Hostess Has the Brands With the Mostest

While its lineup cuts against trends toward healthier eating, we believe

The company has significant opportunities to recover sales lost during its hiatus, build distribution in new channels, and capture attention through innovation. Its warehouse distribution architecture has allowed it to build a strong presence in dollar stores and a larger profile in drug stores, and we believe Hostess should be able to leverage its brands in service of new freezer case and in-store bakery offerings.

Furthermore, the company has long garnered prices well above offerings from category leader Little Debbie (owned by McKee Foods) and private-label alternatives. In addition to signaling customer demand, the premiums suggest Hostess' labels are more valuable to retailers, offering a chance to earn a higher profit relative to other category players.

As it rounds out distribution, we anticipate management will seek acquisitions to leverage Hostess’ infrastructure and brand equity, as it did with its 2016 purchase of in-store bakery item manufacturer Superior Cake Products. Leadership’s operational record is strong, and deals could build on Hostess’ strengths in adjacent categories such as cookies and frozen desserts.

Category dynamics are challenging, with competition rising in the center of the grocery store as retailers respond to consumer desire for fresh products as well as specialty offerings like natural, organic, and clean-label items. Hostess has made strides in eliminating the inefficiency inherent in its legacy business model by increasing automation, centralizing production, and moving to warehouse distribution. While we believe this will free resources for brand-building investment, category headwinds lead us to conclude that its competitive standing is weakening.

Trailing Share, but Premium Pricing We assign Hostess a narrow economic moat rating on the strength of its brand's intangible assets. The company's results since its bankruptcy support our assessment with a 2016 adjusted return on invested capital of 28%, well outpacing our 6% weighted average cost of capital estimate.

While Hostess trails Little Debbie’s sales in the sweet baked goods category, its second-ranked 17% market share comes together with a demonstrated ability to command premium pricing relative to peers. Hostess’ items sell at about an 80% premium to Little Debbie’s lineup and around 30% above the average price in the sweet baked goods category. Hostess’ ability to charge premium prices improves retailer profits relative to other manufacturers in the sector, making the company a better partner for stores carrying its products. We believe the company’s rapid resuscitation of its market share despite an eight-month hiatus that led to retail partners reassigning shelf space to competitors, together with the public outcry that accompanied legacy Hostess’ demise, further indicates the strength of the brands. Hostess’ market share exceeded its legacy counterpart’s mark in the drugstore (48.1% versus 26.3%) and dollar store (22.1% versus 0.9%) channels as of June, despite a complete shift in the company’s distribution (to a warehouse model from direct store distribution) that required it to wholly revise its selling relationships with retail partners.

Hostess’ standing is further improved by category dynamics that have long favored branded products. Value-oriented Little Debbie is also the market share leader in sweet baked goods, a dynamic that has dissuaded private-label entry. Nielsen data indicates that private label’s share of the category stood at only 4% at the end of 2016, versus 18% for packaged food overall (the top three brands accounted for nearly 60% of 2016 category sales). We suspect this reflects customers’ willingness to spend for a product that delivers the taste they desire and the category’s relatively modest selling prices The average sale price per pound in sweet baked goods is about $3.60; Hostess’ is around $4.75.

Although the company’s offerings fly in the face of consumer trends that have pushed natural, GMO-free, organic, and other specialty health attributes into the mainstream culinary lexicon, products’ taste profile remains critical. An IRI survey in 2016 indicated that indulgent products outgrew healthy snacks for the year; we believe this lends credence to the idea that while consumers are attempting to eat healthier foods overall, they are still receptive to products that satisfy their taste cravings more than their diets. Data shows tension between taste and nutrition in snacking, with a Packaged Facts study in 2015 stating that while over half of adults say they try and eat healthy foods, nearly 60% say they eat foods they like regardless of calories; furthermore, roughly 40% of adults say they favor sweet items.

We believe the legacy company’s bankruptcy was mostly attributable to an exorbitantly expensive, ossified labor structure, high leverage, and a convoluted production network, all of which were shed after the insolvency. The resultant costs limited the legacy company’s ability to innovate (through new flavors and line extensions) in response to consumer trends and competitive pressure. Strong initial results for Hostess’ recent new products, such as chocolate Twinkies and peanut butter-flavored items, suggest the reconstituted company has newfound ability to respond to mercurial customer demands by leveraging its brand lineup, particularly among millennials who demand authentic, differentiated culinary experiences.

While we agree with management that its brands can be leveraged to make headway in the in-store bakery section, we do not believe Hostess’ offerings (spearheaded by the 2016 acquisition of Superior) contribute significantly to its competitive position. In-store bakery offerings constitute less than 10% of Hostess’ overall sales in a category that commands lower margins than the company’s sweet baked goods offerings. Around 70% of sales in the in-store bakery category come from private-label products, and while we anticipate Hostess’ labels can be used to boost branded sales in the sector (through products such as Hostess Bake Shop cookies), we expect the strong unbranded presence to limit pricing power. Still, the lineup offers Hostess another sales channel while allowing it to leverage Superior’s frozen infrastructure (nearly all in-store bakery items are delivered frozen) to extend its brands’ reach. Moreover, as the unit scales, it should make Hostess more valuable to its retail partners, entrenching its relationship with grocers and supporting another facet of its intangible asset.

While other packaged food manufacturers we cover have secured cost advantages based on scaled production, privileged access to ingredients, size that can support vast marketing and product development expenditures, we do not believe Hostess has achieved such an edge. Although the company’s production structure is far better suited to its needs than the legacy organization was (particularly as Hostess has invested heavily in automation, culled excess capacity, and more effectively blended in-house and third-party contract manufacturing), we think entrants can copy best practices relatively easily and large-scale consumer packaged goods companies can better leverage their size in procurement, sales, and distribution.

We do not believe Hostess’ switch to warehouse distribution from direct store distribution affects the company’s competitive standing. While a warehouse model cedes control over the last leg of distribution and limits the level of service that Hostess can provide its retail partners, eschewing a direct-to-store approach cuts costs while allowing the company to better access small-format outlets (like drugstores) that would otherwise be unprofitable. As many of Hostess’ products are sold in single-serve formats, the lineup is attractively positioned for such channels.

Moreover, its shift to longer-shelf-life products has allowed the company the flexibility needed to ship products to retailers’ warehouses for further distribution to individual outlets (though we do not believe this affords Hostess a cost advantage). After baking, much of Hostess’ lineup is marked at a 60- to 65-day span, with the retailer getting 45 of those days to distribute and sell the product, relative to the 25- to 30-day period typical of most baked goods and legacy Hostess’ products. The longer shelf life also enabled Hostess to centralize production, reducing costs and the likelihood of overcapacity. Still, Hostess’ experience reinforces our view that optimal distribution model decisions in packaged food depend on the products offered and the sales channels used, and we think upstarts in the category can similarly optimize their structure.

Competition, Consumer Tastes, and Commodities All Risks Snack products have been a rare growth contributor in the center of the grocery store and have drawn the attention of large food companies and upstarts alike. While competition forces further in-segment innovation, consumer desire for convenient, portable, and health-oriented foods has blurred lines between categories. Consumers are increasingly balancing their yen for sweet snacks with health concerns, leading to greater crossover between sweet and salty or savory products. This dynamic could leave Hostess behind if the company fails to keep pace through innovation and distribution, particularly as its product portfolio and brand positioning is largely inconsistent with the better-for-you trend. Circumstances could be complicated further if grocers devote more floor space to the fresh products at the perimeter of the store, which could lead to intensifying competition over a shrinking battlefield in the categories Hostess depends on.

Customer tastes are changing rapidly, with the recent shift toward snacking especially sharp (per IRI, the average number of snacks consumed daily is up 17%, and the percentage of people snacking at least thrice daily is up 5 points in just the past year). A shift in preferences (or an acceleration of trends) could lead Hostess to deviate from our expectations.

Hostess relies on several commodities, particularly flour, sugar, and edible oils as well as packaging materials. Weather, regulations, export conditions, and other exogenous factors can significantly affect input costs, and competitive dynamics limit the extent to which pricing can be adjusted to protect margins.

We assume U.S. corporate tax reform will benefit Hostess starting in 2018; deviation from our targets (calling for a mid- to high-single-digit-point reduction in the effective rate) could lead performance astray.

Stewardship Is Exemplary Dean Metropoulos, architect of turnarounds at Pabst Brewing and Pinnacle Foods, teamed with Apollo to purchase Hostess out of bankruptcy for $410 million in 2013. The transaction was a success, with the bakery subsequently acquired by special-purpose acquirer Gores Holdings in 2016, effectively taking the company public at a $2.3 billion total value including debt. While Apollo has exited its investment, Metropoulos retains the executive chairman role and a 25% stake in the company as of April.

William Toler was named CEO in April 2014 after heading AdvancePierre Foods during 2008-13. He has presided over the restoration of production and distribution, streamlining of infrastructure, and efforts to extend the company’s brands into new flavors and products. We have a favorable view of Toler’s focus on brand-building and derisking the company’s cost structure through centralized, automated production via a warehouse distribution model.

The company has primarily focused cash on organic growth rather than acquisitions, dividends, or share buybacks. Management has indicated it plans to pursue acquisitions to add to Hostess’ production and distribution platform in addition to organic expansion. While excess indebtedness played a big part in legacy Hostess’ insolvency, we believe management’s move to a warehouse model, automated and centralized production, and a less unionized workforce has reduced risk considerably. Legacy Hostess had as many as 22,000 workers covered by 372 bargaining contracts in 40 bakeries and servicing 5,500 direct store delivery routes; the current company has 1,350 employees (with 420 covered by collective bargaining agreements) at 5 bakeries, with 3 third-party distribution centers and customers responsible for last-mile delivery.