J & J Snack Foods: The Soft Pretzel King Is Overvalued
Summary
- J & J Snack Foods is a mid-cap consumer staples company that is the market leader in soft pretzels.
- It has raised the dividend for 14 consecutive years. The dividend is well-covered by earnings and free cash flow.
- The company grows organically and through bolt-on acquisitions.
- The stock is presently overvalued.
Investment Thesis
As dividend growth stocks go, I like consumer staples companies with dominant market share or ones that are the major players in niche markets. One has to only look at the success of Hormel Foods Corporation (HRL), McCormick & Company (MKC), PepsiCo Inc. (PEP), and Coca-Cola Company (KO) to understand why. These companies dominate their respective market areas of branded meats, spices, salty snacks, and non-alcoholic beverages. In turn, this has translated into solid capital return to shareholders through dividends and share buybacks over many years.
In this article, I discuss J & J Snack Foods Corp. (NASDAQ:JJSF), a mid-cap consumer staples company. J & J Snack Foods is probably not well-known to most investors, but it has strong brands in soft pretzels, frozen ices and drinks, funnel cakes, and other snacks. The company is a Dividend Contender, having raised the regular dividend for 14 consecutive years. The total annual return for the company with dividend reinvested in the past 10 years has crushed that of the S&P 500 at ~18.4% versus ~13.2%. This is not easy for a consumer staples company and points to a strategy that is working and has excellent operational execution. The company has grown the top line for 48 straight years, which validates its strategy and execution. In turn, this has led to a high valuation of about 35X based on earnings. Although I like the company’s operational excellence, the high valuation, combined with margin pressures, are keeping me on the sidelines for now.
(Source: Dividend Channel)
Overview of J & J Snack Foods
J & J Snack Foods Corp. traces its history to 1971, when the current CEO bought the company out of bankruptcy. Since that time, it has grown from eight people to over 4,600 employees and roughly $1.2 billion in sales. The company manufactures, markets, and distributes snack foods and beverages in the United States, Mexico, and Canada. It operates in three businesses segments: Food Service, Retail Supermarkets, and Frozen Beverages. Some of its more well-known brands include Superpretzel, Luigi’s, Icee, Minute Maid, and Slush Puppie. Superpretzel is the No. 1 soft pretzel brand in the world. The company’s food is sold at snack bars, supermarkets, sports stadiums, restaurants, vending machines, theme parks, schools, etc.
(Source: J & J Snack Foods)
Decades of Continuous Growth
J & J Snack Foods has grown since its modest beginnings through organic growth and bolt-on acquisitions. Much of its success can probably be traced to its CEO and seemingly excellent operational execution. The company has grown in niche markets that are fragmented with many small players. There are larger players in pretzels, such as privately held Utz, Snyder’s-Lance owned by Campbell Soup Co. (CPB), and PepsiCo. But most of these companies focus on hard snack pretzels rather than soft pretzels. J & J Snack Foods also expands through innovation by introducing new products. This has led to a growing top line that cleared $1 billion of sales in fiscal 2017.
(Source: TIKR.com)
The Company is Facing Margin Pressures
J & J Snack Foods has also maintained high margins compared to some other consumer staples companies. But with that said, gross margins and operating margins have trended down a bit in the past few years. The company has been able to increase pricing, but not enough to offset margins that are declining due to sales of lower-margin products. In the recent quarterly earnings call, the company has stated:
Our margin for this year were impacted by a couple of factors. One being the higher sales of the lower margin ICEE machines. Overall, our margins in the balance of the business were higher. So that kind of, distorts the numbers somewhat. We also had some issues especially in our fourth quarter relating to new production for one of our customers. In our bakery business, we compacted our margin in the fourth quarter.
But with that said, the declining margin trend is longer than one quarter alone. The issue is largely related to mix, as J & J Snack Foods is increasing sales in bakery products in the food service segment, which have lower margins. Bakery products include biscuits, fig and fruit bars, cookies, breads, rolls, crumb, muffins, and donuts. These likely have little pricing power compared to other snack products that the company sells. J & J Snack Foods is also challenged with headwinds for freight and shipping costs that most other consumer staples companies are currently facing.
Some of the recent decline in margins can also be traced to the acquisition of two smaller bakeries: Hill & Valley Inc. in 2016 and Labriola Baking Company in 2017. The combined sales of these two companies was over $62 million. This boosted bakery product sales in the Food Service segment.
The company is cognizant of the declining margin trends and is attempting to increase pricing and reduce costs. Along these lines, it has sold a facility and is trying to manage supply chain costs. But these take time to implement, and margin pressure will likely remain going forward.
Dividend and Safety
J & J Snack Foods is a Dividend Contender, having raised the dividend for 14 consecutive years. But the forward yield is currently low at ~1.7%. The dividend is well-covered by earnings, free cash flow, and one of the strongest balance sheets out there for a consumer staples company.
Consensus fiscal 2020 earnings per share is $5.19 and the forward dividend is $2.30. This gives a forward payout ratio of ~44.3%. This is a good value and below my criterion of 65%. Despite the margin pressures, earnings are likely to continue growing in the foreseeable future. If we forecast on average an 8% earnings growth rate and 7% dividend growth rate for the next few years, then the payout ratio should remain between 40% and 45%.
In fiscal 2019, the dividend required $36.6 million in cash. Operating cash flow was $147.5 million and capital expenditures were $57.1 million, giving free cash flow of $90.4 million. This gives a dividend-to-FCF ratio of ~40.5%. This is well below my criterion of 70% and is a good value.
J & J Snack Foods carries no debt except a very small amount of capital leases. At the end of fiscal 2019, the company had $243.5 million in cash, equivalents, and short-term investments on hand. Clearly, debt is not an issue from the context of dividend safety at this moment.
Risks
The biggest risk for J & J Snack Foods is overpaying for an acquisition. However, I view this risk as small. The company has been successfully conducting bolt-on acquisitions for many years. These acquisitions have grown the top and bottom lines with time. The other risk due to acquisitions are the addition of less-profitable product areas. This is a real risk, as the company is presently facing this situation now in bakery products. J & J Snack Foods also faces inflationary pressures from rising input costs, labor, and freight costs.
Company Valuation
J & J Snack Food’s valuation is sky-high right now, trading at a multiple of over 35X earnings based on consensus fiscal 2020 earnings of $5.19. But the stock price keeps trending up due to the combination of long-term growth, a growing dividend, no debt, and a small float due to high insider ownership. If we use a price-to-earnings ratio of 25.0, which is slightly above the 10-year trailing multiple, then we get a fair value estimate of $129.75. Based on this valuation metric, the stock is grossly overvalued.
Estimated Current Valuation Based On P/E Ratio
P/E Ratio | |||
24.0 | 25.0 | 26.0 | |
Estimated Value | $124.56 | $129.75 | $134.94 |
% of Estimated Value at Current Stock Price | 147% | 141% | 136% |
(Source: DividendPower.org Calculations)
But with that said, J & J Snack Foods tends to grow its bottom line both organically and through acquisitions. The company is sitting on over $240 million in cash (as end of fiscal 2019), which is the highest amount in the past decade. If J & J makes an accretive acquisition or acquisitions, then the valuation multiple based on earnings makes more sense depending on the size of the deal or deals. The market is likely pricing this in at this point due to the past history of acquisitions, combined with recent statements from company leadership. The CEO has stated:
We continued to look for acquisitions as a use of our cash... But we are continually looking at acquisitions, some small, some big and the best use for that cash in my estimation is for acquisition.
How does this above fair value estimate compare to other valuation metrics. Morningstar’s discounted cash flow model gives a fair value of $147.90, somewhat higher than a fair value based on earnings. The Gordon Growth Model gives a fair value of $230 based on an expected return of 8% and a dividend growth rate of 7%. This is a wide range, but an average of all three models gives a fair value of $169.22. This indicates that the stock is still overvalued.
How does J & J Snack Foods compare to other consumer staples stocks. This is a more difficult exercise, since there are few companies of comparable size that directly compete with J & J. Most other consumer staples are much larger. However, the most similar publicly traded company is probably Lancaster Colony Corp. (LANC). Another potential comparison is Tootsie Roll Industries (TR). But, arguably, all three stocks are overvalued due to the high earnings multiples.
Technical Comparison of Valuations
J & J Snack Foods | Lancaster Colony | Tootsie Roll | |
Price-to-earnings ratio | 35.3 | 29.6 | 36.1 |
EV-to-EBITDA | 19.4 | 19.8 | 21.7 |
(Source: Dividend Power and Seeking Alpha)
J & J Snack Foods is a reasonably safe stock when one considers the conservative balance sheet. The trailing 5-year beta is 0.32, so the volatility is very low. But there is likely little to no moat, as the barriers to entry for consumer staples are low. Morningstar gives the stock a narrow moat. Value Line gives it an average safety rating of 1 and a financial strength of A+, and the earnings predictability is 100. The stock is a Dividend Contender, so I have recently generated a Dividend Power score of 8.23 for J & J Snack Foods. This is below baseline of 9.0 and is not a great score, mostly because the valuation is so high.
Final Thoughts
J & J Snack Foods is not that well-known of a stock. But most of us have probably eaten its products. The company has a long track record of growing revenue and earnings. Management responsible for this past success is still in place. But the main risk here is that valuation is so high, and margins are slowly declining. But with that said, J & J Snack Foods continues to grow the dividend and, in all likelihood, will become a Dividend Champion. But for now, I am staying on the sidelines until the valuation comes down.
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Disclosure: I am/we are long PEP, KO, HRL, JJSF, MKC. 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.