Investors betting on Hostess Brands Inc. warrants (TWNKW) at $1.03 are getting them far too cheap. The warrants have several near-term catalysts that could make this leveraged bet on the American sweet-tooth pay off big time. From their current prices, Hostess warrants could return over six-fold from $1.03 to $6.50 if Hostess stock rises from its current $11.33 price to $24 a share in the next two-and-a-half-years.
The standard Black-Scholes options pricing model says the warrants are undervalued by 19% and should trade at $1.27 today. Hostess shares trade relatively cheap versus its major peers. Hostess sports a forward P/E of 18.3x, that compares to 47.4x for Grupo Bimbo on a trailing basis, and is below the 20.7x multiple on Flowers Foods, and above the P/E of 13.5x for Kellogg, according to Seeking Alpha data.
Why is it cheap?
Much has been made of American’s diet increasingly favoring healthy food. Still, there remains resilient demand for small guilty pleasures, just the product Hostess offers. Quick sugar fixes are impulse buys that can be found in grocery checkout isles and convenience stores when you need a pick-me-up. Twinkies, America's guilty pleasure, are bucking the healthy-eating trend. There will always be a place for Hostess and other sugary snack treats in the American diet even if we don’t expect rapid growth. The Hostess growth strategy is focused on winning back shelf space from Little Debbie and others who took the territory it lost when the brand went bankrupt in 2012 and briefly disappeared. They are not trying to convince millennials to give up quinoa for Ding Dong.
Mutual fund managers reflexively shun companies that buck such demographic trends because they prefer simpler growth stories easy to explain to retirement plan managers. Hedge funds and private equity firms are often more willing to bet on a contrarian business plan when returns on capital are outstanding.
We believe Hostess Brands (TWNK) is an exceptionally well-run company, led by Dean Metropoulos, a consumer goods turnaround guru who revitalized a long list of consumer brands including Ghirardelli chocolate and Pabst Blue Ribbon beer. Metropoulos took tough steps that old Hostess could never pull off: cut the fleet of drivers making daily deliveries, reduce plants to just five state of the art automated facilities, and revised the Twinkie formula to extend its shelf-life dramatically. His plan worked. Going forward the brand is looking to get its Hostess brands better distribution through partnerships and deals with retailers.
Despite some bumps in the road, most notably Wal-Mart cutting back some of its shelf space for Hostess last year, we expect the plan will work and create tremendous value for Hostess shareholders. The warrants, which provide long-date leverage on this plan’s execution, are the best way to capture outsized returns as this plan
We expect three scenarios could materialize in the next two years, boosting Hostess Brands’ value and delivering huge returns to holders of the Hostess warrants.
1. Bidding War For Hostess: Hostess is a prime acquisition target for large packaged food companies that face stalled growth. When in bankruptcy, Hostess attracted 100 firms bidding for its assets. Those included Post Foods (POST), Grupo Bimbo (GRMBMF), Flowers Foods (FLO) and Swiss-based Aryzta AG. The company is much more efficient and profitable under its new operating model and should command a premium offer from industry rivals, bigger packaged food companies or private equity firms. Bolting on a $2 billion company with iconic brands and sales growth would be a no-brainer for companies like Bimbo and Flowers who need to show investors revenue growth as their core revenue stalls. Suitors emerge in $2 billion Hostess bidding
2. Strikes Transformative Deal: Hostess is not shy about its own ambitions to build scale, hunting for acquisitions including bidding for Kellogg's Keebler and Famous Amos brands and fruit snacks business. The ongoing M&A deal could fetch $1.5 billion, according to a CNBC report. If struck, such a deal could send Hostess shares skyrocketing as more scale means greater distribution and leverage vis-à-vis retailers and grocers. The added bulk also makes it a more attractive target for a bigger packaged food rival.
3. Take out warrants at a premium: The warrants offer investors the most potential upside as Hostess grows, but as a result are also the costliest part of the company's capital structure. Many Special Purpose Acquisition Company (“SPAC”) like Hostess with good prospects have decided to bite the bullet by tendering for their warrants or exchanging warrants for common shares delivering a premium to warrant holders. I wouldn’t be surprised if the same happens for Hostess. For example, GTY Technology Holdings was forced to pay a 55% premium to get its warrant holders to sell.
The upcoming quarter
Hostess Brands reports its next quarterly results on February 27. Investors will be watching closely on the progress Hostess has made integrating a February 2018 acquisition of Cloverhill Brand, which gave it access to the Honey Bun, Danish, and Cinnamon Rolls categories.
Another key focus will be Hostess sales at Wal-Mart. When Hostess first re-launched out of bankruptcy it cut a distribution deal with Wal-Mart to quickly get back in front of customers. Starting about a year ago, Wal-Mart - which accounted for roughly 20% of Hostess sales - began reducing those promotions and it hit Hostess sales hard. This will be the last quarter where its results will be compared to that earlier high-promotion period. This case illustrates how essential it is for Hostess to broaden its distribution capabilities
How do Hostess warrants work?
The most intriguing quirk of SPACs for value investors is that IPO investors in SPACs receive warrants offering big upside if the SPAC succeeds. This extra kicker pays early investors for the uncertainty they face writing a “blank check” for a sponsor to go find a deal. Hostess warrants trade under the ticker TWNKW and expire on November 4, 2021. This gives them just over 2 years and 8 months to pay off.
Warrant holders can exchange two warrants for the ability to buy a share of Hostess at $11.50. However, the warrant upside is capped when Hostess shares reach $24, meaning that the two warrants would be worth at most $12.5 or $6.5 a piece. Hence, at today’s prices, Hostess warrants are an asymmetric bet: You can lose at most $1, but your potential upside is $6.5.
On the other hand, if Hostess shares remain below $11.50 until November 4, 2021 – they will expire worthless and warrant investor would lose their entire principal invested. If an investor buys the warrants at $1.03 today, she would need to have the stock reach $13.56 to break even (because two warrants must be exercised to buy a share at $11.50).
A well-run business, a savvy dealmaker at the helm, and plenty of time for a buyout or a takeout of the warrants at a premium, there’s lots of ways that Hostess Brands warrants (TWNKW) could provide some sweetness to your portfolio’s returns.
Investing in warrants is not for all investors and should be approached cautiously. Warrants generally trade with greater volatility than common stocks.
Disclosure: I am/we are long TWNKW. 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.
Additional disclosure: This article and associated research does not constitute investment advice.You should consult with your investment adviser and conduct your own research before making any investment decisions. We take no liability for any losses or fees you may incur from such investments. We may buy or sell securities related to or mentioned in this article at any time and will not update on those changes in position. Invest at your own risk and do your own work.