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Hostess Stocks Up on Cookies

We like the deal with Voortman and think the shares are undervalued.

Hostess Brands TWNK announced this week that it would pay $320 million for Voortman Cookies, the number-one player in wafer cookies and sugar-free cookies in the United States. We have a positive view of the deal, which brings appealing 5% revenue growth and a low 20s operating margin after synergies, expands Hostess’ presence into the $8.4 billion adjacent cookie category, and was executed at a reasonable acquisition price of 9.1 times EBITDA after $15 million in annual synergies (compared with the 10.8 three-year average for packaged food transactions). We’ve raised our fair value estimate to $17.60 per share from $15.70 to reflect the boost in revenue growth in the next few years as the company expands the Voortman brand into the U.S. convenience and drug store channels, where Hostess currently has minimal presence.

We have been impressed by Hostess’ record of creating shareholder value from its disciplined acquisition strategy, which is one factor underlying our Exemplary stewardship rating. The deal, which is expected to close in early January 2020, will be funded with cash on hand and a $140 million term loan. Net debt/adjusted EBITDA will increase from 3.4 currently to 4.5 times immediately following the transaction, but we expect this to fall to a manageable 2.5 times by 2021.

We think investors don’t appreciate the growth potential of the company, which is in the early stages of expanding the Hostess brand into the dollar and club store channels. We expect operating margins to increase from 2018’s 15.6% to over 22% by 2021 as Hostess improves the profitability of the acquired Cloverhill business and divests itself of the lower-margin in-store bakery business. We expect the net result will be three-year average organic revenue growth of 4.7% and average organic earnings growth of 17%, which we think is underappreciated by the market.

Powerful Brand Digs Narrow Moat The Hostess brand has exhibited impressive staying power despite changing consumer dietary preferences over its 100-year history, and as such, we award the company a narrow economic moat based on brand intangible assets. Although the previous owners filed for bankruptcy in 2004 and 2012, we contend it was due not to a lack of brand equity but rather highly inefficient manufacturing and distribution systems, a powerful unionized workforce, and a high debt load. Furthermore, a lack of financial flexibility limited the company's ability to respond to consumers' changing desires, resulting in declining sales as low-carb diets and clean eating movements swept the nation. Changes to the company's cost structure were insufficient during its initial reorganization, which led to the second trip to bankruptcy court. However, the current Hostess is not the result of another reorganization but the creation of an entirely new company.

Despite a broad move toward healthy and clean eating, consumers seem to feel nostalgic about the Hostess brand, generating a public outcry at the 2012 bankruptcy, with many reports of consumers stocking their freezers with the sweet treats in fear of no longer having access to them. However, we think the most impressive and relevant evidence of the brand’s sustainable intangible asset value is its demonstrated pricing power, with Hostess selling at a consistent premium to its branded competitors across all products. Hostess is the second-largest brand in the sweet baked goods category, and its products sell at a 32%-163% premium to the number-one brand, Little Debbie. Even for products that appear identical, Hostess sells at a significant premium. Hostess Ho Hos sell at a 128% premium to Little Debbie Swiss Rolls, and Hostess Cupcakes sell at a 32% premium to Little Debbie Cupcakes, a nearly identical product, complete with the white frosting swirl. Although number-three Entenmann’s is positioned as a premium brand, Hostess products sell at a 17%-31% premium to the Entenmann’s equivalents. For example, Hostess brownies sell for $0.40 per ounce--a 31% premium to Entenmann’s, a 163% premium to Little Debbie, and an 11% premium over an in-store freshly baked equivalent.

The significant price premiums have not deterred consumers. Hostess has steadily increased market share of the sweet baked goods category by 1-2 points every year since its July 2013 relaunch, from 7.4% in 2013 to 19.0% in 2019, according to Nielsen. The top three brands account for 62% of the category, while the rest of the category is fairly fragmented. Private label is only 3.9% of the category, compared with 17.4% for overall packaged food, implying that consumers show a strong preference for trusted brands in this category.

We believe that a second source of Hostess’ brand intangible asset advantage is its status as a valued partner in the convenience store channel. We think the cakes, pastries, and sweet pies category is a significant category for c-stores, ranking as the channel’s 10th-largest category per GlobalData with $20.9 billion in revenue. The morning goods category, which Hostess also plays in, is a top 20 category, adding another $10 billion in revenue. Hostess is the number-one player in the sweet baked goods category in this channel, with 24.2% share according to Nielsen. We estimate that it is one of the largest channels for Hostess, representing about 30% of the company’s revenue. Hostess works closely with its retail partners to optimize revenue in this highly impulsive category, in which merchandising can have a large impact on sell-through. In fact, management has said display merchandising is a more significant driver of sales than price for the category. We believe that Hostess supports its retail relationships with the significant amount of data it has amassed on consumer purchasing patterns for sweet baked goods, and we anticipate that it will continue to harness these insights to optimize category shelf space for its retail partners.

Excluding the 2018 Cloverhill acquisition, Hostess’ operating margins are 24%-25%, significantly higher than those of public competitors Grupo Bimbo at 8%-9% and Flowers at 8%, even though Hostess invests about 5% of revenue in marketing compared with 4% for Bimbo and 1% for Flowers. In our view, this provides evidence that Hostess maintains a competitive advantage, which we believe stems from the pricing power afforded by its brand intangible asset and its preferred status with its convenience store partners. Furthermore, Hostess reports very healthy returns on invested capital (excluding goodwill) of around 25% on average over the past three years, significantly higher than our 7% estimate of the company’s cost of capital. We believe that it is poised to continue generating excess returns for the next decade.

Consumer Tastes, Customer Concentration Are Risks Consumers are focused on health and wellness and have heightened awareness of the potential negative impacts of product ingredients such as artificial flavors and colors and high-fructose corn syrup. As a result, the sweet baked goods category has lost share of the overall food and beverage market, with flat sales the past two years while the overall food and beverage market grew by low single digits. Hostess has responded to consumer concerns by launching some products without artificial flavors and colors and HFCS, but if these changes alter the taste of the goods, consumers may balk. Furthermore, we believe that beyond these changes to a cleaner label, the company's ability to portray its products as healthy is quite limited.

Walmart is Hostess’ largest customer, representing 21% of revenue. If Walmart changes its strategy for the sweet baked goods category, Hostess could be negatively affected. For example, in 2018 Walmart reduced the floorspace allocated to Hostess display cases, causing a sharp deceleration of the company’s organic revenue growth from 5.7% in the first quarter to negative 4.3% in the second quarter when the cuts went into effect.

After the 2012 bankruptcy, investors purchased only the brand rights and recipes from the bankruptcy court, freeing them of employee benefits and other labor obligations that had weighed down the company. The new company has a highly efficient cost structure and operates with a cost-effective direct-to-warehouse model, whereas the predecessor company operated with a more expensive direct-store-delivery model. As a result, the current company operates with a low 20s operating profit margin compared with a low-single-digit loss for the predecessor. We believe another bankruptcy filing is highly unlikely.

That said, the company has a rather high leverage ratio, with net debt/adjusted EBITDA at 4.8 times in 2018. But it generates an impressive amount of free cash flow, which we expect will be used to pay down debt. Hostess’ free cash flow as a percentage of sales averages midteens versus low double digits for most packaged food companies. We expect that net debt/adjusted EBITDA will be 2.5 times by 2021. Further, we don’t anticipate it will struggle to service its debt, as our forecast calls for adjusted EBITDA to cover interest expense 8.5 times on average annually over the next decade.

The company does not currently pay a dividend, and we don’t expect it will implement one in the next 10 years. In 2020 and beyond, when leverage reaches a comfortable level, we expect the company will begin repurchasing shares, assuming the absence of sizable tie-ups.

Stewardship Is Exemplary Dean Metropoulos, a turnaround specialist for food and beverage brands such as Pabst Brewing and Pinnacle Foods, purchased the Hostess brand out of bankruptcy for $410 million in 2013 and built it from the ground up, as it exists today; he maintains a 15% stake and serves as executive chairman. Andrew Callahan, a 23-year veteran of the packaged food industry with prior roles at Tyson, Hillshire, and Kraft, was named CEO in spring 2018. Callahan has a broad range of experience in sales, marketing, and operations. We believe Metropoulos and Callahan make a powerful team with their successful records and vast industry experience.

We are impressed by the board’s deep experience in the consumer product industry and broad expertise across finance, operations, sales, marketing, and human resources functions. Beyond Metropoulos and Callahan, the board consists of five independent directors, most of whom have been on the board since its 2016 inception. When Apollo, one of the initial investors along with Metropoulos, sold its stake in 2017, it surrendered its board seat, which was replaced with an independent director. Gores Group, which took a significant stake in the company around the time of the 2016 initial public offering, maintains a 16% stake but no board seat.

We think the compensation structure successfully aligns officer incentives with shareholder interests. Although threshold levels for incentive compensation were not met in 2018, in 2017, over 70% of senior management’s compensation was performance-based. Short-term and long-term incentives are balanced, with metrics focusing on revenue, EBITDA, and other strategic goals. We believe the addition of an ROIC target would be beneficial, as it would help ensure efficient use of capital, as well.

In our view, the company’s capital allocation prudence is evident in its recent pursuit of tie-ups. In 2016, Hostess paid $51 million for Superior Cake Products, a producer and distributor of treats to be sold in retailers’ in-store bakeries, with annual revenue of around $40 million. Although the margins in this business are lower than the Hostess branded mix, we initially expected they would improve as the company rolled out Hostess Bake Shop, a line of Hostess-branded products for in-store bakeries. However, the launch failed to meet expectations, and Hostess discontinued the products and sold the business in 2019, realizing a 38% return on investment despite the failed strategy.

In 2018, Hostess acquired the breakfast assets of Aryzta for $25 million. The acquisition consists of two value brands, Cloverhill and Big Texas, along with private-label contracts. The business has $80 million in annual revenue and reported a $14 million EBITDA loss in 2018, although we expect the business to generate a $20 million-$25 million EBITDA profit in 2020. In fact, by the fourth quarter of 2018, the business was operating at break-even. Although these brands don’t appear to have the pricing power that the Hostess brand does, and we expect margins will continue to be lower than the Hostess-branded business, the acquisition helps the company expand into the breakfast category, an area where it has been underrepresented. The acquisition also greatly improves Hostess’ presence in the attractive, growing club channel.

Hostess expects the $320 million acquisition of Voortman Cookies, a highly profitable business with margins rivaling those of the Hostess brand, to close in early 2020. After $15 million in synergies, the deal reflects a 9.1 multiple, a very reasonable price, considering the high margins and 5% average annual sales growth the business has generated the past three years.

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