium acquisitions.

The issue is that despite these deals, growth has been non-existing while the promise of higher earnings have not come through. The new earnings guidance marks just a 1-6 cent improvement from 2017 earnings, despite an anticipated 16-cent benefit from tax reform.

Besides the dividend and relative strong balance sheet, investors were looking for two things. For starters is additional cash flows, as the company is essentially shrinking and capital spending lags depreciation charges by roughly $50 million a year. That works down to roughly $0.25 per share in additional cash flow power on top of reported earnings.

The bigger anticipated driver were margin improvements projected as a result of restructuring efforts. The goal was to reported EBITDA margins of 13-14% in 2019 and beyond. Note that if those margins would be achieved, earnings could see huge gains. Based on a $4 billion revenue number, that translates into EBITDA potential of $520-$560 million. D&A runs at roughly $150 million, as interest on a near $1 billion net debt load could work down to $40 million in interest expenses. With a 20% tax rate that would work out to $280 million in net earnings potential, or about $1.30 per share in earnings power.

Such a number with modest growth, and a lower leverage ratio could push shares to $25 or higher, but it is clear that those margin numbers cannot be obtained anytime soon.

Note that the latest deal will not change the needle in a big enough manner either. With pro-forma sales up 1.5-2% as a result of the Canyon deal, even a 20% organic growth number for that business adds just about 0.3-0.4% to the overall reported sales growth.

Still Not Buying It

While Flowers Foods is a very defensive stock, the simple fact of the matter is that despite hundreds of millions in deal-making, the company cannot change the lack of growth narrative. Even worse, margins are taking a beating as well as shares cannot be called cheap given its current margin profile. While the stock looks attractive if better margins can be reported, I seriously doubt if management can pull off to report these higher envisioned margins.

Given the current earnings power, I am still not happy to buy a troubled consumer staples name for the 4% dividend yield as leverage increases, sales growth is flat at best (with volumes down quite a bit) and management failing to deliver on its promises.

While I appreciate that shares trade towards the lower end of the trading range and could offer appeal, I am only seeing real appeal for the long end if shares touch the $15 mark. This comes as many of its peers see depressed valuations as well, creating greater choice among investors within the consumer staples sector.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.